Introduction

Marshall was born in Clapham, England, 26 July 1842. His father was a bank cashier and a

devout Evangelical. Marshall grew up in the London suburb of Clapham and was educated at

the Merchant Taylors' School and St John's College, Cambridge, where he demonstrated an

aptitude in mathematics, achieving the rank of Second Wrangler in the 1865 Cambridge

Mathematical Tripos.

 Marshall experienced a mental crisis that led him to abandon physics and switch to

philosophy. He began with metaphysics, specifically "the philosophical foundation of

knowledge, especially in relation to theology." Metaphysics led Marshall to ethics, specifically

a Sidgwickian version of utilitarianism; ethics, in turn, led him to economics, because economics

played an essential role in providing the preconditions for the improvement of the working class.

He saw that the duty of economics was to improve material conditions, but such improvement

would occur, Marshall believed, only in connection with social and political forces.

His interest in liberalism, socialism, trade unions, women's education, poverty and progress

reflect the influence of his early social philosophy on his later activities and writings.

Marshall was elected in 1865 to a fellowship at St John's College at Cambridge, and became

lecturer in the moral sciences in 1868. In 1885 he became professor of political economy at

Cambridge, where he remained until his retirement in 1908.

Over the years he interacted with many British thinkers including Henry Sidgwick, W.K.

Clifford,Benjamin Jowett, William Stanley Jevons, Francis Ysidro Edgeworth, John Neville

Keynes and John Maynard Keynes. Marshall founded the "Cambridge School" which paid

special attention to increasing returns, the theory of the firm, and welfare economics; after his

retirement leadership passed to Arthur Cecil Pigou and John Maynard Keynes

Utility and Demand

The marginal utility of a good or service is the gain from an increase, or loss from a decrease, in

the consumption of that good or service. Law of diminishing marginal utility, meaning that the

first unit of consumption of a good or service yields more utility than the second and subsequent

units, with a continuing reduction for greater amounts. The marginal decision rule states that a

good or service should be consumed at a quantity at which the marginal utility is equal to

the marginal cost. Law of diminishing marginal utility states that the marginal utility of good or

service declines as its available supply increases. Economic actors devote each successive unit of

the good or service towards less and less valued ends. The law of diminishing marginal utility is

used to explain other economic phenomena, such as time preference.

Whenever an individual interacts with an economic good, he or she necessarily acts in a way that

demonstrates the order in which he or she values the use of that good. Thus, the first unit of a

good is dedicated to the individual's most valued end; the second unit is devoted to the second

most valued end and so on.

Consider a man on a desert island after a case of bottled water washes on shore. He might drink

the first bottle, indicating that satisfying his thirst was the most important use of the water. He

might bathe himself with the second bottle, or he might decide to save it for later. If he saves it

for later, he is indicating that he values the future use of the water more than bathing today, but

still less than the immediate quenching of his thirst. This is called ordinal time preference. This

concept helps explain savings and investment versus current consumption (spending).

This also helps explain why demand curves are downward-sloping in microeconomic models,

since each additional unit of a good or service is put towards less valuable ends. This application
of the law of marginal utility demonstrates why a rise in the money stock (other things being

equal) reduces the exchange value of a money unit, since each successive unit of money is used

to purchase a less valuable end.It also provides an economic argument against the manipulation

of interest rates by central banks, since the interest rate affects the saving and consumption habits

of consumers or businesses. By distorting the interest rate, consumers are encouraged to spend or

save out of accordance with their actual time preferences, leading to eventual surpluses or

shortages in capital investment.

Rational Consumer Choice:

Rational choice theory is a framework for understanding and often formally modeling social and

economic behavior. The basic premise of rational choice theory is that aggregate social behavior

results from the behavior of individuals, each of whom is making their individual decisions. The

theory therefore focuses on the determinants of the individual choices.

Rational choice theory assumes that an individual has preferences among the available choice

alternatives that allow them to state which option they prefer. These preferences are assumed to

be complete i.e. the person can always say which of two alternatives they consider preferable or

that neither is preferred to the other. These preferences are also transitive which states that if

option A is preferred over option B and option B is preferred over option C, then A is preferred

over C. A rational individual is assumed to take account of available information, probabilities of

events, and potential costs and benefits in determining preferences, and to act consistently in

choosing the self-determined best choice of action.

Alfred Marshall formulated the consumer behavior theory and it connected economics rational

choices. Marshall’s neoclassical economic theory of the consumer was designed to describe,
explain and predict which bundles of goods consumers would buy at various quantities and

prices. Consumers carefully allocate their scarce household resources among various purchase

alternatives to maximize the expected utility that includes satisfactions of needs, solution of

problems, pleasure or happiness that the product provides. Rationality means that the buyers

make choices that produce optimal results for themselves, maximizing the utility within the

constraint of their financial budgets. For example, if a consumer has a certain amount of money

which he can allocate to buy clothes or to go on vacation, he is weighing two different types of

expenditures equally. Now, he would spend the money on the thing from which he would get

more utility.

Marshall’s model suggested that marketers should give more product quantity to consumers for

their money than competitors. They should also offer better product quality for the same price as

competitors.

Law Of Demand:

Alfred Marshall was one of the most influential economists of his time. His book, Principles of

Economics published in 1890, was the dominant economic textbook in England for many years.

It brings the ideas of supply and demand, marginal utility, and costs of production into a coherent

whole. Marshall’s law of demand follows directly from the concept of diminishing marginal

utility and rational consumer choice. He stated that the demand of a product increases with a fall

in price and diminishes with a rise in price. There is an inverse relationship between quantity

demanded and its price. The consumers know that when price of a commodity goes up its

demand comes down. And when there is decrease in price the demand for a commodity goes up.
There is inverse relationship between price and demand. The law refers to the direction in which

quantity demanded changes due to change in price.

Suppose that the expenditure of a consumer is in equilibrium such that the last dollar spent on

each of the several products have same marginal utility. A consumer is buying oranges and

apples and the marginal utility of these products, to the consumer, is same. Now, the price of

apples decreases but the prices of oranges remains constant. Marshall reasoned that a rational

consumer would buy more of the apples as compared to oranges. This is because, the decline in

the price of apples has increased the marginal utility per price of the apple, while the marginal

utility per price of orange remained the same. To restore a balance of expenditures, the consumer

would substitute more apples for less orange. As this substitution occurs the marginal utility of

apples would decrease and the marginal utility of oranges would increase. At some point, the

decreased marginal utility of apples would become equal to the marginal utility of oranges and

thus equilibrium would be restored.

Marshall held tastes and preferences constant along with the wealth of consumer, purchasing

power of consumer and the price of substitute commodities. These factors are known as

‘determinants of demand’. The changes in these factors would cause the entire demand curve to

shift. Change in price alone would cause an upward or downward movement along the same

demand curve while change in any other factor would shift the entire demand curve rightwards

or leftwards.

Marshall assumed the purchasing power of money to be constant. He stated that when the price

of a product decreases it is accompanied with two effects; substitution effect and income effect.
The income effect explains that when the price of a product decreases, the purchasing power of

consumer increases as they can buy more of the product from same amount of money.

Consumers’ Surplus:

Marshall's belief that the marginal utility of money was constant for small changes in prices

permitted him to draw certain conclusions in the area now known as welfare economics. The

concept of consumer surplus is another of Marshall’s contributions. He noted that the price is

typically the same for each unit of a commodity that a consumer buys, but the value to the

consumer of each additional unit declines. A consumer will buy units up to the point where the

marginal value equals the price. Therefore, on all units previous to the last one, the consumer

reaps a benefit by paying less than the value of the good to himself. The size of the benefit equals

the difference between the consumer’s value of all these units and the amount paid for the units.

This difference is called the consumer surplus, for the surplus value or utility enjoyed by

consumers.

The marginal utility of a product, say A, is given by the formula; MUa = Pa x MUm. Assuming

that the marginal utility of money is constant, the price of good A and the marginal utility of

good A are directly related. Marshall concluded that the price of good A is a measure of the

marginal utility of good A to a consumer. Demand curves slope down and to the right because of

diminishing marginal utility. Their downward slope indicates that consumers will be willing to

pay more for earlier consumed units of a commodity than for later consumed units. In the

market, however, consumers are able to buy all the units they consume at one price. Because this

price measures the marginal utility of the last unit consumed. The consumers obtain the earlier

units at a price less than they would be willing to pay. The difference between the total amount

consumers would be willing to pay and what they actually pay constitutes consumers' surplus.
Marshall wished to use the concept of consumers' surplus to draw welfare conclusions; therefore,

he was concerned with the surplus of consumers as a group rather than with the individual

consumer's surplus. He worked with market-demand curves, not individual-demand curves.

Consumers' Surplus

Given a market-demand curve as shown in the figure, we can analyze consumers' surplus. If the

market price is OC, the quantity demanded will be OH. Because DD' is a market-demand curve,

there are buyers who would have been willing to pay a higher price than OC. The OMth buyer

would have been willing to pay a price of MP but paid only a price of MR. RP then represents

the consumer's surplus. All the other intramarginal buyers also receive a consumers' surplus. The

total consumers' surplus is equal to CDA, which is the difference between what consumers spent
to buy the commodity, or OCAH, and what they would have been willing to spend, or ODAH.

CDA is a measure of the monetary gain obtained by consumers in purchasing a commodity.

CDA is therefore the amount the consumers save.

Consumer surplus is the area above the market price and below the demand curve. Consumer

surplus increases significantly in a productive social environment in which price of good fall as

they are produced more efficiently. As an individual reaches equilibrium at a lower point at the

demand curve, his consumer surplus grows because he will buy more goods as they are cheaper.

Marshall explained the concept of consumer surplus using the example of tea. The amount a

person spend on tea is very less as compared to his total expenditure therefore a decline in price

of tea would have a little or no effect on the purchasing power of the customer. On the other side,

if the price of natural gas goes down, the purchasing power of the consumer would increase

because of the increase in real income. Therefore, not all of the units of money used to measure

consumer surplus possess the same utility value.

Another problem associated with measuring consumer surplus is dealing with markets as

opposes to individual demand curves. Market demand curves are aggregation of thousands of

individual curves. Calculating the consumer surplus requires adding together interpersonal units

of utility. The diversity of individual preferences and income level make this calculation

difficult, if not impossible.

Marshall also introduced the concept of producer surplus, the amount the producer is actually

paid minus the amount that he would willingly accept. Marshall used these concepts to measure

the changes in well-being from government policies such as taxation.

Elasticity Of Demand:

Elasticity of demand is a measure used in economics to show the responsiveness of the quantity

demanded of an item to a change in its price. Marshall analyzed the concept of elasticity of

demand in detail using diagrams and tables. He stated that, other things being equal, the desire of

a commodity for the consumer decreases with the increase in supply of that product. Therefore,

lower the price, the consumer would buy more. Mathematically, elasticity of demand can be

expressed as

EP =( ∆∆ QP )( QP )
From the equation it is observed that;

 When percentage change in quantity demanded is greater than the percentage change in

price, then price elasticity will be greater than 1 and in this case demand is said to be

elastic.

 When percentage change in quantity demanded is less than the percentage change in

price, the price elasticity will be less than 1 and demand would be inelastic.
  When percentage change in quantity demanded is equal to the percentage change in price,

the price elasticity will be equal to 1 and demand would be unit elastic.

Determinants Of Elasticity:

Marshall also discussed the determinants of elasticity. The overriding factor in determining

elasticity of demand is the willingness and ability of consumers after a price change to postpone
immediate consumption decisions concerning the good and to search for substitute. A number of

factors can thus affect the elasticity of demand for a good:

 Availability of substitute goods: The more and closer the substitutes available, the higher

the elasticity is likely to be, as people can easily switch from one good to another if an

even minor price change is made. In other words, there is a strong substitution effect. If

no close substitutes are available, the substitution of effect will be small and the demand

inelastic.

 Percentage of income: The higher the percentage of the consumer's income that the

product's price represents, the higher the elasticity tends to be, as people will pay more

attention when purchasing the good because of its cost. The income effect is thus

substantial. When the goods represent only a negligible portion of the budget, the income

effect will be insignificant and demand inelastic.

 Necessity: The more necessary a good is, the lower the elasticity, as people will attempt

to buy it no matter the price, such as in the case of insulin for those that need it.

 Duration: For most goods, the longer a price change holds, the higher the elasticity is

likely to be, as more and more consumers find they have the time and inclination to

search for substitutes. When fuel prices increase suddenly, for instance, consumers may

still fill up their empty tanks in the short run, but when prices remain high over several

years, more consumers will reduce their demand for fuel by switching to carpooling

or public transportation, investing in vehicles with greater fuel economy, or taking other

measures. This does not hold for consumer durables such as the cars themselves,
 however; eventually, it may become necessary for consumers to replace their present

cars, so one would expect demand to be less elastic.

 Brand loyalty: An attachment to a certain brand either out of tradition or because of

proprietary barriers can override sensitivity to price changes, resulting in more inelastic

demand.

 Who pays: Where the purchaser does not directly pay for the good they consume, such as

with corporate expense accounts, demand is likely to be more inelastic.

The principle of elasticity helps in understanding a wide range of problems and policies.

Governments, for example, tax commodities for which there are inelastic demand (cigarettes,

alcohol) rather than those with elastic demands, because the revenue yield is greater.

Restrictions of agricultural output result in greater gross revenue to farmers if the demand for

product is inelastic (wheat) and smaller revenue if the demand is elastic.

Supply

Marshall’s most important contribution to the theory of supply was his concept of the time

period and cost of production.

Cost of Production

Marshall divided total cost of production into prime costs and supplementary costs.

Prime Costs

The prime cost (what we call today variable cost) is that part of total cost which varies with

quantity of output produced. The prime cost is made up of the monetary cost of the raw material

used in making the commodity and the wages of labor employed in it.

Supplementary Costs

The supplementary cost (what we call today fixed cost) is that part of total cost which does not

vary with quantity of output produced. Whatever the quantity of goods produced, charges on

account of rent, taxes, salaries etc must be paid. Even if the orders cease to flow in and the

factory is closed, these costs continue.

Time Period

Marshall identified four time periods:

Market Period

The market period is a very short period in which the supply of a commodity is fixed. The time

period is so short that supply is not responsive to demand. This market period may be an hour, a

day or a few days, or even a few weeks depending upon the type of the commodity under

consideration as to whether it is a perishable or semi-durable one.

Short Run

The short run is a period in which the firm can change production and supply but cannot change

plant size. Here there is a reflex action, as higher prices cause larger quantities to be supplied. In

the short run all variable costs must be covered, but some of the fixed costs may not be.

Long Run

Long run is the period of several years. In long run all costs are variable and none are fixed.

Since all costs are variable, the firm has to cover all of the costs in the long run.
Supply Curve

Marshall introduced the concept of real cost of production of a commodity. According to

Marshall, real cost of production of a commodity is the exertions of all different kinds of labor

that are directly or indirectly involved in making the commodity along with the abstinence (or

waiting) required to save capital used in making it. These costs are also known as incentives and

if the firm wants to produce more it has to provide extra incentive to the people who are

providing their services or capital. For this reason, Marshall said that supply curve slopes upward

to the right.

Equilibrium Price and Quantity

Marshall said that equilibrium price and quantity depend on both supply and demand. Marshall

determined the equilibrium price and quantity in both tabular and graphical form.
Tabular Representation

Price (Shillings) Amount seller are willing to Amount buyers are willing to

sell (Supply) buy (Demand)

37 1000 600
36 700 700
35 600 900

Assumptions

 Marshall assumed that the amount each seller offers for sale at any price is governed by

his immediate need for money or by the estimate of future prices.

 Marshall assumed equality of bargaining power between buyers and sellers.

Marshall said that the bargaining between buyers and sellers will result in a market price of 36

shillings because only at this point quantity supplied is equal to quantity demanded. Therefore,

equilibrium price will 36 shilling and equilibrium quantity will be 700 units. If price was 37

shillings then supply will be more than demand. This surplus of supply will push the price

downward. If the price was 35 shillings then demand will be more than supply due to which

there will be an upward pressure on price.

Graphical Representation

Marshall explained equilibrium quantity and price graphically too. His graphical representation

is known as Marshallian Cross. In the figure given below the vertical axis measures the price of

the good. The horizontal axis measures the quantity of the good exchanged. The negatively-

sloped demand curve, D, represents the law of demand. The positively-sloped supply curve, S,

represents the law of supply.

According to Marshall, equilibrium will take place at the point where quantity supplied is equal

to quantity demanded. Equilibrium quantity is Q* and equilibrium price is P*.

If the price is set too high, excess supply will be created within the economy. At price P1 the

quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the
quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2

is greater than Q1, too much is being produced and too little is being consumed. Forces in the

market will continue to drive the price up until the quantity supplied equals the quantity

demanded.

Excess demand is created when price is set below the equilibrium price. Because the price is so

low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.

Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus,

there are too few goods being produced to satisfy the wants (demand) of the consumers.

However, as consumers have to compete with one other to buy the good at this price, the demand

will push the price up, making suppliers want to supply more and bringing the price closer to its

equilibrium.

DISTRIBUTION OF INCOME:
The basic idea in neoclassical distribution theory is that incomes are earned in the production of

goods and services and that the value of the productive factor reflects its contribution to the total

product.

In a competitive economy the income is distributed by the pricing factors of production. Alfred

Marshall said that Business people must constantly compare the relative efficiency of every

agent of production they employ and they also must consider the possibilities of substituting one

agent for another. Like, Horsepower replaces hand-power and horsepower is replaces by steam

power. At the margin of indifference between two substitutable factors of production, their prices

must be equivalent to the money value they add to the total product.

The remarkable advantage of economic freedom is manifest when a business man experiments at

his own risk to find the combination of factor inputs which will yield the lowest costs in

producing the output. Entrepreneurs should estimate how much net addition to the value of their

total product will be contributed by an extra unit of any one factor of production. Entrepreneurs

will employ or hire each agent up-to that margin at which its net product would no longer exceed

the price that they would have to pay for it. Alfred Marshall based this analysis on the

diminishing returns that results from the disproportionate use of an agent of production.

WAGES:

Marshall said that the Wages are not just determined by the marginal productivity of labor. The

marginal productivity of labor determines the demand for labor. But wages depend on both
demand and supply. If the supply of labor increases, other things remaining constant, the

marginal productivity of labor will fall hence, the equilibrium wage rate will fall. On the other

hand if the supply of labor is reduced the marginal productivity of labor will rise and the wage

rate will rise. Therefore, the marginal productivity does determine wages itself, because varying

the number of workers or employers will produce many possible marginal productivities. So, we

can say that wages measure and are equal to marginal with a given supply of labor. For every

employer the wage rate is fixed at the market wage i.e, the firm is a wage taker so, in order to

reach the optimal level of employment it varies the number of employees. This optimum occurs

where the wage rate equals the extra revenue that the firm gains by selling the marginal product.

Marshall’s four laws of derived demand:

1) Other things equal, the greater the substitutability of other factors for labor, the greater

will be the elasticity of demand for labor.

For example, In circumstances if robots can easily substitute, elastic demand for labor. A

wage rate will increase therefore will produce a unequal decline in unemployment.

2) Other things equal, the greater the price elasticity of product demand, the greater will be

the elasticity of labor demand. For example suppose that the product restaurant meals the

demand of the restaurant meals is elastic and the wage rate rises this will in turn increase

the cost of production and due to which the price of the product raises. This higher

product price will be met with a substantial decrease in purchases. Thus, necessitating an

equally substantial decrease in the number of workers hired e.g, cooks, waiters etc.

3) Other things being equal, the larger the proportion of total production cost accounted for

by labor, the greater will be the elasticity of labor demand.

For example where labor costs are 100% of total costs, a wage rate will also increase of
 20%. But where the cost of labor are just only 10% of the total costs then the wage rate

will increase of 2% and will increase total cost by 2%. In the first case the relatively high

increase in the costs would be expected eventually to cause a huge rise in product price, a

sizeable decrease in production and sales and thus a large drop in employment.

4) Other things being equal, the greater the elasticity of the supply of other inputs, the

greater the elasticity of demand for labor. For example, wage rate in a certain industry

rises and this stimulates an attempt to substitute capital for labor. This increased demand

for capital drive up its prices and retard the substitution process if the supply of the

capital is highly inelastic. But if the supply of capital is highly elastic that increased

demand for capital does not drive up prices and will not retard substitution process too.

INTEREST:

Another distributive share was interest rate that was considered by Alfred Marshall. A rise in the

rate of interest decreases the use of machinery. Mostly, Business people avoids the use of all

machines whose net annual surplus is less than the interest rate. Lower interest rates increase

capital investments. The demand for the loan of capital is the aggregate demands of all

individuals in all trades. The higher the price of the final commodities the less demand for

capital. On the other side, the lower the price of the final commodities there is more demand for

capital. This relationship is based on diminishing marginal productivity associated with the

increase in the quantity of factor, just like the demand for consumer goods is based on

diminishing marginal utility from successive quantities consumed. The diminishing marginal

productivity of capital as more units are acquired constitutes the demand for capital, with the

recorded prices in terms of rates of interest.

The quantity of saving supplied depends on the interest rate and the interest rate depends on the

supply of saving. Just like demand is the series of quantities that would be taken at different

prices, the supply of saving is the whole series of quantities that would be offered at different

interest rates. For saving the price that is the interest rate settles at the point of intersection of the

demand and supply curves as for the supply of other items. Hence, the price determines the

quantity of the commodity supplied.

The willingness of people to postpone present consumption in hopes of gaining a greater reward

in the future is the main motive for saving. If we talk about the Human being nature what it is we

are justified in speaking of the interest on capital as the reward for the sacrifice in the waiting for

the enjoyment of the material resources because less people would save much without reward

just like if we talk about wages as the reward for labor because few people would work hard

without reward.

The sacrifice of the pleasant pleasure for the sake of the future reward has been called the

abstinence by the economists. But for the greatest accumulators of wealth this term has been

misunderstood. The greatest accumulators of wealth are very rich people some of which live in

luxury and do not practice abstinence in this sense it is convertible with abstemiousness. When a

person abstained from consuming anything which he had power of consuming to increase his

resources in the future his abstinence from that particular act of consumption to increase the

accumulation of wealth. We can say that the accumulation of wealth is the result of the

postponement of enjoyment or waiting for it.

Alfred Marshall also recognized the other motives for saving that are also important. He

mentioned the following other motives:

  Family affection

 Force of habit

 Miserliness

 Magnitude of income

 Prudence in wishing to provide for the future

Therefore, some saving might occur even if the interest rate were zero or negative. A person

might save less at a high rate of interest than at a low rate if the person wanted a certain annuity

for his old age.

Profits, Rent, Quasi-Rent:

According to the Alfred Marshall normal profits typically include interest, the earnings of the

management and the supply of the business organization. Above we discussed interest in detail.

The earnings of the management are a payment for a specialized form of labor. The supply price

of business organization is a reward to entrepreneurship.

Marshall said that for the individual producer land is a particular form of capital. Between land

and buildings there is not much difference. Both land and buildings are subject to diminishing

returns as their owners are tries to gain additional output from them. For the society as a whole

the supply of land is permanent and fixed. If the one person has land, there is less for others to

have. On the contrary, if the one person were to invest in improvements of the land or in

buildings on it, the person would not appreciably curtail the opportunities of others to invest

capital in the same improvements. The concept of quasi rent was given by Alfred Marshall. He

defined quasi rent as surplus earnings generated by the factors of production, except land. E.g.

the earnings from machines and instruments are termed as quasi rent. The quasi rent refers to the
income produced when demand for products increases suddenly. It is commonly used for a short

period of time.

In the economic rent the supply of the factor is fixed such as land. Whereas, in the quasi rent the

supply of the factor is temporary and can also be increased or decreased after some time such as

machine. E.g. there is sudden increase in the demand of houses, But, the supply of houses does

not increase with that much speed because of the limited building material. The sudden increase

in the return from the selling of houses is termed as quasi rent.

Quasi rent is regarded as the surplus that is temporary in nature. When the building material

would be available then the amount of surplus would automatically be eradicated. Some type of

surplus arises in case of other goods such as ships, machines and automobiles.

In the long run the earnings from the durable goods is equal to the current rate of interest.

However, they can provide surplus earnings for temporary period which are termed as quasi rent.

Whereas, in the short run the equipment is used for only one purpose and not for other purposes

this implies that the transfer earning for such equipment is zero in the short run. Therefore, the

total earnings generated from the short run equipment are termed as quasi rent. In the short run

the supply of equipment is fixed and cannot be increased with the increase in demand. However,

in the long run the supply of equipment can be increased that would result in the extinction of

surplus earnings.

Quasi rent can also be expressed in terms of revenue which is as follows:

Quasi rent= total revenue- total variable cost

In the long run all the costs are considered as variable cost and in the long rub equilibrium can be

attained when the total revenue is equal to the total cost. In such a case there is no quasi rent.

GRAPHICAL REPRESENTATION:

In above figure the SS curve represents the inelastic supply curve. The demand (DD) and supply

(SS) both curves intersect at the equilibrium point E.

At point E Price is equal to the OP and the quantity of equipment is equal to the OS. In the short

run the increased demand D’D’ reaches to the price level of OP’ with the constant supply of

OS.As we can see in the above figure that the number of equipment’s are constant in the short

run. Therefore, the transfer earnings are zero and the quasi rent is equal to the total earnings from

the equipment. However, in the long run the supply of equipment is perfectly elastic. Therefore,

any number of equipment can be supplied at OP. Now, the supply reaches to OM and the prices
fall to E’’M. The quasi rent would disappear because the price gets equal to the transfer earning

OP.
Increasing and decreasing returns to the scale:

Returns to the scale are of the technical properties of the production function. If we increases the

amount of all the factors employed by the same amount (proportional), the production will

increase. The interest question is whether the resulting output will increase in the same

proportion, more than proportionately, or less than proportionally. In other words, when we

double all input, do double output, more than double or less that the double. These three basic

results can be identified respectively of increasing returns to scale (doubling of the inputs more

than the double production), the constant returns to scale (input double as well as Output) and the

decreasing returns to scale (doubling of inputs less double output).

The concept of returns to scale is as old as the economy itself, but they remained unreliable and

are not defined properly until perhaps Alfred Marshall. Marshall has used the concept of returns

to scale to capture the idea that industries may also face "economies of scale" (i-e the benefits to

the size) or "diseconomies of scale" (i-e disadvantages to the size). Marshall has presented an

different reasons for which the industries or firm might face changing returns to scale and the

justifications he offered were sometimes technical, sometimes due to the changing of prices.

Although any function of particular production may present an increase, constant or diminishing

returns throughout, it used to be a common proposal that has the function of the single

production would have different yields of scale to different levels of output. More specifically, it

was natural to assume that when a company is the production of a very small scale, it is often

done in the face of the increase in yields, because by increasing its size, it can make a more

effective use of resources by the division of labor and the specialization of skills. However, if a

business is already produce to a very large scale, it will have to cope with the diminishing returns
to scale, because it is already quite heavy for the producer to properly manage, as well any

increase in the size will probably do its work even more complicated.

If an industry is governed by the law of constant returns to scale, an increased demand for its

product will in the long run not affect the price. If it is an industry with decreasing returns, an

increase in demand will raise the product’s price; more will be produced, but not so much as

would be produced if it was characterized by constant returns. If the industry conforms with the

law of increasing returns to scale, increased demand will ultimately cause the price to fall, and

more will be produced than if it were an industry of constant scale.

Welfare Effects of Taxes and Subsidies

Marshall’s analysis of constant, increasing and decreasing cost industries led him to the

following novel policy conclusions

1. Either a tax or a subsidy will reduce net consumer utility in a constant cost industry

2. A tax may add to net consumer utility in an increasing cost industry

3. A subsidy may add to net consumer utility in a decreasing cost industry.

This figure shows the simplest situation of constant-cost industry. The horizontal supply curve S

in figure shows that this is a constant cost industry means that the changes in the demand will not

change the present equilibrium price OA. Now suppose that a tax of IH or AB is levied on each

unit of this product and therefore that the cost per unit including the tax rises to OB(OA+AB).

According to the Marshall tax will yield revenue to the government equal to ABEF. Consumer

surplus was originally ACI which after tax falls to BCE, hence the loss of consumer surplus is

ABEI. Because the loss in consumer surplus exceeds the gain in tax revenue, ABEF, net

consumer utility declines. Marshall pointed out that the same outcome results from a subsidy to a

producer in a constant cost industry; the amount of the subsidy exceeds the gain in consumer

surplus and the initial supply curve will be S’ and that the government provides a subsidy of HI

or BA per unit to the producers.

Marshall applied this same type of analysis to increasing and decreasing cost industries. In the

former case his analysis showed that a tax would raise tax revenue by more than it would reduce
consumer surplus. By restricting the output of firms in the increasing cost industry, unit costs

would actually fall, exclusive of tax. The revenue receive should then be used to subsidize the

industries experiencing decreasing costs. As the output of decreasing cost industries rises, their

unit costs exclusive of the subsidy, will fall. The gain in consumer surplus will exceed the

subsidy.

The implication of this argument is that competitive prices and laissez-faire do not necessarily

result in maximum satisfaction to the community. Marshall was well aware of this. If producers

are very much poorer than consumers, he said, restricting supply and raising prices will increase

aggregate satisfaction; conversely, if consumers are poorer then producers, expanding production

and selling commodities at a loss may increase total utility.

References

Brue, S., & Grant, R. (2011). The Evolution of Economic Thought. Boston: Cengage Learning.

Reisman, D. (1986). The Economics of Alfred Marshall. New York City: St. Martin's Press.

Wood, J. C. (1996). Alfred Marshall: Critical Assessment Second Series. New York City:

Routledge.