History of Economic Doctrines Session 17 Neoclassical Economics I Review: The birth of classical economics is usually attributed to publication of the Wealth of Nations [1776], by Adam Smith (1723-1790). However, inklings of the classical advocacy of market forces are found in the works of William Petty (1623-1687), Richard Cantillon (1680-1734), and the French physiocrat François Quesnay (1694-17774). Classical economics peaked when it was synthesized in Principles of Political Economy [1848], by John Stuart Mill (1806-1873). The end to the dominance of classical economics was inevitable after neoclassical economics emerged when French engineers started applying calculus to economic issues in the 1830s. Early French Engineers Who Addressed Economic Issues A. Jules E. Dupuit Arsene Jules Etienne Dupuit (1804-1866) was a French engineer now credited with being the first writer to apply calculus to economic problems. Duplicate material below should be merged with the preceding paragraph. In his 1844 article titled “On the Measure of the Utility of Public Works”, Dupuit implicitly uses the concept of diminishing marginal utility to construct an early version of demand curve for public goods. He asserts that as the quantity of a good consumed by the user rises, the marginal utility of the good declines. Therefore, the lower the toll for crossing the bridge (lower marginal utility), the more people would use it (higher consumption). Following his logic, the concept of diminishing marginal utility should translate itself into a downward-sloping demand function. In addition, Dupuit argues that it would be inefficient to charge a price equal to an average costs to people who gains very little by crossing the bridge, and proposes that the government should charge people according to the different utilities they receive from the service (price discrimination). (Note: Dupuit’s logic does not address the fact that marginal utility is particular to an individual while market demand is an aggregate.) Dupuit’s Price Discrimination Model Consider a bridge with a high fixed cost. Once built, the marginal cost of using it is zero. Thus, to equate marginal social benefit and marginal social cost, the optimal price for the last person interested in crossing the bridge is zero (point a in this figure). Dupuit implicitly argued that efficiency requires advantageous transactions to be consummated until any further transaction is at best a zero-sum game. (This condition is now known as Pareto efficiency). Anytime you can gain and someone else does not lose, then you have an inefficient point because you could voluntarily trade and increase gains. For example, the draft is inefficient because you have a group that that is willing to exchange voluntarily by paying the other party a higher wage than the army pays in order to take their place. In this case, both would be efficient through exchange. This is also why the lottery system is inefficient for a draft. Dupuit contended that inefficiencies in public goods such as bridges could be corrected through the use of price discrimination. Dupuit’s price discrimination model is illustrated in the following example. Note: a. Charge the highest amount to those who value crossing the most. b. For efficiency: Marginal Social Benefit = Marginal Social Cost è MSB = MSC. c. By setting MSB=MSC at the margin, you maximize net social welfare. d. Price the marginal [indifferent] customer pays equals MSB = zero. Application: To deal with the problems of public goods, government could charge a much higher rate to people who receive greater satisfaction than to those who do not. This use of a “benefit principle of taxation” is effectively an example of price discrimination. For Editing: Potentially useful material to integrate with paragraphs above when constructing a better set of notes: Figure 2 In the top diagram, a single price (P) is available to all customers. The amount of revenue is represented by area P,A,Q,O. The consumer surplus is the area above line segment P,A but below the demand curve (D). In the bottom diagram, the demand curve is divided into two segments (D1 and D2). A higher price (P1) is charged to the low elasticity segment, and a lower price (P2) is charged to the high elasticity segment. The total revenue from the first segment is equal to the area P1,B,Q1,O. The total revenue from the second segment is equal to the area E,C,Q2,Q1. The sum of these areas will always be greater than the area without discrimination assuming the demand curve resembles a rectangular hyperbola with unitary elasticity. The more prices that are introduced, the greater the sum of the revenue areas, and the more of the consumer surplus is captured by the producer. A monopolist might theoretically practice perfect price discrimination – extracting every cent that the highest voluntary bidders would be willing to pay for each possible unit of a good. This might be efficient, but is it fair? à It turns social welfare loss (dead-weight loss) from non-discriminatory monopoly pricing into pure profit. How is this relevant to file sharing? - Cost of society of file sharing of existing files = zero à MSC = zero - If we can generate revenue to somehow pay for production costs, record companies will still produce. - Price = value of next best alternative forgone Optimal solution to problem of sharing intellectual property? - Some type of price discrimination? Pareto Efficiency: Definition: (See Byrns’ Illustrated Glossary for more definitions.) Pareto (global) efficiency A condition under which it becomes impossible for anyone to gain unless someone else loses. Pareto efficiency requires (a) that from given resources and states of technology, the value of output be maximized; (b) that production costs be minimized for each form of production, given the outputs of all other types of products, and (c) that all possible gains from exchange have occurred. Pareto efficiency does not address questions of equity; e.g., the distributions of income or wealth. Also called Pareto optimality. - There are inefficiencies whenever someone can gain and no one else loses. Antoine August Cournot In his 1838 treatise, Research into the Mathematical Principles of the Theory of Wealth, Antoine August Cournot (1801-1877) uses marginal analysis to develop a fairly thorough analysis of the economics of firms. His contribution includes: Differentiating Changes in Quantity Supplied [Demanded] from Changes in Supply[Demand] Example: The movement along demand curve D0 from Q1 to Q2 when price changes from P1 to P2 represents a change in quantity demanded. The shift from D0 to D1 represents a change in demand Applying Calculus to Derive the Demand and Supply Curve QD=f( P, P , P ,Y ,N, T, E) (Price, Price of Other Good, Preferences, Income, # of People, Time, Expectations) dQD/dP= Demand Curve dQS/dP= Supply Curve Mathematically Deriving the MC=MR Rule for Profit-Maximization dPQ/dQ – dTC/dQ = 0: Profit Maximizing MC=MR: Profit Maximizing Developing the Duopoly Model (the basis for modern game theory) A duopoly is an industry containing only two firms. The two major duopoly models are – the Cournot Quantity-Adjustment Model and the Bertrand Price-Adjustment Model. Cournot Model (quantity-adjusting) Cournot developed this model to explain competition in a duopoly for spring water. Because the water flows naturally from the earth, he assumes that marginal costs were zero and firms complete in quantities. Graphically Finding the Cournot Duopoly Equilibrium p1 = firm 1 price, p2 = firm 2 price q1 = firm 1 quantity, q2 = firm 2 quantity c = marginal cost (constant) at equilibrium: p1 = p2 = P(q1+q2) NOTE: The miscellaneous figures in the section on Cournot and Bertrand duopoly models are here are random, and they are the figures students in previous classes submitted. Sort these figures out and expand the discussion if you want extra credit for straightening out a set of student notes. Figure 4 Suppose firm1 believes firm2 is producing quantity q2. The curve d1(q2) is firm1’s residual demand curve. For firm 1, the marginal revenue is a curve - r1(q2). Based on MC=MR, the point at which the marginal cost curve (c) and marginal revenue curve (r1(q1)) intersect corresponds to quantity q1’(q2). Therefore, Firm 1’s optimum q1’’(q2), depends on what it believes firm 2 is doing. Figure 5 Diagram 2 considers two possible quantities for firm2. If q(2)=0, the optimal solution for firm1 is q1’’(0)=q^m, and if q(2)=q^c, then q1’’(q^c)=0 Figure 6 Given the linear demand and constant marginal cost, we can graph firm1’s reaction function, which gives firm1’s optimal choice for each possible choice by firm2. Figure 7 Firm2’s reaction curve is symmetrical to firm1’s since they have the same cost function. At equilibrium, firm1 produces q1 and firm2 produces q2. At equilibrium, Cournot concludes that price is 1/3 of the initial price and quantity is 2/3 of the initial quantity. Bertrand Model (price -adjusting) Bertrand model has similar assumptions, except firms compete solely on price. Graphically Finding the Bertrand Duopoly Equilibrium p1 = firm 1 price, p2 = firm 2 price, p^M = monopoly price level MC = marginal cost (constant) Figure 8 Firm1’s optimum price depends on what it believes firm2 will set price. Setting price just below the other firm will obtain full market power and maximizing profit. At the same time, if price is set below the marginal cost, the firm will suffer a loss. Diagram 1 shows firm 1’s reaction function p1’’(p2). When P2 is less than marginal cost (firm 2 pricing below MC) firm 1 prices at marginal cost, p1=MC. When firm 2 prices above MC but below monopoly prices, then firm 1 prices just below firm 2. When firm 2 prices above monopoly prices (P^M) firm 1 prices at monopoly level, p1=p^M Figure 9 Because firm 2 has the same marginal cost as firm 1, its reaction function is symmetrical with respect to the 45 degree line. Diagram 2 shows both reaction functions. At equilibrium, p1=p1’’(p2), and p2=p2’’(p1). At equilibrium, Bertrand concludes that a duopoly will result in perfect competition because the competition between two firms will push prices down to the marginal cost level. (Note: the disagreement about quantity adjustments versus price adjustments between Cournot and Bertrand is echoed in the later debate between Marshall and Walras, and between Keynesian and classical macroeconomics) Jean Jacques Emile de Cheysson [1836-1910] History of thought scholar Robert Hebert identified Emile de Cheysson, a French engineer who applied calculus and wrote about prices, as having generated an early version of the cobweb model. This interpretation requires a lot of imagination, because Cheysson drew only a crude graph in his discussion of pricing, and he did not explicitly label the axes on the graph Hebert cited. The more recent versions of the cobweb model show how achieving a supply and demand equilibrium might yield significant instability across time if, as seems reasonable, the suppliers react by adjusting quantity based on a previous period's price, and consumer behavior causes the current price to reflect the price associtaed with that quantity on the demand curve. For some slopes of the demand and supply curves, the equilibrium can be unstable. It is the classic demonstration that dynamic behavior by economic agents might not converge to a stable equilibrium with supply equal to demand. Cobweb Theorem: Tries to explain, for example, swings in agricultural prices. Supply Curve=Flat Supply Curve=Steep Demand Curve=Steep Demand Curve=Flat Application: Suppose college students choose to major in accounting because they hear that there is a great market for accountants. The supply of accountants explodes and shifts the supply curve rightwards causing the wage to fall. For 4-5 years there is an oversupply of accountants. Students stop majoring in accounting and shift the supply curve leftwards. A few years later, college students start majoring in accounting due to the lack of supply of accountants. Thus, the cycle repeats due to the lagged response of quantity to the change in price. Depending on the model above, the market either reaches a state of equilibrium or overreacts more and more each time.

These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.