The Pasinetti Paradox arises in a model of an idealized economy inhabited by two distinct classes: workers who save a fraction of their wages and of any profit income (also called interest) earned by their past savings; and capitalists who live exclusively off the profits generated by their wealth, saving a fraction, s, of their profit income. All wealth is held in the form of capital, and the ratio of profit to capital is called the rate of profit (or the rate of interest by some writers), r. The growth rate of capital is equal to the growth rate of the labor force, n, so that the economy remains in a state of full employment. Under these conditions, Luigi L. Pasinetti showed that a very simple equation describes the long-run (or steady state) relationship between the rate of profit and the rate of growth: r = n/s. This remarkable equation implies that the rate of profit is determined by the rate of growth and the saving rate of the capitalists, independently of the saving of workers or the underlying technology of the economy, which constitutes the Pasinetti Paradox. It has been at the center of a lively controversy between two different schools of economic thought since its discovery.
One might find it paradoxical that an increase in the saving rate of workers would have no effect on the rate of profit since this, by making capital (e.g., machines and factories) more abundant in relation to labor, might bid up wages and drive down the rate of profit. Pasinetti (a leading classical or neo-Ricardian economist) showed that this effect will not persist into the long run. The rate of profit will decline temporarily, but that would reduce the income of capitalists, allowing the share of wealth owned by workers to increase. Because workers are, by assumption, less thrifty than capitalists, this redistribution will eliminate the need for any change in the rate of profit in the long run. Profits thus have a privileged status in the classical theory of income distribution, for capitalists receive a rate of profit that is just high enough, after deductions for their own consumption, to support the saving necessary for sustained full employment; wages emerge as a kind of residual.
The neoclassical economists find it paradoxical that the rate of profit is not in some way determined by technology, as this seems to refute their marginal productivity theory of income distribution. Paul Samuelson and Franco Modigliani (leading neoclassical economists) pointed out that the Paradox only applies to an economy in which the workers’ saving rate is low relative to the capitalists’ saving rate. When workers save so much that their wealth grows permanently faster than the capitalists’ wealth, the system will tend toward a one-class economy in which the capitalists’ share of wealth becomes vanish-ingly small. This discovery led to an ongoing controversy about whether the two-class or one-class model better describes existing capitalist economies. While the early debates were often tied up with the validity of the marginal productivity theory, it has become evident that even when marginal productivity theory fails, it is usually possible for an economic model to have two possible outcomes, depending on whether the workers’ saving propensity exceeds or falls short of some well-defined threshold value.
