Reproduced from: http://www.debtdeflation.com/blogs/2016/08/19/incorporating-energy-into-production-functions/

Incorporating energy into production functions

By Steve Keen August 19, 2016 Debtwatch

In my last post on my Debtwatch blog, I finished by saying that the Physiocrats were the only School of economics to properly consider the role of energy in production. They ascribed it solely to agriculture exploiting the free energy of the Sun, and specifically to land, which absorbed this free energy and stored it in agricultural products. As Richard Cantillon put it in 1730:

The Land is the Source or Matter from whence all Wealth is produced. The Labour of man is the Form which produces it: and Wealth in itself is nothing but the Maintenance, Conveniencies, and Superfluities of Life. (Cantillon, Essai sur la Nature du Commerce in Général (Essay on the Nature of Trade in General)

Quesnay’s famous but neglected “Tableau Economique” therefore described the agricultural sector as “the productive sector” and manufacturing as “sterile”—see Figure 1.

Figure 1: Quesnay’s “Tableau Economique“, first drafted in 1759, two decades before Watt’s steam engine

This was a justified assertion at the time, given that the Physiocrats wrote before the Industrial Revolution—and in particular the widespread exploitation in manufacturing of stored solar energy in fossil fuels– and originated in France, which was then overwhelmingly a rural nation.

Smith, who was influenced by the Physiocrats and wrote in Britain when industry was starting to exploit fossil fuels (specifically coal) on a grand scale, could have corrected this oversight. But rather than following the Physiocrats’ lead on energy, Smith instead saw labour—not energy—as the font of wealth (which he described in the same terms as Cantillon: the “conveniencies of life”), and ascribed the increase in productivity over time to “the division of labour”:

The annual labour of every nation is the fund which originally supplies it with all the necessaries and conveniencies of life which it annually consumes, and which consist always either in the immediate produce of that labour, or in what is purchased with that produce from other nations…

The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour. (Smith 1776, An Inquiry into the Nature and Causes of the Wealth of Nations)

Economics thus lost the Physiocrats’ focus on energy, and instead descended first into the “Labour theory of value” and then into the Neoclassical (and Post Keynesian) notions of “production functions” in which energy played no role at all.

The abiding weakness of all schools of economics, ever since the Classicals—including today’s Neoclassical and Post Keynesian schools, which are normally at pains to point out how superior one is to the other—is this failure to acknowledge the key role of energy in production. In this brief note, I want to record some speculations about how modern mathematically-inclined economics, with its use of production functions, might be made as energy aware as the Physiocrats were two and a half centuries ago. For the sake of non-mathematical readers, I’ve put the equations in an appendix at the end of this post.

Post Keynesian models typically see Output (Y) as a function of Capital (K) with a fixed ratio (v) between Capital and Output, and a fixed ratio (a) between Output and Labour (L) (see Equation 1).

When they go further than “corn economy” models, they employ a so-called “Leontief production function”, in which the ratio between capital and labour is fixed in each industry, though it varies between industries.

Neoclassical economists criticise this approach because it ignores the substitutability of capital and labour in production, which they embody in their core concept of an “isoquant” which alleges that the same level of output can be produced by very different combinations of labour and capital. Post Keynesians normally respond that this substitutability is a chimera, and continue using this “fixed coefficients” model of production anyway.

Neoclassicals typically see output as a function of capital and labour where one can be smoothly substituted for the other. Their canonical model is the Cobb-Douglas Production Function with constant returns to scale (Equation 2).

Neoclassicals tout this model’s fit to empirical data as a strength; Post Keynesians note that this is simply the result of accounting identities, since this “production function” can be derived by manipulating the identity that Output equals Wages plus Profits under conditions of a relatively constant (or slowly varying) distribution of income (see Anwar Shaikh’s brilliant paper “The Humbug Production Function”).

In this “he said/she said” battle, both sides ignore the shared weakness that their models of production imply that output can be produced without using energy—or that energy can be treated as just a form of capital. Both statements are categorically false according to the Laws of Thermodynamics, which—in strong contrast to so-called “Economic Laws” like the “Law of One Price” and the “Law of Demand“—cannot be broken. As Sir Arthur Eddington once put it:

The law that entropy always increases holds, I think, the supreme position among the laws of Nature. If someone points out to you that your pet theory of the universe is in disagreement with Maxwell’s equations — then so much the worse for Maxwell’s equations. If it is found to be contradicted by observation — well, these experimentalists do bungle things sometimes. But if your theory is found to be against the second law of thermodynamics I can give you no hope; there is nothing for it but to collapse in deepest humiliation. (Sir Arthur Stanley Eddington, The Nature of the Physical World (1915), chapter 4)

Arguably therefore, the production functions used in economic theory—whether spouted by mainstream Neoclassical or non-orthodox Post Keynesians—deserve to “collapse in deepest humiliation”.

This unacceptable state of affairs has inspired a number of ecologically oriented economists to attempt to come up with production functions in which energy plays a crucial role. One such model is the LINEX (“LINear-Exponential”) or KLEC (“capital-labor-energy-creativity”) model used by Kummel, Lindenberger, Ayres and colleagues. At a basic level, this treats output as a function of labour, capital, energy and time—effectively adding Energy as a third input to the Cobb-Douglas model (Equation 3).

While this is an improvement on the basic Cobb-Douglas model, it still implies logically that the contribution of energy to production could be nil: just set its exponent ? to zero. This is still in violation of the Laws of Thermodynamics: we need a production function in which energy plays an essential and irreducible role.

A potential way to achieve this is to accept that the whole idea of “labour” and “capital” without energy is a farce: labour without energy is a corpse, and capital without energy is a sculpture.

Why not acknowledge this by, as an initial abstraction, treating labour and capital as both being means to harness energy to do work, and treating output (Y) itself as work? Then we start from treating Labour and Capital as means to harness the energy they contain: E_L for the energy flow that a worker can harness in a day, and E_K for the energy flow that a machine can harness in a day (Equation 4).

The type and amount of energy that a worker or a machine can embody (as flows of energy at a point in time) are of course vastly different: the former is limited to food, and has a biophysical maximum (say, 5000 calories per day) whereas the latter can be the Sun itself directly, agricultural products, fossil fuels, or nuclear energy, and has risen from trivial levels before the Industrial Revolution to truly astronomical levels today.

Unpacking this further, we also need to acknowledge that not all the energy embodied in labour or capital can be used for work. Energy available to do work (these days called “exergy”) is the relevant factor, rather than the total energy embodied in labour or a machine; the efficiency with which that available energy is harnessed is also a vital ingredient.

So rather than simply showing the energy embodied in labour and capital, we need to multiply it by the ratio of available energy (exergy, with Ex_L for labour and Ex_K for machinery) to energy, and by the efficiency with which that exergy is harnessed . Then, using L to signify the number of workers and K (however imperfectly) to signify the number of machines, we get Equation 5, which treats output as a function of labour, capital and energy.

Rearranging Equation 5, we can derive the basic Cobb-Douglas formulation for labour and capital, times energy inputs. This is superficially like the Kummel/Ayres LINEX formulation, but it has the advantage that the energy contribution of either labour or capital cannot be set to zero without setting the contribution of the related “factor of production” also to zero, since they have the same exponents (see Equation 6). Energy therefore plays a crucial role in production using this formulation: if the energy input is zero, then so is output.

It may also transpire that the available energy embodied in machinery, and the efficiency of its exploitation, is the major explanation for the “Solow Residual”—the apparent paradox that, despite economists seeing output at any point in time as a function of labour and capital, the vast majority of the change in output over time comes not from an increase in the amount of Labour or Capital employed, but from the relatively unspecified A(t) term in the standard Cobb-Douglas function.

With this term replaced by two energy related terms—one of which  has a definite maximum (since there is only so much exergy that a human body can exert in a day, and this can comfortably be treated as a constant), the other of which  has gone from that of a water wheel in pre-Industrial times to that harnessed by the Spacex Falcon Heavy today—the “Solow Residual” may turn out to be the exponential increase in energy and exergy input into production over time (see Figure 2).

Figure 2: US Energy consumption over time

This energy-aware model of production is just a first step in properly integrating energy and the ecological effects of using energy into economics. It does not as yet consider the different types of energy resources, the impact of energy use upon energy resources and the ecology, or the mining (not “production”) costs of energy in terms of energy itself (the “Energy Return on Energy Invested” or EROEI). But it is necessary to have a model of production in which energy plays an essential role to be able to consider these issues about the viability of our energy usage properly.

Equations

Published on Nov 12, 2016

Economic theory has failed to incorporate the role of energy in production for two centuries since the Physiocrats. In this video I derive a production function that includes energy in an essential manner. It implies that economic growth has been driven by the increase in the energy throughput capabilities of machinery.

NOTE: As a viewer pointed out, I should set alpha to 0.3 rather than 0.7 here. I swapped usual treatment of which input was raised to alpha but forgot to swap the values as well. I’ll fix that for the presentation and whenever I do this on a video again.

Published on Jan 16, 2016

Only one school of economic thought came close to getting the relationship between energy and economics right: the Physiocrats. I give a basic outline of thermodynamics, then explain why any theory of production which doesn’t acknowledge the fundamental role of energy in creating economic value is wrong–including the “Marxian” labor theory of value. I then introduce Marx’s dialectical philosophy, which I cover in more detail in the next lecture.

Published on Jan 20, 2016

This is a long prelude to explaining the development of Minsky’s Financial Instability Hypothesis, and an exposition of the foundations of my approach to economics as well–which starts from Marx’s dialectical philosophy. An essential aspect of my approach is that I reject the “Labor Theory of Value” on the basis of Marx’s own philosophy. Since this is such a non-standard approach to Marx, a lengthy digression covering the development of Marx’s approach to economics is required.

Published on Jan 10, 2017

What is “value”? I take the question back to the basics of how is it that we can produce a net output? The answer has to be consistent with the Laws of Thermodynamics, and on that basis, every school of thought from the Neoclassicals to the Marxists, is wrong. I introduce a new production function in which energy plays an essential role. I’ve previously posted a video on this topic, but this is my first presentation of the concepts to a group of students.

Published on Jan 17, 2017

Most of my lectures annoy Neoclassicals; this one is going to annoy Marxists. Using the energy-aware production function derived in the previous lecture, I argue that the “Labour Theory of Value” asserts that production is entirely a function of the energy input to unskilled labour–which is absurd. I then explain the dialectical interpretation of Marx, which thankfully contradicts the “Labour Theory of Value” and is also compatible with an energy-based model production. It also provides a rich foundation for a non-equilibrium, monetary theory of capitalism.

Published on Feb 2, 2017

This is a slightly expanded presentation on developing a model of production in which energy plays an essential role, and it includes a recording of the very useful discussion that followed with my Kingston colleagues and students. I critique the Labor Theory of Value as well as the Neoclassical model of production and distribution in this talk.

Published on Aug 14, 2016

Professor Steve Keen (Kingston University) explains Hyman Minksy’s Financial Instability Hypothesis, based on the work of Irving Fisher and Keynes. The FIH is not well accepted/understood by the mainstream because it is fundamentally non-equilibrium and includes endogenous money.

See the whole video here: https://www.youtube.com/watch?v=-uZzV…

Excerpt from: The Shadow Banking System and Hyman Minsky’s Economic Journey by Paul A Mcculley

The Financial Instability Hypothesis

Minsky took Keynes to the next level, and his huge contribution to macroeconomics comes under the label of the “Financial Instability Hypothesis.” Minsky openly declared that his Hypothesis was “an interpretation of the substance of Keynes’s General Theory.” Minsky’s key addendum to Keynes’ work was really quite simple: providing a framework for distinguishing between stabilizing and destabilizing capitalist debt structures. Minsky summarized the Hypothesis1 beautifully in his own hand in 1992:

“Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified.

Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to ‘roll over’ their liabilities (e.g., issue new debt to meet commitments on maturing debt).…

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principal or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.…

It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and -containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.”

Those three categories of debt units – hedge (note: no relation to hedge funds), speculative, and Ponzi – are the straws that stir the drink in Minsky’s Financial Instability Hypothesis. The essence of the Hypothesis is that stability is destabilizing because capitalists have a herding tendency to extrapolate stability into infinity, putting in place ever-more risky debt structures, up to and including Ponzi units, that undermine stability.

The longer people make money by taking risk, the more imprudent they become in risk-taking. While they’re doing that, it’s self-fulfilling on the way up. If everybody is simultaneously becoming more risk-seeking, that brings in risk premiums, drives up the value of collateral, increases the ability to lever and the game keeps going. Human nature is inherently pro-cyclical, and that’s essentially what the Minsky thesis is all about. He says “from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system’s reactions to a movement of the economy amplify the movement – inflation feeds upon inflation and debt-deflation feeds upon debt-deflation.”1

This pro-cyclical tendency applies to central banks and policymakers as well; it is hard for me to avoid the conclusion that too much success in stabilizing goods and services inflation, while conducting an asymmetric reaction function to asset price inflation and deflation, is a dangerous strategy. Yes, it can work for a time. But precisely because it can work for a time, it sows the seeds of its own demise. Or, as Minsky declared, stability is ultimately destabilizing, because of the asset price and credit excesses that stability begets. Put differently, stability can never be a destination, only a journey to instability.

Minsky’s Hypothesis richly explains the endemic boom-bust cycles of capitalism, including the bubbles in property prices, mortgage finance, and shadow banking that characterize the current bust. You may ask, why all these endemic boom-bust cycles? Isn’t capitalism driven by that Smith dude’s invisible hand, where markets are efficient and always find just the right prices for things through what people like me call a “discovery process?” Well, much of the time that is right – but not all the time. Indeed, the most interesting, and profitable, times to be involved in investment management are when Mr. Smith’s invisible hand is visibly broken. What Mr. Minsky’s Hypothesis did was provide a framework for how and when Mr. Smith’s hand would break.2

1 Minsky, Hyman P., “The Financial Instability Hypothesis” (May 1992)

2 Smith, Adam, Book IV of The Wealth of Nations (1776)

Published on Jun 1, 2014

Take Krugman’s Loanable Funds model of banking, add the realism that banks make loans to non-banks, and hey presto you get the real world of Endogenous Money, where change in debt (as well as change in velocity) affects aggregate demand. Illustrated with a simulation using Minsky software (download from https://sourceforge.net/p/minsky/).