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History
of Economic Doctrines Lecture 16 Neoclassical Economics I The Marginalist Revolution Marginalism began to dominate microeconomic theory when thinkers aware of the frontiers of mathematics began applying calculus to economic reasoning during the middle of the nineteenth century. Although marginal analysis had been used earlier (notably, e.g., in David Ricardo’s theory of rent), the marginalist revolution, aside from its obvious usefulness, quickly began to influence economic analysis in areas of methodology, value theory, and utility theory. Marginalism Marginalism is the key to optimization. That people try to operate where marginal benefit = marginal cost: MB = MC is an article of faith for most modern economists. For example, people try to minimize cost subject to a given output, or to maximize value and output subject to a given cost. All the decisions are made at
the margin. (Open link for more discussion.) Even lumpy decisions (buying a house or a car, for example) can be “at the margin.” You can buy cars more often, or get more options. Consider what seems to be a binary decision: Is marriage “Zero or 1?” à Even marriage is not “zero or one” – there are many different forms of marriage. Pre-Marginalist Methodology Adam Smith The earliest economists were interested in the process of economic development and polices that can produce high rates of economic growth. Their theories blended economic analysis with history, and there was little interest in abstract economic theory per se. Ex. Adam Smith – the theory of absolute advantage Thomas Robert Malthus – the theory of population growth David Ricardo David Ricardo had transformed economic analysis both in terms of its scope and its method. Instead of contextual analysis, he focused on more abstract deductive analysis and emphasized internal logical consistency. Ex. David Ricardo – the labor theory of value. Transition
from the Classical to the Neoclassical Era Isaac Newton [1643-1727] and Gottfried Wilhelm von Leibniz [1646 – 1716] independently discovered calculus around 1675, ushering in a mathematical revolution in physics and other “hard” sciences, but almost 170 years passed before more than a handful of economic thinkers were sufficiently familiar with calculus to recognize its applicability to significant chunks of economic behavior. The middle of the nineteenth century was the tipping point when economic analysis began to evolve from the relatively informal description and logic employed by classical economists towards the more mathematical formalism of models based in calculus. For the early neoclassical school, the scope of economic analysis was almost exclusively focused on microeconomic problems, applied the principle that, … all decisions are made at the
margin. Marginalists William Stanley Jevons, Carl Menger, and Léon Walras are considered to be the first generation of marginalists. All three, working independently from each other, found the classical theory of value inadequate to explain the forces determining prices. According to these three writers, preclassical and classical economics suffer from two fundamental flaws. Value Theory: Are Factors of Production Price-Determined or
Price-Determining? Whereas the classical school had assumed that demand was always adequate and was a given (Say’s Law), the marginalists asserted that both supply and demand determine prices. They argued that the cost of production theory of value is problematic because the production costs incurred in the past (sunk cost). Once the goods arrive to the market, their value depend on the marginal utility received from consumption in the future, not the costs occurred in producing these goods. W.S. Jevons – “The fact is, that labour once spent has no influence on the future value of any article: it is gone and lost forever. In commerce bygones are for ever bygones.” Both Ricardo’s labor theory of value and Senior and Mill’s cost of production theory require a separate model to explain the price for goods that have fixed supply. For these goods, with a perfect inelastic supply curve, their value is completely independent of the costs in their production, and varies with the consumers’ preferences and income. Therefore, Jevons, Menger, and Walras maintained that factors of production are valuable in the extent of their value is determined by the marginal utility received from consuming the final products that are produced by these factors. Utility
Theory: Diamond-Water Paradox Why is that diamonds have little total utility but high prices, whereas water has high total utility but a low price? Jevons, Menger, and Walras recognized that classical thinkers could not explain this paradox because the earlier thinkers approached diamonds and water in terms of their total utility and failed to understand marginal utility. That is, diamonds are much more expensive than water because it is marginal utility that determines consumer choice, which is another fundamental flaw in the classical value theory. Following in the classical tradition, early marginalists assume individuals are rational and calculating. In consumption decisions, households consider the marginal utility they expect to receive from consuming the goods, which raised the question of how utility is measured. From the time of Jeremy Bentham through the analysis of William Stanley Jevons, the cardinal utility was commonly used by economists. [On the other hand, the ordinal utility represents a more modern approach that was developed by Vilfredo Pareto and Sir John Hicks.] Forerunners of Marginal Analysis Even prior to the 19th century, a number of writers understood from introspection that the satisfaction [marginal utility] from consuming a particular good tends to decline as more of the good is consumed. However, none of these writers was able to formally elaborate the concept of diminishing marginal utility and to apply it to economic problems. Overview Dupuit
(France) -
price discrimination, the inefficiencies associated with non-discriminatory
monopoly power A.A.
Cournot ( -
applied mathematics to economics -
known in -
Marginalism -- first to clearly define a demand curve: QD
= f (P,P,P,Y,N,T,E) (price, price of other goods, preferences, income,
#of people, time, expectations) -- hold all influences on QD constant
except for price and take the partial derivative to get the demand curve Profit
maximizing rule: MC=MR - took the 1st derivative of TR and subtracted the
derivative of TC. Set result to zero. d
PQ/dQ- dTC/dQ =0 à maximum profit - example: water in a monopoly situation --
ultimately: 2/3 Q and 1/3 P --
sets the stage for game theory Carl Menger, von Wieser, Eugen von Bohm-Bawerk
(Austria) * focus on the subjective nature of demand - incorporated marginalism - MUx/MUy = Px/Py à MUx/Px
= MUy/Py à Maximum Utility - the relative marginal utility of 2 goods has to
deal with the subjective value that you place on those goods, as manifested
in market prices --
individuals will adjust so that their subjective values adjust to market
prices - Interests reflect the values that we place on
goods today v. goods tomorrow --
low discount value rate: willing to give up a lot today for more tomorrow
(ex: going to --
high discount value rate: willing to give up a lot tomorrow for more today
(ex: going William Stanley Jevons ( - labor and leisure - the marginal utility of leisure equals the wage
(offsets disutility of work) W/P =
MUL/P - a bit of analytical determinism |
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These web pages are significantly edited and elaborated versions
of student notes based on lectures by Ralph Byrns, 2002-2006.
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