ECN 315 Update PDF

Study Session 1: NEOCLASSICALSCHOOL OF THOUGHT
NEOCLASSICALSCHOOL
Introduction
This study session
ion looks into the economic ideas of the immediate school of though
thought after the
classical economics known as the neoclassical economics. Under this, how the neoclassical
school of thought sprang up and the foundation of the tool marginal analysis will be
examined. Their major contribution to the concept of utility and the marginal utility theory
proper will be studied alongside
side the basic principles underlying this theory and their
applicability.. We shall also look at the marginal utility link with the theory of demand and
exchange as well as the link with the value of facto
factors
rs of production. In addition to this, the
various writers under this school of thought will be pointed out.
Learning Outcomes for Study Session 1

At the end of the study session, you should be able to:
1.1 Identify the evolution of the neoclassical school of thought
1.2 Highlight the foundation of the marginal analysis
1.3 Explain the concept of utility
1.4 Relate the marginal utility analysis to the theory of demand and exchange
1.5 Explain how the value of factors of production is determined under the
marginal utility analysis
1.1 The NeoclassicalSchool

chool of Thought
The Neoclassical Economists is that school of thought which concentrated and refined the
classical school of thought. They date back to 1870 and their economic ideologies reigned
over three decades before the Keynessian school of thought came up in the 1900s.
1900s The
foundation of the neoclassical economic ideas was based on the classical economic theories
1
though after being sieved. Some of the classical’s underlying assumptions and adopted
methodology was questioned but the technical contents remained.
Therefore, while restructuring
ucturing the classical’s theories and reviewing their perspectives, the
neoclassical built up economic analysis. Hence, the reformation of the classical school of
thought built up the neoclassical school. However, the gradual transformation came up
through the adoption of new tools of analysis among which is the popular and well accepted
tool of marginalism. Prominent contributors among others in this school of thought are names
such as W.S Jevons, Carl Menger, Heinrich Gossen and Leon Walras.
What formed the emergence of the neoclassical economists?
The neoclassical economics began with the introduction and application of

new tools of economic analysis among which is the popular and well accepted tool of
marginalism. The usage marginal analysis
analysis tool was extensively adopted by W.S Jevons and
Carl Menger.
1.2 The Foundation of Marginal Analysis

Prior to the full application of the concept of marginal utility, the concept of margin was
not strange. Some ancient great thinkers had the idea of this concept but could not apply it
to solving economic problems. The literal meaning of the word ‘margin’ had always been
inherent in their analysis. Margin refers to small change in any variable and the effects
such small change produces. The kind of effect eventually determines whether the small
change is to be added or removed.
In line with this, a host of early writers including Aristotle and Jeremy Bentham, in their
different way, made statements that pinpointed the meaning of this concept as it is known
2
today. Also, the law of diminishing marginal utility was a common knowledge to them
even to classical economists like David Ricardo and Thomas Malthus. The extensive
usages of these concepts were however not explored.
Moreso, through the periods of the early eighteenth century, some writers showed some
level of understanding to the concept of diminishing marginal utility which they
interpreted thus “as an increasing quantity of a good is consumed, the good will yield
diminishing marginal utility to the consumer”. These writers include: T.A Von Thunnen,
Samuel M. Longfield, W.F Lloyd, Jules Dupuit, H.H. Gossen, R. Jennings and
AugustinCournots. Each of them brought up this idea through their individual work that
came out either in form of lectures or articles.
They all recognized the measuring nature of marginal analysis and hence applied it to
most microeconomic analysis which helped in increasing the use of mathematical tools
especially differential calculus and abstract model. These contributions were made at
different periods ranging from the 1830s to 1860s. A common idea they pinpointed also
include the relevance of the marginal utility approach to the theory of demand.
In the late eighteenth century, other prominent writers who emphasized more on the
importance of marginal analysis sprang up. They first applied marginal analysis to the
theory of demand after which the marginal utility theory was developed. The marginal
analysis was logically developed and explicitly applied to economic problems. The ideas
brought up in these centuries greatly influenced subsequent development of economic
theories.
Notably in the early 1870s, three great thinkers adopted and applied the marginal
analysis tools fully to some relevant areas of microeconomic theories such as
determination of values of final goods and services. These thinkers were W.S Jevon,
Carl Menger and Leon Walras who were referred to as the Marginalists. The neoclassical
marginal analysis concept basically refers to the additional gains from consuming an extra
unit of a commodity. As a result of this, the marginal analysis as applicable to the theory
3
of consumer’s demand studies and explains the consumers’ actions and reactions to
certain circumstances while making economic choices among avail
available
able goods and
services.
Hence, the marginal analysis
sis was applied to utility theory which recognizes the existence
of additional utility derivable from additional consumption of goods but noted that the
utility decreases as more of a particular good is consumed. This forms the basis of
economic decisions regarding production, distribution and consumption within which the
conditions of maximization and minimization apply depending on the economic decision
to be made. However, the extensive application of the tool of marginal analysis became
more acceptable when the tools earlier adopted by the classical economists were taken as
unrealistic. This and some other reasons are exp
explained in sub-section 1.2.1
Highlight the foundation of the marginal analysis?
Marginal analysis as a tool of economic analysis had been signified

signified in
the economic thinking of past writers but the copious use of it started with
the neoclassical school of thought. The contributory members of this
school applied this to several relevant
releva economic theories.
1.2.1 The Inadequacy of the Classical Theory of Value

Classical economists developed the theory of value investigate economic dynamics.
However, the classical economists failed to develop this theory in full during their period.
The classical
lassical theory of value was displaced by the marginalist schools of thought which sees
value as being derived from the marginal utility that consumers finds in a good as well as
marginal opportunity cost of the inputs that make up a product.
Furthermore in
n the classical economic analysis, the analytical tools adopted were deemed
appropriate from the onset until some discrepancies were noticed which prompted the need to
4
develop new sets of tools and new economic ideas. Within the classical framework, in the
determination of prices or values for goods and services, costs of production were seen as the
major determinant. John Stuart Mill used cost of production in value determination and David
Ricardo used labour cost as value determinant.
However, these were found to be generally inapplicable especially with goods that have
perfectly inelastic supply curve. In their analysis of the theory of value, they held that value
was produced in a final or consumer good through the costs incurred on the factors of
production.
ction. According to them, a higher cost of production will attract higher values for
commodities produced and vice versa. Contrary to this, the Marginalist pointed out that it is
the utility derived from the final goods produced that confer values on them regardless of the
past or present costs incurred on such goods. The values of factors of production are
indispensable but not the major determinant of commodity’s value.
Price determination requires some significant elements but to the Marginalists, the marginal
ma
utility is the most significant. The classical economists did not understand the importance of
marginal utility but saw total utility as majorly significant in price determination. For
instance, A. Smith failed to use the concept of marginal utility in analysing
ing the diamond
diamond-
water paradox but he used total utility instead. However, it is the marginal utility derivable
from commodities’ consumption that first determine
determines choices and hence prices.
Pinpoint the major shortcomings

shor in the classical theory of value?
The classical cost of production theory of values was found to be

generally inapplicable especially with goods that have perfectly inelastic
supply curve. Also, the classical economists did not understand the
importance of marginal utility but saw total utility as majorly significant
in price determination. However, the
theproof that it is marginal utility that
5
first determine choice and hence price makes the classical theory
inadequate.
1.3 The Concept of Utility

Utility means the ability of a commodity or service to satisfy an economic need. The concept
is majorly applicable to human activities of meeting needs or satisfying desires regardless of
the effects on the consumer. The dictionary of economics defines utility as the power of an
article to satisfy any human want e.g. food, cloth, shelter, cinema show, automobile e.t.c.The
utility concept is different from satisfaction in that the latter is what is actually attained while
the former is like an enablement towards the attainment of the latter. In other words, utility
confers satisfaction to the consumer.
Utility is subjective to the consumer in as much as human beings are dynamic which means
that a particular article that can confer satisfaction to one person may fail to do the same to
another person. Often times, the ability to confer satisfaction depends on time, tide, place as
well as persons. The applicability of the concept of utility is numerous and indispensable
because it helps in explaining the rationale behind individual’s demand or the market’s
demand.
However, the Marginalists described the word ‘utility in their different ways though not using
the exact word as it is used now. They all saw utility as inherent satisfaction derivable from
final good which was why Carl Menger described utility as ‘importance of satisfaction’.To
him, utility is the capacity of a thing to serve for the satisfaction of human needs. The
neoclassical utility analysis was not based on any specific measure but they believed in its
unspecified unit of measurement and that it had capacity.
Hence, they not only brought up cardinal measurement of utility, but also drew the fact that
utility is additive. The utility analysis takes into cognizance that consumers have perfect
knowledge of prices and availability of commodities and that they are rational which means
that they always compare and aim at the maximum satisfaction. It was based on these
assumptions that the neo classical applied the concept of utility to the theory of demand and
supply.
6
Jevon first presented his marginal analysis method on his mathematical theory of value after
which he focused attention on what he termed coefficient of utility. He defined this as the
ratio between the last increment of object consumed and the increment of ple
pleasure
asure derived.
Menger also stressed the importance of marginal utility as the major determinant of value or
worth of a good upon which rate of exchanges was based. The marginalists worked
exclusively on the theory of demand but gave little attention to the theory of supply. They
assumed in most of their analysis that supply was given or fixed.
How did the Marginalists described the concept of utility?
The Marginalists saw utility as inherent satisfaction derivable from

final good which was why Carl Meng
Menger
er described utility as ‘importance
of satisfaction’. The neoclassical utility analysis was not based on any
specific measure for utility but they believed in its unspecified unit of
measurement.
1.4 Utility, Demand

emand and Exchange
Generally, as proven by the Marginalists, every commodity possesses utility and while
valuing such, it is utility that determines the price. In other words, the satisfaction a consumer
derives at the margin determines the value placed on such commodity. In the first instance,
the utility
ility theory was broken down into total utility and marginal utility. The total utility is
the sum total of utilities obtained by a consumer from consuming different quantities of a
particular commodity while the marginal utility is the addition to total utility by consuming
an extra unit of commodity.
However, they noted that utility has a decreasing nature as more of a particular good is
consumed. This is referred to as the law of diminishing marginal utility which was first
7
implied by Herman Heinrich Gossen in 1854. The fact that Gossen implied this law made
Jevon to refer to it as Gossen’s first law. It simply states that ‘the magnitude of one and the
same satisfaction, when we continue to it without interruption, continually decreases until
satiation is reached.’ It was Marshall that called it the law of diminishing marginal utility and
he explained it as ‘ as more of a commodity is consumed, the marginal utility starts falling
though the total utility is rising but at a decreasing rate and this cont
continues
inues till the satiety point
after which disutility sets in.’
The law of equimarginal utility among other laws was based on the law of diminishing
marginal utility. It is Gossen’s second law and as Marshall described it ‘if a person has a
thing which he can
n put to several uses, he will distribute it among these uses in such a way
that it has the same marginal utility in all’.This law was an attempt by the Marginalists to
explain the conditions required for utility maximization aand
nd then exchanges. Based on tthese
laws, they brought up a link between utility and demand and showed that the fundamental
force lying behind demand is marginal utility.
In line with the above laws, they also brought out a reasoning that since higher utility is
attached to lesser units
ts of a particular commodity, then a diminishing marginal utility means
that a consumer will buy more unit of that commodity only when its price falls. According to
Jevon, ‘this
his degree of utility is defined as a diminishing function of the quantity of the
commodity held, so that the
he degree of utility decreases as that quantity increases
increases’. This
explains the theory of demand.
Analysee the link between the law of diminishing marginal utility and the law of
demand?
Higher utility is attached to lesser units of a particular commodity, then a

diminishing marginal utility means that a consumer will buy more unit of that
commodity only when its price falls. According to Jevon, ‘this
‘this degree of utility is
8
defined as a diminishing
nishing function of the quantity of the commodity held, so that tthe
degree of utility decreases as that quantity increases
increases’. This explains the theory of
demand.
1.5 The Value of Factors

actors of Production
The Marginalists criticized the Classical economists’ postulations
stulations that prices or values of
goods were majorly determined by the costs of production. The fact that factors of production
were often times not used in the same quantities and qualities made the classical view
incorrect. For instance, the cost of la
labour
bour as a factor of production varies in terms of quality
and the time of its usage. Hence, Jevon in his application of marginal analysis pointed out
that after a certain usage of labour, a further increment will be more painful than the pleasure
derived from
rom the increased product.
They further argued that the values of goods depend on the marginal utility while the
prices of factors of production depends upon the utility of the final good produced.
Under this, they explained how cost
costs of production indirectly
ctly influence values of
commodities through their supply.
• Cost of production determines supply
• Supply determines final degree of utility
• Final degree of utility determines value.
The first link was between the cost of production and supply in which the major
consideration is on commodities that are relatively scarce. Such scarcity will influence the
marginal utility of such commodities which points to the second link between supply and
final degree of utility. The last link is marginal utility as described
ed as the finaldegree of
utility will in turn influence the vvalue placed on such commodity in the market.
In what way is the price of factor of production determined?
9
The prices of factors of production depend upon the utility of the final good
produced.
1.6 Important Writers

1.6.1 Stanley W. Jevon: He wrote on the theory of political economy in 1871. H
He
studied chemistry and engineering.
ngineering. He started working on mathematical theory of
political economics in which he employed the marginalist method on the principle of
pleasure and pain. He believed that the problem of economic is centred on resource
allocation in a way that will maximize pleasur
pleasuree and minimize pains. Optimum
allocation to him wass therefore the equalizations of the marginals of the variables
involved.
This was first presented on his mathematical theory of value after which he focused
attention on what he termed ‘coefficient of uti
utility’.
lity’. He defined this as the ratio
between the last increment of object consumed and the increment of pleasure derived.
This, he also applied to the usage of labour in which he pointed that after certain usage
of labour, a further increment will be more painful
painful than the pleasure derived from the
increased product.
Also, on the theory of exchange, he said extent of trade is dependent on the equality of
increment of utility lost or gained. And on the rate of interest, it is the ratio of new
increment of product
uct to the increment of capital used in the production.
1.6.2 Carl Menger: He wrote on the principle of economics in 1871. He applied the
marginal analysis to demand and supply and to the theory of firm.
1.6.3 Leon Walras: He was called a Mathematical Econ
Economist.
omist. He wrote on elements of
pure economics in 1874. Like Menger, he also applied the marginal analysis to
demand and supply and to the theory of firm. He further used the general equilibrium
theory to analyse economic problems.
10
Summary of Study Session 1
In this study session, we studied the emergence of the neoclassical school of thought and the
contributions of the different writers under this school to the development of economic
theories over time. The shortcomings noted in the applicability of the classical economists
ideas gave room tothe development of more appropriate tools of economic analysis within
which the proponents
ents of such sprang as the neoclassical economists. We learnt that the
extensive use of the tool of margin announced this sc
school of thought. Also, marginal analysis
was used in different economic theories such as the theory of value: demand and supply, the
theory of firm, distribution and others.
Self-Assessment
Assessment Questions (SAQs) for Study Session 1
Now that you have completed this
his study session, you can assess how well you have achieved
its Learning Outcomes by answering these questions. Write your answers in your Study Diary
and discuss them with your Tutor at the next Study Support Meeting. You can check your
answers with the Notes on the Self-Assessment
Self Assessment Questions at the end of this Module.
SAQ 1.1: Identify the major factors that contributed to the evolution of the neoclassical
economists?
SAQ 1.2: How did the neoclassical economists describe the word utility?
Multiple Choice Questions:

s:
1 The emergence of the neoclassical economist was within which of the following
decades?
A) 1770s – 1870s
B) 1830s -1870s
C) 1870s – 1900s
D) 1770s - 1800s
2 All of the following statements are true except?
11
A) Marginal analysis emerged as early as 1830s
B) Marginal analysis emerged earlier than 1830s
C) Marginal analysis emerged as early as 1870s
D) Marginal analysis emerged as early as 1770s
3 According to the Marginalists, the major determinant of value is?

A) Total utility
B) Marginal utility
C) Costs of production
D) All of the above
4 Which of the following names is the odd one?

A) T.A Von Thunnen
B) Jules Dupuit
C) Leon Walras
D) AugustinCournots
(5) Jevon ,Menger and Walras exclusively applied the marginal analysis to the theory of
demand and supply. This statement is
A) True
B) False
C) I don’t know
D) None of the above
Reference
Bhatia, H.L. (2006), History of economic thought, 4th Edition.New Delhi:Tata Mcgraw-Hill.
Jhingan, M. L. (1999).Microeconomic theory.Revised Edition.India: Vrinda Publications

Limited.
12
Landreth, C. and D. C. Colander (2001). History of economic thought:
hought: Fourth Edition.
Boston: Houghton Mifflin Company.
Samuel W.J, Biddle J.E & Davis J.B(Eds.)

J. (2003).A Companion to the history
istory of economic
thought.London: Blackwell Publishing.
Suggested Books for Further Reading

Samuel W.J, Biddle J.E & Davis J.B (Ed) (2003), A companion to the history of economic
thought. London: Blackwell publishing.
Should you require more explanation on this study session, please do not hesitate to contact
your e-tutor
tutor via the LMS.
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by e-mail
e or phone on:
iag@dli.unilag.edu.ng
08033366677
13
Study Session 2: EXTENSION OF MARGINAL ANALYSIS
Introduction
This study session looks into the further applications of the marginal analysis tool. Another
school of thought cropped up that sharpened the marginal analysis tool and this school was
referred to as the second generation marginalists.
marginalists. They brought up the use of marginal
analysis tool in the theory of production and distribution in which they specifically applied it
to payments to the factors of production. Hence the marginal productivity theory of
distribution was adopted in the aanalysis
nalysis of rent and wages while relevant theories were
adopted in determining profit and interest.

2.1 Identify the other applications of the marg
marginal analysis
2.2 Explain the marginal productivity theory
2.3 Explain how profit is determined
2.4 Explain how interest is determined
2.1 Extension of the Marginal

arginal Analysis.
The first set of neoclassical economists that adopted the tool of marginal analysis extensively
were the first generation marginalists because the tools though were well accepted has some
noticeable flaws. The first marginalists worked exclusively on the theory of demand but paid
little
le attention to the theory of supply which they assumed in most cases was given or fixed.
Moreso, the theory
heory of firm or production was not extensively analysed.
However, the
he usefulness and relevance of the marginal analysis applicability to
microeconomic theories made it considered for further applications. It was therefore broadly
14
applied to the theory of production, theory of costs, prices of factors of production and
distribution of income by other advocates of this tool and they were called the second
generation marginalists. This school was also referred to as the Austrian Marginalists.
This school came up with intensions to unify the principles of value and thus extended the
use of the marginal tool to explain the theory of price and distribution. Prominent in this
school was first Carl Menger and others like Friedrich Von Wieser, Eugen Von Bawerk,
J.B.Clark, Knut Wicksell, P.H.Wickseed and F.Y Edgeworth. Led by Carl Menger, they
brought in subjectivism into the application of the marginal analysis tool. This made their
contribution different and relevant to subsequent generation of Austrians.
Although in earlier literatures, marginal analysis had been applied to factor pricing and
distribution of incomebut was not given credit. These can be traced to the work of S.M
Longfield who criticized the labour theory of value and then presented a marginal
productivity theory of distribution. Also, Von Thunen used differential calsulus with which
he developed marginal products of the various factors of production and presented theory of
distribution based on these principles.
To the Austrian Marginalists, utility is the “capacity,”ascribed to a good by humans, to satisfy

some need, not the hedonic sensation that a good produces when it satisfies that need. Thus,
the marginal utility of a good is the capacity of a concrete quantity of that good to satisfy the
least important specific need that it can satisfy.
The application of the marginal analysis tool was extended to the analysis of the demand for
factors of production and the payments thereof. The classicalists used a residual theory of
distribution in which payments to the factors of production were equated to the total product.
The second generation Marginalists however held that the factors’ payments are actually the
marginal products. In their words, ‘the value of complementary factors is determined through
the marginal principle. They also emphasized that the value of a productive factor depends
upon its contribution to the value of the product it creates.
15
The contributions of the Austrian marginalists represent both a distinct tradition in modern
economics and a part of the family tree that comprises the consensus around which twentieth-
century microeconomics was constructed.
• ITQ:Explain the reason behind the extension of the marginal analysis tool?
o ITA: The first marginalists worked exclusively on the theory of demand but paid little
attention to the theory of supply which they assumed in most cases was given or
fixed. Moreso, the theory of firm or production was not extensively analysed. Hence,
the numerous usages to which the marginal tool could be applied were put to limited
use by the first generation marginalists.
2.2 Marginal Productivity Theory

Given a production function, the combinations of factor inputs determines to a large extent
the quantity and quality of outputs i.e. the total or the maximum output obtainable. The input-
output relationship is further affected by the prevalent situation in the production
environment and the levels of technology. Since the quantum of output relies heavily on the
inputs, there arose the need to determine how much of relevant inputs is required. Therefore,
the prices of and the demand for factor inputs became necessary. The neoclassical economists
used the marginal principle in the determination of the demand side of factor pricing. The
marginal productivity theory was then adopted in the theory of distribution.
The concept of marginal productivity theory initially cropped up when David Ricardo
adopted the marginal analysis tool to all factors of production especially land rent. He applied
it to the production process in agriculture. Overtime, the concept became more pronounced
especially with the use of marginal analysis tool to analyse marginal productivity of factors of
production. Hence, the marginal productivity theory was used to explain how the rewards to
the factors of production are arrived at through their marginal physical products. The
marginal physical product is the increment made to total product when an additional unit of a
factor is used while the other factors are kept constant. However, principle of the diminishing
16
returns crops in when the units of a particular factor input is increased while the other factors
are held constant.
er recognized that any of the factor inputs could be varied and their
The Austrians however
marginal products computed. It is the marginal products of factor inputs that determine the
payments to these factors after w
which thee demand for each can be derived. Demand for an
input is defined as the quantities the firm would hire at various prices. In line with this, the
marginal productivity theory was based on some unrealistic assumptions which include: the
unit of factor service are homogenous and that factors
fac are perfect substitutes
tes for each other.
Other assumptions are perfect mobility of factors, existence of perfect competition in both the
factor market and the product market and full employment of factors.
For a competitive firm that targets optimal production, marginal productivity
tivity theory indicates
that all factor inputs will receive a price equal to the value of their marginal products.It
products.
emphasized the structure of production and viewed the value of inputs as being based on the
prospective value of the outputs they produce. In other words, the value of inputs depends
depen
upon the marginal output it could help to produce.
Afterward, J.B.Clark gave a production exhaustion theorem in which he explained how the
total product of an economy can be fully distributed among the factors in an economy. This
theorem was based on the assumptions of two factors in which one is allowed to vary while
the other is fixed. The total product is produced by the rate of combining these factors. The
price paid to each will then depend on the total produ
product
ct which will be distributed among the
factors.
What does the marginal productivity theory states?
Marginal productivity theory indicates that all factor inputs will receive a price
equal to the value of their marginal products. They emphasized the structure of production
17
and viewed the value of inputs as being based on the prospective value of the outputs they
produce. In other words, the value of inputs depends upon the marginal output they could
help to produce.
2.3 Determination of Profit

The emergence of profit in a market or an economy depends on the recognition assigned to
entrepreneur as a factor of production. In this regards, profit is the residue left to the
entrepreneur after he has made payments for all factor services used by him in the process of
production. These payments include remunerations for land, labour and capital.
However, the peculiar nature of profit gave room to distinct meanings given to it by
economists. The early classical economists assigned the reward “profit” to capital but the
combination of the meaning of profit and interest as they are known today, are inherent in
their meaning of profit. They accrued profit to the capitalist who not only owned the business
but also make capital available. Hence, the roles of entrepreneur and capitalist were
combined.
Moreso, J.B Clark, J.A Schumpeter and F.H Knight saw profit as an income that arises out of
change, uncertainty and friction inherent in a dynamic world. These three economists realized
that the peculiar nature of profit does not permit the use of marginal productivity theory in its
determination but other relevant theories. In essence, they introduced different relevant
theories of profit.
In 1900, J. B Clark used the dynamic theory of profit to explain the nature and behaviour of
profit. This he based on the assumption of dynamic state in which some unavoidable
structural changes could lead to profit making. He identified five of such dynamic changes
which are: changes in population, structure of capital, production techniques, forms of
business organization and consumer’s wants. Nevertheless in a static state, J.B.Clark, on one
hand took payments to the entrepreneur as wages and on the other hand took profit as a
residual remaining after all the inputs used by a firm are paid a price equal to their op-
portunity cost.
18
F.H. Knight used the uncertainty
uncertainty-risk bearing theory to explain the nature of profit. Under
this, profit is regarded as the reward for bearing non
non-insurable
insurable risks and uncertainties. By
non-insurablee risks and uncertainties, he referred to certain risks whose probability of
occurrence cannot be statistically calculated due to uncertainties in them. These uncertainties
could be changes in prices, demand or supply.
Furthermore,
more, J.A.Schumpeter used the innovation theory in which he attributed profit to
dynamic changes resulting from an innovation. To him, profit emerges whenever any
innovation, which tends to reduce the cost of production of the commodity below its selling
price, is introduced by an entr
entrepreneur.
epreneur. However, the profit may be temporary if other
entrepreneurs follow this new innovation.
Contrary to the above theories, F.Y. Edgeworth and few others based the determination of
profit on marginal revenue productivity. According to this, the higher
higher the marginal revenue,
the higher the profits accruable to the entrepreneur and vice versa.
Why is the marginal productivity theory related to profit determination?
F.Y. Edgeworth and few others based the determination of profit on marginal
revenue productivity.
oductivity. According to this, the higher the marginal revenue, the higher the
profits accruable to the entrepreneur and vice versa.
2.4 Existence and Determination of Interest

The nature of interest as the return to capital is distin
distinct and there are divergent
gent views to its
meaning. To the economists in general, interest is the payment for the use of capital or it is
the reward received for parting with capital. To the classical economists, it is the reward for
abstinence which can be in form of postponing present
present consumption or saving. The Austrians
saw interest as the premium for time preference which explains the difference between the
present utility and future utility of a particular commodity. Lastly, to the
19
neoclassicaleconomists, interest is the price of credit which is determined by the demand and
supply for loanable funds.
The existence and determinationof interest brought up some questions which makes the
marginal productivity theory insufficient in answering these questions. More so, the marginal
productivity theory concluded with the concept of product exhaustion which states that all
products’ revenue be received by the factors of production. With this concept, where then
does interest flow from if capital has already received the value of land and labour which
were previously used to create the capital. Furthermore, unlike profit, interest might not
disappear in the long run but might continue to linger. Hence, the marginal productivity
theory’s assumptions and postulations do not hold for the return on capital.
Some relevant theories were however brought up to explain the determination of interest.
Few theorists explained the time-preference theory of the interest rate which tried to explain
the origin or the existence of interest and not the interest rate at any given moment in time.
One of such writers was Böhm-Bawerk whose analysis was on the theory of interest. To him,
the payment of interest was clearly linked to capital which had a distinct time element to it.
Answering the question why did capital earn interest?Böhm-Bawerk’s said that interest
originates from the fact of human time preference in which he pointed out that Human value
the present more than the future. In order to get people to wait for output in the future, they
require additional compensation when that output arrives.
Likewise, Irvin Fisher pointed out the fact that individuals prefer present goods or income to
an equal amount of future goods or income. As such he saw interest as the price that is paid to
the people for present income rather than the future income. This interest is determined by the
rate of marginal time preference and marginal return over cost.
Furthermore, Knut Wicksell gave a distinction between the natural rate and the market rate of
interest. He explained the natural rate of interest as that at which the demand for loan capital
and the supply of savings exactly agree while the market rate is that rate of interest that
depends upon the demand and supply of money. To him, the natural rate is determined by the
demand for loan which in turn depends on expected profitability of new investment.
20
Why is the marginal productivity theory insufficient as determinant of interest?
The marginal productivity theory concluded with the concept of product

exhaustion which states that all products’ revenue be received by the factors of production.
With this concept, where does interest flows from if capital has already received the value of
land and labour which were previo
previously used to create the capital?

In this study session, we have studied more applications of the marginal analysis tool by the
supporters of the first marginalists. The tool when applied to the theory of production and
distribution brought up the marginal productivity theory which was majorly applicable in
determining the returns to land and llabour but insufficient in analysing
ing the returns to capital
and entrepreneur for which other relevant theories were brought up.
Self-Assessment
Now that you have completed this study session, you can assess how well you have achieved
its Learning Outcomes by answering these questions. Write your answers in your Study Di
Diary
SAQ 2.1: In what ways has the marginal productivity theory of distribution helped in
factor pricing?
SAQ 2.2: There are divergent views on the meaning of interest. Explain these views
Multiple Choice Questions

1. Who among the following wrote on interest determination?
21
A) F. H. Knight
B) F. Y. Edgeworth
C) Knut Wicksell
D) J. B. Clark
2. The use of marginal productivity theory by the marginalists was applied to which side
of factor pricing
A) Both demand and supply side
B) Demand side only
C) Supply side only
D) None of the above
3. The existence and determination interest brought up questions which make the
marginal productivity theory insufficient
A) True
B) False
C) Neither A nor B
D) Both A and B
4. Which theory did J.B. Clark used in 1900 to explain the nature and behaviour of profit
A) Innovation theory
B) Dynamic theory of profit
C) Uncertainty-risk bearing theory
D) Theory of productivity
5. The theory used by F. H. Knight to explain the nature of profit is known as ____.
A) Innovation theory
B) Dynamic theory of profit
C) Theory of productivity
D) Uncertainty-risk bearing theory
22
References
Bhatia, H.L. (2006), History of Economic Thought, 4th ed. New Delhi: Tata Mcgrow
Mcgrow-Hill
Jhingan, M. L. (1999).Microeconomic
Microeconomic theory.Revised Edition.Vrinda
inda Publications Limited.

Samuel W.J, Biddle J.E & Davis J.B (Ed

(Eds.) (2003).A
A companion to the history of economic
thought.London: Blackwell publishing.

Landreth, C. and D. C. Colander (2001).
(2 History of economic thought:
Samuel W.J, Biddle J.E & Davis J.B (Ed

(Eds) (2003).A
A companion to the history of economic
thought.London: Blackwell publishing.
your e-tutor
tutor via the LMS.
e or phone on:
08033366677
23
Study Session 3: THE MARSHALLIAN METHOD OF
NEOCLASSICAL ECONOMICS
Introduction
Among the various contributions by different economic thinkers in their time,
me, those of Alfred
Marshall (1842 -1924) were very relevant. Alfred Marshal was a mathematician and an
historian who later developed interest in economics and then acquired knowledge in this line.
He was claimed to have been the forerunner of the neoclassical school of thought. This was
because he borrowed
rrowed majorly from the ideas of the classical economists and thereby merged
the old and new doctrines which formed the basis of neoclassical ideas. His work of
analytical framework cuts across nearly all of the present day partial microeconomic theory
as well as in formulating economic policies.
Therefore, in this study session, the analysis of Marshallian version of the neoclassical
economics will be studied. He built some analytical tools applicable to relevant economic
theories. His methods are presented
presented as they relate to the theory of demand which he based on
the cardinal measurement of utility and from which he drew out the concept of consumer
surplus.
rplus. His works also extend to taxes and welfare, supply and distribution, stable and
unstable equilibrium, economic fluctuations
fluctuations, money and prices.

3.1 Identify Alfred Marshal’s methods of economic analysis
3.2 Explain his analysis on demand and consumer
co surplus
3.3 Discuss his analysis on taxes and welfare
3.4 Explain his analysis on supply and distribution
3.5 Describe his analysis on stable and unstable equilibrium
3.6 Explain his analysis on economic fluctuations, money and prices
24
3.1 The Marshallian Method
Alfred Marshall (1842 -1924)was an English economist whose work on marginal analysis
was influenced by the writings of Cournot and Von Thunen whom he acknowledged. In his
methodology, he recognized the realities that are inherent in economic phenomena and hence
he based majority of his works on abstractions in which he combined facts with theories. He
believed that economic is majorly centred on the efficient and effective allocation of
resources to improve the welfare of all citizens especially the poor and this made him focus
his works on that aspect that would benefit humanity. Therefore, he blended his knowledge of
mathematics, history, humanity, ethics and metaphysics together and combined it with a new
area of interest, political economic. He applied all these approaches with the belief that each
will make its peculiar influence on better understanding of the workings of the economy.
Majority of his views were expressed verbally and further supported mathematically through
footnotes and appendices.
He was able to form some theories which were masterpiece in providing explanations to
economic life. His analysis of partial equilibrium was based on his belief of ‘a small bit at a
time’ in which he emphasized the study of individual actions within the framework of
totality. This he did by first analysing a part of the whole and then putting the parts together
to work as a whole. Part of this is the fact that he recognized the complexity, numerousness,
interdependence and variability of economic variables and he also took cognizance of time
horizons. In line with the time element, he introduced the concept of stationary state in which
the whole economy changes in terms of its various components. Here, things are changing at
individual levels or microeconomic angle but the general level or macroeconomic angle
remain constant. The logic here is that the changes are pre-estimated on the basis of the initial
performance or position of the component variables. Like Karl Marx, he used the stationary
state to elucidate some of the complex economic problems.
Reviewing the work of W.S. Jevon, who gave an admirable introduction of margin, Marshall
fine-tuned ‘the margin’ concept while identifying its relevant role as a reliable indicator that
25
shows the actions of an economic unit under different circumstances or conditions. He further
discovered and gave the fullest and most accurate exposition of the marginal principles which
he believed to be highly potent in solving economic problems. As a result of this, he used the
concept of margin in profit maximization where marginal cost equals marginal revenue. On
marginal productivity theory of distribution, he applied the principle ‘we must go to the
margin to study the action of those forces which govern the value of the whole’. Hence, he
used incremental analysis on returns to factors of production.
What are the major thing

things you can say about Alfred Marshall’s methodology?
He based majority of his works on abstractions in which he combined facts with

theories. Also, majority of his views were expressed verbally which he further supported
mathematically through footnotes and appendices.
3.2 Demand and Consumer’s Surplus

Marshall’s theory of demand is based on the law of diminishing marginal utility. As you have
studied in study session 1, you should note that the underlying assumptions by the
neoclassical economists on utility analysis also formed the basis for this theory of demand.
Marshall pointed out the link between utility and demand. According to him, individuals
desire commodities because of the utility received through consumption and that consumers
choose commodities in a descending order of their utilities. Hence, he defined total utility as
the sum total of utilities derived from different amo
amounts
unts of a particular commodity consumed
while marginal utility is the addition to total utility as a result of consuming additional
amount of that particular commodity.
In line with this, as more and more of a particular commodity is consumed, the addition to
total utility increases at a decreasing rate. This is refe
referred
red to as the law of diminishing
marginal utility. He reasoned that since higher utility is attached to lesser units of a particular
26
commodity, then diminishing marginal utility means that a consumer will buy more unit of
that commodity only when its price falls. This explains the theory of demand in which he
defined demand for a commodity as its quantity which consumers are willing and able to buy
at various prices during a given period of time. While the law explains the direction in which
quantity demanded changes with a change in price. The law of demand basically states that
the amount of goods demanded increases with a fall in price, and decreases with a rise in
price. This statement gives an inverse relationship between price and quantity demanded and
when expressed geometrically gives a downward sloping demand curve.
Alfred Marshal later introduced the concept of consumer’s surplus in 1895 which was based
on the theory of demand. This concept crops up anytime a consumer buys a commodity
whose price is low relative to the usefulness or importance of such commodity. According to
Marshal, the consumer’s surplus is the excess of price which the consumer would be willing
to pay rather than go without the goods, over that which he actually paid. It is an economic
measure of surplus satisfaction. He applied this concept to solving the problem of social
welfare.
3.3 Taxes and Welfare

The contributions of Alfred Marshall from the onset were humanly oriented in the sense that
he worked towards economic analysis that would bear positive fruits to humanity. On this
account, he brought up the possibilities of equitable distribution of income through taxation
and subsidies. By this, he used the concepts of consumer’s and producer’s surplus through
which he suggested taxing industries with decreasing return to scale while subsidizing
industries with increasing return to scale. He also viewed a personalized expenditure tax as
ideal.
3.4 Supply and distribution

The supply of goods and services as discussed by Marshall depends on some relevant
variables which will not only determine the price but also the volume supplied. In essence,
the concept of supply is closely linked with the level of production which in turn is
determined by the availability and the efficiency of factors of production. He recognized the
27
relevant roles of the agents of production as well as the factors of production whose usages
impact greatly on the cost of production.
The supply of land depends on the stock gifted by nature. However, its efficient use and
productivity can be enhanced or marred by man’s efforts. Linking supply with distribution,
he advocated that every agent or factor of production tends to be applied in production as far
as they are profitable. This determined the rate at which factors are paid signifying the cost of
production. Here, the principle of equi-marginal returns applied which guides the users of
factors of production in the choice of input.
He identified the concept of supply price as the price that is required to call forth the exertion
necessary for producing any given amount of commodity. He also identified the supply price
of labour as the wage rate at which a certain supply of labour will be called forth. In other
words, the average earnings of labour play a vital role in the supply of labour. The supply
price of land depends on the fruitful or faulty use to which land is put. This drives home the
fact that the proportionate combination of productive agents will yield productive efficiency.
Hence, the disproportionate combination of labour and capital to a given land will lead to the
law of diminishing returns.
3.5 Stable and Unstable Equilibrium

Equilibrium literarily means equal balance and generally, economic variables can be said to
be in a state of equilibrium when there is agreement among such variables and no tendency of
change. Stable equilibrium describes the situation where any little disturbance in an
equilibrium position eventually adjusts itself back to the former position. Stable equilibrium
can be static or dynamic. It is static when counteracting force reaches a state of rest from
which there is no tendency of moving away from it. It is dynamic when equilibrium position
keeps changing to another new equilibrium position. On the other hand, unstable equilibrium
is when any disturbance in equilibrium position causes changes that push the position farther
apart never to be restored.
In analysing market forces, Alfred Marshall regarded quantity as the independent variable
while price is the dependence variable for both demand and supply functions. As a result of
28
this, it is majorly the quantity adjustment that bring
brings about equilibrium. In his words,
word “if at a
given quantity, demand price exceeds supply price, “then sellers will bring larger quantity to
the market”. Also,“if
if at another quantity, the supply price exceeds the demand price, the
sellers would bring smaller quantity to the market
market”.. With these two situations, the response oof
quantity supplied to the demand price and supply price tends to bring about equilibrium. In
essence, the first situation would make sellers to increase quantity supplied towards the
equilibrium quantity while the second situation would cause them to redu
reduce
ce quantity supplied
and make it tends back to the equilibrium quantity.
The position of equilibrium in this previous explanation is stable in that any displacement
from the equilibrium position will stimulate market forces that would push it back to the
former equilibrium position. However, unstable equilibrium ccan
an arise if the supply curve
slopes downward rather than upward and if the price is taken as the independent variable
rather than Marshall’s proposition of quantity being the independent variable. In this case,
any displacement of price will push it ffurther from the equilibrium price.
What can lead to unstable equilibrium in the Marshallian demand and supply
analysis?
Unstable equilibrium can arise if the supply curve slopes

lopes downward like the
demand curve and if the price is taken as the independent variable.
3.6 Economic fluctuations, M

Money and Prices
J.S.Mill, Marshall recognized the existence of fluctuations in economic activity, but still
followed Say’s
ay’s law and believed in stability of th
thee economy. This prompted him to write on
economic stability or instability and the forces that determine the general level of prices.
Along this line, he studied the influence of monetary forces on the general level of prices. He
joined his colleagues and put forward a different version of the quantity theory of money. In
29
this theory, he argued that people normally want to holdd part of their wealth in the fform of
money and that people’s demand for money is related to their individual’s income. This he
pointed out in his supplementary publication of money, credit and commerce in 1923.
More so, like
ike other business cycle theorists, he posited that seasonal and business cycle
fluctuations do occur in economic activities
activities,hence,, an economy could go through periods
pe of
boom and depression. He further suggested that public policies could address the problem of
depression and unemployment.

In this
is study session, we looked at the Marshallian version of the neoclassical economics
analysis.
is. His analytical tools that were applicable to relevant economic theories were studied.
His methods were presented as they relate to the theory of demand which he based on the
cardinal measurement of utility and from which he drew out the concept of consumer
cons surplus.
We also looked at the extension of his work towards taxes and welfare, supply and
distribution, stable and unstable equilibrium aass well as economic fluctuations,
fluctuations money and
prices.
Self-Assessment
and discuss them with your Tutor at the next Study Support Meeting. You can check yyour
SAQ 3.1: Highlight the major areas in economic theories where Alfred Marshall’s
contributions are remarkable?
SAQ 3:2: Differentiate between stable and unstable equilibrium
30
1. These reasons explain why Alfred Marshall was referred to as the forerunner of the
Neoclassical school except?
A) He borrowed ideas from the classical economists
B) He merged the old and new doctrines together
C) He reviewed the work of Stanley Jevon
D) He adopted and modified classical’s tradition
2. Von Thunen and Cournot are:

A) Marshall’s teachers
B) Marshall’s students
C) Marshall’s predecessors
D) Marshall’s friends
3. Marshal’s concept of consumer’s surplus was based on the _________.

A) theory of surplus labour
B) theory of supply
C) theory of demand
D) theory of production
4. The disproportionate combination of labour and capital to a given land will lead to
_________.
A) law of diminishing returns
B) law of diminishing marginal utility
C) indifference curve
D) law of supply
5. In discussing welfare, Marshal brought up the possibilities of equitable distribution of

income through ____________.
31
A) demand and supply
B) taxation and subsidies
C) savings and investments
D) grants and loans
References
Bhatia, H.L. (2006), History of Economic Thought, 4th ed. New Delhi: Tata Mcgraw-Hill
Jhingan, M. L. (1999) Microeconomic tTheory.Revised Edition.India: Vrinda Publications

Limited.
Landreth, C. and D. C. Colander, (2001). History of Economic Thought: Fourth Edition.

Ogunmuyiwa, M. S (1997) Economic thought: history, analysis and evaluation.Ijebu Ode:

Lucky Odoni Press
Samuel W.J, Biddle J.E & Davis J.B (Ed) (2003), A companion to the history of economic
thought. London: Blackwell publishing.

Bhatia, H.L. (2006), History of Economic Thought, 4th ed.New Delhi: Tata Mcgrow-Hill
Landreth, C. and D. C. Colander (2001). History of Economic Thought: Fourth Edition.


Lucky Odoni Press
32
Should you require more explanation on this study session, please ddo
o not hesitate to contact
your e-tutor
tutor via the LMS.
contact the DLI IAG Center by e-mail or phone on:
08033366677
33
Study Session 4: LEON WALRAS & GENERAL
EQUILIBRIUM THEORY
Introduction
Leon Walras,
alras, born in 1834 in France, was
was a widely celebrated economist and
econometrician.He was
as the first to ffind
d the basis of modern economic analysis by formulating
a multi-equation
equation general equilibrium model of economic relationships for the first time in
economic history of the general equilibrium analysis. This study session will take you
through the brief biography of Leon Walras. It will further presen
presentt a discussion on the general
equilibrium theory and the early proponents that inspired Leon Walras in his formulation of
the theory. It also presents a comparison between the partial and general equilibrium analysis.
Learning Outcomes
At the end of this study session, learners should be able to:
1. Define and use correctly, the key words printed in bold.
2. List
ist some milestones from the life and works of Leon Walras
3. Define the concept of general equilibrium theory
4. Differentiate between partial and general equilibrium model
4.1 Biography of Leon Walras

Leon Walras whose full name was Marie Esprit Leon Walras was born in Evreux, France and
lived between 1834 and 1910. Walras spent more than half of his adult life in Switzerland; he
however retained his France citizenship. Walras father, AugusteWalras, encouraged his son
to pursue a career in economics with emphasis on mathematics. After spending his youth in
several careers, student at School of Mines, journalist, novelist, a railway clerk, bank director
and art
rt critic among others, Walras eventually returned to the study and teaching of
economics in the Academy (now University) of Lausanne in Switzerland.
34
Walras followed his father’s socialist policy positions on taxation, land reform and
subjectivistt theory of value and mathematiz
mathematization
ation of economics. He was in fact a proponent of
outright land nationalization. He maintained that land rents represented unearned income and
should therefore accrue to the government. Walras socialist views were later extended
exte by
theorists in the 1930s and beyond in what is today referred to as socialism
socialism-capitalism
capitalism debate.
Separately but almost around the same time with two other marginal economist, Stanley
Jevons and Carl Menger, Walras developed the idea of marginal utili
utility
ty and he is thus
considered as one of the founders of the marginal revolution. His work on marginalism was
in many ways more sophisticated than that of Jevons and Menger, but, the dominant thinking
in economics at the time was in Britain, and Walras writi
writings
ngs in French, it did not have the
same impact. The biggest contribution by Walras was in what is now called general
equilibrium theory. According to Walras, general equilibrium meant two things. First, that
demand and supply are equilibrated in all markets
market (market equilibrium) and secondly, that all
economic agents maximize their satisfaction under given incomes (subjective equilibrium).
equilibrium)
Before Walras, economists had made little attempt to show how a whole economy with many
commodities
ies fit together and reachequilibrium.
rea equilibrium. Walras goal was to present this. Although he
did not succeed, but he took major steps and these steps were the first attempts. First, he built
a system of simultaneous equations to describe a hypothetical economy, and then shows that
because the number of equations equalled the number of unknowns, the system could be
solved to give the equilibrium prices and quantities.
What were Walras major contributions to the field of Economics?
Application of Mathematics to Economics and the General

Genera
Equilibrium Theory.
35
4.2 Definition of General Equilibrium Theory
General equilibrium is the analysis of the economy in which all sectors are considered
simultaneously. General equilibrium analysis addresses precisely how vast numbers of
individual and seemingly
emingly separate economic decisions, balances supply and demand, and
leads to an efficient allocation of goods and services in the economy. General
eneral equilibrium
theory attempts to explain the behaviour
behavio r of supply, demand, and prices in a whole economy
with several
everal or many interacting markets, by seeking to prove that a set of prices exists that
will result in an overall equilibrium.
The interrelationship of the sectors of the economy is relatively simple to conceptualize, but
it is an extremely complicated id
idea
ea to formally document. Walras first contribution was to
formally model the general equilibrium system mathematically. However, Walras was aware
that the mere fact that such a system of equations coul
could
d be solved mathematically for
equilibrium did not mean that in the real world it would ever reach that equilibrium. Hence,
Walras second major step was to simulate an artificial market process that would get the
system to equilibrium, a process he referred to as ““tatonnement” or groping.
Equilibrium is an ideal
al and not a real state. It never happens in the real world that the
effective demand and supply of products or services are absolutely equal. However,
equilibrium is a normal state, a state towards which things spontaneously tend under a regime
of free competition
mpetition in exchange and in production.
Define the General Equilibrium
General Equilibrium is the analysis of the behavio

behaviour of supply,
demand, and prices in a whole economy with several or many interacting
markets.
36
4.3 Partial Versus General Equilibrium Analysis
The essence of most economic models and theories is to give abstracts of world phenomena.
Hence, some elements are held constant so that they will not influence the behaviour of the
variables of the model. Economists often distinguish between partial and general equilibrium
models in terms of the degree of abstraction in the model. In partial equilibrium analysis,
more factors are held constant than in the general equilibrium analysis.
Partial equilibrium is a condition of economic equilibrium which takes into consideration
only part of the market to attain equilibrium. It is an examination of equilibrium and changes
in equilibrium in one market in isolation. Partial equilibrium analysis allows only a small
number of variables to vary with all others held constant. By holding fixed or excluding the
possibility of changes in variables or activities from other markets or economic sector, partial
equilibrium analysis ignores the possibility that events in the market or sector of interest
affects other markets equilibrium.
On the other hand, general equilibrium analysis studied how equilibrium is determined in all
markets simultaneously. Events in one market may have effect on other markets, through
demand or supply, because output in a market is an input to another market. General
equilibrium analysis allows as many variables to change as possible. It does not allow all
variables to change and influence the model, however, it is restricted only to those regarded
as being within the scope of economics. For example, general equilibrium model assume as
given, the tastes and preferences of individuals, the technology available in producing goods,
the institutional structure of the economy and society. A mathematical general equilibrium
model becomes feasible because the scope of economics as a social science has historically
been limited by orthodox theory to variables that appear to be quantifiable.
Following the tradition of Alfred Marshal, most partial equilibrium models limit themselves
to the analysis of a particular household, firm, or industry. Assuming we want to analyse the
influence of corn prices of a reduction in production costs in the corn industry. Following the
partial equilibrium approach, the starting point is that the industry in the assumed equilibrium
position disturbs the equilibrium by reduction in cost, and then we deduce the new position of
equilibrium. During the analysis, all other forces in the economy are assumed to be fixed and
37
that they have no influence on the corn industry. The reduction in production costs in the corn
industry would result in an increase in the supply and the price of corn falling to a new
equilibrium level.
Now suppose we further make our model less restrictive and include in our analysis both the
corn and soybean industries (by assuming both goods are substitutes). The immediate effect
of lower costs of production on the corn industry is to lower corn prices as the supply of corn
increases. However, the decrease in price of corn will also influence the demand for soybean.
As corn prices fall relative to soybean prices, the demand for soybean will decrease as the
quantity of corn demanded increases; consumers will substitute soybean for corn. The
decrease in demand for soybean will result in a fall in price of soybean, which will result in a
decrease in the demand for corn and a further fall in its price. The interaction between the
prices and demand of these two commodities will continue, with a resulting change in prices
and outputs becoming smaller and smaller, until new equilibrium conditions are established
in both industries.
To further explain the partial equilibrium model of the behaviour of prices, demand and
supply of the corn and soybean industries, a simple graph can be plotted to depict the
consequence of a reduction in production costs in the corn industry using the demand and
supply curves. The supply curve of corn industry, following the reduction in cost, increases
by moving out to the right, and a new equilibrium emerges. Further depicting the interactions
between the corn and soybean industries, the resulting graph becomes more complex. Figure
1 depicts the shift in the supply curve of corn from S to S1 as a result of the decrease in
production costs in the corn industry. The fall in price of corn result in an immediate decrease
∗ ∗
in the demand for soybean from to which thus lowers the price of soybean. The
decreased price of soybean brings about a fall in the demand for corn from Dto . These
successive interactions between prices and demand for these two products are indicated by
continuous downward shift of demand curves until a final equilibrium is reached.
38
1: Demand and Supply Graph for Corn and Soybean
The partial equilibrium analysis, for instance of the corn and soybean industries, reflects an
attempt to reduce a more complex problem into a manageable form by isolating other sectors
or industries of the economy. However, the benefits of clarity, simplicity and analytical
neatness are achieved at the expen
expense of completeness and theoretical rigour.
r. Moving further
towards a more general equilibrium analysis by adding additional industries, say a third and a
fourth industry as in the example of corn and soybean, the analysis would become so
complex that the diagrammatical
agrammatical representation as obtained for the two industry model would
produce more confusion that clarity. Walras immense contribution was his attestation that the
complex interdependence of industries can be best understood and communicated through
mathematical representations.
4.4 Walras Analysis in Retrospect

Walras high position in the history of economic theory rests on two aspects, partly on his
independent discovery of the marginal utility theory, and
and largely on his conceptualization of
the interdependence of the sectors of a market economy. Although others before Walras had
perceived the reciprocity of households, firms, prices of final goods, prices of factors of
39
production, and quantities demanded and quantities supplied of final and intermediate goods,
no one had been able to express this perception as precisely as Walras did by stating it as a
system of simultaneous equations.
Walras started his demonstration of the general equilibrium solution by discussing two-
commodity pure exchange, where demand and supply are derived from utility-maximization.
He examined the case of the simplest economy that possessed only two goods to be
exchanged (say X and Y). All persons were assumed to be buyers of one good or sellers of
the other. On these assumptions, it could be argued that the supply of X and the demand of Y
and vice versa were interdependent because the market demand for Y (or X) was derived
from the incomes received by sellers of X (or Y). Consistent with the neoclassical procedure,
it was further assumed that the terms on which sellers were prepared to exchange were
regulated by the marginal utilities of X and Y, and through competitive bidding, an
equilibrium price ratio would be established.
Walras introduced the “tatonnement” process of reaching stability (equilibrium).
Tatonnement (otherwise referred in English to as groping) was a trial-and-error process in
which the price was called-out (fixed), and people in the market revealed how much they are
willing to demand and supply at the revealed price. If there is an excess of supply over
demand, then the price would be lowered so that less would be supplied and more would be
demanded. Thus price would grope toward equilibrium. Although highly unrealistic, Walras
assumed that no actual exchanges were made until equilibrium was reached through this
process. This proposition is known as “Walras Identity”. In other words, Walras Identity
states that the money value of all planned market purchases when added together equal the
aggregate money value of all planned market sales.
To further synthesize these aspects into the equilibrium model, Walras introduced counted
equations and unknowns to find the existence of equilibrium and considered what is referred
to as “multimarket tatonnement”. This procedure had an important recommendation in that
it emphasized the interdependence of all prices within an economic system. At the same time,
Walrasian general equilibrium dissolved the standard lines of demarcation between micro and
40
macro theory that is activities of households, firms and industries could not be understood in
isolation from one another or separated from the economy as a whole.
The Walrasian identity has two major implications – generality of equilibrium
um and states of
disequilibrium. If one of the markets in an economy is in equilibrium, then the other markets
in that economy must be in equilibrium. The implication of Walras identity when at least one
market is in disequilibrium is referred to as “Walras
“ Law”.
”. Walras law states that the sum of
excess demands over all the markets in the economy must equal zero, whether or not the
economy is in general equilibrium. This implies that if positive excess demand exists in one
market, negative excess demand mustt exist in some other market. Thus, Walras law states
that the
he sum of surplus must equal the sum of demand for all markets. Mathematically, this
can be written as:
What does the Walrasidentity

dentity state
states?
Walrasidentity
dentity states that the money value of all planned market
purchases when added together equal the aggregate money value of all planned
market sales
Define the Walras Law
41
Walras law states that the sum of excess demands over all
the markets in the economy must equal zero, whether or not the economy
is in general equilibrium

In this study session, we have learned about Leon Walras and the general equil
equilibrium
ibrium theory.
We studied his brief biography, his economic views and his contributions to the field of
economics. We further learned about the differences between the general equilibrium and
partial equilibrium analysis.
Self-Assessment
Assessment Questions for Study
Stud Session 4
and discuss them with your Tutor at the next Study Support Meeting.
Meeting. You can check your
SAQ 4.1: Present a brief biography of Leon Walras and state some of his contributions
to Economics.
SAQ 4.2: Explain the partial equilibrium analysis using a hypothetical example.

1. Leon Walras called his famous process in which the economy finds its way to a
general equilibrium through a process of trial and error.
A) Market titration
B) Retrograde contracting
C) Contango
D) Tatonement
2. Leon Walras believed that a solution to the economic sy system

stem was possible if
thenumber
number of behavioural equations was ____ the number of unknowns.
42
A) greater than
B) equal to
C) less than
D) sometimes it’s hard to come up with four answers
3. Whereas Alfred Marshall advocated _______ analysis, Leon Walras advocated

_______ analysis
A) partial equilibrium, general equilibrium

B) general equilibrium, partial equilibrium
C) disequilibrium, continuous equilibrium
D) unconditional rational equilibrium, bounded rational equilibrium
4. The proposition which states that money value of all planned market purchases when
added together equal aggregate value of all planned market sales is ________.
A) Walras identity
B) Walras law
C) Say’s law
D) Law of demand
5. ________ states that the sum of excess demands over all the markets in the economy
must equal zero.
A) Walras identity
B) Walras law
C) Consumer’s surplus
D) Law of demand
References
Bhatia, H.L. (2006), History of economic thought, 4th ed.New Delhi: Tata Mcgraw-Hill
Hutchison, T. W. A (1953) “Review of economic doctrines”, 1870-1929. Oxford: Clarendon

Press.
Jaff, William (1969). “Thebirth of Leon Walras’ elements.” History of Political Economy, 1
(Spring).
Landreth, C. and D. C. Colander (2001). History of economic thought: Fourth Edition.

43
Schumpeter, Joseph A (1951). “Marie Esprit Leon Walras.”In Ten Great Economists. New
York: Oxford University Press.
Walras, Léon (1954). Elements of pure economics. Homewood,, 111.: Richard D. Irwin

Bhatia, H.L. (2006), History of Economic Thought, 4th ed.New
ed. Delhi:: Tata Mcgraw-Hill.
Mcgraw
Jhingan, M. L., Girija, M. and Sasikala, L. hought, 3rd Edition.

L (2003). History of economic thought,
Delhi: Virinda
da Publications (P) Ltd.

your e-tutor
tutor via the LMS.
Are you in need of General Help as regards your studie

studies?
s? Do not hesitate to
e or phone on:
08033366677
44
Study Session 5: INSTITUTIONAL SCHOOL OF
ECONOMIC THOUGHT
Introduction
The neoclassical economics was not without some controversies and critics. Institutional
economic is much better known as a critique of conventional economic theory than as a
system of analysis in its own right. Institutionalism continues to be regarded as a collection of
unconnected ideas and doctrines providing an impressionistic definition of an ever-changing
ever
economic system. This study session discusses the
theinstitutionalist
institutionalist views and their criticism of
the neoclassical theory. It is not easy to decide which writers to include.
include. However, emphasis
is placed on Thorstein Veblen and Mitchell Clair, both selected among the American writers
of the early twentieth century because of their acknowledged influence on subsequent
thoughts.
Learning Outcomes
1. Define the institutional
onal school of economic thought.
2. Identify the factors that distinguish the institutional school of thought
thoug from the
conventional school.
3. Explain Veblen’s criticism
iticism of neoclassical thought.
4. Define
ne the Veblenian Dichotomy
5. Explain the contributions of Wesley C. Mitchell
5.1 Institutional School of Economic Thought: Defined

The difficulty in having a unique definition of institutional economics is the uncertainty of
the meaning of an institution. Sometimes an institution seems to mean a framework of laws
or natural rights within which individuals act like inmates. Sometimes it seems to mean the
45
behaviour of the inmates themselves. Sometimes anything added to or critical of the classical
or hedonic economics is deemed to be institutional. Sometimes anything that is "economic
behaviour" is institutional. Sometimes anything that is "dynamic" instead of "static," or a
"process" instead of “commodities”, or “activity” instead of “feelings”, or “mass action”
instead of “individual action”, or “management” instead of “equilibrium”, or “control”
instead of “laissez faire”, seem to be institutional economics. All of these notions are
doubtless involved in institutional economics, but they may be said to be metaphors or
descriptions. Institutional economics focuses on understanding the role of man-made
institutions in shaping economic behaviour. It is concerned with the social systems, or
institutions, that constrain the use and exchange of resources and their consequences on
economic performance.
One important distinguishing feature of the institutional school of economic thought is that it
is a collection of connected ideas with no common or unique framework of analysis.
However, institutional economics is not distinguished from other schools of economic
thought and analysis by mere absence of a common analytical framework, but by the
presence of at least disinterest in a systematic and orderly representation of ideas and theories
and this have benefited institutionalism as an open system of thought, capable of assimilation
of new empirical developments and modes of thinking.
Three important factors distinguish institutional economics from conventional economic
thoughts and these are:
1. A primary interest in economic and cultural change under the combined impact of
technology and investment for profit.
2. A refusal to distinguish between economic analysis using the normative notion of
what is economic and non-economic.
3. A critical attitude towards the perceived hidden biases and preconceptions of pure
economic theory.
To express it more precisely, institutional economist perceived the economy and the
economic process as part of social structure in functional relationships with each other.
Institutionalism plays an active role as agents of economic development and change.
46
Contrary to the support for the thesis of an inevitable stagnation and maintenance of the
status quo, institutional thought regards process and structural change as the key ca
categories of
all social analysis.
Define the Institutional school of thought
Institutional school of economic thought focuses on

understanding of the role of man-made
man social institutions in shaping
economic behaviour.
5.2 Thorsten Veblen

ThorsteinBunde Veblen (1857-1929)
1929) was an American economist and he was regarded as the
leader of institutional economist movement. His disagreement from orthodox theory greatly
influenced the development of heterodox thinking in the United States. Veblen is credited for
the main technical principle employed by institutional economist known as the “Veblenian
Dichotomy”,aa distinction between what he referred to as institutions and technology. His
popular and witty criticisms of classical and neoclassical approaches were contained
throughout his works. He felt that both the classical and neoclassical approaches were
unscientific.
Veblen combined sociology with economics in his masterpiece titled “The
“The Theory of Leisure
Class (1899)”” where it was argues that there was a fundamental split in society between those
who make their way via exploitation and those who make their way via industry. Veblen was
sympathetic to state ownership of industry; however, he did not support labour movements of
the time. His viewss on socialism and the nature of the evolutionary process of economics
differed sharply from that of Karl Marx. While Marx saw socialism as the final political
precursor to communism, or the ultimate goal for civilization, and believed that the working
class
ss would be the group to establish it, Veblen saw socialism as one intermediate phase in an
47
on-going
going evolutionary process in society that would be brought about by the natural decay of
the business enterprise system.
What is Veblenian Dichotomy?
Veblenian
ian dichotomy is a technical principle used to distinguish between
institutions and technology.
5.3 The Concept of Conspicuous Consumption

The term “conspicuous consumption” was introduced in the 19th century by Thorstein Veblen
in his popular book “Theory of Leisure Class”. The concept was used to describe the
behavioural characteristics of the “new rich” social class who emerged as a result of the
accumulation of capital wealth during the industrial revolution that lasted between 1860 and
1914. Veblen usedd the term to describe the men, women and families of the upper class who
applied their great wealth as a means of public manifestations of their social power and
prestige. Conspicuous
onspicuous consumption denotes the act of buying many things,
thing especially
expensive things that are not necessary to one’s life, done in a way that will make people
notice the purchases.
In the 20th century, there
re was significant improvement in the material standard of living of a
society, and the consequent emergence of the middle class,
clas who also broadly applied the term
“conspicuous consumption” to the men, women, and households who possessed the
discretionary income that allowed them to practice the patterns of economic consumption —
of goods and services — which were motivated by the desire for prestige, the public display
of social status, rather than by the intrinsic, practical utility
utility of the goods and the services
proper. Also in the 1920s, economists proposed that changes in the style of life, made feasible
by the economics of the industrial age, had induced to the mass of society “philosophy of
futility” that is an increase in the consumption of goods and services as a social fashion; an
48
activity done for its own sake and desire for the immediate gratification of hedonic
expectations, rather than for the value and utility derived from the consumption of such goods
and services.
5.4 Criticism of Neoclassical Theory

Veblen criticisms of the neoclassical theory could be summarized as follows:
1. Veblen felt that orthodox theories (both classical and neoclassical approaches) were
unscientific. He also criticised prior heterodox thinking (historical school and
Marxian economics) on the same grounds that they are deficient because their
assumptions and preconceptions were unscientific.
2. Veblen suggested that orthodox economists in their focus on price theory do not only
study the formation of prices and resource allocation but also investigate the very
variables they held constant (for example, tastes and preference, technology and
organizational structure).
3. Orthodox theories assume that in competitive markets, the self-interest of the business
person corresponds to the society’s interests. Veblen maintained on the contrary that it
was obvious to all economists that producing goods and making profits were two
distinct things. He was delighted to cite examples that general societal interest is
damaged by the pursuit of individual profit.
4. Orthodox economic theory was also culpable in ignoring developments in
psychology, sociology, and anthropology, and in building model based upon
unscientific notions of human nature and behaviour. Orthodox economic theory
assumes that humans are driven by the desire to maximize gain and minimize pain.
However, the logic according to Veblen was impeccable but the assumption was
wrong.
5. Another criticism of the orthodox theory was its failure to reconcile the theory of the
economy with the facts of the economy. Hence, Veblen writings incorporate implicit
plea for more empirical works and more emphasis on inductive research.
49
Why did Veblen criticise the Orthodox and Heterodox theories?
Veblen criticises the Orthodox and Heterodox theories

heories because their assumptions
and preconceptions were unscientific.
5.5 Veblenian Dichotomy

One fundamental principle of institutional economics is that human activity is organized by
institutions. Veblenian dichotomy has been developed as an analytical tool. The Veblenian
dichotomy is a construct that facilitates an appraisal of the character an
andd import of social
change. Analytically, institutions are separated into two primary aspects: instrumental
behaviour and ceremonial customs. Each of this behaviour is a way of knowing, doing and
valuing. Both are aspects of human behaviour and both help to explain human activities.
The fundamental Veblenian distinction, a dichotomy connoting mutually exclusive paired
constructs, originates with his concept of instincts – “workmanship
workmanship and predation”
predation”. These
instinctive drives of human beings create tensions. The first one, the instinct of workmanship
(otherwise called parenthood or idle curiosity) would lead humans to produce high quality
products with great efficiency. On the other hand, the predatory (or acquisitive) instinct leads
to behaviour that would benefit
nefit individuals even though it might have deleterious
consequences in the whole of the society.
The workmanship instinct is said to support life process generally. The workmanship instinct
occupies the interest with practical expedients, ways and means, devices and apparatuses of
efficiency and economy, proficiency, creativity and technological mastery of facts, and a
proclivity of taking pains. It exhibits an unselfish solitude for the well
well-being
being of incoming
generation, with a drive seek knowledge and va
value
lue such knowledge. On the other hand, the
acquisitive instinct is regarded as contaminants of that process. It encompasses impulse to
predatory behaviour and discriminatory emulation. Practice of exploit, prowess, pecuniary
acquisition and dominance.
50
Veblen distinguishes between constructive proclivities that generate and sustain the well
well-
being of communities and the contaminating proclivities that sabotage the community’s
ability to generate materials means of life. To Veblen, institutions determine how
technologies are used. Institutions, according to Veblen, may be roughly distinguished into
two classes or categories, accordingly as they serve one or the other of two divergent of
economic life. Economic institutions are institutions of acquisition or of production. They are
pecuniary or industrial institutions. They are institutions serving either the invidious interest
(business) or the non-invidious
invidious economic interest (industry).
What are the two categories Veblen classified institutions?
Economic (or Business) institutions that serves the invidious interest and Pecuniary
(or Industrial) institutions that serves the non-invidious
non economic interests.
5.6 Wesley Clair Mitchell

Wesley Clair Mitchell (1874-1948),
1948), was an American economist popu
popularly
larly known for his
empirical work on business cycles and his pioneer role in establishing a research agency for
studying economics. He studied classics in the University of Chicago and after taking course
from Thorstein Veblen and John Dewey, he became mo
more
re interested in philosophy and
economics but finally pursued economics. Although he did not fully accept with many of
Veblen’s ideas, his economics is mainly identified with the institutional school.
Mitchel accepted and improved some of Veblen’s criticisms
criticisms of orthodox economic theory,
however with no attempt to build a complete theoretical structure in explaining the evolution
of the industrial economy. Mitchell views were expressed in a number of his essays and
majorly in his Lecture Notes on Types of Ec
Economic Theory.. Mitchell noted that Veblen’s
system had the same methodological weakness as did orthodox theory; both failed to test
either their assumptions or their conclusions satisfactorily.
51
Mitchell criticised the abstract models of orthodox theory. He argued that economic theory of
the speculative kind is as cheap and easy provided one has the gift. It also has problems in
relation to reality as do those products of imagination. Mitchell claimed that the social
sciences could develop a better explanation of the activities of humans by basing their
explanation upon empirically grounded behaviourist psychology. Therefore, he advocated a
more generalized approach to studying human behaviour that could be achieved by letting the
various branches go their own ways. Orthodox theory had incorrectly focused on normality
and equilibrium in the system instead of examining its dynamic interrelationships.
Mitchell followed Veblen’s distinction between the pecuniary and industrial employments in
his approach to the study of business cycles using. Fluctuations in economic activity can be
accounted for largely by the reactions of businesses to changing rates of profit. Since
businessmen make decisions with certain expectations and uncertainty assumptions, the
decisions will always be a reflection of either an optimistic or a pessimistic look into the
future. Mitchell argued that since fluctuations in economic activity are to be expected in
economies with developed monetary systems, therefore the conceptual framework of
orthodox theory based on normal, static and equilibrium is not appropriate. Although, he did
not build a new abstract model of business cycle, however, he tried to illustrate what happens
during the business cycle using a descriptive analysis of the cycle. He revealed the
interactions of economic forces during the various phases of depression, recovery, boom and
recession.
Others before Mitchell had seen the business cycle as a self-generating process between the
four phases, he was the first to give the conception in an explicit form and further support it
with extensive empirical data. His explanation was based on reactions of businesses to
changing levels of profits. According to him, a depression carries the seeds of the subsequent
recovery, as interest rates fall inefficient firms are eliminated from the industry, costs (both
fixed and variable) decline, inventory decrease, and so on. Also in the same vein, prosperity
or boom carries the seeds of recession or crisis and subsequent depression as costs rise, with a
consequent squeeze on profits.
52
Mitchell had a pioneer role in the establishment of the National Bureau of Economic
Research, a private, non-profit organization and research agency for studying economics in
1920. The organization has been tremendously important in financing economic research in
the United States. Although, the most important efforts of the organization have been
involved in researches related to measuring national income and business-cycle, it has also
sponsored research in nearly all areas of the economy.
5.7 John R. Commons
The second fountainhead of the institutional school of economic thought after Wesley
Mitchell is John Rogers Commons (1862-1945). Commons, from Midwestern United States
but born in Ohio, was five years younger than Veblen but twelve years older than Mitchell.
He attended Oberlin College, where he received the standard classical education of that time.
However, he did graduate work in economics at John Hopkinsuniversity, where he was
strongly influenced by Richard T. Ely. Commons left John Hopkins after two years and
taught at several places before finally moving with Ely to Wisconsin in 1904.
At the University of Wisconsin, an approach to economics, sometimes called the Wisconsin
school, was developed, largely under the influence of Commons. This approach was
important in sustaining economic heterodoxy in the United States and in initiating reforms
that have changed the structure and functioning of the American economy. During his
twenty-eight years at Wisconsin, until his retirement in 1932, Commons made significant
contributions to economics in three broad areas: social reform, graduate education, and labour
economics. Perhaps his most significant contribution was the social legislation he was
instrumental in formulating. This legislation changed the structure of the American economy.
During Commons’ years at Wisconsin (1904-1932), a relationship developed between
academics and politicians that was repeated on a national scale in the New Deal of Franklin
Roosevelt, a relationship that has become commonplace today. The state government of
Wisconsin made extensive use of the faculty at Madison as a brain trust for new ideas, as
drafters of legislation, and as members of appointed commissions. A history of Commons’
53
career at Wisconsin reveals that he spent a great deal of time helping to draft, pass, and
implement social legislation.
The year after his arrival in Madison in 1904, he drafted a civil service law for Governor La
Follette; in subsequent years he influenced social legislation in the following areas: regulation
of public utilities, industrial safety laws, workers’ compensation, child labour laws, minimum
wage laws for women, and unemployment compensation laws. The unemployment
compensation legislation was possibly Commons’ greatest achievement in social legislation.
His reaction to the depression of 1920 and his study of European unemployment
compensation programs led him to draft a bill for the Wisconsin legislature. Versions of this
bill were introduced again and again, until finally in 1932 a former student of Commons,
Harold Groves, then both a senator and a professor of economics specializing in public
finance at the university, introduced the bill that finally passed
A second contribution of Commons is related to his endeavours in the area of social reform.
The economics department of the University of Wisconsin became known as a major
graduate training centre for economists throughout the world. At one time more Ph.D.
degrees in economics were being granted by Wisconsin than by any other university. More
important, Commons’ particular approach to economics became embedded in the fabric of
the department; thus, until the 1980s, a “Wisconsin school” approach was maintained. This
legacy is in sharp contrast to that of Veblen or Mitchell, who had no lasting impact on any
graduate program.
In these efforts a discernible pattern developed. Commons would thoroughly study a
problem, often with the help of his graduate students. He would then discuss the issues with
those in the economy who would be influenced by any new legislation and get the support of
the more progressive businesses or labour leaders. After the legislation was passed,he would
travel and use other means to promote the spread of the new legislation to other states. There
is little doubt that a number of ideas that took shape in the social legislation ofthe New Deal
came from Wisconsin.
54
The third contribution of Commons was to the field of labour economics. Because Richard
Ely, Commons’ major influence, was interested in the history of the labour movement, he
began to collect documents in labour history. He wanted Commons to produce from these
materials a definitive history of labour in the United States, a work that was to occupy a good
part of Commons’ academic time at Wisconsin. Aided extensively by his graduate students,
in 1910 Commons published A Documentary History of American Industrial Society, a ten-
ten
volume collection of major documents pertaining to labo
labour history.
istory. This was followed by two
volumes in 1918 and two in 193
1935 of the four-volume History of Labourr in the United States.
Commons became a recognized authority on labo
labourr in the United States, and Wisconsin
became the leading university for producing labour
labo economists.
Finally, in describing the economic ideas of Commons, he arrived at his criticisms of the
orthodox economic theory independently and parallel of Veblen and Mitchell.
Mitchell His entire
approach to social problems rejected the narrow, static, deductive
deductive approach of neoclassical
theory. Commons tried to bring all the social sciences and law into the analysis. He viewed
society and the economy as evolving and changing and sharply objected to the almost
exclusively deductive orthodox approach, with its as
assumptions
sumptions of hedonistic agents and
a
competitive markets. Commonsfound that the implicit assumption of harmony in the
economy, on which the laissez
laissez-faire
faire policy was based, was contrary to his empirical
observations.

In this study session, we have studied the institutional critique of the neoclassical economics.
We studied the brief biography and contributions of Thorstein Veblen and Wesley Mitchell.
We also learned about their criticisms of the neoclassical economic theory.
Self-Assessment
nt Questions for Study Session 5
55
answers with the Notes on the Self-Assessment Questions at the end of this Module.
SAQ 5.1: Explain the important factors that distinguishes institutional economics from
conventional economic thoughts.
SAQ 5.2: Explain the concept of “VeblenianDichtomy”.

1.Thorstein Veblen believed that the source of economic growth was
A) entrepreneurs
B) engineers
C) intellectuals
D) the working class
2. Thorstein Veblen thought that the capitalist system should be replaced with ____.
A) a dictatorship of the proletariat
B) a technocracy
C) syndicalism
D) fascism
3. Whereas Marx thought that technological progress was likely to be ____, Veblen thought it
would be ____.
A) resource saving, resource using
B) resource using, resource saving
C) labour saving, capital saving
D) capital saving, labour saving
4. ________ is the distinction between institutions and technology.

A) Constructive proclivities
B) Veblenian dichotomy
C) Contaminating proclivities
D) Tatonnement
5. Who was the first to support analysis of business cycle with empirical data?
A) Adam Smith
56
B) David Ricardo
C) Wesley C. Mitchell
D) John M. Keynes
References
Commons, John R. (1934). Institutional economics. New York: Macmillan
Hutchison, T. W. A (1953) Review of economic doctrines, 1870-1929. Oxford: Clarendon

Press.

Mitchell, Wesley Clair (950) Thebackward art of spending money. New York: Augustus M.
Kelley
Schumpeter, Joseph A (1951). “Marie Esprit Leon Walras.”In ten great economists. New
York: Oxford University Press.
Veblen, Thorstein (1919) The Place of Science in Modern Civilization. New York: B. W
Huebsch,
--------- (1904).The Theory of Business Enterprise. New York: Charles Scribner’s Sons

Roll, E. (1950).A history of economic thought. London: Faber and Fabe
Taylor, O. H. (1960). A history of economic thought.New York: McGraw Hill Book Co.
57
your e-tutor
tutor via the LMS.
e or phone on:
08033366677
58
Study Session 6: MARXIAN SCHOOL OF ECONOMIC
THOUGHT
Introduction
Karl Heinrich Marx, a German, was not just an economist, bu
but also a philosopher, sociologist,
sociologist
historian, revolutionary socialist, and journalist. Marx writings in economics inspired
generations of economic thinkers, although sometimes opposed to each other but in many
cases Marxian analysis is used to complement oorr supplement each other and hence all
belongs to the Marxian school of economic thought. Marxian economics basically concerns
itself variously with the analysis of the crisis in capitalism, the role and distribution of
surpluses in different economic systems,
systems, the nature and origin of economic value and the
impact of class and class struggle on economic processes. The core ffocus
ocus of this study session
centress on explaining Marx’s economic theories and his critique of classical economics.
Learning Outcomes
At the end of this study session, you should be able to:
1. Differentiate between key concepts as related to
to the Marxian School of Thought
2. Explain the axioms
ioms of the Marxian System
3. Itemize and explain Marx’s economic theories.
6.1 The Life of Karl Marx

Karl Heinrich Marx (1818-1883)
1883) was born on May 5, 1818 in Prussia in the city of Trier,
Germany. His father,, Heinrich Marx was a lawyer who came from a long line of Rabbis, but
had changed his faith to Christian ((Protestantism) in order to keep his job. Karl
rl Marx went to
the University of Bonn to study law when he was 17 years old. There
ere he became engaged to
Jenny von Westphalen, whose father, Baron von Westphalen, influenced Marx to read
Romantic literature and Saint-Simonian
Simonian politics. Only a year later, Marx
Marx was moved by his
59
father to the University of Berlin where he studied Hegelianism, influenced by Ludwig
Feurbach and other Hegelians. He admired G.W.F. Hegel's dialectics and belief in historical
inevitability, but Marx questioned the idealism and abstract thought of philosophy and
maintained his belief that reality lies in the material base of economics. In distinct contrast to
G.W.F. Hegel's concentration on the state in his philosophy of law, Marx saw civil society as
the sphere to be studied in order to understand the historical development of humankind. In
1841 Marx earned his doctorate at Jena with his work on the materialism and atheism of
Greek atomists.
It was difficult for Marx to find publishers because of his radical political views, so he moved
to Cologne, which was known to house a strong liberal opposition movement. The liberal
group the Cologne Circle published a paper by Marx defending the freedom of the press in
their newspaper The Rhenish Gazette (in 1842 he was made the editor of the paper). In
Cologne, Marx met Moses Hess, a radical who organized socialist meetings, which Marx
attended. At these meetings Marx learned of the struggles of the German working-class.
Based on the information he gathered from the members present at the meetings, Marx wrote
an article on the poverty of the Mosel wine-farmers in which he was highly critical of the
government. When the article was published in 1843, the Prussian authorities banned The
Rhenish Gazette and threatened Marx with his arrest. Marx married his fiancée and they fled
together to Paris. There he took a position as editor of a political journal called Deutsch-
FranzösischeJahrbücher (Franco-German Annals) that was designed to connect French
socialism and radical Hegelianism. Although the journal only lived as long as one issue, it
was a valuable opportunity for Marx. Through it he met his life-long friend Friedrich Engels,
a contributor to the journal. Other prominent contributors included his old mentor from
Berlin, Bruno Bauer, and the Russian anarchist Michael Bakunin.
While in Paris, Marx became a communist, and worked primarily on studying political
economy and the history of the French Revolution. He wrote a series of papers known as
Economic and Philosophical Manuscripts, 1844; however they were not published until the
1930s. The manuscripts are influenced by Feuerbach and outline a humanist idea of
communism. Marx contrasts capitalist society, and an alienated nature of labour, with
60
communist society, in which human beings in cooperative production develop their nature
freely. In 1844 Marx reviewed Bruno Bauer's book On the Jewish Question. More than a
review, Marx used the article to critique the continued influence of religion over politics, and
propose a revolutionary change to the structure of European society.
In 1845, Marx was expelled from France by Guizot. He fled with Friedrich Engels to
Brussels where they stayed for three years with intermittent trips to England to visit Engels'
family who had cotton-spinning interests in Manchester. While in Brussels Marx wrote a
piece against the idealistic socialism of P.J. Proudhon called “The Poverty of Philosophy”.
He also worked on his materialist conception of history, and developed the manuscript that
would come to be named The German Ideology when it was published after his death. This
paper argues that the nature of an individual is dependent upon the material conditions that
determine his production. It is a historical study of modes of production through the ages, and
in it Marx predicts the collapse of industrial capitalism and the advancement of communism.
Marx joined the Communist League at this time, which was an organization of German
émigré workers centred in London. Marx and Engels became the major theoretical force of
the League, and at a conference in 1847 they were commissioned to write a declaration of the
League's position. The hope was that the Manifest der kommunistischenPartei (The
Communist Manifesto) would inspire social revolution, and no sooner was it published than
the 1848 revolutions broke out across Europe. This work marks a turn in Marx's writing from
appealing to natural rights as justification for social reform, to indicating that the laws of
history would inevitably lead to the power of the working class. The Manifesto distinguishes
communism from other movements, proposes specific social reforms, and includes a
description of the struggles between the proletariat and the bourgeoisie. It also explicitly
encourages workers to unite in revolution against the existing regimes.
The panic caused by the February revolution of 1848 caused the Belgian government to expel
Marx from Brussels. He was invited by the French provisional government to return to Paris.
From there, he returned to Cologne with some friends to start the newspaper the
NeueRheinischeZeitung. The government there attempted to shut down the paper through
61
legal means, and finally succeeded by finding pretexts to expel the editors. Marx and his
friends were expelled after the revolts of May 1849, and the newspaper's last edition was
June 1849. Marx had to return to Paris, but he was expelled again immediately, and moved
on to London, which would be his final home.
In London Marx re-joinedthe Communist League, confident that there would be further
revolutionary action in Europe. He proceeded to write two pamphlets about the 1848
revolution in France and its effects, titled, “The Class Struggles in France” and “The 18th
Brumaire of Louis Bonaparte”. He felt that new revolution would only be possible if there
was to be a new crisis, and he hoped to uncover what would cause this crisis. He spent a large
amount of his time in the British Museum studying political economy toward this end. For
the first part of the 1850s Marx, Jenny, and their four children lived in an impoverished state
in a three room flat in London's Soho. The couple would have two more children, but only
three in all would survive. The family survived primarily on gifts from Friedrich Engels
whose own income came from the family business in Manchester. Marx also earned a small
amount from articles he wrote as the foreign correspondent for the New York Daily Tribune.
In 1864 Marx and Friedrich Engels together founded the International Workingmen's
Association, which would finally break up due to disagreements between Marx and the
anarchist Mikhail Babuknin.
By 1857 Marx had written an 800-page manuscript which was to become Das Kapital
(Capital). This is his major work on political economy, capital, landed property, the state,
wage labour, foreign trade and the world market. In the early part of the 1860s he took a
break from his work on Das Kapital to work on Theories of Surplus Value, a three-volume
work. This text discusses specific theories of political economy, primarily those of Adam
Smith and David Ricardo. In 1867 Marx published volume I of Das Kapital, an analysis of
the capitalist process of production, with an elaboration on his version of labour theory value,
surplus value, and exploitation, that he predicted would lead to a falling profit rate and the
collapse of industrial capitalism. Marx continued to work on Volumes II and III of Das
Kapital for the rest of his life, even though they were essentially finished in the late 1860s.
Friedrich Engels published the last two volumes after Marx's death. By 1871 Marx's daughter
62
Eleanor, who was 17 at the time, was helping her father with his work. She had been taught at
home by Marx himself, and grew up with a rich understanding of the capitalist system which
would allow her to play an important part in the future of the British labour
labo r movement.
Some important concepts used interchangeably while referring to the works of Karl Marx and
followers of his thoughtsaredefined
defined below:
i. Marxian
Marxian connotes the theory and principles ascribed to Karl Marx. It includes several
different theories and multiple thoughts, which sometimes contradicts each other but
all ascribed to Karl Marx.
ii. Marxism
Marxism implies the criticisms and speculations
speculations which Marx set out to unify and
systemize. Stated differently, Marxism is a method and worldview of societal analysis
that focuses on class relations and societal conflict.
iii. Marxist
Marxists are the followers and adherents of the ideas of Karl Mar
Marx.
x. There is no single
definition of Marxist theory, however, the analysis has been applied to diverse
subjects and it has been misconceived and modified in the course of its development.
iv. Marxian School of Thought
The Marxian school of economics (or Mar
Marxian
xian economics) refers to a school of
economic thought tracing its foundations to the critique of classical political economy
first expounded upon by Karl Marx and Friedrich Engels. Marxian economics refers
to several different theories and includes multiple
multiple schools of thought which are
sometimes opposed to each other, and in many cases Marxian analysis is used to
complement or supplement other economic approaches.
Who are the Marxists?
63
The followers and adherents of Karl Marx ideas.
6.2 General Overview of Marx Ideas

Karl Marx (1818-1883)
1883) is best known not just as a philosopher but also as a revolutionist,
whose works inspired the foundation of communist economic regimes. Marx felt his job was
not just to interpret and analyssee society but to promote the changes in society that he
considered desirable. It is hard to think of many who have had as much influence in the
creation of modern economic world as Marx. A fundamental contrast between classical
position and Marx position was
as his advocacy for a fundamental revolution in the society and
economy.
Although Marx was majorly associated with the economic systems of socialism or
communism, much of his studies were centred on capitalism, (his major work is titled “Das
Capital” or “Capital”),
), and in all of his major works and that of his collaborator, Friedrich
Engel,, there is little reference on how a socialist or communist economy is to be organized.
Karl Marx was interested in studying capitalism and his economic theory is an application
appli of
his theory of the history of the capitalist economy. Marx was interested in and focused on the
th
dynamic process of change. Hee had societal equality in view and as such he wanted to lay
bare the laws of the dynamics of capitalism.
Marx tried to show
w how capitalism has fulfilled its historic mission to accumulate capital and
to develop new productive methods. He asserted that capitalism which ought to improve the
fortune of workers as a result of capital accumulation has turned into means of cheating
labour power. In this sense, he therefore submitted that the capitalist gets richer at the same
rate as he squeezed out the labour power of others, and then forced on the labour abstinence
from all life’s enjoyment.
In discussing growth, Marx placed important
important emphasis on the deterministic role of
technology and increasing returns. He argued that firms would get bigger for technological
reasons. This emphasis, although broader and far
far-reaching,
reaching, anticipated the modern
64
endogenous growth theory, by focusing on same issues – that technology is important in
determining the working of the economy and it has the implications of increasing returns.
What is the difference between Marx and Classical economists propositions?
The contrast between classical position and Marx position was his advocacy for a
fundamental revolution in the society and economy
6.3 Axioms of the Marxian System

The principles and theory of Karl Marx rested on some axiomatic formulations which could
be said to form the basis of evaluating his
his theory. These axioms are explained below:
6.3.1 Labour is Value
Marx believed that commodities are nothing but the products of human labour
which are produced for the market. Final products are traceable to human efforts
used in their production. According to Marx, value is nothing but that fragment of
the total labour potential existing in a given society in a certain period (e.g. a year
or a month) which is used for the output of a given commodity, at the average
social productivity of labour existing then and
and there, divided by the total number
of these commodities produced and expressed in hours (or minutes), days, weeks,
or months of labour.
6.3.2 Socially Necessary Labour
Socially necessary labour is important in determining the exchange value of
commodities in trade, according to Marx, and consequently constrains producers
produc
in their attempt to economize
economize on labour. Labour is socially necessary when it is of
average skill and intensity, it uses modern instruments of production and produces
commodity which is in dem
demand.
and. By socially necessary labour, Marx refers
65
specifically to the total labour time required to produce an output. It is this current
labour cost which determines the value of output.
6.3.3 Surplus Value
Although Marx did not invent the concept, however, surplus value is an important
concept in his critique. It is a translation of the German word “Mehrwert”, which
means “value-added”. According to Marx, surplus value equals the new value
created by workers in excess of their own labour cost, which is appropriated by
the capitalist as part of profit when commodities are sold. For instance, the
capitalist takes the whole day of the labour, say 15 hours, to produce a given
commodity but pays the wage equals to 10 hours. The remaining 5 hours over and
above the wage rate paid by the capitalist to the labour is what is referred to as
surplus value, which the capitalist keeps to himself.
6.3.4 Constant and Variable Capital
By variable capital, Marx refers to that proportion of capital which is invested in
wages, that is in the purchase of labour-power. This proportion of capital is
referred to as variable by Marx because if used wisely, it may produce a new
surplus value in the course of the labour process, over and above the necessary
labour time. On the other hand, the constant capital refers to that proportion of
capital invested in the materials and components purchased but embodied in the
product when it is sold, and the materials, tools, machinery etc., which are used up
in the course of production, and which for all intents in purposes are the same as
the materials materially incorporated into the products. These materials must be
renewed when they are used up or obsolete. The ratio of constant capital and
variable capital is what is referred to as “organic composition of capital” that is
the ratio of the value of the materials and fixed costs embodied in production of a
commodity to the value of the labour-power used in making it.
6.3.5 The Rate of Surplus Value
According to Marx, the rate of surplus value in production is defined as the
volume of surplus value produced by the workforce divided by the variable capital
66
incurred to produce the product. The basic meaning of rate of surplus value is the
rate of exploitation of labour which is the net capital yield obtaine
obtained from
employment of labour.
What is Socially Necessary Labour

Labour?
Socially necessary labour time is the amount of labour time required by a

worker of average skill and productivity, working with tools of the average productive
potential, to produce a given
ven commodity. It is an "average unit labour
labour-cost",
cost", measured in
working hours
6.4 Marx Analysis of Capitalism

The fundamental aim of Marx in his book “Capital” was to carry out a comprehensive
analysis of the capitalist system. Marx applied his theory of history to the society and
economy of his time in order to discover the law of motions of capitalism and to also id
identify
the contradictions between the forces and relations of production. He was concerned with
long-run
run trends in the economy. In his analysis of capitalism, Marx formulated certain
principles that have become known as Marxian laws and treated with reverence
revere by some
Marxists as the laws of supply and demand are treated by some orthodox economists.
In his analysis of the economics of capitalism, Marx used, with a few exceptions, the basic
tools of classical economics, particularly Ricardian theory. Thus, he proposed the following
assumptions:
i. A labour cost theory
ory explaining relative prices
ii. Neutrality of money
iii. Constant
stant returns in manufacturing
iv. Diminishing
iminishing returns in agriculture
v. Perfect competition
67
vi. A rational, calculating economic man
vii. A modified version of the wages fund doctrine.
Marx however rejected the Ricardian assumption of fixed coefficients of production, full
employment and the Malthusian population doctrine. It is important to realize that part of the
difference between Marx and
nd Ricardo in their analysis of the economics of capitalism does
not proceed from any difference in their basic analytical framework; rather, it comes from a
difference in their respective ideologies. Because Marx was critical of capitalism, he
examined it with a view to finding faults or contradictions in the system; Ricardo basically
accepted it and saw it as a harmonious working-out
working of the economic process.
The capitalist’s search for profits and reaction to changing rates of pr
profits explain, in large
part,
rt, the dynamics of the capitalist system. But whereas capitalists in the Marxian system
rationally and calculatingly pursue their economic advantage and sow the seeds of their own
destruction, in the Ricardian system these same rational and calculating capitalists,
ca in
following their own self-interest,
interest, promote the social good. Although the classical economists’
long- run prediction of a stationary state is certainly pessimistic, such a state is not the fault of
the capitalistic system; rather, in their view,
view, it follows fromMalthusian population doctrine
and historically diminishing returns in agriculture. For Marx, however, the capitalistic system
produces undesirable social consequences
consequences. He noted that the contradictions in capitalism
become more manifest over
ver time, and capitalism as a phase of history will pass away
What is Wages Fund Doctrine?
The wage–fund
fund doctrine is an expressionearly economic theory
that shows that the amount of money a worker earns in wages, paid to them
from a fixed amount of funds available to employers each year. In essence,
68
wage–fund doctrine states that workers’ wages are determined by a ratio of
capital to the population of available workers
6.5 Marxian Economic Theories

Marx’s system is a mixture of philosophical, sociological and economic analysis, however,
important economic theories, or Marxian laws from the works and propositions of Marx
could be identified and they are explained below:
6.5.1. Labour Theory of Value
Marx inherited the labour theory of value from the classical school. He obviously
owes a lot to Ricardo. In developing his theory of relative prices, or the quantitative
relationship between commodities or things, he essentially used Ricardo’s theory of
value. For Ricardo, labour is essentially a numeraire (that is a basic unit
measurement), which enables a common computation of labour and capital as basic
elements of production costs. On the contrary, for Marx, labour is value.
Commodities manifest in their prices certain quantitative relationships and this
implies that all commodities must have one element in common that must exist in
certain measurable quantities. Marx turned to labour as the common element and
concluded that it is the amount of labour time necessary to produce commodities that
governs their relative prices. According to Marx, the only social cost of producing
commodities was labour. This does not imply that Marx’s concept of value is
detached from consumption. However, it means that the feedback of consumers, their
behaviour and wishes upon value is only meditated through changes in the allocation
of labour inputs into production, labour being divided into living (human) labour and
dead (dated) labour, that is tools and raw materials.
The law of value is Marx’s version of Adam Smith’s “invisible hand”. In a society
dominated by private labour, private producers and private ownership of productive
resources, it is the law of value that regulates the economy, determines what is
produced and how it is produces, and therefore what can be consumed. The law of
value is an objective economic law operating behind the backs of all people and
69
agents involved in production and consumption. It regulates the exchange between
commodities, according to the quantities of socially necessary abstract labourit
embodies.
The production of any commodity requires the use of a part of the total supply of
abstract labour. The concept of homogeneity of productive human labour, underlying
that of abstract human labour as the essence of value does not imply a negation of the
difference between skilled and unskilled labour, that is labour with varying skills will
have varying outputs. To solve this problem, Marx reduced the level of abstraction
and measured the amount of labour required to produce a commodity by socially
necessary labour time, which is defined as the time taken by a worker with the
average degree of skill possessed by labour at the time. Labour with greater skill than
the average is reduced to the average by measuring its greater productivity and
making an appropriate adjustment. For example, if a given labourer has natural ability
and as a result produces twice as much of what a labourer with average skills, each
hour of the superior labour would count as two hours of average labour. In this
manner, all labour time is reduced to socially necessary labour time. While Smith
measured differences in labour skills by wages paid to labour, Marx circumvented the
entire process by assuming that measuring differences in labour is not by wages but
by differences on physical productivity.
One of the problems raised by the labour theory of value is how to account for the
influence of capital goods on relative prices. Capitalist production is production for
profit. Mobility of capital is determined by existing or expected profit differentials.
Capital moves from branches (countries, regions) with lower profits (or profit
expectations) towards branches (countries, regions) with higher ones. These
movements lead to an equalisation of the rate of profit (existing or expected) between
different branches of production. Approximately, equal returns on all invested capital
coexist with unequal proportions of inputs of labour in these different branches. So
there is a disparity between the direct value of a commodity and its “price of
production”. Price of production is defined by Marx as the sum of production costs
70
(costs of fixed capital and raw materials plus wages) and the average rate of profit
multiplied with the capital spent in the given production.
What is Abstract Labour according to Marx?
According to Marx, abstract (human) labour is conceived of as

total labour available to society for commodity production as a
homogeneous quantity, disregarding the differing skills of labour
Define price of production according to Karl Marx?
Price of production is defined by Marx as the sum of production costs

(costs of fixed capital and raw materials plus wages) and the averag
averagee rate of
profit multiplied by the capital spent
spen in the given production.
6.5.2 Theory of Rent
Marx’s Theory of Rent
ent is the most difficult part of his economic theory, and therefore
has received fewer comments and developments, by both followers and critics, than
other major part of his economic systems.
systems. However, it is not obscure, as it represents
a straight forward application of the labour theory of value. It does not imply any
emergence
ergence of supplementary value (surplus value or profits) in the market, in the
process of circulation of commodities, which
which is abhorrence to Marx and all consistent
upholders of his labour theory of value. It also does not suggest that land or mineral
deposits create value. What the theory of rent simply means is that in agriculture and
mining, less productive labour determi
determines
nes the market value of food or minerals (as in
71
the general case of labour theory of value), and therefore more efficient farm and
mines enjoy surplus profits which Marx called differential (land or mining) rent.
The Marx theory of rent also means that as long as productivity of labour in
agriculture is generally below the average of the economy as a whole, the sum total of
surplus-value produced in agriculture will accrue to landowners and capitalist farmers
taken together, and will not enter the general process of distribution of profit
throughout the economy as a whole. Stated differently, theory of rent asserts that
when the composition of capital, machinery and raw materials expenditure against
wages, is inferior in agriculture to that in industry and transportation, the total surplus-
value produced in agriculture will accrue to landowners and capitalist farmers taken
together.
6.5.3 Theory of Money
Karl Marx economic theory of money is another straightforward application of the
labour theory of value. Similar to the assertion that value is the embodiment of
socially necessary labour, commodities exchange with each other in proportion to the
quantities of labour they contain. This is true for the exchange of gold against maize
as it is true for the exchange of gold against iron or silver.
In the first place, Marx sets out by rejecting the idea that there is no significant
qualitative difference between a barter economy and a capitalist one, and ridicules the
notion that money is just a device for overcoming the technical difficulties presented
by barter. Marx theory of money is a commodity theory of money that is, a given
commodity can play the role of a universal medium of exchange, as well as fulfill all
other functions of money, just because it is a commodity and because it is also a
product of socially necessary labour. This is applicable to precious metals as well as
all other various commodities that throughout history have played the role of money.
Marx held that metallic money, such as gold, is a commodity, and its value is the
labour time necessary to produce it (mine it, smelt it, etc.).
Marx argued that gold, silver and other metals are conventionally used as money
because they embody a large amount of labour in a small, durable, form, which is
72
convenient. In this model, paper money is also a representation of gold or silver,
almost without value of its own but held in circulation by government legislation. It
therefore follows that strong upheavals in the intrinsic value of the money-commodity
will cause strong upheavals in the general price level.
6.5.4 Theory of Surplus Value
In his letter to Engels in 1867, Marx considered his theory of surplus value as his
most important contribution to the progress of economic analysis. Surplus value is
essentially the money form of the social surplus of product or the money product of
surplus labour. The theory of surplus value is basically a residual theory of ruling
classes’ income. The total surplus value (which is also the net national income) is
produced in the course of production process, just exactly the same way the whole
crop is harvested by peasants. What happens thereafter in the market through the
allocation of the produce is a distribution of what has already been created.
The surplus product as well as its money form (surplus value) is the residual of the
new social product that remains after the producing classes (labourers) have received
their compensation (wages).
6.5.5 Theory of Crises
According to Karl Marx, capitalism is an economic system that is inherently prone to
crisis. He described capitalism as “a society that has conjured up such gigantic means
of production and of exchange, like a sorcerer, who is no longer able to control the
powers of the nether world whom he has called up by his spells”. Although he did not
write a systematic treatise on capitalist crises, his comments are spread around his
major economic writings and articles. Marx argues that capitalism dispels all fixity
and security in the situation of the labourer. It constantly threatens and attempt to
snatch from the hands of labourer, his means of sustenance and make him
superfluous.
Crises theory is central to Marx writings as it helps to underpin his understanding of a
need for systematic change. In the words of the Marxist, economic crises are crises of
overproduction and impoverishment of the workers who, were it not for the capitalist
73
control of the society, could be the determiners of both demand and production in the
first place. Crises mean that the very functioning of the capitalist system cannot
guarantee even the crumbs, in terms of small wage, thrown at the worker.
Crises also have an impact on the fortunes of the capitalists as well, not just the
labourer. Crises break up the “operating fraternity of the capitalist class” and produce
an all-out fight for survival between capitalist. As a result, relatively minor economic
crises can lead to political instability, ideological confusion among the ruling class,
intensification of class struggle and war. Marx argued that crises carry along the most
frightful devastation and like an earthquake, cause a bourgeois society to shake to its
very foundations. Thus, it is out of impact of capitalist crisis that the possibility of
revolutionary change emerges as a possibility in the hands of the working class.
6.5.6 The Laws of Motion of the Capitalist Mode of Production
Marx applied his theory of history to the society and economy of his time in order to
discover the laws of motion of capitalism and to identify contradictions between the
forces and relations of production. Marx was concerned with the long-run trends of
the economy and he was able to foresee in a coherent way how capitalism would
function, develop and transform the world. In logical order, some of the laws of
motion are presented below:
a. Capitalist’s compulsion to accumulate. By definition, the search for profit is at
the basis of all economic operations by owners of capital. Capital in the capitalist
state appears in form of money, released into circulation in order to increase in
value. No owner of capital will engage in business in order to recuperate the exact
sum as invested, and nothing more than that.
b. Tendency towards constant technological change. The main weapon in
competition between capitalist firms is cutting costs. Hence, more advanced
production techniques and more rational labour organization are the main means
to achieve that. Therefore, the basic trend of capital accumulation in the capitalist
mode of production is a trend towards more and more sophisticated machinery
and constant technological progress.
74
c. Capitalist’s continuous thirst for surplus value. The irresistible urge for capital
accumulation could only be realized through a constant drive for the increase in
the production of surplus-value. Capital accumulation is nothing but surplus-value
capitalization which is the transformation of part of the new surplus value into
additional capital.
d. Tendency towards growing concentration and centralization of capital.
Capitalism is the big ‘expropriating’ force that suppresses private property of the
means of production for many, in favour of private property for few. The growth
of the value of capital implies that each capitalist firm will be operating with more
capital. Marx termed this occurrence the tendency towards growing concentration
of capital. Also, in every competitive process, there is victor and vanquished with
the victor growing and the vanquished going bankrupt or absorbed by the victors.
This process is what Marx called centralization of capital. This results in a
reduction in the number of firms which survive in each of the key fields of
production, with many small and medium sized capitalists disappearing. They in
turn become salary earners under employment of successful large capitalist firms.
e. Tendency for organic composition of capital to increase. Marx postulates that
the basic historic trend of capital accumulation is to increase constant capital
(buildings, machinery, raw materials, energy) at a quicker pace than variable
capital (wages of productive workers).
f. The tendency for the rate of profit to decline. Marx maintained that competition
in commodity and labour markets would lead to a fall in rate of profits. There is a
strong urge for the capitalist to accumulate capital and capital accumulation means
more capital will bid for labour, forcing up wages and the rate of profit will fall.
Thereafter, this will force capitalist to react by substituting machinery for labour,
which also implies increasing the quantity of capital in the economy, which will
push rates of profits even lower. Marx suggests that each individual capitalist in
reacting to rising wages and falling profits, will take actions that will further
reduce the rate of profit in the economy.
75
g. The inevitability
bility of class struggle under capitalism. Irrespective of the social
global framework or historical background, wage-earners
wage earners fight everywhere for
higher real wages and a shorter work day. They form elementary organizations
(trade unions) for the collectiv
collectivee instead of individual sale of the commodity labour
power.
h. The tendency towards growing social polarization. In a capitalist system, the
proportion of the active population represented by wage
wage-labour
labour in general
increases, while the proportion represented by self-employed
employed (small and medium
sized capitalists, handicraftsmen, peasants, trade-people
trade people and free-professions
free
working without wage
wage-labour) decreases.
i. The inevitability of economic crises. Marx asserted that periodic crises of
overproduction were inevi
inevitable
table under the capitalist regimes. Capitalist economic
crises are always crises of overproduction of commodities (exch
(exchange
ange values), as
opposed to pre and post
post-capitalist
capitalist economic crises, which are essentially crises of
underproduction of use
use-values. Under capitalist crises, economic growth is
brutally interrupted, not because too few commodities have been produced but, on
the contrary, because a mountain
mounta of produced commodities find no buyers. This
unleashes a spiral movement of collapse of firms, firing ooff workers, contraction of
sales (or orders) for raw materials and machinery, new redundancies, new
contraction of sales of consumer goods etc.

In this study session, we have studied the Marxian school of economics founded by Karl
Marx. We learned some important concepts related to the Marxian school. We also learned
the axioms of the Marxian system as well as economic theories of Karl Marx.
76
Self-Assessment Questions for Study Session 6
SAQ 6.1: Explain three axioms of the Marxian system

SAQ 6.2: Discuss any three of the Marxian theories.

1. __________ connotes theory and principles ascribed to Karl Marx.
A) Marxist
B) Marxian
C) Marx School of Thought
C) Marxism
2. In Marx propositions, he asserts that technological progress could be ______.

A) resource saving
B) capital saving
C) labour saving
D) resource using
3. The method of societal analysis that focuses on class relations and societal conflict is
known as __________.
A) Socialism
B) Capitalism
C) Economic system
D) Marxism
4. If Mr. X as a result of addition innate skills produces triple of what a labourer with an
average skill will produce and he works for twenty-four hours in a given week. What is
the average labour hours worked by Mr. X for four weeks, using the socially necessary
labour time of Marx.
A) 288
B) 72
77
C) 96
C) 156
5. Society does not consist of individuals, but expresses the sum of interrelations, the
relations within which these individuals stand?
A) Adam Smith
B) J. B. Say
C) K. H. Marx
D) J. M. Keynes
References
Berlin, Isaiah.(1959) Karl Marx: His life and environment. New York: Oxford University
Press.
Bober, M. M. (1948) Karl Marx’s interpretation of history. Cambridge, Massachusetts:

Harvard University Press

Houghton Mifflin Company.
Marx, Karl (1926). Capital. 3 vols. Chicago: Charles H. Kerr.
Neff, F.A. (1950). Economics Doctrines. New York: McGraw-Hall

Lucky Odoni
Roll, E. (1950).A History of economic thought. London: Faber and Fabe
Schumpeter, Joseph A. (1950) “The Marxian doctrine.” In Capitalism, Socialism, and

Democracy. New York: Harper.
Taylor, O. H. (1960). A History of Economic Thought.New York: McGraw Hill Book Co.


Lucky Odoni
78
Roll, E. (1950).A History of Economic Thought. London: Faber and Fabe
your e-tutor
tutor via the LMS.
e or phone on:
08033366677
79
Study Session 7: KEYNESIAN SCHOOL OF ECONOMIC
THOUGHT
Introduction
Keynesian economics is named after John Maynard Keynes (1883-1946),, whose father, J. N.
Keynes, was an important economist in his own right. Keynes’s departs from the past in a
more complete way by breaking with the laissez
laissez-faire
faire tradition running from Smith through
Ricardo, J. S. Mill, and Marshall. Although he was fami
familiar
liar with the basic Marshallian partial
equilibrium analysis, he constructed a new theoretical structure to address the aggregate
economy that had significant effects on both economic theory and policy. In this study
session, we discuss the Keynesian macro
macroeconomics
economics and general theory. The Keynesian
multiplier, Keynesian policy and Keynes’s philosophical approach to policy were discussed.
Learning Outcomes
1. Identify the feature of the Keynesian m
macroeconomics
2. Explain the central argument of the General Theory
3. Explain the Keynesian multiplier
4. Explain Keynes’s philosophical approach to policy
7.1 Keynesian Macroeconomics and the General Theory

Keynesian economics was named after John Maynard Keynes (1883-1946).
1946). Keynes was a
British economist whose ideas have up to date fundamentally affected the theory and practice
practic
of modern macroeconomics, and as well informed the economic policies of governments. He
extended and thoroughly refined earlier work on bbusiness
usiness cycles. Keynes’s thoughts led a
revolution in economic thinking; he overturned the old ideas of the neoclassical economists
that held that free markets would automatically produce full employment as workers were
80
flexible in their wage demands. On the contrary, Keynes argued that aggregate demand could
lead to prolonged periods of high unemployment. Accordingly, state intervention was
necessary to moderate bursts and booms in the economic activity cycles.
Keynes advocated the use of monetary and fiscal measures to mitigate the adverse effects of
economic recessions and depressions. Following the outbreak of World War II, Keynes's
ideas concerning economic policy were adopted by leading Western economies. Although he
died in 1946, but during the 1950s and 1960s, the success of Keynesian economics resulted in
almost all capitalist governments adopting its policy recommendations.
Keynes greatest work titled “The General Theory of Employment, Interest and Money” was
published in 1936. It was researched and indexed by one of Keynes students known as David
Bensusan-Butt. The work served as a theoretical justification for the interventionist policies
Keynes put forward for tackling economic recession. The General Theory challenged the
earlier neoclassical economic assertion that provided non-interference by government; the
market would naturally establish full employment equilibrium.
The central argument of the General Theory is that the level of employment is determined,
not by the price of labour as in neoclassical economics, but by the spending of money
(aggregate demand). Keynes challenged his former teachers, Marshall and Pigou, and argued
that it is wrong to assume that competitive markets will in the long run deliver full
employment or that full employment is the natural, self-righting, equilibrium state of a
monetary economy. On the contrary, under-employment and under-investment are likely to
be the natural state unless active measures are taken. One implication of The General Theory
is that an absence of competition is not the main issue regarding unemployment and that even
reducing wages or benefits have no major effect.
Keynes argued that the classical economists believe in Say's law which states that "supply
creates its own demand", and that in a free market workers willing to lower their wages to a
level where employers could profitably offer them jobs was a "special case" that applied only
to the particular conditions present in the 19th century, and his own theory is a general one.
An innovation from Keynes was the concept of price stickiness – the recognition that in
81
reality workers often refuse to lower their wage demands even in cases where a classical
economist might argue it is rational for them to do so. Due in part to price stickiness, it was
established that the interaction of "aggregate demand" and "aggregate supply" may lead to
stable unemployment equilibria – and in those cases, it is the state, and not the market, that
economies must depend on for return to equilibrium state.
The General Theory argues that demand, not supply, is the key variable governing the overall
level of economic activity. Aggregate demand, which equals total un
un-hoarded
hoarded income in a
society, is defined by the sum of consumption and investment. In a state of unemployment
and unused production capacity, one can only enhance employment and total income by first
increasing expenditures for either consumption or investment. Without government
intervention to increase expenditure, an economy can remain trapped in a low employment
equilibrium. The book advocated active economic policy by government to stimulate demand
in times of high unemployment, for example by spending on public works. In Keynes words,
he wrote in 1928 “Let
Let us be up and doing, using our idle reso
resources
urces to increase our wealth.
With men and plants unemployed, it is ridiculous to say that we cannot afford these new
developments. It is precisely with these plants and these men that we shall afford them”.
What measures did Keynes prescribe to correct the economy during recession
and depression?
Monetary and Fiscal policy measures
What was the central theme of the General Theory?
82
The central theme of the General Theory is that the level of employment is
determined, not by the price of labour as in neoclassical economics, but by the aggregate
demand.
7.2 The Keynesian Multiplier

In the 1940s and 1950s, economists explored the multiplier model, developing it in
excruciating detail. It was expanded to include international effects, various types of
government expenditure, and different types of individual spending. Terms such as the
balanced budget multiplier became standard parts of economic terminology, and every
economics student had to learn Keynes’s model.
It is interesting to note that the model
model and the monetary and fiscal policies that were, and are,
generally called Keynesian are not to be found in Keynes’s book. There is not a single
diagram in The General Theory, nor any discussion of the use of monetary and fiscal policy.
How, then, did the multiplier model (done algebraically and geometrically) become the focal
point of the macroeconomic debates of the 1950s? Part of the reason is that it seemed to
provide a better description of current reality than did the alternatives. But other factors were
also at work. The initial policy debates about the validity of Keynesian economics focused on
fiscal policy (government deficits during the war had apparently pulled the Western world
out of the Depression). Because the multiplier model nicely captured
captured the effects of fiscal
policy, it tended to become the Keynesian model.
It was in the United States that the multiplier analysis caught on. Paul Samuelson and Alvin
Hansen (1887-1975)
1975) developed it into the primary Keynesian model. Samuelson’s textbook
introduced
roduced it and other books copied Samuelson’s, and soon the multiplier model was
Keynesian economics. The multiplier analysis had advantages of being easy to teach and
learn. It allowed macroeconomics to develop as a separate field by providing a core analytical
anal
structure for the course, just as supply and demand analysis had for microeconomics.
Following the depression of 1930s, the context within which society and economists viewed
the market changed. Prior to the period, the neoclassical arguments in favour
our of laissez faire
83
had been based not only on economic theory but also on a set of philosophical and political
judgments about government. The general orientation of almost all individuals in the early
1990s was against major government involvement in th
thee economy. With the onset of the
Depression, attitudes began to change. Many people felt that if the free market could lead to
such economic distress as existed during the Depression, it was time to start considering
alternatives. As economists began to analyse
analyse the aggregate economy in greater detail, many
became less confident of their policy prescriptions and much more aware of the shortcomings
of neoclassical theory. Consequently, economists began to advocate a variety of policy
proposals to address unemployment
ployment that were inconsistent with their mainstream neoclassical
views.
When did the concept of multiplier bec

become popular?
The Keynesian multiplier became popular in the 1940s and 1950s after the
death of Keynes.
7.3 Keynesian Policy

Keynesian economics
ics subsumed policy argumentation and developed a model that had built
into it the need for activist government policies. In this model, aggregate demand controlled
the level of income in the economy, and the government had to control aggregate demand
through
ugh monetary and fiscal policies. During the 1950s and 1960s, Keynesian policy came to
mean fine-tuning
tuning through monetary and fiscal policy. One prominent and influential force in
fine-tuning
tuning Keynesian analysis was Abba Lerner (1903
(1903-1982).
1982). In his Economics of Control
published in 1944, Lerner advocated that government should not follow a policy of sound
finance (always balance the budget); it should instead follow a policy of functional finance,
which considered only the results of policies, not the policies themselves.
Functional finance allowed the government to drive the economy with monetary and fiscal
policy portrayed as government steering wheel. Lerner contended that fiscal and monetary
84
policy were the tools government should use to achieve its macroec
macroeconomic
onomic goals of high
employment, price stability, and high growth. The size of budget deficit was totally
irrelevant, if there was unemployment, the government should increase the deficit and money
supply; and if there was inflation, the government should reduce deficit and money supply.
Monetary and fiscal policies were, moreover, politically palatable. Many economists and
others believed the Depression proved that the government had to assume a much larger role
in directing the economy. The use of monetary
monetary and fiscal policy kept that role to a minimum.
Markets could be left free to operate as before. The government would not directly determine
the level of investment; it could simply affect total income indirectly by running a budget
deficit or surplus. Forr many, the legitimization of deficits had a second desirable
characteristic: it allowed government to spend without taxing.
What was the main emphasis of the Keynesian policy?

policy
The main emphasis of the Keynesian policy was the important role of the
government
ent in the economy contrary to llaissez
aissez faire policy of the classical economists.
7.4 Keynes’s Philosophical Approach to Policy

Policy combines theory with normative judgments. Understanding the Keynesian revolution,
therefore, requires a considerati
consideration
on of the general philosophical views of economists at the
time and of Keynes in particular. Keynes was not a radical, although he was accused of being
one after publishing The General Theory. It was hardly expected from a person of his
background, education,
on, and experience to argue for drastic changes in the institutional
structure of his society. Keynes was basically conservative in his views about altering the
structure of society generally advocating only such changes as would preserve the essential
elements
ments of capitalism. His view was that if the worst defects of the system were not
removed, individuals would discard the capitalistic system and lose much more than they
85
gained. His rejection of Marxism reflects both a criticism of Marx’s economics and
recognition that a Marxian social system would destroy the social class of which Keynes
himself was very much a part.
In Keynes’s words, he submitted that: “How can I accept a doctrine which sets up as its bible,
above and beyond criticism, an obsolete economic textbook which I know to be not only
scientifically erroneous but without interest or application for the modern world? How can I
adopt a creed which, preferring the mud to the fish, exalts the boorish proletariat above the
bourgeois and the intelligentsia who, with whatever faults, are the quality in life and surely
carry the seeds of all human achievement?”
Keynes was dismayed by the growth of totalitarian government and dictatorship in Germany,
Italy, and Russia. He was willing to admit that these changes in social organization might
solve some economic problems, but such a solution, he felt, would be purchased only at the
cost of individualism and its economic and political advantages. The economic advantages of
individualism, stemming from the use of self-interest to achieve greater efficiency and
innovation, are well known to economists.
Keynes’s broad philosophical views on the structure of the good society led to attacks from
two sides. Some critics on one hand considered him an apologist for capitalism and for his
own class, and those to the right regarded him as a wild-eyed reformer-socialist seeking to
dismantle the capitalistic system. This was because of his response to the Marxist approach.
The other set of critics were more conciliatory, willing to make concessions in their views
and Keynes’s views.
The Depression of the 1930s convinced many economists that the failure to provide full
employment was a major fault of capitalism. An important question faced by post-war was
what policies can be used to preserve the best of capitalism and simultaneously prevent major
economic depressions. Initially, Keynes’s view on policies seemed to be too liberal.
However, the monetary and fiscal policy of Keynes was finally embraced by US economists,
because they required little direct government intervention in the economy.
86
In this study session, we studied the Keynesian school of economic thought. We learned the
Keynesian macroeconomics and general theory. The evolution of Keynesian
Keynesian multiplier is also
learned. We presented Keynes’s policy and his philosophical approach to economic analysis.
Self-Assessment
Self Questions at the end of this Module.
SAQ 7.1 What is Price Stickiness?
SAQ 7.2 Distinguish between sound finance and functional finance

1) Who wrote the General Theory of Employment, Interest, and Money?
A) Adam Smith
B) David Ricardo
C) Milton Friedman
edman
D) John Maynard Keynes
2) Keynesian economics includes the idea that
A) economic policies are ineffective.
B) the economy is basically stable.
C) prices adjust to clear the markets.
D) labour markets don't always clear due to wage rigidities.
rigid
3) Among the propositions of the Keynesian school of thought is
A) economic policies are ineffective.
B) aggregate supply management is the key to a stable economy.
C) aggregate demand determines equilibrium output.
D) rational expectations.
tions.
4) Which of the following did Keynes believed inin?
A) The government has a role to play in fighting inflation, but not in fighting
unemployment.
87
B) The government has a role to play in fighting unemployment, but not in
fighting inflation.
C) The government does not have a role to play in fighting inflation or
unemployment.
D) The government has a role to play in fighting inflation and unemployment.
5) Many economists challenged the idea of activist government intervention in the economy
following the
A) inflation of the 1970s and early 1980s.
B) recession of 1974-1975.
C) recession of 1980-1982.
D) all of the above
References
Harrod, R. F. (1962) The Life of John Maynard Keynes. New York: Harcourt Brace
Jovanovich
Keynes, John Maynard (1936). The General Theory of Employment, Interest, and Money.
London: Macmillan.

Ogunmuyiwa, M. S (1997) Economic thought: history, analysis and evaluation.Lucky Odoni,

Ijebu Ode

Bhatia, H.L. (2006), History of Economic Thought, 4th ed.Tata Mcgrow-Hill, New Delhi.


Lucky Odoni,
88
your e-tutor
tutor via the LMS.
e or phone on:
08033366677
89
Study Session 8: MODERN HETERODOX ECONOMIC
THOUGHT
Introduction
Disagreement, arguments and counter
counter-arguments
arguments have always been part of economics, and it
remains so today. The neoclassical era ended, in part, because some of their flaws had been
pointed out by dissenting, or heterodox, economists. Heterodox economics refers to
methodologies or schools of economic thought that are considered outside of "mainstream
economics", often represented by expositors as contrast
contrasting
ing with or going beyond neoclassical
economics. Heterodox economics is an umbrella term used to cover various approaches,
schools, or traditions. Modern heterodox thinkers fall roughly into five
fi e dissident groups:
radicals, modern institutionalists, post
post-Keynesians,
eynesians, public choice advocates, and neo
neo-
Austrians. We will discuss each of these dissident groups in this study session. These groups
were classified according to their political points of view, ranging from liberal to
conservative.
Learning Outcome
Outcomes
1. Identify the dissident categories of modern heterodox thinkers
2. Explain the contribution of radical school to economics
3. Identify the three categories of modern institutional Economist
4. Explain the Post-Keynesian
Keynesian contribution
5. Describe the views of Public Choice advocates
6. Describe the fundamental tenets of the Austrian school
90
8.1 The Radicals
The radical school has its origins in Marx’s analysis, but it has extended the Marxian
economic analysis and moved beyond it. As neoclassical economics was being established,
Marx had few followers among Western economists, partly because of his inherent anti-
capitalist views. Societies and their institutions will not support analysis that advocates their
own destruction. Marx’s analysis did attract followers among non-economists, and a few
Marxian economists have achieved some status in the economics profession.
Radical economics, based in part on Marx, evolved into a school of thought in its own right
in the late 1960s and 1970s, partly in response to the social strains of the Vietnam War. In
1968, a group of young economists formed the Union of Radical Political Economy. This
organization publishes the Review of Radical Political Economics, a central journal of radical
economic thought. It is supplemented by the Monthly Review, Science and Society, and
Cambridge Journal of Economics. Although radical views are diverse, certain ideas about
what is wrong with neoclassical economics and market-oriented economics bind them
together.
According to Eileen Applebaum (1977), the radical position encompasses the following three
points:
1. Radical economists thought that “major socioeconomic problems can be solved
only through a radical restructuring of our society.” They argued that poverty,
racism, sex discrimination, destruction of the environment, alienation of workers,
and imperialism “are not pathological abnormalities of the system, but rather are
derived directly from the normal functioning of capitalism.”
2. Radicals argue that there are major inconsistencies between neoclassical theory
and real-world experience. Where mainstream economists see social harmony,
radicals see conflict.
3. Following their Marxist heritage, radicals view society as an “integrated social
system existing in concrete historical circumstance.” They believed that
mainstream economics simply accepts existing institutions, such as the market, as
given and does not consider a wide variety of proposals to change those
91
institutions. They see the incremental changes advocated by mainstream
economics as hardly worth considering. As Eileen Applebaum states, radicals “are
interested in ending - not salvaging or stabilizing - monopoly capitalism” and
replacing it with “a socialist society based on participatory planning, public
ownership of the means of production, the elimination of private appropriation of
profit, and a genuinely egalitarian redistribution of income and wealth.
Given these views, radical analysis of the economy is significantly different from mainstream
analysis. The radical premise is that the problems of Western society are inevitable
consequences of the capitalist institutional structure. Radicals emphasize in their analysis that
technology embodies the social relations between individuals and that any analysis must
study why capitalism exists rather than take it as given.
Most radicals also believe that capitalism embodies internal contradictions that inevitably
will bring the system down, although this process is slowed by the repressive state, which
exists to serve the interests of the capitalist class, and by institutions such as schools, which
are arms of the state.
Another contribution of radical thought into mainstream economics came from what is
referred to as a “more acceptable” radical. This contribution is based on Michael Piore’sdual
labour market analysis. Piore argued that it is wrong to view the labour market as a single
market, because major structural and social constraints limit the mobility of labour. For
example, a worker hired as a shipping clerk will find it almost impossible to be promoted to a
managerial position, no matter how capable he or she is. It follows that the relative
desirability of various jobs cannot necessarily be ranked by pay, because a position with
possibilities of upward mobility may initially pay less than a position without such
possibilities. Because each job is done by a separate class within labour, Piore says,
neoclassical analysis of the labour market as competitive does not fit the reality. One should
instead analyse the labour market as a structurally constrained market, which he calls a dual
labour market. Although this analysis conforms to Marxian analysis in that it incorporates a
type of class distinction, the dual labour market has become part of mainstream Keynesian
analysis.
92
8.2 Modern Institutionalists
Institutionalists from the turn of the century to the 1930s played a more significant role in
economics than their contemporary counterparts because the former were involved in
implementing significant policy changes in the U.S. economy. Except for Marxists, the
institutionalists have the longest history as a nonmainstream heterodox American school of
economic thinking. They spawned a school of thought, persisting until the present day, that
has influenced a wide variety of heterodox economists. Consequently, the label
“institutionalist” often extends far beyond describing the followers of these three founders –
Thorstein Veblen, Wesley C. Mitchell and John R. Commons.
Landreth and Colander divided the description of institutionalists into three:
1. Traditional institutionalist economists – the followers of Veblen, Mitchell and
Commons. One prominent follower of the Veblen-Mitchell-Common views is
Clarence E. Ayres (1891-1972)
2. Quasi-institutionalists - writers whose ideas resemble those of the institutionalists
but who are too individualistic to fit the traditional institutionalist sphere. Example of
writers in this group include Joseph Schumpeter, Gunnar Myrdal and John Kenneth
Galbrath.
3. Neo-institutionalists– economists who write in a neoclassical choice-theoretic
tradition but who believe that institutions must be far better integrated into current
practice than is currently done. Neo-institutionalism is sometimes also called rent-
seeking analysis or neoclassical political economy. Its proponents contend that
rational individuals try to improve their wellbeing not only within a given institutional
structure but also by changing that structure. Economic analysis, they contend, must
include a consideration of the forces determining that institutional structure. An
equilibrium institutional structure is one in which it is not worthwhile for individuals
to expend further effort to change the institutions. Only on the basis of an equilibrium
institutional framework, they say, can one produce relevant analysis.
93
What are the three categories institutionalist
i could be classified?
(1) Traditional Institutionalist; (2) Quasi

Quasi-Institutionalist, andd (3) Neo
Neo-
Institutionalist.
8.3 Post-Keynesians
In the consideration of macroeconomics, mainstream economics has followed only one of the
many threads found in Keynes writings. This situation arose partly from the general inability
of economists to reach a consensus on what exactly Keynes was saying about the working of
the macro- economy. Therefore, in
in the 1970s a group led initially by Sidney Weintraub and
Paul Davidson on this side of the Atlantic and by Joan Robinson and John Eatwell in England
joined forces
orces in articulating a criticism of the mainstream neo
neo-Keynesian
Keynesian model that was
specific enough to allow its authors to view themselves and be viewed as an economic
school. Calling themselves post--Keynesians,
Keynesians, they held an organizational meeting in 1974, at
where they founded their publication, the Journal of Post-Keynesian
Keynesian Economics (JPKE). In
the inaugural issue of that journal, the various founders and supporters attempted to state
what post- Keynesian economics meant to them. Joan Robinson called it a “method of
analysis which takes account of the difference between th
thee future and the past” J. K.
Galbraith said it considers that “an industrial society is in a process of continuous and organic
change, that public policy must accommodate to such change, and that by such public action
performance can, in fact, be improved.” Other writers focuse
focused
d on different issues, but all
agreed that neoclassical and neo--Keynesian economics are inappropriate.
8.4 Public Choice Advocates

Economists assume that individuals are rational in economic affairs; why not assume that
they are rational in other affairs aass well? This is the question James Buchanan and Gordon
Tullock asked in the early 1950s, and so began the public choice school. Tullock and
Buchanan left the University of Virginia in the 1960s, partly because of their unorthodox
94
policy positions, and founded
ded the Public Choice Centre at the Virginia Polytechnic Institute,
moving it in 1983 to George Mason University.
The central idea of the public choice school is that individuals are as rational in their
interactions with government as they are in their economic
economic affairs. Government is not an
agency for good or for bad; it is simply an agency by which individuals achieve their
economic goals through politics. The public choice theorists have devised an economic
theory of politics. Using the same framework that
th classical and neoclassical theory uses in
modelling household and firm behaviour, they analyse political, or public, choice.
The important insights of public choice theorists have sometimes been obscured by the anti
anti-
statist views of a number of public cchoice
hoice adherents, just as the insights of economists such
as Galbraith have been obscured by their pro
pro-statist
statist views. This is unfortunate on both sides.
Public choice theorists have made important contributions to our understanding of both
policy issues and economic theory. Economists of all political persuasions agree that
government failures – that is governmental policies that do not achieve the social good - exist
and must be included, along with market failures, in our analysis of policy. Of all the critical
cri
schools of thought mentioned,, the public choice school has been the most successful, and
their analysis of rent-seeking
seeking activities has spread into the mainstream. A number of
introductory textbooks with a public choice flavour have been widely adopted.
adopte James
Buchanan’s selection for a Nobel Prize in 1986 also reflects some acceptance from the
mainstream.
What was the major contribution of the Public Choice theorists to economics?
The Public Choice theorists introduced what is referred to as politic

political
al economics.
They analyse politics (or public choice) using the same framework that the classical and
neoclassical economists used.
95
8.5 Austrians Economics
Austrian economists parted company from the mainstream for much the same reason that
post-Keynesians did - the formalization of economics, which, they argue, has lost or
abandoned many insights of earlier writers. The Austrian school is another school of
economic thought that is based on methodological individualism. Its origin could be traced to
Vienna with the works of Economists like Carl Menger, Eugen von Bohm-Bawerk, and
Friedrich von Wieser among others. Until 1960, Austrian economics was considered part of
the mainstream; but as neoclassical economics faded and mainstream economics opted for
formal model building, the Austrians re-emerged as dissenters.
The Austrian School theorizes that the subjective choices of individuals underlie all economic
phenomena. Austrians seek to understand the observed economy by examining the social
ramifications of such individual choice. This approach, termed methodological
individualism, differs significantly from many other schools of economic thought, which
have placed less importance on individual knowledge, time, expectation, and other subjective
factors and focused instead on aggregate variables, equilibrium analysis, and the
consideration of societal groups rather than individuals.
The typical views of Austrian Economic thinking which could be referred to as their
fundamental tenets could be summarised as follow:
1. Methodological Individualism: In the explanation of economic phenomena we have
to go back to the actions (or inaction) of individuals; groups or "collectives" cannot
act except through the actions of individual members.
2. Methodological Subjectivism: In the explanation of economic phenomena we have
to go back to judgments and choices made by individuals on the basis of whatever
knowledge they have or believe to have and whatever expectations they entertain
regarding external developments and especially the consequences of their own
intended actions.
3. Tastes and Preferences: Subjective valuations of goods and services determine the
demand for them so that their prices are influenced by (actual and potential)
consumers.
96
4. Opportunity Costs:: The costs with which producers and other economic actors
calculate reflect the alternative opportunities that must be foregone; as productive
services are employed for one purpose, all alternative uses have to be sacrificed.
5. Marginalism:: In all economic designs, the values, costs,
costs, revenues, productivity, etc.,
are determined by the significance of the last unit added to or subtracted from the
total.
6. Time Structure of Production and Consumption
Consumption:: Decisions to save reflect "time
preferences" regarding consumption in the immediate,
immediate, distant, or indefinite future,
and investments are made in view of larger outputs expected to be obtained if more
time-taking
taking production processes are undertaken.
7. Consumer Sovereignty:: The influence consumers have on the effective demand for
goods and services
rvices and, through the prices which result in free competitive markets,
on the production plans of producers and investors, is not merely a hard fact but also
an important objective, attainable only by complete avoidance of governmental
interference with the markets and of restrictions on the freedom of sellers and buyers
to follow their own judgment regarding quantities, qualities, and prices of products
and services.
8. Political Individualism:: Only when individuals are given full economic freedom will
it bee possible to secure political and moral freedom. Restrictions on economic
freedom lead, sooner or later, to an extension of the coercive activities of the state into
the political domain, undermining and eventually destroying the essential individual
liberties
rties which the capitalistic societies were able to attain in the nineteenth century.

In this study session, we learned the heterodox
eterodox economic thought which is an umbrella term
used to cover various approaches, schools, or trad
traditions.
itions. We studied the five dissident groups
and their contribution and critic of the mainstream economic thought. These groups are
97
radicals, modern institutionalists, post-Keynesians, public choice advocates, and neo-
Austrians.
Self-Assessment Questions (SAQs) for Study Session 8

SAQ 8.1 Discuss thethree points that encompass the arguments of the Radical
economists, according to Applebaum (1977).
SAQ 8.2 Describe the three categories of modern institutionalists

1) Which among the following isnot one of the dissident group of heterodox school of
thought?
A) Neo-Austrian
B) Post-Keynesian
C) Quasi-Institutionalist
D) Neoclassical
2) The radical school evolved into a school of thought in its own right, but their position
largely follows ____________.
A) Karl Marx
B) J. M. Keynes
C) Adam Smith
D) Alfred Marshal
3) Which among the following is not one of the groups used to describe institutionalists?
A) Pre-Institutionalist
B) Quasi-Institutionalist
C) Neo-Institutionalist
D) Traditional Institutionalist
98
4) The central idea of public choice advocates is that
A) the government has a no role in affairs that are economic.
B) the government is an agency through which people achieve their economic
goals through politics.
C) theinterference of government leads to market failure.
D) the government failure is more severe than market failure.
5) Which among the following is not one of the tenets of the Austrian school?
A) Methodological Subjectivism
B) Methodological Individualism
C) Political Individualism.
D) Material Individualism
References
Blaug, Mark. (1983) “A methodological appraisal of radical economics.” In methodological
controversies in Economics: Historical Essays in Honour of T. W. Hutchison. Ed. A.
W Coats. Greenwich, Conn.: JAI Press.

Weintraub, Sidney, ed. (1977) Modern economic thought. Oxford: Basil Blackwell.

Bhatia, H.L. (2006), History of economic thought, 4th ed.Tata Mcgrow-Hill, New Delhi.

99
your e-tutor
tutor via the LMS.
e or phone on:
08033366677
100
Study Session 9: MODERN MICROECONOMIC
THOUGHT
Introduction
Neoclassical economics was not a single entity but a multidimensional school of thought that
evolved over time. It focused on marginalism, assumptions of rationality, and a strong policy
presumption that markets worked. The neoclassical school moved away from its neoclassical
footing bit by bit. Marginalist calculus was replaced by set theory; rationality assumptions
were modified by insights from psychology; the set of issues to which economic analysis was
applied expanded; evolutionary game theory raised the possibility
possibility that individuals exhibit
class-consciousness;
consciousness; and sociological explanations were used to supplement analyses of the
labour market.
In this section we discuss the evolution of microeconomics from neoclassical to modern. We
trace that path from the 1930ss through a highly formalistic stage in which there was an
attempt to tie microeconomics together within a single theory
theory—with
with little regard for that
theory’s empirical relevance—to
to its modern state, in which microeconomics consists of a set
of models focused
ed almost entirely on empirical relevance.
Learning Outcomes
1. Identify who are the formalists
2. Describe the formalist contribution to Marshallian ec
economics
3. Explain Paul Samuelson’s concept of equilibrium and stability
4. Describe the contributions of Milton Friedman of the Chicago school
5. Explain the differences between neoclassical and modern microeconomics
101
9.1. The Movement Away From Marshallian Economics
Marshall’s engine of analysis, combining supply and demand curves with common sense,
could answer certain questions, but others exceeded its scope. Supply-and-demand analysis
was partial equilibrium analysis applied to problems of relative prices. But many of the
questions economists were trying to answer, such as what determines the distribution of
income or what effect certain laws and taxes would have either introduced problems beyond
the applicability of partial equilibrium analysis or violated its assumptions. Nonetheless,
economists continued to apply partial equilibrium arguments to such issues, assuming that the
aggregate market must constitute some as yet unknown combination of all the partial
equilibrium markets.
Most economists were content with this state of affairs for quite a while. After all,
Marshallian economics did provide a workable, if not formally tight, theory that was able to
answer many real-world questions. It was the middle ground. Marshallian economists were
engineers rather than scientists, and engineers are interested not in pondering underlying
forces but in building something that works. Marshallian economists were interested in the art
of economics, not in positive or normative economics.
Marshallian economics attempted to walk a fine line between a formalist approach and a
historically institutional approach. For instance, the institutionalists wanted simply to
eliminate the theory, arguing that history and institutions should be emphasized and the
inadequate theory dropped. The formalists went in the opposite direction: they believed that
economics should be a science, not an engineering field, and that if economics were to
conclude that the market worked well, we needed a theory to show how and why it did so.
The formalists also agreed with the institutionalists that Marshallian economic theory was
inadequate, but their answer was not to eliminate the theory: they wanted to provide a better,
more rigorous general equilibrium foundation that could adequately answer more
complicated questions.
102
Why were Marshallian
rshallian economists referred to as middle ground?
Marshallian economists were engineers rather than scientists, and

they were interested in building something that works rather than pondering over
underlying rationale.
9.2. The Formalist Revolution in Microeconomics

In the late 1930s the formalist research program won and the Marshallian approach started to
fade. By the 1950s the formalists had reformulated microeconomics into a mathematical
structure dependent on Walras, no
nott Marshall. Applications became less important than logical
consistency.
With the completion of that general equilibrium work, economists turned once again to
applied work. But they did not return to Marshall’s engine of analysis approach, which
downplayed
d the use of mathematics and stressed judgment. Instead, they integrated policy
prescriptions into the mathematical models. As that happened, the neoclassical era evolved
into the modern modelling era. In the modelling approach, mathematics is used to deve
develop
simple models that ideally capture the essence of the problem. Then econometric techniques
are used to test those models. This development and empirical testing of models has become
the modern economic method.
The mathematical approach is rooted in the thought of several nineteenth-
nineteenth and early
twentieth-century
century figures discussed in our earlier chapters on neoclassical economics. The
first of these great pioneers in stating hypotheses in mathematical form was Cournot, who
published his “Researches
Researches into the
the Mathematical Principles of the Theory of Wealth
Wealth”in 1838.
Although, Cournot expected that his attempts to bring mathematics into economics would be
rejected by most economists, but he adhered to his method nonetheless because he found the
literary expression of theory that could be expressed with greater precision by mathematics to
be wasteful and irritating.
103
Leon Walras and Vilfredo Pareto, who succeeded Walras as professor of economics at
Lausanne, were other early devotees of mathematical economi
economics.
cs. Whereas Marshall had
focused on partial equilibrium, Walras, using algebraic techniques, focused on general
equilibrium. His general equilibrium theory has substantially displaced Marshallian partial
equilibrium theory as the basic framework for econom
economic
ic research. Jevons, in his influential
Theory of Political Economy (1871), also advocated a more extensive use of mathematics in
economics.
Jevons was followed by another pioneer in mathematical economics, F. Y. Edgeworth (1845-
(1845
1926), who pointed out in 1881 that the basic structure of microeconomic theory was simply
the repeated application of the principle of maximization. This finding raised the question,
why re-examine
examine the same principles over and over again? By abstracting from the specific
institutional
onal context and reducing a problem to its mathematical core, one could quickly
capture the essence of the problem and apply that essence to all such micro
microeconomic
questions. Following this reasoning, Edgeworth declared that both an understanding of the
economy and a basis for the formulation of proper policies were to be found in the consistent
use of mathematics. He accused the Marshallian economists of being seduced by the “zigzag
windings of the flowery path of literature.
Who is the first person to introduce mathematics into economics and in

what year?
A. Cournot in 1838
9.3. Paul Samuelson

Of the many economists involved in this formalization, Paul Samuelson is probably the best
known. Born in 1915, Samuelson began graduate economics studies at Harvard in 1935 after
acquiring a strong undergraduate background in mathematics. There he proceeded to publish
104
significant articles applying mathematics to both micro- and macroeconomic theory. He
received his Ph.D. in 1941 at the age of twenty-six, and by the time he was thirty-two had
become a full professor at the Massachusetts Institute of Technology and the first recipient of
the American Economic Association’s John Bates Clark Award, which is given to economists
under forty years of age who have made significant professional contributions. Samuelson
later became the first American to receive the Nobel Prize in economics. Economic historian
Randall E. Parker calls him the "Father of Modern Economics" and The New York Times
considered him to be the "foremost academic economist of the 20th century
The sources of Samuelson’s intellectual inspiration were Cournot, Jevons, Walras, Pareto,
Edgeworth, and Fisher, all of whom contributed piecemeal applications of mathematics to
economic theory. Using his mathematical background, Samuelson extended their work and
helped to lay the mathematical foundations of modern economic theory. Like Edgeworth, he
had harsh words for Alfred Marshall, whose ambiguities, he said, “paralysed the best brains
in the Anglo-Saxon branch of our profession for three decades.
9.3.1. The Concept of Equilibrium and Stability

According to Samuelson, the theoretical structure that underlies and unifies the individual
elements of micro- and macroeconomic theory rests on two very general hypotheses
concerning the conditions, first, of equilibrium and second, of its stability. For problems of
comparative statics, the conditions of equilibrium can be placed in the familiar maximization
framework in which much of the previous work in microeconomic theory had been done.
Samuelson illustrates the unity of this approach by working through the firm’s minimization
of costs and maximization of profits, the consumer’s maximization of satisfaction, and
welfare theory. Whereas previous economists had paid less attention to dynamic analysis,
Samuelson demonstrates that once the dynamic properties of a system are specified, its
stability can be assessed. Equilibrium and stability conditions thus emerge as the two-part
structure underlying economic theory.
Although Samuelson’s Foundations and his subsequent work have dealt almost exclusively
with mathematical economic theory, he is sensitive to the relationship between mathematical
105
economics and the process of economic research. He consistently attempts to for
formulate
operationally meaningful, not merely elegant, theorems
theorems—in
in other words, to provide testable
hypotheses useful in economic research. “By a meaningful theorem,”
,” he says, “I mean simply
a hypothesis about empirical data which could conceivably be refute
refuted,
d, if only under ideal
conditions.”
What are the two underlying theoretical structure that unifies the
individual structure of microeconomic and macroeconomic theory
Equilibrium and Stability
9.4. Milton Friedman and the Chicago Approach to Microeconomics

The modern modelling approach that has come to dominate the profession has some
grounding, too, in the Chicago approach to economics, which ran counter to the formalist
approach from the 1950s through
ough the 1970s. The Chicago approach was characterized, first,
by a belief that markets work better than the alternatives as a means of organizing society
and, second, by its connection to the Marshallian informal approach to modelling.
Milton Friedman wass a counterweight to Paul Samuelson throughout the modern period of
economics. Friedman summarized his Chicago approach as follows:
1. In discussions of economic policy, “Chicago” stands for belief in the
efficiency of the free market as a means of organizin
organizing
g resources, for
scepticism about government affairs, and for emphasis on the quantity of
money as a key factor in producing inflation.
2. In discussions of economic science, “Chicago” stands for an approach that
takes seriously the use of economic theory as a tool for analysing
ing a
startlingly wide range of concrete problems, rather than as an abstract
mathematical structure of great beauty but little power; for an approach
106
that insists on the empirical testing of theoretical generalizations and that
rejects alike
What characterises the Chicago approach to economics
The Chicago approach was characterized, first, by a belief that markets

work better than the alternatives as a means of organizing society and, second, by its
connection to the Marshallian informal
info approach to modelling.
9.5. Neoclassical Versus Modern Microeconomics

There are six attributes that distinguish neoclassical from modern economics.
1. Neoclassical economics focuses on allocation of resources at a given time. This
attribute is embodied in Robbins’s definition
definition—the
the allocation of scarce resources
among alternative uses—
—which
which became the standard definition of neoclassical
economics. However, the
he focus on allocation at a given point in time ended long ago.
The focus of research in modern economics has turned to allocation over time.
time
2. Neoclassical economics accepts some variation of utilitarianism as playing a central
role in understanding the eco
economy.
nomy. The movement to demand and subjective choice
theory, and away from supply considerations, was a hallmark of early neoclassical
thought. On the other hand, ffew
ew modern economists accept utilitarianism—most
utilitarianism view
it as merely historical—and
and utility theory
theory is rarely used today. While it is true that, in
principles and intermediate books, students are still taught versions of utilitarianism,
these are presented for pedagogical reasons only, not because utilitarianism is the
reigning approach of modern econo
economists.
3. Neoclassical economics focuses on marginal trade
trade-offs.
offs. It came into existence as
calculus spread to economics, and its initial work was centred on the marginal trade-
offs that calculus focused on. While many undergraduate texts still present economics
econom
107
within a marginal framework that is not the way it is presented in graduate schools or
the way top economists think about issues. In fact, in cutting-edge theory, calculus
was already being dropped, having been mined for its insights and the mathematics
being used was moving to set theory and topology, as economists tried to expand the
domain of economics to include a wider variety of topics. In modern graduate
microeconomics, game theory has almost completely replaced calculus as the central
modelling apparatus.
4. Neoclassical economics assumes far-sighted rationality. In order to structure an
economic problem within a constrained-maximization framework, one has to specify
rationality in a way that is consistent with constrained optimization. Specific
rationality assumptions quickly became central to the neoclassical approach. In
modern economics, bounded rationality, norm-based rationality (perhaps established
through evolutionary game theory), and empirically determined rationality are fully
acceptable approaches to problems.
5. Neoclassical economics accepts methodological individualism. This assumptionis
closely tied to the constrained-maximization approach. Someone must be doing the
maximizing, and in neoclassical economics, it was the individual. One starts with
individual rationality, and the market translates that individual rationality into social
rationality. While individualism still reigns, it is under attack by certain branches of
modern economics. Complexity theorists challenge the entire individualistic
approach, at least when that approach is used to understand the aggregate economy.
6. Neoclassical economics is structured around a general equilibrium conception of the
economy. Admittedly it is important, but if it were absolutely central, it would
eliminate Marshall from the neoclassical school.The existence of a unique general
equilibrium is still the predominantly held view, but that is primarily because general
equilibrium models are seldom used. Neoclassical economics never seriously
considered the problem of multiple equilibria. In modern economics, theoretical
economists are quite willing to consider multiple equilibria. It is true that modern
work in policy generally avoids any discussion of multiple equilibria, and that is one
108
of the contradictions in modern econ
economics,
omics, but the topic of multiple equilibria is no
longer out of bounds.

In this study session, we learned the evolution of microeconomics from neoclassical to
modern. We studied the contribution of formalist, Paul Samuelson and the Chicago school in
modern microeconomic theory. We also learned the similarities and difference between the
neoclassical and modern microeconomic school.
Self-Assessment
answers with the Notes on the
he Self-Assessment
SAQ 9.1 Describe the Chicago approach according to Milton Friedman?
Friedman
SAQ 9.2 Compare and contrast the neoclassical and modern microeconomics

1) __________ reformulated microeconomics
microeconomics into a mathematical structure dependent on
Walras.
A) The Radicals
B) The Formalists
C) The Classicals
D) The Institutionalists
2) According to economic historian, who is the father of modern economics and foremost
academic economists of the 20th century?
A) Adam Smith
B) Paul Samuelson
C) Stanley Jevons
D) Carl Menger
109
3) The theoretical structure that underlies and unifies the individual elements of
microeconomic and macroeconomic theory rests on ______ and _______.
A) equilibrium and stability
B) demand and supply
C) partial and general equilibrium.
D) constant and variable.
4) ____________ could be described as the leader of the Chicago school of economics

A) Paul Samuelson
B) Simon Kuznets
C) Milton Friedman
D) J. B Say
5) In analysing economics, the neoclassical focused on marginal analysis using calculus,

while the modern microeconomic uses more of __________.
A) econometrics
B) statistical analysis
C) game theory
D) regression analysis
References
Friedman, Milton. (1953) “The Marshallian Demand Theory.” Journal of Political Economy,
57, 463-495. December
---------. (1953)“The Methodology of Positive Economics.” In Essays in Positive Economics.

Chicago: University of Chicago Press
Hicks, John R. (1946) Value and Capital. Oxford: Clarendon Press

Samuelson, P. A. (1968). "What Classical and Neoclassical Monetary Theory Really Was,"
Canadian Journal of Economics, 1(1), pp. 1-15, & Collected Scientific Papers, 1972,
v. III. pp. 529-543.
110
Roll, E.. (1950).A History of Economic Thought. London: Faber and Fabe
your e-tutor via the LMS.
e or phone on:
08033366677
111
Study Session 10: THE DEVELOPMENT OF MODERN
MACROECONOMIC THOUGHT
Introduction
Interest
nterest in macroeconomic issues has fluctuated throughout the years, reaching its depths
around the turn of the nineteenth century. The attitude of the economics profession toward
macroeconomic thought at that time could be characterized as one of benign neglect.
n The
macroeconomic thinking that did exist, moreover, was somewhat confused. Alfred Marshall,
who had codified and organized microeconomics in his Principles of Economics,
Economics always
intended to do the same for macroeconomics, but he never did. This sec
section
tion will first consider
early work on macroeconomic issues and then deal with the development of modern
macroeconomics. It will then cover the monetarism, and finally consider the current state of
macroeconomics.
Learning Outcomes
At the end of this study
dy session, you should be able to:
1. Identify the forerunners of modern macroeconomics
2. Explain some of the contributions of these economists
3. Identify the problems with IS
IS-LM analysis
4. Trace and discuss the movement back to growth and supply
10.1. Historical Forerunners of Modern Macroeconomics

Modern macroeconomics consists primarily of monetary theory, growth theory, and business-
business
cycle theory. Emphasis on these has fluctuated over the years, in part as the experience of the
economy has changed and
d in part as techniques have allowed economists to deal with issues
that they previously found unmanageable.
112
Analysis of economic growth was the primary concern of Adam Smith, who emphasized the
relationships between free markets, private investment spending, laissez faire, and economic
growth. Ricardo refocused economics, turning it away from economic growth and toward the
issue of the forces determining the distribution of income. This change in viewpoint between
Smith and Ricardo concerning the essential subject matter of economics was fundamentally a
reorientation of economics away from the growth macroeconomics of Smith and toward
Ricardo’s microeconomic concerns—what determines wages, rents, profits, and other prices,
and thus the distribution of income. This emphasis on microeconomics, the allocation
problem, continued to dominate mainstream economic thought from Ricardo in the first
quarter of the nineteenth century until the major depression that engulfed the industrialized
world in the 1930s.
As neoclassical economics developed, the movement away from a focus on growth
accelerated. The neoclassical, with the possible exception of Alfred Marshall, whose views
on growth resembled Mill’s, focused more on static equilibrium. Both Mill and Marshall held
that technological progress could temporarily create the conditions of growth but that the law
of diminishing returns in agricultural and raw materials would ultimately win out.
Joseph Schumpeter, in the discussion of growth in his famous book on the history of
economic thought, distinguishes two types of economists by their thinking about growth: the
optimists and the pessimists. He argues that most mainstream economists fall within the
pessimist group, the strongest pessimists being Malthus, Ricardo, and James Mill. These
mainstream economists strongly emphasized decreasing returns, ever-increasing rent, and the
stationary state toward which the economy was progressing. They did this even as the
economy around them was growing at rates far exceeding those of earlier times.
In his discussion on economic system, Schumpeter argued that capitalism would give way to
socialism because (among other things), the children of entrepreneurs would be educated by
socialist professors. He believed that the Great Depression was caused by the coincidence of
the troughs in economic cycles and the cure to depression was for the federal government and
federal reserve to take limited actions, and wait for the economy to turn up again on its own.
113
Somewhat of an exception to this among the major mainstream economists was John Stuart
Mill, who discussed growth and technology more than Malthus or Ricardo did, and who,
moreover, was much more optimistic about the possibility of continued growth. But a close
reading of Mill shows that he did not base his belief so much on the continued growth of
technology and capital as on his belief that societies would ultimately voluntarily restrict the
birth rate and thus slow the inevitable diminishing marginal returns.
10.2 Monetarism
The Monetarist school emphasises the role of government in controlling the amount of
money in the circulation. Under the leadership of Milton Friedman, they provided an
effective opposition to Keynesian policy and theory. The consumption function model used
by Keynesians in the 1950s had no role for money, nor did it consider prices or the price
level. This initial lack of concern about money supply and prices manifested itself in policy
based on Keynesian analysis. The theory draw its roots from two historically antagonistic
schools of thought: the hard money policies that dominated monetary thinking in the late 19th
century, and the monetary theories of John Maynard Keynes, who, working in the inter-war
period during the failure of the restored gold standard, proposed a demand-driven model for
money. While Keynes had focused on the value stability of currency, with the resulting
panics based on an insufficient money supply leading to alternate currency and collapse, then
Friedman focused on price stability, which is the equilibrium between supply and demand for
money.
In an agreement with the Treasury that developed during World War II, the Federal Reserve
Bank agreed to buy whatever bonds were necessary to maintain the interest rate at a fixed
level. In so doing, the Fed relinquished all control of the money supply. Monetarists argued
that the money supply played an important role in the economy and should not be limited to a
role of holding the interest rate constant. Thus, the rallying cry for early monetarists was that
money mattered. The monetary transmission mechanism works through the effects of
changes in the money supply on investment.
114
Keynesians were soon willing to concur with the monetarists that money mattered, but they
felt that the monetarists differed from them in believing that only money mattered. The
debate was resolved by means of the IS-LM Keynesian-neoclassical synthesis, in which the
monetarists assumed a highly inelastic LM curve and Keynesians assumed a highly elastic
LM curve. Thus, at least in terms of the textbook presentation, monetarist and Keynesian
analyses came together in the general neo-Keynesian IS-LM model, about which they
differed slightly on some parameters.
Modern macroeconomics was a result of economists working through the neo-Keynesian
model and discovering many problems, some purely theoretical, and some becoming
apparent as neo-Keynesian policy failed.
10.2.1 Problems with IS-LM Analysis

IS-LM analysis remains part of most macroeconomists’ toolbox; it provides the framework
most economists initially use in tackling macroeconomic analysis. By the 1960s, however, it
had been well explored in the literature and found wanting in several ways. First, it forced the
analysis into a comparative static equilibrium framework. In the view of many economists,
Keynes’s analysis concerned—or should have concerned—speeds of adjustment. They
believed that Keynes was arguing that the income adjustment mechanism (the multiplier)
occurred faster than the price or interest rate adjustment mechanisms. Comparative static
analysis lost that aspect of Keynes.
Second, in IS-LM analysis the interrelationship between the real and nominal sectors had to
occur through the interest rate and could not occur through other channels. Monetarists were
unhappy with this because they thought money could affect the economy through several
channels. Many Keynesians were unhappy with the framework because it shed little light on
the problem of inflation, which in the 1960s was beginning to be seen as a serious economic
problem.
Third, the demand for money analysis used to derive the LM curve was not based on a
general equilibrium model; instead, it was assumed in a rather ad hoc fashion. It had not truly
integrated the nominal and real sectors. Because it did not capture the true role of money and
115
the financial sector, it trivialized their function. It made it seem as if a fall in the price level
could bring about an equilibrium, when in fact most economists believed that a falling price
level would make matters worse, not better. Nonetheless, the IS-LM model was adopted. It
was neat, it served its pedagogical function well, it was a rough and ready tool, it provided
generally correct insight into the economy, and it was the best model available.
Dissatisfaction with existing analysis, however, led many macroeconomists to turn to other
models in their research. This led to a dichotomy. While IS-LM analysis remained the key
undergraduate model in the 1970s and 1980s, graduate research started to focus on quite
different issues. By the early 1990s the change in focus was filtering down to undergraduate
courses. Modern theoretical debates in macroeconomics have little to do with the shapes of
the IS-LM curves. Instead, they approach macroeconomic issues from a microeconomic
perspective, and they deal with issues such as the speeds of quantity and price adjustment. In
a sense, many macroeconomic researchers in the 1970s and 1980s argued that we should skip
the Keynesian IS-LM interval and return to the macroeconomic debate, as it existed in the
1930s, when issues were framed in microeconomic terms. Thus, starting in the 1970s, we saw
a reaction against Keynesian economics.
10.3 The Rise of Modern Macroeconomics

Monetarism’s focus on inflation brought it to the fore in the 1970s as inflation increased
substantially. As this happened, Keynesian policies and theory lost favour. Fiscal policy
proved politically too hard to implement; decisions on spending and taxation were made for
reasons other than their macroeconomic consequences. Monetary policy became the only
game in town, but the Keynesian models did not include the potential inflationary effects of
monetary policy and so were not well suited to dealing with discussions of monetary policy.
As a result there was a movement away from Keynesian economic models for formulating
policy.
Simultaneously, there was a movement away from the Keynesian models on theoretical
grounds. As economists tried to develop the microfoundations for those models, they found
that they could not do so within the context of the standard general equilibrium
116
microeconomic approach. This desire for microfoundations deserves some comment, since
it is important in understanding the movement away from neoclassical economics and into
modern formalistic eclectic model-building economics.
Keynesian macroeconomics does not fit the neoclassical fold, and thus it can be seen as a step
in the direction away from neoclassical and into the eclecticism that characterizes modern
economics. It starts with analysis of interrelationships of aggregates rather than developing
these relationships from first principles. Thus, it has always had a tenuous theoretical
existence, its primary role being as a rough-and-ready guide to policy. Loose
microfoundations were added to macroeconomics throughout the 1950s and 1960s where
they seemed to fit, but no attempt was made to develop macroeconomics models from first
principles. Macroeconomics was simply out there—a separate analysis with little direct
connection to the Walrasian theory that was at the core of theoretical microeconomics.
10.4 The Movement Back to Growth and Supply

New classical economics notably influenced macroeconomics, but it did not garner
significantly more proof for its theories than had Keynesian macroeconomics. Data were
simply insufficient to provide any answers. At that point macroeconomists stopped looking at
business-cycle issues and started to focus macroeconomics on growth. This fit with the events
of the time, as the U.S. economy grew throughout the 1990s and did not experience a
business cycle.
The analysis of growth started by going back to the Solow growth model, which had been
developed in the 1950s as a response to the Harrod-Domar model. That model had argued
that growth was a knife-edge and that, unless the economy was extremely lucky, it would
likely fall into a depression. Solow’s model challenged that conclusion by eliminating the
assumption of a fixed capital/labour ratio; it showed that the economy would always come
back to a balanced growth path. The economy was stable, not unstable. The Solow growth
model, also called the neoclassical growth model, focused completely on supply; demand
played no role in determining output. New classicals found it to their liking and developed it
further as they attempted to explain why growth rates among countries differed.
117
The movement of macroeconomics toward an emphasis on growth changed the nature of
macroeconomics. Growth models were supply
supply-based
ed models: they had no role for demand in
them. Thus, as growth models became more prominent, Keynesian models became less so.
As these growth models worked their way first into intermediate books and then into
introductory books, the association of macroe
macroeconomics
conomics with Keynesian economics faded, and
instead the quantity theory of money and the growth theories became the focus of modern
macroeconomics. Classical growth theory was supplemented with new endogenous growth
theory.. In endogenous growth theory, te
technological
chnological change was not considered something
that occurred outside the economic model; it was endogenous to the model. It was the natural
result of investment in research and development. Endogenous growth theory allowed
increasing returns to overwhelm diminishing marginal returns, and the result of this could be
continual growth and no eventual movement to the stationary state. Thus it brought
mainstream macroeconomics back into the optimist, rather than the pessimist, fold.
The focus on growth displaced
ed much of Keynesian macroeconomics. Keynesian-type
Keynesian models
were still used, but the multiplier was deemphasized and any discussion of demand policy
was downplayed. Monetary policy was to be used to prevent inflation; fiscal policy was
impractical, and the real policy focus had to do with supply
supply-side incentives.
But questions also arose about the Solow growth model: it did not neatly fit into the empirical
events. Two modifications helped to solve this problem: it was adjusted, and it was replaced
by new growth
owth theory, which focuses on technology, and goes back to Smith.

In this study session, we learned about the historical forerunners of modern macroeconomics
and some of their contribution. We further learned about the monetarists
monetarists and there IS-LM
analysis. We also learned that the main focus of macroeconomics today is on a new growth
theory that deviates significantly from the earlier classical growth theory, especially in
emphasizing endogenous technology and in not considering
considering the stationary state as inevitable.
118
Self-Assessment Questions (SAQs) for Study Session 10
SAQ 10.1 What are some problems with IS-LM analysis?

SAQ 10.2 The movement of macroeconomics toward an emphasis on growth changed
the nature of macroeconomics, explain briefly

1) Joseph Schumpeter believed that to cure the depression the main point would be for _____.
A) the federal government to run large budget deficits
B) the federal reserve to buy government bonds
C) the federal reserve to sell government bonds
D) the federal government and federal reserve to take limited actions, and wait for
the economy to turn up again on its own
2) Schumpeter believed that the Great Depression was caused by _____?

A) bad monetary policy
B) bad fiscal policy
C) the coincidence of the troughs in economic cycles
D) lack of coordination among markets
3) One of the main insights of monetarism is that

A) sustained inflation is a purely monetary phenomenon.
B) the government can effectively manage aggregate demand by using its
spending and taxing powers.
C) velocity is unstable and subject to wide fluctuations.
D) inflation can continue indefinitely without the cooperation of the Federal
Reserve.
4) The leading spokesman for monetarism over the last few decades was
A) John Kenneth Galbraith.
119
B) Milton Friedman.
C) Robert E. Lucas.
D) Paul
aul Samuelson.
5) The monetary transmission mechanism works through the effects of changes in the money
supply on __________.
A) the budget deficit
B) government expenditures
C) investment
D) taxation
References
Lucas, Robert
rt (1981). Studies in business cycle theory.
ory. Cambridge: Cambridge University
Press.

Weintraub, Roy (1979). Micro-foundations:

Micro The compatibility of microeconom
icroeconomics
andMacroeconomics. New York: Cambridge University Press.
Press

Taylor, O. H. (1960). A history

istory of economic thought.New
hought.New York: McGraw Hill Book Co.
your e-tutor
tutor via the LMS.
e or phone on:
120
08033366677
ANSWERS TO SELF-ASSESSMENT QUESTIONS
STUDY SESSION 1
Notes on Self-Assessment Questions
SAQ 1.1: The reformation of the classical school of thought built up the neoclassical
school. However, the gradual transformation came up through the adoption of
new tools of analysis among which is the popular and well accepted tool of
marginalism. Prominent contributors among others in this school of thought
are names such as W.S Jevons, Carl Menger, Heinrich Gossen and Leon
Walras
SAQ1.2: They all saw utility as inherent satisfaction derivable from final goods which
was why Carl Menger described utility as ‘importance of satisfaction’. To
him, utility is the capacity of a thing to serve for the satisfaction of human
needs. The neoclassical utility analysis was not based on any specific measure
but they believed in its unspecified unit of measurement and that it has
capacity. Hence, they not only brought up cardinal measurement of utility, but
also drew the fact that utility is additive. The utility analysis takes into
cognizance that consumers have perfect knowledge of prices and availability
of commodities and that they are rational which means that they always
compare and aim at the maximum satisfaction. It was based on these
assumptions that the neo classical applied the concept of utility to the theory
of demand and supply
Answers to Multiple Choice Questions 1
Question 1 2 3 4 5
Answer B D B C B
STUDY SESSION 2
SAQ 2.1: Under the Marginal Productivity Theory, the Austrians recognized that any of
the factor inputs could be varied and their marginal products could be
121
computed. It is the marginal products of factor inputs that determine the
payments to these factors.
SAQ 2.2: Views on the Definition of Interest
1. To the economists in general, interest is the payment for the use of capital or it
is the reward received for parting with capital.
2. To the classical economists, it is the reward for abstinence which can be in
form of postponing present consumption or saving.
3. The Austrians saw interest as the premium for time preference which explains
the difference between the present utility and future utility of a particular
commodity.
4. To the neoclassical economists, interest is the price of credit which is
determined by the demand and supply for loanable funds.
Question 1 2 3 4 5
Answer C C A B D
STUDY SESSION 3
SAQ 3.1: Marshal’s contributions to aspects economic theories
1. Demand and consumer surplus
2. Taxes and welfare
3. Supply and distribution
4. Stable and unstable equilibrium
5. Economic fluctuations, money and prices
SAQ 3.2: Stable and Unstable Equilibrium

Stable equilibrium describes a situation where any little disturbance in an equilibrium
position eventually adjust itself back to the former position. Stable equilibrium can be
static or dynamic. It is static when counteracting forces reach a state of rest from
which there is no tendency of moving away from it. It is dynamic when equilibrium
122
position keeps changing to another new equilibrium position. On the other hand,
unstable equilibrium is when any disturbance in equilibrium position causes changes
that push the position farther apart never to be restored.

Question 1 2 3 4 5
Answer D C C A B
STUDY SESSION 4
SAQ 4.1: Leon Walras full name was Marie Esprit Leon Walras. He was born in
Evreux, France and he lived between 1834 and 1910. Walras taught
economics in the Academy (now University) of Lausanne in Switzerland. His
biggest contribution was the general equilibrium theory.
SAQ 4.2: Suppose we want to analyse the influence of corn prices of a reduction in
production costs in the corn industry following the partial equilibrium
approach. The immediate effect of lower costs of production in the corn
industry is to lower corn prices as the supply of corn increases. However, the
decrease in price of corn will also influence the demand for soybean. As corn
prices fall relative to soybean prices, the demand for soybean will decrease as
the quantity of corn demanded increases; consumers will substitute soybean
for corn. The decrease in demand for soybean will result in a fall in price of
soybean, which will result in a decrease in the demand for corn and a further
fall in its price. The interaction between the prices and demand of these two
commodities will continue, with a resulting change in prices and outputs
becoming smaller and smaller, until new equilibrium conditions are
established in both industries

123
Question 1 2 3 4 5
Answer D B A A B
STUDY SESSION 5
SAQ 5.1: Three important factors distinguish institutional economics from conventional
economic thoughts and these are:
1. a primary interest in economic and cultural change under the combined
impact of technology and investment for profit
2. a refusal to distinguish between economic analysis using the normative
notion of what economic and non-economic is
3. a critical attitude towards the perceived hidden biases and preconceptions of
pure economic theory
SAQ 5.2: The Veblenian dichotomy is a construct that facilitates an appraisal of the
character and import of social change. The Veblenian dichotomy separates
institutions into two primary aspects: instrumental behaviour and ceremonial
customs. Each of this behaviour is a way of knowing, doing and valuing. Both
are aspects of human behaviour and both help to explain human activities.
The fundamental Veblenian distinction, a dichotomy connoting mutually
exclusive paired constructs, originates with his concept of instincts –
“workmanship and predation”. These instinctive drives of human beings create
tensions. The first one, the instinct of workmanship (otherwise called parenthood
or idle curiosity) would lead humans to produce high quality products with great
efficiency. On the other hand, the predatory (or acquisitive) instinct leads to
behaviour that would benefit individuals even though it might have deleterious
consequences on the whole of the society.
Question 1 2 3 4 5
Answer B B C B C
124
STUDY SESSION 6
SAQ 6.1: Axioms of Marxian System
1 Labour is Value
Marx believed that commodities are nothing but the products of human labour which
are produced for the market. Final products are traceable to human efforts used in
their production. According to Marx, value is nothing but that fragment of the total
labour potential existing in a given society in a certain period (e.g. a year or a month)
which is used for the output of a given commodity, at the average social productivity
of labour existing then and there, divided by the total number of these commodities
produced and expressed in hours (or minutes), days, weeks, or months of labour.
2 Socially Necessary Labour
Socially necessary labour is important in determining the exchange value of
commodities in trade, according to Marx, and consequently constrains producers in
their attempt to economise on labour. Labour is socially necessary when it is of
average skill and intensity, it uses modern instruments of production and produces
commodity which is in demand. By socially necessary labour, Marx refers
specifically to the total labour time required to produce an output. It is this current
labour cost which determines the value of output.
3 Surplus Value
Although Marx did not invent the concept, however, surplus value is an important
concept in his critique. It is a translation of German word “Mehrwert”, which means
“value-added”. According to Marx, surplus value equals the new value created by
workers in excess of their own labour cost, which is appropriated by the capitalist as
part of profit when commodities are sold. For instance, the capitalist takes the whole
day of the labour, say 15 hours, to produce a given commodity but pays the wage
equals to 10 hours. The remaining 5 hours over and above the wage rate paid by the
capitalist to labour is what is referred to as surplus value, which the capitalist keeps to
himself.
125
SAQ 6.2: Marxian Theories
1 Labour Theory of Value
Marx inherited the labour theory of value from the classical school. For Ricardo,
labour is essentially a numeraire (that is a basic unit measurement), which enables a
common computation of labour and capital as basic elements of production costs. On
the contrary, for Marx, labour is value.Commodities manifest in their prices certain
quantitative relationships and this implies that all commodities must have one element
in common that must exist in certain measurable quantities. Marx turned to labour as
the common element and concluded that it is the amount of labour time necessary to
produce commodities that governs their relative prices. According to Marx, the only
social cost of producing commodities was labour.
2 Theory of Rent
What the theory of rent simply means is that in agriculture and mining, less
productive labour determines the market value of food or minerals (as in the general
case of labour theory of value), and therefore more efficient farm and mines enjoy
surplus profits which Marx called differential (land or mining) rent.The Marx theory
of rent also means that as long as productivity of labour in agriculture is generally
below the average of the economy as a whole, the sum total of surplus-value produced
in agriculture will accrue to landowners and capitalist farmers taken together, and will
not enter the general process of distribution of profit throughout the economy as a
whole. Stated differently, theory of rent asserts that when the composition of capital,
machinery and raw materials expenditure against wages, is inferior in agriculture to
that in industry and transportation, the total surplus-value produced in agriculture will
accrue to landowners and capitalist farmers taken together.
3 Theory of Money
126
Similar to the assertion that value is the embodiment of socially necessary labour,
commodities exchange with each other in proportion to the quantities of labour they
contain. This is true for the exchange of gold against maize as it is true for the
exchange of gold against iron or silver. Marx theory of money is a commodity theory
of money that is, a given commodity can play the role of universal medium of
exchange, as well as fulfill all other functions of money, just because it is a
commodity and because it is also a product of socially necessary labour. This is
applicable to precious metals as well as all other commodities that throughout history
have played the role of money. Marx held that metallic money, such as gold, is a
commodity, and its value is the labour time necessary to produce it (mine it, smelt it,
etc.).

Question 1 2 3 4 5
Answer B C D A C
STUDY SESSION 7
SAQ 7.1: Price Stickiness is the recognition that in reality workers often refuse to lower
their wage demands even in cases where a classical economist might argue it
is rational for them to do so. Due in part to price stickiness, it was established
that the interaction of "aggregate demand" and "aggregate supply" may lead to
stable unemployment equilibria – and in those cases, it is the state, and not the
market, that economies must depend on for return to equilibrium state.
SAQ 7.2: Sound finance and Functional finance are policy tools of government
advocated by Lerner. Sound finance implies balanced budget policies, while
functional finance considered the results of the policies. Functional finance
allowed the government to drive the economy with monetary and fiscal policy
portrayed as government steering wheel
127
Question 1 2 3 4 5
Answer D D C D D
STUDY SESSION 8
SAQ 8.1: According to Eileen Applebaum (1977), the radical position encompasses the
following three points:
1. Radical economists thought that “major socioeconomic problems can be
solved only through a radical restructuring of our society.” They argued that
poverty, racism, sex discrimination, destruction of the environment, alienation
of workers, and imperialism “are not pathological abnormalities of the system,
but rather are derived directly from the normal functioning of capitalism.”
2. Radicals argue that there are major inconsistencies between neoclassical
theory and real-world experience. Where mainstream economists see social
harmony, radicals see conflict.
3. Following their Marxist heritage, radicals view society as an “integrated social
system existing in concrete historical circumstance.” They believed that
mainstream economics simply accepts existing institutions, such as the
market, as given and does not consider a wide variety of proposals to change
those institutions. They see the incremental changes advocated by mainstream
economics as hardly worth considering. As Eileen Applebaum states, radicals
“are interested in ending - not salvaging or stabilizing - monopoly capitalism”
and replacing it with “a socialist society based on participatory planning,
public ownership of the means of production, the elimination of private
appropriation of profit, and a genuinely egalitarian redistribution of income
and wealth.
SAQ 8.2: Landreth and Colander divided the description of institutionalists into three:
128
1. Traditional institutionalist economists – the followers of Veblen, Mitchell
and Commons. One prominent follower of the Veblen-Mitchell-Common
views is Clarence E. Ayres (1891-1972)
2. Quasi-institutionalists - writers whose ideas resemble those of the
institutionalists but who are too individualistic to fit the traditional
institutionalist sphere. Example of writers in this group include Joseph
Schumpeter, Gunnar Myrdal and John Kenneth Galbrath.
3. Neoinstitutionalists – economists who write in a neoclassical choice-theoretic
tradition but who believe that institutions must be far better integrated into
current practice than is currently done. Neoinstitutionalism is sometimes also
called rent-seeking analysis or neoclassical political economy. Its proponents
contend that rational individuals try to improve their wellbeing not only within
a given institutional structure but also by changing that structure. Economic
analysis, they contend, must include a consideration of the forces determining
that institutional structure. An equilibrium institutional structure is one in
which it is not worthwhile for individuals to expend further effort to change
the institutions. Only on the basis of an equilibrium institutional framework,
they say, can one produce relevant analysis.
Question 1 2 3 4 5
Answer D A A B D
STUDY SESSION 9
SAQ 9.1: Friedman summarized his Chicago approach as follows:
1. In discussions of economic policy, “Chicago” stands for belief in the
efficiency of the free market as a means of organizing resources, for
skepticism about government affairs, and for emphasis on the quantity of
money as a key factor in producing inflation.
129
2. In discussions of economic science, “Chicago” stands for an approach that
takes seriously the use of economic theory as a tool for analyzing a startlingly
wide range of concrete problems, rather than as an abstract mathematical
structure of great beauty but little power; for an approach that insists on the
empirical testing of theoretical generalizations and that rejects alike
SAQ 9.2: Differences (1-5) and Similarity (6) between Neoclassical and Modern
Microeconomics
1. Neoclassical economics focuses on allocation of resources at a given time,
while the focus of research in modern economics has turned to allocation over
time.
2. Neoclassical economics accepts some variation of utilitarianism as playing a
central role in understanding the economy. On the other hand, few modern
economists accept utilitarianism—most view it as merely historical—and
utility theory is rarely used today.
3. Neoclassical economics focuses on marginal trade-offs, using calculus. In
modern microeconomics, game theory has almost completely replaced
calculus as the central modeling apparatus.
4. Neoclassical economics assumes far-sighted rationality. In modern economics,
bounded rationality, norm-based rationality (perhaps established through
evolutionary game theory), and empirically determined rationality are fully
acceptable approaches to problems.
5. Neoclassical economics accepts methodological individualism. While
individualism still reigns, it is under attack by certain branches of modern
economics.
6. Neoclassical economics is structured around a general equilibrium conception
of the economy. In modern economics, theoretical economists are also quite
willing to consider multiple equilibria.
130
Question 1 2 3 4 5
Answer B B A C C
STUDY SESSION 10
SAQ 10.1: Problems of IS-LM Analysis
1. First, it forced the analysis into a comparative static equilibrium framework
2. In IS-LM analysis the interrelationship between the real and nominal sectors
had to occur through the interest rate and could not occur through other
channels. Monetarists were unhappy with this because they thought money
could affect the economy through several channels
3. The demand for money analysis used to derive the LM curve was not based on
a general equilibrium model; instead, it was assumed in a rather ad hoc
fashion.
SAQ 10.2: Movement of Macroeconomics Back to Growth
1. The analysis of growth started by going back to the Solow growth model,
which had been developed in the 1950s as a response to the Harrod-Domar
model. But questions also arose about the Solow growth model: it did not
neatly fit the empirical events. Two modifications helped to solve this
problem: it was adjusted, and it was replaced by new growth theory, which
focuses on technology, and goes back to Smith.
2. The movement of macroeconomics toward an emphasis on growth changed
the nature of macroeconomics. Growth models were supply-based models:
they had no role for demand in them. Thus, as growth models became more
prominent, Keynesian models became less so. The focus on growth displaced
much of Keynesian macroeconomics. Keynesian-type models were still used,
but the multiplier was de-emphasized and any discussion of demand policy
was downplayed. Monetary policy was to be used to prevent inflation; fiscal
131
policy was impractical, and the real policy focus had to do with supply-side
incentives.
3. Also, classical growth theory was supplemented with new endogenous growth
theory.
Question 1 2 3 4 5
Answer D C A B C
132

ECN 315 Update PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

ECN 315 Update PDF

Uploaded by

Copyright:

Available Formats

Study Session 1: NEOCLASSICALSCHOOL OF THOUGHT

Learning Outcomes for Study Session 1

1.1 The NeoclassicalSchool

What formed the emergence of the neoclassical economists?

The neoclassical economics began with the introduction and application of

1.2 The Foundation of Marginal Analysis

Highlight the foundation of the marginal analysis?

Marginal analysis as a tool of economic analysis had been signified

1.2.1 The Inadequacy of the Classical Theory of Value

Pinpoint the major shortcomings

The classical cost of production theory of values was found to be

1.3 The Concept of Utility

How did the Marginalists described the concept of utility?

The Marginalists saw utility as inherent satisfaction derivable from

1.4 Utility, Demand

Higher utility is attached to lesser units of a particular commodity, then a

1.5 The Value of Factors

In what way is the price of factor of production determined?

1.6 Important Writers

Multiple Choice Questions:

2 All of the following statements are true except?

3 According to the Marginalists, the major determinant of value is?

4 Which of the following names is the odd one?

Jhingan, M. L. (1999).Microeconomic theory.Revised Edition.India: Vrinda Publications

Samuel W.J, Biddle J.E & Davis J.B(Eds.)

Suggested Books for Further Reading

Learning Outcomes for Study Session 2

2.1 Extension of the Marginal

To the Austrian Marginalists, utility is the “capacity,”ascribed to a good by humans, to satisfy

2.2 Marginal Productivity Theory

What does the marginal productivity theory states?

2.3 Determination of Profit

Why is the marginal productivity theory related to profit determination?

2.4 Existence and Determination of Interest

The marginal productivity theory concluded with the concept of product

Summary of Study Session 2

Multiple Choice Questions

Landreth, C. and D. C. Colander (2001). History of economic thought:

Samuel W.J, Biddle J.E & Davis J.B (Ed

Suggested Books for Further Reading

Samuel W.J, Biddle J.E & Davis J.B (Ed

Learning Outcomes for Study Session 3

What are the major thing

He based majority of his works on abstractions in which he combined facts with

3.2 Demand and Consumer’s Surplus

3.3 Taxes and Welfare

3.4 Supply and distribution

3.5 Stable and Unstable Equilibrium

Unstable equilibrium can arise if the supply curve slopes

3.6 Economic fluctuations, M

Summary of Study Session 3

2. Von Thunen and Cournot are:

3. Marshal’s concept of consumer’s surplus was based on the _________.

5. In discussing welfare, Marshal brought up the possibilities of equitable distribution of

Jhingan, M. L. (1999) Microeconomic tTheory.Revised Edition.India: Vrinda Publications

Landreth, C. and D. C. Colander, (2001). History of Economic Thought: Fourth Edition.

Ogunmuyiwa, M. S (1997) Economic thought: history, analysis and evaluation.Ijebu Ode:

Suggested Books for Further Reading

Landreth, C. and D. C. Colander (2001). History of Economic Thought: Fourth Edition.

Ogunmuyiwa, M. S (1997) Economic thought: history, analysis and evaluation.Ijebu Ode:

4.1 Biography of Leon Walras

What were Walras major contributions to the field of Economics?

Application of Mathematics to Economics and the General