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History
of Economic Doctrines
Lecture 19
Neoclassical Economics: England and the US
Pricing
English
tradition (Micro)
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supply factors determine pricing in the LR
Continental
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demand determines pricing in the LR (non-reproducible goods only)
William Stanley Jevons
(English)
Jevons
married demand and supply together as determining price in the LR
Jevons, following in the line from William Petty,
advocated using statistical procedures to establish casual relationships
between economic variables.
Theory of Political
Economy (1871)
Jevons began by outlining the
principle of diminishing marginal utility and showed how it governed
individual choice via the equimarginal principle. In a pure
exchange economy, Jevons showed how this principle served as a foundation for
a new and comprehensive theory of value. By combining two
"laws" of exchange: (1)every exchange must be mutually beneficial
and (2) every portion must be exchanged at the same rate, Jevons concluded
that, without price-taking behavior (both S and D determines the price), the
market will work its way necessarily to the market equilibrium (P=MC=MB).
(Note: F.Y. Edgeworth disputed
this notion and said that the equilibrium holds only if the market is
perfectly competitive, otherwise, there would be many solutions.)
“Theory of Pleasure
and Pain” (1871)
Jevons claimed that
pleasure/utility results from the consumption of commodities; pain/disutility
is involved in their production. Thus,
workers face thee choice between income and leisure. At equilibrium, MUx/Px = MUy/Py = MUleisure/w
(assuming there’re only two goods).
The
Solar Period and the Price of Corn (1875)
Jevons argued that there was a
connection between the timing of commercial crises and the solar cycle, from
which he developed his sunspot theory
on business cycle. The power of the sun's rays, according to
him,influence the harvests and thus the price of corn, which in turn,
affected business confidence and gave rise to commercial crises.
Marginalism Extended
Following the lead of the first generation of
marginalists, several economists quickly applied marginal analysis to a broad
array of economic problems. These thinkers included Friedrich von Wieser and
Eugen von Böhm-Bawerk (Austrian, discussed in the previous lecture); John
Bates Clark (an American); Knut Wicksell (a Swede); and Phillip Wicksteed (an
English).
Knut Wicksell [18xx-19xx]
Wicksell’s
most important contribution to the history of economics was his work on
interest. In his Interest and
Prices (1898), he distinguished
the natural rate of interest from the market rate of interest
Natural rate theory:
Natural
rate theory is the notion that the economy is inherently stable and that
unemployment and real interest will coincide with their natural rates in the
long run. According to this theory, traditional Keynesian policy goals are
unattainable because attempts to drive down unemployment or real interest
rates more than can be reconciled with people’s preferences are self‑defeating in the long run. The natural
rate of unemployment is the long run rate consistent with accurately
predicted inflation.
(Note: Wicksell’s separation between natural and market interest
rates influenced the business cycle theories developed by the Austrian
school, John Maynard Keynes’s ideas of growth and recession, and Joseph
Schumpeter's "creative destruction" theory of the business cycle.)
Wicksell
also worked on the theory of marginal productivity. While he was working on product exhaustion,
he developed the concept of the long-run average cost curve, that is, firms
would usually encounter three sequential returns to scales while expanding
output – (a) increasing returns to scale, constant return to scale (the
transition stage from increasing return to decreasing return to scale), and
decrease return to scale
William Stanley Jevons
and Francis Y. Edgeworth (Both mathematicians)
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Jevons à Austrian-French-Benthamite
approach to utility
-- people can determine utility in
a very machinelike manner; very mathematically oriented
-- W = MULeisure à wage is the cost of
leisure at the margin
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Edgeworth – first to develop indifference curves to model utility,
Alfred Marshall (Principles textbook 1890)
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formalized partial equilibrium analysis
* other types of analyses:
static, comparative statics, dynamic, comparative dynamics
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looked at the way things adjust one piece at a time
(Marshall
resembles Cournot calculus: partial derivatives hold everything except price
constant)
Marshall
- Partial Equilibrium
- Elasticity
- Distinguished market
periods (economic time)
- long run
- short run
- market-intermediate (which only applies to non
durable goods, vertical supply)
Analytical
or Economic time v. Chronological time
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analytical: deals with how long it takes to fuly adjust to something
-- when market is clear Qs = Qd
hard to identify markets
where this is true
-- demand and supply deal with desires not the
actual transactions (inventories adjust to the Qs and Qd)
Viewed
Math as something used to obscure issues rather than to clarify them
- his applications of math are fairly simple
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made value judgments: what we should do
Major Contributions
Marshall was a highly skilled mathematician, but he was
dismayed as higher level mathematics was increasingly integrated into
economics. Marshall noted that mathematical proofs sometimes yield erroneous
conclusions, and viewed math as often obscuring important economic concepts.
Marshall Distinguished Three Different Periods of
Analytical Time for Production
Marshall wove time into economic analysis:
The long run: The
long run (LR) is an analytical
period of sufficient duration to make all feasible resource adjustments to
any event, although, for convenience, technology is usually assumed constant
for purposes of long-run analyses. Fixed costs are zero in the long run.
The short run: The short run (SR) from a
microeconomic perspective is an analytic
period of time in which at least one resource is fixed so that firms can
neither enter nor leave the marketplace‑‑a firm can shut its
plant down, but it cannot leave the industry.
Note:
The short run from a macroeconomic perspective is a period insufficiently
long for full adjustment to some disequilibrating event, such as a
significant change in government policy, a major external shock, or the
widespread implosion of speculative bubbles in financial markets.
The market (intermediate) period is so short that
firms cannot adjust output. Because nondurable goods cannot be inventoried
and must be sold immediately, their supply curve is vertical and the price of
the good is determined by demand during that period.
Marshall Formalized the Use of Partial Equilibrium Analysis
Partial equilibrium: is a method of economic analysis
which looks at the direct effects of some chosen variables on others,
assuming all other influences constant. This technique relies on the ceteris parebus (all else held
constant) assumption.
In partial equilibrium analysis, some potential influences
on relationships are held constant.”
Example: hold everything constant except for price
and examine the effects of price on Qd or Qs.
Qd = f(P, Pog, Pref,
Y, N, T, E)
Qs = g(P, Pog, w, r, i, Tech, N*, T, E)
Note: This amounts to taking
the partial derivatives of these functions with respect to price, and follows
the technique pioneered by A. A. Cournot.
Example: Production and Analytical Time
Immediate
(Market) Period à
production cannot be changed
For
non-storable goods, supply is vertical (firms can't vary supply of
nonstorable goods)
Prices of are determined by demand for, e.g.,
strawberries, event tickets
Short Run à
at least one factor of production is fixed
Q=f(L), and capital is assumed fixed.
Long Run à
all resources are variable and firms
can enter or leave a competitive industry.
Q=g(K, L) . . . , but
Marshall assumed technology to be fixed.
Issue: In the long run, is
anything other than all “laws of nature” truly constant?
FACTOID: Technology can often
change faster in response to profit opportunities than can the number of
firms. [Think about, e.g., high tech industries.]
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1.
Technology often changes faster than you could
adjust capital or labor.
2. Technology may be
determined by profitability
3. In an industry with huge
profits:
Rate of Technological
change = h (Π)?
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If competitive firms operate
profitably (point a, shown with
blue cost curves), then new technology induced by these profits may cause
firms to experience lower costs, but competition is likely to eliminate the
profits in the long run (point b,
shown with red/orange curves).
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Note: Leon Walras rejected
Marshallian partial equilibrium approach.
Marshallian Quantity
Adjustments: Perhaps
again unconsciously following the pioneering assumptions of Cournot, Alfred
Marshall theorized that economic agents adjust quantities (rather than prices)
to clear competitive markets that are out of equilibrium. Disequilibrium
exists if, at the current quantity being sold, the supply price differs from
the demand price so that a market experiences a surplus or a shortage. In a
Marshallian adjustment, the quantity supplied will adjust until demand and
supply prices are equal. Quantity increases in response to a shortage, and
decreases in response to surpluses. NOTE:
Contrast this with the Walrasian
adjustment mechanism, which posits that the market price will fall if the
quantity supplied exceeds the quantity demanded, and that the market price
will rise if the quantity demanded exceeds the quantity supplied.
Competitive
Equilibria: Marshall identified a competitive
equilibrium as occurring when economic profit is zero, and identified the
entry of new firms as driving prices down and resource costs up as potential
mechanisms to drive down profits in a profitable industry, and rising prices
and falling resource costs as mechanisms that eliminate losses as firms exit
an industry in which economic profit is negative.
Elasticity: Following some ideas expressed by John Stuart
Mill, Marshall mathematically specified elasticity as a measure of the
sensitivity of one variable relative to some other variable.
Internal
Economics of Scale: These are gains in productivity and reductions
in cost inside a firm due to expanded production.
External
Economics of Scale: These are gains in productivity and reductions
in cost outside the firm. These are usually gained in the industry due to
expansion of that industry. An example would be the massive expansion of the
highway system that has reduced the cost of transportation for each company
in the trucking industry.
Increasing Cost Industry:
An industry in which expansion through the entry of new firms increases
the prices firms in the industry must pay for resources and therefore
increases their production costs.
Decreasing Cost Industry: An
industry in which expansion through the entry of firms decreases the prices
firms in the industry must pay for resources and therefore decreases their
production costs.
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Quasi –
Rent: A quasi-rent is a transitory surplus, often associated
with previous investments in physical or human capital. These surpluses are
ultimately dissipated by, e.g., depreciation, or by rent-seeking initiated
by other parties.
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Consumer
Surplus: The gain consumers derive from differences between the amounts
of money they would willingly pay to consume alternative quantities of a
good and the smaller payments required for them to consume those quantities
of the good. Graphically, this is the area below consumers’ demand
curves but above the price line.
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Problems with Partial
Equilibrium Analysis
Leon Walras - When prices change other things adjust/change automatically
(PPPYNTE)
Static
Analysis
- demand
and supply curves are treated as independent and stable.
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let's see how we get to equilibrium: focus on shortages, surpluses, price
adjustment
Dynamic
Analysis
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begin at equilibrium: focus on expectations associated with changes in Qs and
Qd
Exceptions
to Marshall: example: you can't hold everything constant
when prices vary
- an increase in demand
may result in a decrease in supply in the short run.
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example: demand for beef rises b/c of Atkin's Diet and FDA
recommendations. The increase in price that results with Marshallian P/E may
cause expectations of further price increases.
(a) when wage and price
controls were expected to be eliminated: beef producers, expecting the prices
to rise, built up inventory. The price of beef fell when controls were
eliminated.
(b) why sell now when you can
increase production, hold in inventory, and sell for even higher prices
later?
(c) manufacturers try to time
things so that they will enter the market when the prices are highest:
(d) the point? expectations can't be held
constant
(e) increases in price à decreases in income
(source of the income effect)
(f) there are cases (e.g. the
seller of the good) when increases in price à increases in income à increases in Qd
*
these were the problems with Marshall's
approach
Economics of the Firm
in the Long-run
Long-run:
In
long-run, market and technological constraints relax, factor prices change,
fixed inputs becomes variable, tastes change and technology changes.
Long-run Average Total Cost (ATC):
Long-run ATC is a sequence of Short-run ATC at different scale of
production.
Figure 1
Economies of scale:
Economies of scale exist when
increases in inputs result in more than proportional increases in output so
that long-run average costs fall as output rises.
Constant returns to
scale:
A production function exhibits
constant returns to scale if increases in all inputs by a given proportion
yields a precisely proportional increase in output.
Diseconomies of
scale:
Diseconomies of scale exist
when increased inputs result in less than proportional increases in output so that long-run average
costs rise with output.
Figure 2
American Marginalist
John Bates Clark:
John Bates Clark [1847-1938]
John Bates Clark, the first significant American
economic theorist, developed the concept of marginal productivity in his The Philosophy of Wealth (1886), and the product
exhaustion thesis behind the Marginal Productivity Theory of Distribution
in his Distribution of Wealth (1899).
Aware of
Henry George’s claim that land rent is socially illegitimate because it
is an unearned income, Clark asserted that
under perfectly competitive market, the return to each factor of production equals
to its marginal productivity. The
distribution of income under a perfectly competitive market reflects each
factor’s contribution to the social product, therefore, is ethical. He claimed that production
exhaustion exists, that is, paying each factor its marginal productivity will
just exhaust the total product.
(Note: J.B. Clark’s son,
J.M. Clark maintained that his father’s work was a rebuttal to
Marx’s exploitation theory.)
In addition, Clark suggested that the returns to
entrepreneurs are not profits but wages. Firms assume risks – if total
revenue exceeds total cost, firms gain profits, and if total revenue is less
than total cost, firms suffer from loss.
So, returns to entrepreneurs result from disequilibrium in an economy
that is moving towards a new long-run equilibrium. And once the new equilibrium is achieved,
the profit would be eliminated through competition. Clark’s idea of
profit to entrepreneurs being the reward for bearing risks was elaborated by
Frank H. Knight in his Risk, Uncertainty,
and Profit (1921).
Certainty, Risk,
and Uncertainty
Certainty: Precise knowledge is available about the current and
future values of variables.
Risk: Some knowledge exists about the probability function for an
event.
Precise risk: The probabilities of alternative outcomes can be
specified mathematically. Examples include the probability functions
associated with cards, coin flips, or dice.
Fuzzy risk: Some current information or historical data are
accessible and appear useful in predicting certain outcomes. For example,
insurance companies use actuarial tables yield fuzzy estimates of risk in
predicting morbidity, mortality, or rates of accidents. This guides the
pricing of insurance premiums. Fuzzy risk exists when events occur according
to unstable or to incompletely known Poisson distributions.
Knightian uncertainty: Any assessment about the probability
function for a possible event is based on raw speculation because historical
data are either sketchy or absent.
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marginal productivity theory of income distribution:
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The marginal productivity theory of income
distribution concludes that competitive markets will result in income [Y]
being distributed to resource [R] owners in proportion to the values of the marginal productivities
of the resources they own. [VMPR = P ×
MPPR and Y = VMPR×R]. See also Clark-Wicksteed theorem.
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§
In the end, Y = (L x VMPL) + (K x VMPK) + (N x VMPN)
+ (πE)
§
Note: VMP = MPP x P, where MPP = ∆Q / ∆L
§
Income goes to people in accordance with the
well-being that their production provides all of society.
§
Clark naively
argued this analysis provides a scientific, objective, and ethical basis for
market distributions of income… but normative is unavoidably here
… viz. his theory assumes that
resources are ethically owned.
o Did
not explicitly address the role of the entrepreneur in a capitalist economy
Note: Clark’s arguments can be interpreted as debunking
“rugged individualism” because his analysis identifies
productivity as interdependently determined.
o VMP(labor)
= f(K), f(N), f(tech)
o production
is an activity that is structured by society
§
if someone disappears, everyone else will just
move up one slot in the world to fill the space; the only loss of
‘shmoo’ in the world is that which was being produced by the
least productive person in society because that position is not filled by
anyone
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land and capital are inherited -- tax them to create
equality of opportunity?
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Clark argues for the
status quo, assuming justice in current system of distribution
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He wanted to shoot down the Marxists
o PQ
= w + r + i + ∏
§
r, i, ∏ as surplus that is stolen from
the worker
§
Clark argued
that labor is not the only productive resource
Phillip H. Wicksteed
Philip H. Wicksteed was another economist who worked on
marginal productivity theory and product exhaustion under perfect
competition. His important works included An Essay on the Coordination of the Laws of Distribution, The Common Sense of Political
Economy, and The Scope and Method of Political Economy
in the light of the 'Marginal" Theory of Value and Distribution.
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