Production is interaction of man and nature 
Karl Polanyi, The Great Transformation

Almost fifty years ago William Nordhaus and James Tobin, both professors at Yale University and later Nobel Prize laureates in economics, wrote an article with which they intervened in the debate aroused by the well known Report to the Club of Rome, The Limits to Growth (Meadows et al, 1972)¹. Among other things, they wrote: "The prevailing standard model of growth […] is basically a two-factor model in which production depends only on labor and reproducible capital. Land and [natural] resources, the third member of the classical triad, have generally been dropped" (Nordhaus and Tobin, 1973, p. 522).

Nordhaus and Tobin made reference to an analytical tool largely used by the standard theory, the aggregate production function. That function is normally presented in the form Y = f(L, K), in which the determinants of product (Y) are labor (L) and capital (K) - the “factors of production”. Sometimes, along with labor and capital, “technology” or “efficiency” are considered causes of economic growth.

One may wonder why natural resources, traditionally represented by “land”, were dropped from the production function. There are several answers. 

Firstly, some neoclassical economists in the late 19th and early 20th century included “land” in capital assets (see Daly and Cobb, 1989, pp. 109-113; Czech, 2013, pp. 91-116); so in the following years many economists didn’t see “land” in the function and simply “forgot” it, consequently forgetting natural resources.  

Secondly, after World War II the general atmosphere of economic optimism meant that many  economists considered natural resources not scarce (see Nordhaus, 1974, p. 22, Daly, 1999a, p. 79), and so irrelevant for economics; if and when a single resource would became scarce, it could be substituted with  another resource on the basis of the idea that "Nature imposes particular scarcities, not an inescapable  general scarcity" (Barnett and Morse, 1963, p. 11). Moreover, many economists avoided the problem of absolute scarcity by admitting the substitutability of raw materials drawn from nature with man-made capital. According to my knowledge, the first explicit statement for this substitutability was made by Nordhaus and Tobin in the above mentioned paper (1973, pp. 522-3) and, despite the fact that for years ecological economists have repeated detailed criticisms on this point (see for example Daly, 1996, pp. 76- 8), the belief that capital may replace natural resources in production still remains widespread among neoclassical economists².  

Finally, a not negligible reason for failing to consider natural resources was simply a matter of mathematical convenience, as the “two-factor model” is more manageable for mathematical processing and for explanations to students (Daly, 1996, p. 77; Czech, 2013, p. 87).

Having cleared natural resources from the production function, standard economists neglected them  from almost all their models and in general from their remarks, to such an extent that Robert M. Solow (emeritus professor at the MIT and Nobel Prize laureate) – author of the "standard model of growth"  mentioned by Nordhaus and Tobin – came out with the following astonishing statement: "the world can, in  effect, get along without natural resources" (Solow, 1974, p. 11)³. In this regard the ecological economist Herman Daly (former senior economist at the World Bank and emeritus professor at the School of Public Policy of University of Maryland - College Park) wrote: 

"His [of Solow] well-known work in growth theory is based on an aggregate production function in which resources do not appear at all, and which takes production to be a function only of capital and labor. […] Since the production function is often explained as a technical recipe, we might say that Solow’s recipe calls for making a cake with only the cook and his kitchen. We do not need flour, eggs, sugar etc., nor electricity or natural gas, nor even firewood" (Daly, 1999a, p. 77).

In short, the neoclassical production function is a "recipe with no ingredients" (Daly, 1999b, p. 91). On the contrary, we know that production needs “ingredients”, namely raw materials derived from the stock of natural resources, transformed by labor and capital into products. Without natural resources the factors of production cannot produce anything, as everyone knows: "the smithy had been quiet for a month because they had no iron to make tools and horseshoes", wrote Ken Follett in a novel (Follett, 1996, p. 373); a neoclassical economist that reads that passage would think, instead, that the smithy could continue to produce only with blacksmiths (L), anvils, mallets and other equipment (K). 

The offhand attitude of standard economists towards natural resources is reflected in macroeconomics textbooks. In 1991 Herman Daly searched through the indexes of three leading (at that time) textbooks in macroeconomics and found "no entries under any of the following subjects: environment, natural resources, pollution, depletion" (Daly, 1991, p. 255)⁴. So professor Daly asked rhetorically: "Is it really the case, as prominent textbook writers seem to think, that macroeconomics has nothing to do with the environment?" (ib.).  

One can ask if nowadays, thirty years after the above mentioned Daly’s detection, the leading textbooks in macroeconomics recognize the fundamental role of natural resources in the production process and then for GDP growth. In general the answer is “NO”, even though some textbooks take a few steps forward. For example, “Economics” written by the late Paul Samuelson (professor at the MIT and winner of the Nobel Prize), renewed and updated by William Nordhaus, shows a production function with natural resources along with labor and capital (Samuelson and Nordhaus, 2010, p. 503). However this is not a satisfactory solution to consider natural resources, as Nicholas Georgescu-Roegen − one of the "pioneers of Economics of Sustainable Development" (Daly, 1996, p. 169) − showed (Georgescu-Roegen, 1979, p. 17; Georgescu Roegen, 1984). In brief, the reason is that raw materials (i.e. natural resources) perform a different role in the production process compared to labor and capital, as well explained by the following quote of Herman Daly and Joshua Farley: 

"Labor and capital are transforming agents, funds that transform the flow of resources into a flow of product, but are not themselves embodied physically in the product. Labor and capital are agents of transformation (efficient causes, or fund-services), while resources are that which is being transformed (material causes, or stock flows). The neoclassical production function abstracts from the difference between material and efficient causes of production and considers both to be equivalent […]" (Daly and Farley, 2011, p. 157). 

For this reason, considering raw materials a factor of production on the same level of labor and capital is incorrect. In the production function the factors of production are substitutable: we could produce something only by means of labor or only by means of capital (moving on the isoquant line). But in reality we couldn’t produce anything without raw materials: the baker cannot produce bread without water, flour and energy for heating the oven, precisely because production requires a flow of natural resources.

The three-factor production function reported in Samuelson and Nordhaus’ “Economics” raises the logical and economic criticisms I mentioned, but at least it considers the importance of natural resources in the production process. Instead, other textbooks significantly underestimate the role of natural resources. For  example, in the handbook written by two very authoritative Princeton University economists, William  Baumol and Alan Blinder, natural resources and raw materials are rightly considered inputs of the production  process (Baumol and Blinder, 2016, pp. 22, 430), however, when they develop their analysis using the  production function, they consider only labor and capital, natural resources disappear and it seems that  they are no longer needed to generate GDP: "The production function tells us how much output the economy  can produce from the available supplies of labor and capital, given the state of technology" (Baumol and  Blinder, 2016, p. 121; see also pp. 104ss.). 

The same goes for the book Macroeconomics published by Olivier Blanchard (MIT, former chief economist of IMF) and David R. Johnson (W. Laurier University): the aggregate production function is  introduced stating that firms use "also raw materials" (Blanchard and Johnson, 2012, p. 122), but then  these economists forget this statement and raw materials vanish⁵; in this book there are "no entries under any of the following subjects: environment, natural resources, pollution, depletion", just like in the textbooks  examined by Daly in the early nineties.

Let us examine now the interesting case of the textbook written a few years ago by Harvard professor N.  Gregory Mankiw. We can read: "An economy’s output of goods and services - its GDP - depends on: (1) its quantity of inputs, called the factors of production, and (2) its ability to turn inputs into output, as represented by the production function" (Mankiw, 2010, p. 47). Therefore, according to this statement, production does not depend on raw materials and available energy resources derived from nature, which are not considered a factor apart, nor are they included in capital⁶: they simply “do not exist”. The only "natural" thing this text deals with is the unemployment rate.

It is important to note, in the above Mankiw’s statement, the message launched to students according to which the economy "turns inputs into output". The concept is reiterated with these words: "[...] many economists consider the Cobb-Douglas production function a good approximation of how the actual economy turns capital and labor into goods and services" (Mankiw, 2010, p. 527). The same was stated by the aforementioned Baumol and Blinder: "It is useful to think of an economic system as a machine that takes inputs, such as labor and other things we call factors of production and transforms them into outputs, or the things people want to consume" (Baumol, Blinder, 2016, p. 22).

The students who are trained on these texts, therefore, learn that the blacksmith who produces horseshoes and metal railings does not need either raw iron and coal to melt it (contrarily to what Ken Follett wrote): these materials can remain in mines, since what the good craftsman would do is to transform himself, the anvil, the mallet and other equipment ("labor and other things we call factors of production") into metal objects. And in a canned tuna factory, the workers and the canning equipment would turn, according to Mankiw, Baumol and Blinder, into tasty tuna steaks. Mankiw, as we have seen, affirms that "many economists" think so, but it seems quite obvious that they are wrong, given that, as we have said, are not capital and labor to be transformed into products, but raw materials, i.e. natural resources (and to make this transformation is necessary an input of energy). It should be added that fortunately this is the way it goes, because workers would not be happy at all to be transformed into goods or services! However, I must admit that the claims of Mankiw, Baumol and Blinder are sometimes verified: for example, in the Chicago of the early twentieth century, the workers who fell into the boilers used by the canned meat industry were actually transformed into products, as the writer Upton Sinclair recounted in his investigative novel The Jungle (1906).

To confirm his vision Mankiw gives the following example: "… consider production at a bakery: the kitchen and its equipment are the bakery’s capital; the workers hired to make bread are its labor and the loaves of bread are its output. The bakery’s production function shows that the number of loaves produced depends on the amount of equipment and the number of workers" (Mankiw, 2010, p. 48). And not also from the quantity of flour, yeast, water and fuel for heating the oven?  

Fortunately, professor Mankiw in a more recent textbook remembered natural resources (or “land”) and considered them a factor of production (Mankiw, 2017, pp. 22, 242), in line with Samuelson and Nordhaus’ textbook. As we have seen, it is not a satisfactory approach, but at least natural resources are not completely neglected. Instead, in the textbook published by Charles I. Jones (Stanford University) we can read an example similar to that of Mankiw’s bakery, without any reference to the input of natural resources transformed to obtain products. Jones’s example concerns the production of ice cream: the "message" is that ice cream makers (labor) produce ice cream only by means of equipment (capital), without water, milk, sugar and chocolate (or powders); and in Jones’ ice-cream factory the equipment is still, since energy to operate the machinery is not mentioned (Jones, 2014, p. 70).

Faced with arguments of this kind Herman Daly wrote the following words: "The neoclassical production function is worse than alchemy [...] Neoclassical economists, without blushing, write equations in which material output flows require no material input flows" (Daly, 1999b, p. 91).

This fast survey of macroeconomics textbooks is very insightful regarding the attitude of standard economists about natural resources. Daly and Farley noted that "Ignoring the necessary role of natural resources in production is part of a pattern in neoclassical economics that has the effect of denying that nature has any role in economic life" (Daly and Farley p. 160). This pattern can be explained with the Kuhnian paradigm of neoclassical economics (ib., pp. 23-4), a paradigm that denies the absolute scarcity problem for natural resources in order not to question the dogma of infinite growth. The traditional production function is particularly suited to that paradigm.

If the production function envisages only labor and capital, natural resources are neglected, with bad consequences on sustainability: if, just to say, to model the production of canned tuna one uses an analytical tool which considers only workers (the labor factor) and canning equipment (the capital factor) and not caught tuna, the problem of overfishing does not arise by definition. Moreover, if natural resources are inserted in the production function as a factor of production like labor and capital, they are automatically considered substitutable with these other two factors, and this is absurd, as workers and canning equipment cannot substitute tuna.

To conclude, a correct representation of the production process implies the abandonment of the “recipe with no ingredients”. Metaphor aside, economics must stop using the traditional approach based on the production function in which natural resources are almost or completely neglected, and take an approach in which natural resources are explicitly represented as a flow of material taken from natural capital. This approach, which is that of ecological economics, should inspire textbooks used in universities. In this way young students in economics will not absorb misleading knowledge anymore and, once they become economists, they will be able to collaborate with other scientists and with all citizens to use natural resources correctly in order to preserve the ecosystem on which our economy and the life of all creatures depend.

* The author is grateful to professor Herman E. Daly for the kind and helpful suggestions. This article reproduces with adaptations a paragraph of a more extensive paper published in Italian on the blog apocalottimismo.it.

 

Notes 

¹ For an exhaustive overview of the content of the Meadow’s Report, of the criticisms it received and of the developments it has had, see Victor (2019, pp. 168-174). 

² In a treatise written in 2003 important environmental economists wrote that "… many economists believe that evidence points to reasonably high substitution possibilities (although there is by no means a consensus on this) […] between resources and reproducible capital" (Perman et al, 2003, p. 478). More recently an economist expert in these issues wrote that "In the majority of papers on economic growth and natural resource usage the assumption of substitutability between natural resource usage (as an energy source) and physical capital is made" (Malaczewski, 2019, p. 2207).

³ Georgescu-Roegen commented with the following words: "One must have a very erroneous view of the economic process as a whole not to see that there are no material factors other than natural resources. To maintain further that 'the world can, in effect, get along without natural resources' is to ignore the difference between the actual world and the Garden of Eden" (Georgescu Roegen, 1975, p. 361).

⁴ The three textbooks were: Dornbusch R. and Fischer S. (1987), Macroeconomics, McGraw-Hill, 4th ed.; Hall R. E. and Taylor J.B. (1988), Macroeconomics, W. W. Norton, 2nd ed.; Barro R. J. (1987), Macroeconomics, Wiley and Sons, 2nd ed.

⁵ Blanchard and Johnson only deal with oil in a box that shows the different effects of the increase in the price of crude oil in the 1970s and 2000s (p. 153). 

⁶ From the definition given by Mankiw, it is clear that he does not consider raw materials as a component of capital: "capital is the set of tools that workers use: the construction worker’s crane, the accountant’s calculator, and this author’s personal computer" (Mankiw, 2010, p. 47).

 

References 

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