Kautilya- the True Founder of Economics

by Balbir Singh Sihag

  Figure 4.4: FA, FB and FC are the production functions for the poorest quality Land Tract A, middle quality Land Tract B and the best quality Land Tract C, respectively, and LA, LB, and LC are the respective amounts of labour required to produce Y amount of grains. Output Y1 Y2 represents the rent on Land Tract C and Y Y1 is the loss on Land Tract A.

  Rent: Alternatively, Labour, LA can produce output Y on land tract A, output Y1 on land tract B, and output Y2 on land tract C implying that tract C is preferable to tract B, which is preferable to tract A. Thus output Y1 Y2 may be defined as rent on tract C, there is no rent on tract B and tract A ‘is likely to entail heavy losses or expenditure’ that is, there is a loss of Y Y1.

  Production Function: Kautilya did not provide any formal definition of a production function.8 In fact, Atkinson (2002) points out that a mathematical definition of a function itself is relatively of recent origin. Use of the phrase ‘requires less labour and less rain’ by Kautilya indicates that he was aware of the relationship between inputs and output. Similarly, his (p 622) statement, ‘Whoever gets an impregnable fort built on a place best suited for it at less cost and labour is said to outmanoeuvre the other (7.12)’ reflects an understanding of such a relationship. It is also obvious that he emphasized efficiency (use of the word ‘less’) in all activities.

  Proposed Complementary Relationship between Labour and Capital: In today’s terminology, labour and capital are complements to each other means, an increase in capital leads to a shift in the marginal product of labour curve to the right or that both the factors are needed for obtaining a positive level of output. Kautilya (p 637) asserted, ‘Man, without wealth, does not get even after a hundred attempts. Just as elephants are needed to catch elephants, so does wealth capture more wealth (9.4).’ He believed that very little, if any at all, could be accomplished with labour alone implying that he understood the complementary nature of labour and capital.

  Considered Land and Labour as Complements: Kautilya (p 619) stated, ‘The value of land is what man makes of it (7.11).’ He treated land and labour as complementary.9 The following statement also implies the complementary nature of their relationship. He (p 620) stated, ‘It is the people who constitute a kingdom. Like a barren cow, a kingdom without people yields nothing (7.11).’

  Substitution Possibilities: Whether it is the choice of techniques in the production of a given level of output or the choice of goods and services in the consumption basket, the concept of substitution is at the heart of optimization of output or utility. However, in this context Kautilya was much more sophisticated than the classicists.10 Since he was aware of the concept of substitution in its widest sense, and not just between labour and capital. He (p 609) argued, ‘An ally who helps monetarily is preferable because one can always use money but troops only sometimes; and with money one can acquire troops and anything else one wants (7.9).’

  Given the context, perhaps ‘anything else’ meant armament. In Figure 4.5, with troops, only point A is available whereas with money any point on line AB, like point E, which is on a higher isoquant allowing conquest of more land or enhanced national security, is available. Thus, he was aware of the substitution possibilities along the line AB. He provided other examples, also related to substitution possibilities. For example, he (p 665) suggested, ‘When there is a choice of forts, [some teachers think that] one with a better stock of materials shall be preferred. Kautilya is of the view that a fort with men, as well as stocks, is preferable (7.15).’ Similarly, he (p 685) stated, ‘Some teachers say that among Brahmin, Kshatriya, Vaishya, and Sudra troops, a higher varna force shall be mobilized before a lower one because the higher the varna the more the spirit. Kautilya disagrees. An enemy may win over Brahmin troops by prostrating himself before them. It is better to have either an army composed of Kshatriyas trained in the use of weapons or a Vaishya or Sudra army with a large number of men (9.2).’ He understood the substitution possibilities between trained and untrained soldiers and perhaps also understood that training was labour-augmenting. The context has changed but the above examples indicate that Kautilya fully understood the significance of the concept of substitution.

  Figure 4.5: Isoquant Q0 indicates the level of national security that could be achieved by troops only, and isoquant Q1 indicates level of national security that could be achieved through various combinations of Troops and Money (by buying armour).

  A Map of Isoquants: He argued that it would be much harder to He argued that it would be much harder to 619) argued, ‘As between a king entrenched in a land fort and one in river fort, seizing the land from the former is preferable. A land fort is more easily besieged, stormed and captured along with the enemy in it. Capturing a river fort is doubly difficult—the besieger has to cross the water while the besieged gets water and other necessities from it.’

  Then he argued that capturing a king from a mountain fort would be much harder than from a river fort. He explained, ‘As between a king entrenched in a river fort and one in a mountain fort, seizing the land from the former is preferable. A river fort can be assaulted using elephants, wooden bridges, earthworks or boats; a river does not have deep water all the year round and the water in it can be diverted. On the other hand, a mountain fort is protected by the mountain itself and, therefore, not easy to breach or ascend; even if one part is breached, everyone inside is not destroyed; and there is great loss to the besieger due to the rocks and trees thrown from above (7.10).’ The above statements are captured in Figure 4.6.

  Figure 4.6: The isoquants labeled Land Fort, River Fort and Mountain Fort indicate the various combinations of capital and soldiers required to capture each one of them respectively.

  According to Kautilya, for example, a combination of capital (elephants, armament) and labour (soldiers) (KT, LT) might be sufficient to capture a land fort whereas their higher levels (KR, LR) to capture a river fort and their much higher levels (KM, LM) were required to capture a mountain fort.

  4.3  DEMAND-SUPPLY APPARATUS Demand-Supply Mechanism: Significantly, Kautilya exhibited a workable knowledge (in fact more sophisticated than Adam Smith’s or Ricardo’s) of the demand-supply framework to determine the price of a product.11 There were a few implicit applications of the demand-supply apparatus by Kautilya and these could be used for constructing demand and supply schedules. According to Spengler (1971), Kautilya distinguished between competitive markets and non-competitive markets. Spengler (p 74) states, ‘Prices reflected actual or potential scarcity (4.2; 2.21.7-14) as well as the presence of monopolistic arrangements (2.6.10; 4.2.18-19, 28-30).’ Kautilya (p 267) stated, ‘Merchants selling foreign goods were to call out price three times, after paying duty. Likewise, owners of property were to call out the price of whatever property they were selling three times. If, due to competition among buyers, the goods or the property was sold at a higher price, the difference between the sale price and the call price had to be paid into the treasury (2.21).’ Apparently, competition existed at least in some products. Although it is not known with certainty as to the motivation of the suggestion by Kautilya (p 236) that ‘Commodities and products [of the countryside] shall not be sold in the places of their production [but sold only at the designated markets or brought into the city and sold after payment of duty] (2.22),’ but its unintended consequence would have been the creation of competitive markets.

  Demand Schedule: Kautilya discussed price stabilization by creating buffer stocks in periods of surplus and selling out of stocks during lean years. He (p 336) proposed, ‘When there is an excess supply of a commodity, a buffer stock shall be built up by paying a price higher than the prevailing market price. When the market price reaches the support level, the buying price shall be changed according to the situation (2.16).’

  The above statement indicates that he understood the impact of purchases by the government on price: the supply of the product was reduced, consequently its market price rose, and the gap between the support price and the market price dec
reased implying that the adjustment took place along the demand curve. Such an adjustment took place in a single season and not by decreases in production over time, as the one discussed by Adam Smith and Ricardo. Kautilya’s ideas may be expressed by Figure 4.7.

  Where SG and SB were the outputs in a good year and a bad year, respectively, and if left to the market, PG and PB could be the corresponding market prices, and PS was the support price. As government bought a commodity, its supply in the market declined and price moved up from PG to PS and the segment GE could be traced. Similarly, Kautilya recommended that in a bad year, government should sell from its stocks, implying that price declined from PB to PS and the segment BE could be traced. Thus, a negatively sloped

  Figure 4.7: SG and SB were the respective output levels and PG and PB were the corresponding prices during good and bad crop periods. The line PS indicated the support price level fixed by the government. In a good period the movement was from point G to point E and during a bad crop year movement was from point B to point E.

  demand curve was implicit in Kautilya’s policy recommendation related to price stabilization. Negotiating a Treaty Such That Total Revenue was Maximized: Second example relates to sharing the gains from successful joint programmes between two kings. Kautilya (p 623) stated, ‘Some teachers say that a small production of high value minerals is preferable [to a large production of inferior products] because valuable products (such as diamonds, precious stones, pearls, corals, gold and silver) are worth much more than a large amount of inferior products. Kautilya disagrees. Buyers of high-valued products are rare and are found after a long search; there are many buyers and a steady demand for products of small value (7.12).’

  In the above paragraph, Kautilya hinted at several important ideas. First, he pointed out that the total expenditure on a valuable item, say like a diamond, Pe Qe was likely to be less than that on an inexpensive item, Pi Qi. Secondly, the costs of transportation and marketing varied from product to product and could be significant for some items (diamonds, pearls). Thirdly, instability of demand for durable consumer goods (diamonds etc.) was an issue even at that time. Fourthly, larger the number of customers for a product, the more outward would be its demand curve, ie. as the number of consumers increased, the demand curve shifted to the right. Fifth, he understood the forces of market demand and supply, and also that there was the absence of ‘water-diamond paradox’.

  Illiquidity: Finally, according to Kautilya, the ‘Buyers of high-valued products were rare and were found only after a long search’. He revisited the liquidity issue again. He (p 669) stated, ‘If peace is sought on condition of paying money, the weak king shall give articles of high value for which there are no buyers, or forest produce that is unfit for use in war (12.1).’ He clearly understood the distinction between liquid and illiquid assets, since he pointed out the transaction cost as well as the lapse of time as important factors in selling an asset. The essence of these statements may be captured by Figure 4.8.

  Although there was no derivation of a demand curve from optimization conditions, but a negatively sloped demand curve was implicit in Kautilya’s policy statements.

  Figure 4.8: DEDE and DIDI are the respective demand curves and PE, QE and PI, QI are the respective prices and quantities for expensive and inexpensive goods. Supply Schedule: Again, there is no explicit discussion on a supply schedule but it can be derived from his policy recommendations. Kautilya understood that a profit margin or loss depended on the strength of demand, which implies the existence of a supply curve, ie. shifts in the demand curve tracing a supply curve.

  He (p 240) stated, ‘An agent selling goods on behalf of someone else, at the right time and place [ie. realizing the best price], shall hand over to the owner of the merchandise the price as received (the cost price plus the profit made) [less their commission]. If the price realized is lower because of missing the best opportunity for sale, the agent shall pay the owner the cost of the goods at the time he received them and the normal profit. If it is so agreed upon beforehand between the two, the retail seller may pay to the wholesaler, whenever no profit is made, only the price of the goods. If the price falls [between the time of entrusting the goods and the time of sale], only the lower price [actually realized] shall be payable (3.12).’

  A vertical supply curve is implicit in the above statements and the market price depended on the location of the demand curve. That is, price was determined where the demand curve intersected the vertical supply curve.

  Supply Response to a Subsidy: Kautilya proposed incentives to the farmers for bringing additional land under cultivation. He (p 231) recommended, ‘Anyone who brings new land under cultivation shall be granted exemption from payment of agricultural taxes for a period of two years (3.9).’ Similarly, he suggested, ‘For building or improving irrigation facilities, the following exemptions from water rates shall be granted: new tanks and embankments for five years; renovating ruined or abandoned water works for four years and clearing water works over-grown with weeds for three years (3.9).’ These suggestions may be expressed by Figure 4.9. Kautilya believed that tax exemptions would encourage supply of agricultural products by bringing more land under cultivation and increasing the use of other inputs like water. The implication is that tax exemptions would shift point A to point B, or point E to point F and so on. By joining points A, E, etc. (or B and F) a supply curve can be derived implicitly.

  Figure 4.9: SS is the initial supply curve and it shifts to S′S′ due to a tax subsidy. Labour Supply Schedule: Kautilya discussed the effects of incentives on labour supply, also implying a positively sloped supply curve. He (p 233) suggested, ‘For better work [or greater productivity] women who spin shall be given oil and myrobalan cakes as a special favour. They shall be induced to work on festive days [and holidays] by giving them gifts. Weavers, specializing in weaving fabrics of flax, dukula, silk yarn, deer wool and [fine] cotton shall be given gifts of perfumes, flowers and similar presents of encouragement (2.23).’

  He made two points. First, spinners should be paid according to their contribution made both in terms of quality and quantity of output. Secondly, the spinners and weavers should be paid over and above their regular wages, W as an incentive to work on holidays (ie. W + cake or other gift). These statements may be expressed by Figure 4.10.

  It is not claimed that Kautilya had a fully developed neoclassical demand-supply framework. Although Parmar (1987, p 253) remarks, ‘Kautilya formulates a theory of demand and supply and plans production accordingly’, what is claimed is that his framework is a genuine contender to be accepted as the forerunner to the neoclassical price theory, as compared to the one advanced by Adam Smith or Ricardo.

  Figure 4.10: WES is the labour supply curve and LR indicates the regular hours of work and W indicates the regular wage. The positively sloped segment ES shows that a higher than the regular wage, W, is required to induce higher than the regular hours of work, LR.

  Trade in Futures: Understandably, there were no financial derivatives at the time. But surprisingly, Kautilya mentioned trades in futures. He (p 337) stated, ‘Fix prices for trade in futures (ie. for goods to be received at a future date or at a different place) after taking into account the investment, the quantity to be delivered, duty, interest, rent and other expenses (2.16).’

  SUMMARY Pre-Kautilyan writers had identified the four factors payments (wage, interest, rent and profit) separately, and were somewhat aware of the law of diminishing utility. However, Kautilya’s Arthashastra is a landmark contribution in terms of both method and content. His understanding of the law of diminishing returns is at par with the classicists. His applications of concepts like opportunity cost, and of demand and supply framework, are closer to those of the neoclassicals. He comes out on the side of the ordinal approach, which seems more natural. His understanding of the rules (axioms) of comparison and consistency and the exploration of substitution possibilities is way ahead of the classicists. Thus, Kautilya’s original co
ntributions could be identified as: opportunity cost, basic demand-supply apparatus, law of diminishing returns, rent, demand instability for durable goods, discounting, liquidity and the importance of substitution possibilities.

  5

  Accounting Methods and Income Measurement

  Mattessich [1998] identifies elements of modern principles of accounting in Kautilya’s Arthashastra and shows that it contains more accounting theory than in Pacioli’s Summa. Mattessich deserves credit for offering ingenious interpretations of Kautilya’s implicit analysis. He makes insightful and bold observations, noting that many studies in accounting history focused too narrowly in searching for the origin of double-entry bookkeeping. He places Kautilya’s Arthashastra at par with Pacioli’s Summa. He (2000, p 205) concludes, ‘These four items appear to be reason enough to put Kautilya’s Arthashastra beside Pacioli’s Summa, and revere both of them as the most crucial landmarks in the early history of our discipline.’

  A brief introduction to Kautilya’s contributions related to systematic record keeping, periodic accounting, budgeting, and independent auditing is provided in Section 5.1. His ideas on the scope and methodology of accounting are presented in Section 5.2. It is argued that he did not recommend separating accounting from economics, proposed testable hypotheses and thus implied that accounting has an equal claim to using the scientific method. He was preoccupied with the goal of achieving rapid economic growth, which implies that he must have had, at least some vague idea of the concept of national income accounts. Mercantilists emphasized the contribution only of trade and the Physiocrats only of agriculture in augmentation of national wealth/income. However, Kautilya recognized the importance of contributions from all industries, implying that he was ahead of the classical school of economic thought by almost two thousand years. His pioneering ideas regarding national income accounts are presented in Section 5.3.