Theoretical Reasoning

The tendency of many economists to sweep noneconomic factors into the dustbin of ceteris paribus is indeed regrettable. Recently, however, a few economic theorists themselves have begun to question the basic assumptions of the approaches that have dominated their field. The study of macroeconomics has been described as "a religious battlefield," where the most fundamental beliefs are being challenged.^[22] George A. Akerlof, who has contributed to this battle, has said

The unwritten rules that only economic phenomena be considered in economic models, with agents as individualistic, selfish maximizers, restrict the range of economic theory and in some cases even cause the economics profession to appear peculiarly absurd—because, without relaxation of these rules, certain almost indisputable economic facts, such as the existence of involuntary unemployment, become inconsistent with economic theory . . . . Individualistic maximizing behavior constitutes an assumption that sharply restricts the domain of possible economic models. It is an assumption that turns out to be surprisingly restrictive.^[23]

While recognizing the importance of noneconomic factors in governing economic behavior, a theorist such as Akerlof is nevertheless concerned primarily with perfecting an economic model, albeit one that he considers reasonably consistent with reality. For some economic theorists, it might be said, the model is the reality. Many economists tend to value work that contributes to the building of economic theory and to dismiss the study of real data as mere "empirical work." Economic historians, however, have argued for the importance of economic history to the development of theory.^[24] It is our contention that just as economists need to test their theories against historical reality, historians can and should enrich their work through the use of economic theory, as well as economic methods.

Economic theory can serve several purposes for historians. At a practical

[22] An insight attributed to Mark Kuperberg of the Economics Department, Swarthmore College, whom we also thank for the reference to Akerlof's work (see n. 23).

[23] George A. Akerlof, An Economic Theorist's Book of Tales: Essays That Entertain the Consequences of New Assumptions in Economic Theory (Cambridge, 1984), p. 2.

[24] The contributions that historical studies can make to economic theory are outlined in essays in William M. Parker, ed., Economic History and the Modern Economist (Oxford and New York, 1986).

level, some knowledge of economic theory can provide essential context for interpreting evidence that would otherwise be misunderstood. Upon learning of the small share of imported grain (and more generally, of foreign trade) in the economic life of late Qing China, the historian (and even the economist)^[25] naturally assumes that foreign trade must have played a small role in China's economy, especially in the interior. But this assumption overlooks the economists' "marginal principle," which teaches that market prices are determined by the behavior of "marginal" buyers and sellers, who are on the brink of indifference between patronizing the local market or doing business elsewhere. If the demand for and supply of a particular commodity is "inelastic," meaning the amount people will purchase or sell is relatively inflexible in the face of changes in market price (as in the case of heating oil, milk, or insulin), then small changes in quantity may lead to relatively large changes in the price. Alternatively, if the demand for a commodity is elastic, small changes in price may lead to relatively large changes in the quantities people desire to buy or sell. Thus shifts in the behavior of marginal buyers or sellers can generate large changes in the prices or quantities available to all buyers and sellers.

Loren Brandt's study of Yangzi rice markets nicely illustrates these ideas. Despite the small volume of overseas rice trade, Brandt finds that by the end of the nineteenth century, rice prices in interior markets, like Chongqing and Changsha, were quickly affected by fluctuations in Asian grain markets.^[26] This means that the daily lives of rice farmers, rice consumers, would-be rice farmers, grain merchants and shippers, the families and suppliers of these agents, their customers and suppliers, and others in interior regions, like Sichuan and Human, were significantly affected by what seem at first glance to be minor economic phenomena. Brandt's study shows how actions in apparently insignificant components of an economy can produce significant reactions, even in distant places, through the medium of market forces. Many people can verify this "principle" from their personal memories of the oil crisis of the early 1970s, when rising energy costs affected travel habits, auto designs, building codes, and so forth in the United States, Japan, and even oil exporters, like Canada.

The economists' campaign to win the minds, if not the hearts, of historians can probably not succeed merely by reciting economic principles as abstractions or immutable laws. More persuasive, perhaps, is the reasoning that is derived from economic theory. Economic theory can serve as a lever for increasing the power of a given set of data and a tool for squeezing as much meaning and implication from it as possible. For economists, economic

[25] Thomas G. Rawski, "China's Republican Economy: An Introduction" (Toronto, 1978), pp. 2-5.

[26] Loren Brandt, "Chinese Agriculture and the International Economy, 1870s-1930s: A Reassessment," Explorations in Economic History 22 (1985): 168-93.

theory will suggest a story, or sequence of implications, about sets of initial economic circumstances or facts. The predictions obtained from theoretical reasoning can range from simple propositions about the impact on relative prices of meat and fish of the Pope's decision to end the Catholic tradition of meatless Fridays to Karl Marx's grand vision of capitalist decline. The stories told by economic historians fall between these two extremes, typically using short chains of reasoning based on economic concepts to obtain predictions that can be tested with historical evidence.^[27] Their method involves selecting a model, or analytic framework, based on assumptions that appear to fit the historical circumstances under investigation, studying the logical implications of the model in search of testable conclusions, and comparing these predictions, as well as the model's assumptions, with concrete evidence from historical sources.

Several examples can illustrate the value of theory-based analysis as a source of hypotheses for the historian to investigate. Consider the case of railway development, which, by reducing transport costs and transit time, creates new opportunities for trade among cities and between town and countryside. Construction of a new railway line should raise the price that farmers receive for fruit crops, which now gain unprecedented access to urban markets, and lower the cost to farmers of urban factory goods. Terms of trade (price of interregional "exports" divided by price of imports) should improve for both townspeople and farmers. But China's new railways became the focus of military strife among competing political groups, bringing death and destruction to hapless farmers caught between rival armies.

Lacking detailed information concerning changes in local production or the damage inflicted by military operations, how can the historian begin to determine the economic consequences of railway construction in rural China? Here is where recourse to economic theory, with its capacity to reveal causal links that may provide unexpected opportunities to examine the consequences of historical events, begins to display its potential. The concept of entry and exit immediately directs the researcher's attention to changes in population density and migration patterns as indicators of altered patterns of economic opportunity in regions affected by railway development. The economic theory of rent implies that trends in land rents and land prices can reveal whether, from the viewpoint of local farmers, the opportunities created by railway development outweighed the damage caused by periodic military incursions and, if so, by how much.^[28] Another perspective

[27] Donald N. McCloskey, Econometric History (Houndsmills, Eng., 1987), chap. 2.

[28] The idea of using trends in land values to appraise the impact of transport innovation comes from Roger Ransom, "Social Returns from Public Transport Investment: A Case Study of the Ohio Canal," Journal of Political Economy 78 (1970): 1041-60. For Chinese evidence, see Ernest P. Liang, China: Railways and Agricultural Development, 1875-1935 (Chicago, 1982), pp. 141-44.

on the consequences of railway expansion comes from Thomas R. Gottschang's finding that the coming of the railway apparently slowed the pace of out-migration from North China, despite reducing the cost of travel to and from Manchuria. Apparently the increased opportunity arising from proximity to rail transport outweighed the reduced cost of migration in the eyes of farm families in Hebei and Shandong.^[29]

Further examples of how historians can benefit from thinking in terms of economic theory arise from applying the concept of market integration , also known as the law of one price, which postulates that the universal desire to buy cheap and sell dear attracts buyers to low-price markets and sellers to high-price outlets, thus squeezing interregional price differences toward the minimum necessitated by the costs of shipping goods between separate markets. Market integration is made possible by good and cheap transportation, adequate information about costs, and efficient commercial institutions. Consumers, as well as economists, like market integration because it gives them access to a wide range of products at low prices. Producers value market integration because it expands the actual and potential market for their goods. Historians should also be keenly interested in market integration not simply for what markets show about links among various segments of the economy but also because, as the work of Skinner copiously demonstrates, analysis of marketing relationships may affect a host of political and social factors ranging from taxation to marriage and even language.^[30]

Here again, a dose of theory can help the historian to leap over documentary lacunae, as well as overcome skepticism about the heuristic value of economic principles or assumptions. Did agricultural wages, productivity, and incomes rise in China during the decades prior to World War II? To answer this question, one would hope to find reliable information on trends in agricultural production and farmers' incomes. Unfortunately, the information available to the researcher is both thin and of questionable validity. Wage data for nonfarm occupations, however, are relatively abundant. Can theory offer a useful link between agricultural circumstances and non-farm wages?

Unskilled workers in such nonfarm industries as cotton mills and coal mines often came directly from rural villages. China's cotton and coal magnates were profit-seeking entrepreneurs operating in fiercely competitive markets that offered little chance to "pass along" rising costs in the form of higher prices. They had every incentive to keep wages as low as possible. Unless forced to raise wages by government fiat or union pressure, employers sought to avoid raising wages except when it was necessary to assure an

[29] Thomas R. Gottschang, "Economic Change, Disasters, and Migration: The Historical Case of Manchuria," Economic Development and Cultural Change 35, no. 3 (1987): 461-90.

[30] Skinner, "Marketing and Social Structure in Rural China," in three parts, Journal of Asian Studies 24, no. 1 (1964): 3-43; 24, no. 2 (1965): 195-228; and 24, no. 3 (1965): 363-99.

adequate work force. As long as rural labor incomes remain stable, mines and mills can attract workers without raising wages. If rural incomes begin to increase, mines and mills will find their labor supply drying up unless they offer higher wages to village recruits. Under these circumstances, a pattern of rising real wages for unskilled workers in China's cotton and coal industries can be taken as evidence of rising real incomes in the rural regions that supplied miners and mill hands and also in more remote areas linked through labor markets to the immediate supplying regions. Because inter-regional wage differentials induced large numbers of Chinese workers to cross provincial and even international boundaries in pursuit of economic opportunity, evidence of rising real wages for unskilled workers in the widely dispersed cotton and coal industries furnishes strong support for the view that the rising trend of labor income was national in scope.^[31]

Underlying this reasoning is the economists' conception, or model, of how markets, in this case labor markets, function. Textile mills or coal mines located in city A customarily obtain unskilled workers (perhaps indirectly through the agency of labor recruiters) from rural areas B and C. The mills or mines pay wages that are higher than typical farm incomes. This premium compensates workers for the cost of journeying to an unfamiliar locale, separation from their families, and the risk of industrial accidents. If farm incomes in B or C begin to rise, mill or mine wages will look less attractive to potential recruits, who will become less willing to leave their villages. The mill or mine owners (or labor recruiters) can look elsewhere for job candidates or raise wages to encourage more volunteers from the customary locations. If young villagers elsewhere are willing to move in response to economic opportunity, nonfarm employers may prefer the cheap option of seeking recruits from alternate rural locations D and E by offering the standard wage. If the rise in farm incomes is a local phenomenon confined to B and C, this approach will prove successful in damping upward pressure on nonfarm wages for unskilled labor. If, on the other hand, farm incomes are increasing across a wide range of localities from which mills and mines might seek to recruit new workers, nonfarm employers will find themselves unable to maintain an adequate work force without raising the wages offered to unskilled recruits. If farm incomes—which provide the financial alternative against which potential miners and textile workers measure the benefit of leaving their home villages—continue to increase, wages paid by mines and mills will rise too.

Thus, once it is assumed that labor markets function in the manner specified, with employers seeking cheap labor supplies and villagers willing to migrate in response to premium wages, the theory of market integration, here

[31] Thomas G. Rawski, Economic Growth in Prewar China (Berkeley and Los Angeles, 1989), chap. 6.

applied to the market for unskilled labor, encourages the historian to perceive the trend of unskilled workers' earnings in coal mines and cotton mills as a barometer of farm incomes, not only in the workers' home villages but also in other villages where mines and mills could easily have sought fresh recruits. The link between farm and nonfarm wages is not automatic. Application of this reasoning requires the historian to determine that the wage data pertain to occupations open to village recruits and to verify the historical relevance of the behavior patterns postulated in the framework, or model, outlined above. If these tasks can be accomplished, economic theory permits the historian to construct a powerful and revealing analysis of phenomena that are simply not amenable to study through conventional methods.

The theory of market integration can also help to estimate interest rates in historical situations. Interest rates are of historical significance because they are part of broader economic cycles, because they tell us something about trends in the economy, and because they influence individual choices between current and future consumption. Yet interest rates are difficult for historians to discern. Consequently Donald N. McCloskey and John Nash's suggestion that interest rates are inherent in the seasonal fluctuation of grain prices is useful for Chinese historians, since the Chinese historical record contains a great deal of detailed information about grain prices. Whoever holds grain harvested in autumn for resale or consumption in the spring sacrifices the use of the money that could be obtained by immediate sale of the autumn harvest. Whoever loans money during the winter months makes an identical sacrifice. In other words, the opportunity cost of holding grain is the cash that could be obtained from autumn sales, plus whatever interest could be earned by that cash over the winter. The law of one price, here applied to the market for money, insists that, over a suitably long number of years, the earnings from assigning funds to holding grain must match the returns from assigning funds to holding debtors' promissory notes. Thus, McCloskey and Nash explain, interest rates, and the variation of interest rates across time and space, can be calculated from the seasonal rise in grain prices that begins with the annual post-harvest trough and ends at the seasonal preharvest peak.^[32]

To recognize the importance of market integration is one thing; to define and measure it is another. As some of the essays in this volume show, even with good price data, it may be difficult to discern whether and when true market integration existed in history. Even in today's world of data collection and widespread information networks, economists still have difficulty establishing what actually constitutes market integration.^[33] In antitrust cases, the

[32] Donald N. McCloskey and John Nash, "Corn at Interest: The Extent and Cost of Grain Storage in Medieval England," American Economic Review 74, no. 1 (1984): 174–87.

[33] For one suggestion, see George J. Stigler and Robert A. Sherwin, "The Extent of the Market," Journal of Law and Economics 28 (1985): 555–85.

appropriate definition of a market includes both the "product market" (i.e., whether the product has reasonable substitutes) and the geographic market. When Mobil Corporation tried to acquire the Marathon Oil Company in 1981, Marathon brought an antitrust suit against Mobil. Mobil attempted to demonstrate that the relevant market for oil was nationwide and that hence the merger would have only a slight impact on prices. For Marathon, on the other hand, the task was to demonstrate that the markets for oil were regional and that hence the merger was likely to have a great impact on prices. Marathon won the case because, in the words of the court, "the persistence of price differentials in various areas of the nation demonstrates that motor gasoline does not move from area to area in response to price changes easily or as readily as Mobil asserts. Rather, they indicate that the relevant geographic market for motor gasoline is something less than nationwide."^[34] Here the debate among lawyers and economists centered, not on the theoretical importance of market integration, but on exactly how to define and measure it.