GOVT. COLLEGE, LIBRGRY KOTA (Raj) Students can retain library books only for two weeks at the most. BORROWER'S DUE DTATE SIGNATUREHARVARD ECONOMIC STUDIES VOLUME LXXX AWARDED THE PAVID A, WELLS £RIZE FOR THE YEAR 1941-42 AND PUBLISHED FROM THE INCOME OF THE DAVID A. WELLS FUND. THIS PRIZE 15 OFFERED ANNUALLY, IN A COMPETITION OFEN TO SENIORS OF HARVARD COLLFGE AND GRADUATES OF ANY DEPARTMENT OF HARVARD UNIVERSITY OF NOT MORE THAN THREE YEARS’ STANDING, FOR THE BEST ESSAY IN CERTAIN SPECIFIED FIELDS OF FCONOMICS THE STUDIES IN THIS SERIES ARE PUBLISHED BY THE DEPARTMENT OF ECONOMICS OF HARVARD UNIVERSITY, WHICH, HOWEVER, ASSUMES NO RESPONSIBILITY FOR THE VIEWS EXPRESSEDLONDON : GEOFFREY CUMBERLEGE OXFORD UNIVERSITY PRESSFOUNDATIONS OF ECONOMIC ANALYSIS BY PAUL ANTHONY SAMUELSON PROFESSOR OF ECONOMICS. MASSACHUSETTS INSTITUTE OF TECHNOLOGY “Mathematics is a Language” —J. Writarp Giess CAMBRIDGE HARVARD UNIVERSITY PRESS 1953COPYRIGHT, [947 BY THE PRESIDENT AND FELLOWS OF HARVARD COLLEGE THIRD PRINTING FRINTED IN THE UNITED STATES OF AMERICA18 FOUNDATIONS OF ECONOMIC ANALYSIS under consideration, it will appear that the mere fact that the market is in stable equilibrium in the initial situation will remove all ambiguity. For if the market is the familiar Marshallian con- sumer's good market, stability of equilibrium by definition requires that the supply curve cut the demand curve from below (even in the case of decreasing cost due to external economies).5 Thus, ,. oD ars 20) Therefore, dx \° (2) > 0. en However, the algebraic sign of the price change will hinge upon whether there is a positively or negatively inclined supply curve. For op\* ,{axye (52) = (y’- (22) Thus, since (éx/da)" is positive from (21), (9p/de)* and S’ must be of the same sign, or ap ° if (3) S> 0. (23) It is impossible in the Price case to get rid of the final ambiguity. Suppose, however, that this Were a market for a factor of pro- duction, Here the conditions for stable equilibrium are familiarly defined to be either a Positively sloping supply curve with a nega- tively sloping demand curve: or if the supply curve is negatively inclined, it must be backward rising and steeper than the demand curve.* Mathematically, our stability conditions may be expressed s! ap - <0. (24) ae 3 For this case, therefo ; re, the sign of th the Quantity change is ambiguous, 4A. Marshall, Principles *J.R. Hicks, Value and € price change is known, while depending upon the algebraic of Economics (8th edition}, p. 346, n. 1 +B. 806, n. 1. Capital (Oxford, 1939), chap v, ° .EQUILIBRIUM AND COMPARATIVE STATICS 19 sign of the slope of the supply curve. In brief, o (3) > 0, (#)'s'>0 ” da Innumerable other examples could be cited. In general, we should not expect to be able to determine the signs of the rates of change of our variables upon the basis of simple a priori qualitative restrictions on our equilibrium equations. This is not because of the difficulty and complexity of solving a large number of equa- tions; for these could be solved if sufficient were known about the particular empirical values of our conditions of equilibrium. It is rather that the restrictions imposed by our hypotheses on our equilibrium equations (stability and maximum conditions, etc.) are not always sufficient to indicate definife restrictions as to alge- braic sign of the rates of change of our variables with respect to any parameter. Only imagine a change in a parameter which enters into all of a large number of equilibrium equations causing them simultane- ously to shift. The resulting net effect upon our variables could only be calcnlated as a result of balancing the scparate effects (regarded as limiting rates of change), and for this purpose detailed quantitative values for all the coefficients involved would have to be known. SUMMARY Before going on in the next section of our work to indicate how the economist is enabled to deduce significant results in a wide category of cases, it will be well to summarize the thread of the argument thus far, a. For theoretical purposes an economic system consists of a designated sect of unknowns which are constrained as a condition of equilibrium to satisfy an equal number of consistent and inde- pendent equations (see equation 1). These are implicitly assumed to hold within a certain environment and as of certain data. Some parts of these data are introduced as explicit parameters; and, as a result of our equilibrium conditions, our unknown variables may be expressed in function of these parameters (see equation 2),20 FOUNDATIONS OF ECONOMIC ANALYSIS b. The method of comparative statics consists of the study of the responses of our equilibrium unknowns to designated changes in parameters; i.c., we wish to know the properties of the functions in (2). In the absence of complete quantitative information con+ cerning our equilibrium equations, it is hoped to be able to formu- late qualitative restrictions on slopes, curvatures, ete., of our equi- ‘ibrium equations so as to be able to derive definite qualitative restrictions upon the responses of our system to changes in certain parameters. It is the primary purpose of this work to indicate how this is possible in a wide range of economic problems.CHAPTER HI THE THEORY OF MAXIMIZING BEHAVIOR \/ rune Sources OF MEANINGFUL THEOREMS It WILL be remembered that in the case of a unit tax on a firm’s output it was possible to state unambiguously the direction of change of output with respect to a change in the tax rate. This was so because of the fact that the equilibrium output for each tax rate was derived from the condition that prot must be at a niaximum. As will become evident in the course of our exposition, this is by no means an accidental, isolated case; it is merely an application of a very general principle of economic method, which lies at the bottom of much of economic theory. In fact, aside from those parts of economic doctrine whose results are inconclusive—and the most ardent advocates of economic theory will admit that this includes a large part of accepted analysis—there is not much which cannot be brought under this heading.' The general method involved may be very simply stated. Zn cases where the equilibrium values of our variables can be regarded as the solutions of an extremmunt (mtaxtmum or mintnimn) problem, it is often possible regardless of the number of variables involved to de- termine unambiguously the qualitative behavior of our solution values in respect to changes of paraineters.? It so happens that in a wide number of economic problems it is admissible and even mandatory to regard our equilibrium equa- ions as maximizing (amminizingy conditions. A large part of en- trepreneurial behavior is directed towards maximization of profits with certain implications for minimization of expenditure, ete. 1 The reader may verify this result by paging through any good economics textbook, such as Marshall's Princeples, and analyzing the derivation of various theorems stated, 7It may be pointed out that this is essentially the method of thermodynamics, which can be regarded as a purely deductive science based upon certain postulates {notably the Firstand Second Laws of Thermodynamics). That such abstract reasoning shoud in the hands of Gibbs and others fead to fruitful theorems testifies to the validity of the original hypotheses, 2r22 FOUNDATIONS OF ECONOMIC ANALYSIS Moreover, it is possible to derive operationally meaningful restric- tive hypotheses on consumers’ demand functions from the assump- tion that consumers behave so as to maximize an ordinal preference scale of quantities of consumption goods and services. (Of course, this does not imply that they behave rationally in any normative sense.) It is not to be thought that in principle all economic results emerge from these Maximizing assumptions. For, as we have scen, it was also possible to deduce conclusive qualitative results from certain stability assumptions. Nevertheless, many of these stability conditions rest implicitly upon maximizing behavior. . Moreover, certain difficulties arise here. While, of course, it is always possible to lay down arbitrary definitions of stability, it is impossible to deduce them without the implicit introduction of dynamical considerations concerning the behavior of a system oul of stationary equilibrium. Depending upon the dynamical set-up envisaged, different stability conditions are implied. Thus, given supply adjustments of the type assuined in the cobweb cycle phe- nomenon, it is well known that the ordinary Marshallian condition of a positively rising supply curve may not result in “stable” equilibrium.¢ It is true that the identification of equilibrium with a stable maximum position ina sense begs the question of stability. How- ever, where these extremum conditions are realized, it can be shown that many dynamic set-ups will give rise to dampened oscillations a8 a result of small displacements, The relations between dynamic theory and the stability of equilibrium are discussed in the last chapters. There remains still another possibility by which conclusive ‘ theorems may be deduced. We may know in advance certain qualitative Properties of our equilibrium equations. Thus, refer- ence may be made to alleged technological and psychological laws, + Thus, the definition of economic theory tive uses I would regard as too broad from from another, “A stationar differing which te below, ¥ cquihbrium is stable, only slightly from the station. nds (at least in the limit) to Providing the Specification of initial conditions ary equilibrium values results in an evolution approach the equilibrium values, See Part IfTHEORY OF MAXIMIZING BEHAVIOR 23 held to be plausible upon a priori grounds.* Even here, as many economists have pointed out, the reasoning may rest in the last analysis upon certain maximum considerations. Thus, in demonstrating the validity of the law of diminishing marginal phys- ical productivity we ordinarily point to the fact that firms in pure competition are in equilibrium under a given set of factor prices. This would not be possible if the law of diminishing marginal pro- ductivity did not hold. Again we point to the fact that farmers do not devote all their attention to raising grain on one square inch of land; they use much land of the same kind, and even inferior gradesofland. Thus, we really argue backwards from maximizing economic behavior to the underlying physical data consistent with it. There is still another type of problem for which the study of maximizing behavior is illuminating. In some cases, as we shall see later, it is possible to formulate our conditions of equilibrium as those of an extremum problem, even though it is admittedly not a case of any individual's behaving in a maximizing manner, just as it 1s often possible in classical dynamics to express the path of a particle as one which maximizes (minimizes) some quantity despite the fact that the particle is obviously not acting consciously or purposively. 4 For all of these reasons the study of maximizing behavior affords a unified approach to wide areas of current and historical economic thought. There is, moreover, considerable advantage in discussing the problem at first in its full generality. The high degree of abstractness will be more than compensated for in the case with which numerous applications can be deduced as special cases. A CALCULUS OF QUALITATIVE RELATIONS Before I enter upon the theory of maximizing behavior, it may be illuminating to show why intuition and a general feeling for the direction of things does not carry one far in the analysis of a com- plex many-variable system, such as is characterized by equation "Ina problem of any complexity involving a number of variables, intuition is a poor guide for the reasons discussed in the next section. All presumptions become dubious. In such cases the economist often falls prey to the penls of assuming the equiprobability of theunknown. Aga result, every reformulation of the problem results in changed presumptions. This is no doubt one reason why every terminological revolution in economic thought brings with it a recasting of belief.24 FOUNDATIONS OF ECONOMIC ANALYSIS (1) of the previous chapter. —To make matters even simpler than they usually are in reality, let us suppose that we know the quali- tative direction of movement of each of our equilibrium equations with respect to a change in all of the variables and parameters. Thus, we know at least the algebraic sign of each of the frst partial derivatives of the form f,' orf". _[t does not matter how we came about such knowledge; for example, we might confidently believe that individuals will divide an additional dollar of income frac- tionally between consumption and saving, not in consequence of some economic theory of maximization, but simply as a result of everyday observation. ' What then can we say concerning the direction of change of any particular variable in response to a change in some parameter? According to equation {7) of chapter ti, this is given by a compli- cated expression which can be written as the quotient of two by x determinants, whose elements are made up of these first partial derivatives. Now in order for our question to have an immediate definite answer, we must be able to determine unambiguously the signs of each of these determinants. From the original funda- mental definition of a determinant, each consists of n! terms, each term involving the product of # elements. From our hypothesized knowledge, we can be sure of the sign but not the magnitude of each term. Only if all of the w! terms happen to be of the same sign will the sign of the determinant be unambiguous. If our system involves ten variables, the determinants will have more than three million terms. Regarded simply as a problem in probability, the chance that a run of this length should always have one sign is about one out of one with a million zeros afterit. Therefore, unless some special feature is present, we are almost sure to find it neces- sary to weigh the magnitude of some terms against others, which is to enter upon quantitative problems admitting no answer by qualitative methods, Nevertheless, let us see how far qualitative methads will take us in the slightly simpler case where only one parameter is changed in such a manner as to alter only one of the equilibrium relations. As before, the signs of all first partial derivatives are known. Con- sideration of al possible cases that may arise will show that there is no loss in generality in assuming that it is the first equation which is shifted, that the partial derivative of each implicit equation withTHEORY OF MAXIMIZING BEHAVIOR 25 respect to its own variable /,," is always positive, and that the change in the first equation with respect to the given parameter is positive. If these conditions are not realized, they can be brought about by changes in sign of one or more of the equations or variables and the parameter. By our qualitative knowledge we are abie to specify a matrix of the form + + + &: + + + + . totter + signffp=]- -.- . . (1) zt bo + where the 2 columns represent (x), ---,x,), and the x rows repre- sent (f1,---, f"). The sign in each element will represent the as- sumed known sign of the partial derivative of the variable corre- sponding to that row taken with respect to changes in the variable corresponding to that column. By our previous convention, we have made ali diagonal elements plus. All the remaining elements can be of either sign, but in any one case they are assumcd to be of definite known signs. Allin all, there are a vast number of possible matrices of this kind which could arise in any problem, in fact all together 2 raised to the n( — 1) power. We are interested in the direction of change of our unknowns, or in the signs of (dx,/da,---,dx,/da). If nothing is known a priori, these may take on any one of all the possible 2" arrange- ments of signs. 57 + + + + - $F foe 4+ +--+ + - - + : Tl. (2) to — ae eee How many of these can now be eliminated as inadmissible on the basis of our qualitative knowledge as embodied in the specification26 FOUNDATIONS OF ECONOMIC ANALYSIS of the matrix (1)? Ideally, we should hope to be able to rule out all but one of the possible combinations so as to get a unique answer. However, it would be at least desirable to be able to determine the sign of at least one of our unknowns, or, what comes to the same thing, to be able to rule out a particular half of all the possible combinations. So much for our aspirations; turning to the exact procedure by which we rule out a combination, we find ourselves in for dis appointment. If we substitute into equation (6) of chapter ii the signs of the indicated elements, we shall be able to rule out a combination if, and only if, it leads to a contradiction, i.c., if it does not add up to zero, or toa negative number as it should. Coneretely, this can be seen to mean that we can rule out any one of the above combinations of sign in (2) which exactly dupli- cates any of the last (2 — 1) rows of (1), or which is the exact antithesis of any of these same rows, Otherwise, one of the last (x — 1) equations of (6), chapter ii, could not add up to zero as required by the present hypothesis. In addition, we may rule out any combination of (2) which exactly duplicates the first row; but we are not able to rule out its antithesis, All told then, we are at most able to considerations only (2% ~ 1) combinations out of a grand total of 2" possible combinations. Even for moderate sizes of n this leaves Us with all but a minute fraction of possibilities, And this is the largest number that we can rule out on such a hypothesis, In many cases we are not able to tule out even this many. Thus, if any two tows in our original matrix have exactly the same signs, they will both rule out the same combinations, which cannot there- fore be added together for fear of double counting. It can be seen then that purely qualitative considerations can- not take us very far as soon as the simple cases are left behind. Of course, if we are willing to make more rigid assumptions, cither of a qualitative or quantitative kind, we may be able to improve matters somewhat, Ordinarily, the economist is not in possession of exact quantitative knowledge of the partial derivatives of his equilibrium conditions. None the less, if he is 2 good applied economist, he may have definite notions concerning the relative importance of different effects; the better his judgment in these matters, the better an economist he will be. These notions, which rule out by qualitative