ADDIS ABABAUNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS
History of Economic Thought II (Econ 3142), A/Y 2020/2021,
2ndsemesterInstructor: AtlawAlemu

THE MARGINALIST SCHOOL

• The Historical background
• Serious economic and social problems remained unsolved
• The trend was to develop three approaches to attack the
social problems through
– Promoting socialism
– bolstering trade unionism
– Promoting government intervention to ameliorate the
conditions, eliminate abuses and distribute income
• Marginalists opposed all these solutions
saying that, although the value and
distribution theories of the classical
economists were inaccurate, their policy views
were correct.
• Thus the marginalists defended market
allocation and objected to government
intervention.
 Major tents

Methodological
• Focus on the margin
• The use of the abstract, deductive methods
• Equilibrium approach
• Microeconomic emphasis
•  
Theoretical
• Rational economic behaviour
• The pure competition emphasis
• Demand oriented price theory
• Emphasis on subjective utility
• Merger of land with capital goods
• Minimum government involvement
 The validity and usefulness of the school

• The marginalist school made economics more

exact social science
• Placed demand in its rightful position as
determinant of price
• The partial equilibrium approach enabled
disentangling complex phenomenon
• The microeconomic approach complements
the macro-approach
 Lasting contributions
• Mathematical Economics
• Basic monopoly model
• The theory of duopoly
• The theory of marginal utility
• The theory of rational consumer
• The law of demand
• The law of diminishing marginal returns
• Work-leisure choice analysis
• Marginal productivity theory of distribution
 FORERUNNERS OF THE MARGINALIST
SCHOOL
• Cournot
• The first economist to apply mathematics to economic analysis
• He focused on the rates of changes or marginal values
• He was the first economist to derive the profit maximization
condition of: marginal revenue= marginal cost
• He developed the earliest model of derived demand for
resources
• He is remembered for his theory of pure monopoly and his
theory of duopoly where he derived the mathematical reaction
curves and equilibrium conditions
•  
 J. Dupuit
• Established the concept of demand curve, "the
curve of consumption"; he was the first economist
to draw a diagram showing the inverse relationship
between price and quantity demanded
• His curve of consumption led to the concept of the
consumer surplus, which was later elaborated by
Marshall
• He was the one who analyzed the possibility of
monopoly price discrimination
 Von Thunen
• In his location theory of agricultural land use, developed a model
with isolated state assumption and a series of concentric rings around
the central city, each space between the concentric circles devoted to
a particular type of agricultural use.

• The further the ring from the city, the less intensive the production,
the less perishable is the produce, and the greater is the ability of the
commodity to bear the costs of transportation. As the intensification
with in the ring rises, diminishing returns cause the marginal costs to
rise

• He conceptualized the marginal productivity theory of employment :

the farmer must take care not to hire labor beyond that point at
which the cost of the last addition of labor is matched by the value
added agricultural yield
 Herman Heindrich Gossen
• Got posthumous appreciation on his theory of utility
• He stated two laws
– The first law: The law of diminishing returns , explain how
voluntary exchange produces mutual gains in utility

– The second law: the rational person should allocate his/her

money income so that the last unit of money spent on each
product bought yields the same amount of extra utility.
– The marginal utility per unit of money spent on a product is
marginal utility divided by the product’s price. MUx/Px =
MUy/PyThis relates to the balancing of marginal utilities
through rational consumption spending to secure maximum
satisfaction
 THE FIRST GENERATION MARGINALISTS
• Three marginalist thinkers arrived at
same marginalist approaches and
theories independently at about the
time:
– W.S. Javons from England,
– Carl Menger from Austria and
– Leon Walras from France
 W.S. Javons
• Value theory: Value depends entirely on utility
 Theory of diminishing marginal utility
 
 
Total utility
 
  Quantity consumed

  Marginal utility
 
 
Quantity consumed
• Rational choice: the equi-marginal rule

• Theory of exchange: Trade ceases at a point where there

is no further possibility of utility gain from exchange.

• Labor: Its value must be determined by the value of the

produce. When exchange value changes the value of labor
used to produce the good changes.
•  
 .
• Javons on pain of work and pleasure of earning

Pleasure

MUe

MDUw
Pain hours of work
MUe = MDUw(Marginal utility of earning)=(marginal disutility
of work)
The worker compares the marginal utility of earning (MUe) with
marginal disutility of work (MDUw). The optimal amount of work is
at a workday length where MUe = MDUw
 2. Carl Menger and the Austrian followers (the Austrian School)

• The value theory Carl Menger was based on

the concept of utility, like that of Javons, but
with no use of mathematics.
• He showed the possibility of ranking of utility
of commodities horizontally and marginal
utility derived from different quantity of the
same commodity vertically
With the following Implicit Assumption of each unit of commodity represents the same expenditure of money, economizing
individuals are able to rank satisfaction ordinally as well as cardinally

I II III IV V VI VII VIII IX X XI

1st 10 9 8 7 6 5 4 3 2 1 0
2nd 9 8 7 6 5 4 3 2 1 0
3rd 8 7 6 5 4 3 2 1 0
4th 7 6 5 4 3 2 1 0
5th 6 5 4 3 2 1 0
6th 5 4 3 2 1 0
7th 4 3 2 1 0
8th 3 2 1 0
9th 2 1 0
10th 1 0
11th 0
 Conclusions arrived
• If an individual could afford 5 units of food,
the satisfaction he derives will be from the
first 5 items.
• The usefulness of the 5 items will be the 30
units in contrast to what Jevon’s would say. i.e
40.
• For Menger each unit has the same utility as
the marginal unit.
 .

• The basis for exchange for Menger is the

difference in relative subjective valuations of
the same goods by different individuals.
• According to Menger, producer goods also
yield satisfaction to consumers indirectly by
helping produce things that satisfy consumer
wants directly.
• The producer good has usefulness imputed to
it by the usefulness of the consumer good
produced using it.
• Eg.
– The rent received by landowners is governed by
the utility of the products grown on that land.
– The price of labor service is governed by its value
which emanates from the magnitudes of the
satisfaction that would have to remain unsatisfied
if we were unable to command the labor service.
•  
 Other Austrian marginalists
• Fredrich Von Wieser
– Value in use measures utility, exchange value
measures a combination of utility and purchasing
power; e.g. gold prices and the rich, common
goods and the poor)
 
– He made a distinction between natural value (value
according to marginal utility and exchange value
(value according to utility and purchasing power).
• Production is ordered .not only according to
simple want but also according to wealth
• Opportunity costs or the alternative cost
concept:the entrepreneur who produces
something for a market gives up the
opportunity to produce and sell alternative
commodities.
• This idea turned cost of production into a
subjective psychological cost.
 BöhmBawerk
• Incorporate time into economic analysis. This
interest arises for three reasons:
– Present orientation as a result of defective imagination
– Expectation of rising wealth
– Roundabout production
• The value of a final product is greater than the
value of the services that produce it by the
amount of interest over the period of time that
elapses.
 3. LÉON WALRAS
• He was one of the three originators of marginalism.
• He independently arrived at the basic marginalist
principles.
• He developed and advocated general equilibrium
analysis; Modern advanced micro economics in
basically Walrasian
• Emphasized the application of mathematics to
economic analysis and
• He is credited for calling economists attention to
Cournot’s earlier work.
 THE SECOND GENERATION MARGINALISTS

• EDGEWORTH
– Originated the idea of indifference curve

Friday’s
labor

Contract curve

Crusoe’s Money
 .

• Duopoly theory
Duopolist 2 Duopolist 1
Indeterminate equilibrium
oscillating between P0&
P1

P2 P1

MR2 MR1

D2 D1
 Marginal and average product
• .

Total product

Output

Quantity of input
This conception later served to daw MC and Ac curves as Viner (1931)
did
 JOHN BATES CLARK
• Marginal productivity theory of distribution:
– Factors are paid their marginal product.How?
– Marginal productivity diminishes as more and
more of the variable factor is used.
– Diminishing returns do not occur because the
quality of labor or capital inputs decline as more
are added, rather they occur because eventually
the fixed factor becomes overused relative to the
variable factor.
• In other words, at some point the variable factor
becomes so abundant relative to the fixed factor
that additional units of the variable factor can not
contribute much to output.
• As the graphical representation of marginal
productivity theory of distribution in a perfectly
competitive market economyshows the wage rate
and the interest rate are the respective
productivities at the margin; height DC for wage and
D’C’ for interest
• height DC for wage and D’C’ for interest .
• The total wage rate is the area DC x OD and
the total Interest at that instance is the area
ACB
• The total Interest is the area D’C’ x O’D ‘and
the total wage rate at that instance is the area
A’C’B’
The total wage rate is the area DC x OD and the total Interest
at that instance is the area ACB
The total Interest is the area D’C’ x O’D ‘and the total wage
rate at that instance is the area A’C’B’
• .
B B’

Interest
A C Wage C’

Wage
A ’
Interest

O D O’
D’
• This means in a perfectly competitive market
economy no pure profit exists; factors exhaust
all the value of output.
•  
• Profits can only exist temporarily as the
economy moves towards equilibrium. In that
case it will be the difference between say A’
B’C’ and OACD or O’A’C’D’ and A BC
 THE NEO-CLASSICAL SCHOOL 

• Principles and Assumptions

• a)Theoretical
– i) Behavioural assumptions
• Atomistic rational actor,
• maximizing utility on the basis of defined
preferences which are complete and
transitive or
• actors with consistent revealed choice
behaviour,
• 
• ii)Market assumptions
• Competitive markets
• Large number of buyers and sellers
• Homogeneity of products
• Absence of transaction costs
• Perfect information
• Free entry and free exit
• Market forces (Demand and supply) override
other factors
 .

• b) Methodological assumption
– Marginal analysis
– Partial equilibrium analysis

• Alfred Marshall
– Economics in Marsahall’s eye:
• Political economy or economics is a study of
mankind in the ordinary business of life;It examines
that part of individual and social action which is
most closely connected with the attainment and
with the use of material requisites of well-being.
•  
 Marshall on economic laws
• We seek to discover economic laws.
• Any law is a general proposition or statement
of tendencies, more or less certain, more or
less definite.
• Social laws are statements of social tendencies.
Economic laws (or statement of economic
tendencies) are those social laws that relate to
human conduct in which the strength of the
major motives can be measured by financial
price.
• Economic laws are not natural laws that are
necessarily beneficent.
• It may or may not be desirable to allow them to
work without any restraining hand.
• The relationship among supply, demand, and
price tend to produce certain results if they are
allowed to work themselves out by themselves,
but society can influence the outcome if it so
desires.
 – E.gIf supply and demand interactions in higher
education are left to work themselves out they
result in low amount of users because of the high
prices. Higher education users would increase if
prices are reduced through grants and provision of
public universities.

• Marshall’s thinking left room for cautious

reform, that is, for modest departure from
laissez-faire.
 Marshall on utility and demand
• Demand is based on the law of diminishing
marginal utility.
• “ The marginal utility of a thing to anyone
diminishes with every increase in the amount
of it he already has” provided:
– The time interval is too short to change tastes
– The good is indivisible
 .

• Money measures utility and disutility

• The law of demand: the amount demanded
increases with a fall in price, and diminishes
with a rise in price, provided
– Income is held constant (wealth constant)
– The purchasing power of money is constant
– The price of substitutes is held constant
• (These other things held constant are the
determinants of demand)
• Tied the equi-marginal rule to the law of demand.In
deriving the demand curve Marshall used the equi-
marginal principle i.e

• If the price of X falls the ratio exceeds and equilibrium

is restored by consuming more of x and hence reducing
its marginal utility and consuming less of n.
• Marshall focussed on substitution effect (relative price
effect) and ignored income effect (gain in purchasing
power effect)
 Marshall on consumer surplus and total utility and the paradox of value:
.

• Total utility of a good is the sum of successive marginal utilities

of each added unit.
• Therefore, the price a person pays for a good never exceeds,
and seldom equals, that which he/she would be willing to pay.
• Only at the margin will price generally match a person’s
willingness to pay
• Thus the total satisfaction a person gets from purchasing
successive units of a good exceeds the sacrifices required to pay
for the good. This is what is known as the consumer surplus.
• The fact that Marshall believed that the total utility of a good is
the sum of successive marginal utilities of each added unit
places him in opposition to the Austrian school thinking. i.e. the
paradox of value
• Elasticity of demand determinants
• Elasticity of market demand tends to be greater when
the good has a high price relative to the buyers’ income
• Elasticity will be greater the more the good serves as a
substitute for other goods
• Elasticity of demand has policy implications on
• -Taxes
• -Monopoly prices
• -Restriction of agricultural output
 Marshall on Supply
• Supply is governed by cost of production.
– Shape of the Supply curve in Immediate present:
• both supply and demand are fixed, vertical curve
– Shape of the Supply curve in Short run:
• variable costs vary and fixed costs remain the same. Upward sloping
supply curve
– Shape of the Supply curve in Long run:
• all costs are variable. Supply curve shifts right ward or left ward
depending on the price and average cost of production.
• If AC>P firms go out (Market supply curve shift left wards)
• If AC<P firms go in (invest capital)-(Market supply curve shift
rightwards)
 Equilibrium price and quantity
• What determines market price?
• Classicals-cost of production (supply) Marginalist –demand
• Marshall-both demand and supply
– A-consumer surplus;
– B-Producer surplus

Supply
A
Pe
B
Demand

Qe
 Distribution of income (Wage, Interest, Profit, Rent)

• Wage
– Like any price determined by demand for labor and supply of
labor.
– Demand for labor is a derived demand.
– Four laws of derived demand, other things being equal.
– The greater the substitiutability of other factor for labor the
greater the elasticity of demand for labor
– The greater the price elasticity of product demand the greater
will be the elasticity of labor demand
– The greater the proportion of labor cost in the production cost
the greater the elasticity of labor demand
– The greater the elasticity of the supply of other inputs the
greater the elasticity of labor demand
 Interest
• It is the price of capital determined by supply and demand for
capital
– Supply : Interest on capital is the reward of the sacrifice involved in
the waiting for the enjoyment of material resources.
– The higher the interest is the higher will be the saving* and hence
the higher supply of capital.
• *Other motives of saving : family affection, force of habit,
miserliness, magnitude of income, prudence in wishing to
provide for future
– Demand :
• the marginal productivity of capital constitutes the demand for capital.
• The rise in the rate of interest diminishes the use of machinery and the
lower the interest rate the higher the investment
– Equilibrium interest rate is the intersection of demand and supply
 Profit
• Normal profit = interest + earnings of management +
supply price of business organization
• The supply price of business organizations is a reward
to entrepreneurship.

Rent
• He upheld Ricardian rent.
• He promoted the similarity of capital goods
(manufactured capital goods) and land in raising rent.
• He introduced the concept of quasi-rent in the short
run.
 Internal versus external economies
• Internal economies are the efficiency or cost
savings introduced by the growth in the size of the
individual firm resulting from specialization, mass
production, better machines, high grade
managerial ability.
• External economies come outside the firm
(suppliers come nearby, transporters emerge, etc)
• Growth in size reduces cost of production
 
Increasing and decreasing returns to scale
• When all factors used in production expand what
happens
– In industry there is generally increasing returns to scale
– In agriculture where there is dependence on nature
decreasing returns to scale
– When increasing and decreasing returns to scale are
balanced we have constant returns to scale.
• Eg. Blanket production _ wool production exhibits decreasing
returns to scale while manufacturing exhibits increasing returns,
and hence overall with exact counterbalancing constant returns to
scale prevails.
– Under constant returns to scale , future increase in
demand does not affect prices
– Under decreasing returns to scale future increase
in demand increases prices
– Under increasing returns to scale future increase
in demand reduces prices
• Welfare effects of taxes and subsidies
– Either a tax or a subsidy will reduce net consumer utility in a
constant cost industry
– A tax may add net consumer utility in an increasing cost
industry
– A subsidy may add to net consumer utility in a decreasing cost
industry
• Implication on laissez faire – the possibility of improving
welfare better than the market through taxes and
subsidies i.e. there exists better outcome than laissez
faire( market
 Marshall on method:
• He attempted to blend the theoretical, mathematical and the
historical approaches
• Marshall regarded the economy as complex:Everything seems to
depend upon everything
• Time is a chief cause to difficulties in investigating relationships
(often difficult to isolate causes and effects as they work
themselves out over time)
• The laboratory technique of physical sciences is not available for
economics.
• In order to make some head way in analysing the complex
relationship in an economy ceteris paribus assumptions are made.
• At the start of the analysis, many elements are held constant and
gradually more elements are allowed to vary, so that greater
realism is achieved.
 Marshall’s assumption on dependence of price on
quantity and its implication on stability of equilibrium

• Demand:
– Maximum price individuals are willing to pay for a given
quantity. Quantity is an independent variable for Marshall.
Demand price is the dependent variable
• Supply:
– The minimum price at which sellers would be willing to
supply a given quantity. Quantity is the independent
variable. Price is the dependent variable
• Accordingly adjustments that bring about equilibrium
are discussed in terms of quantity adjustments.
 Stable equilibrium
• .
S
P2
E
P1

P’2
D

Q’2
Q1 Q2
• Walras andCournot’s economic theory regard price as the
independent variable.
• Which is correct?
• Both Walrasian and Marshallian assumptions on the
dependent and independent variable have the same
equilibrium if demand is downward sloping and supply is
upward sloping.
• The interaction of supply and demand results in a stable
equilibrium.
• But there are cases where supply could be downward
sloping.
• Will the two assumptions result in the same equilibrium in
that case?
• Unstable equilibrium is possible when supply curve is
downward sloping, which means if price or quantity attain
their equilibrium values they will remain there; but if the
system is disturbed it will not return to these equilibrium
values.
• The two assumptions will have different equilibrium
outcomes in case of downward supply cures depending
on the relative differences of elasticity of the supply and
demand curves as shown below
 Possibilities of Unstable equilibriums
P

• . P

Unstable if qty is
independent
Stable if
QTY is
Unstable independent
if price Stable if
is price is D
indepen Independ
dent S
ent

D Q S
 MONETARY ECONOMICS IN NEOCLASSICAL SCHOOL
• Classical Economists , Marxists and margenalists felt
money is subordinate to more basic factors and was
generally neglected.

• Marshall devoted some attention to monetary analysis

• M= kPT, where
– M= the stock of money
– k= the fraction of income that people collectively wish to
hold in cash
– P= the general price level
– T= Either the volume of trade or real income
 Wicksell and Fisher
• Wicksell and Fisher contributions in monetary
economics differs from other neoclassical thinkers
in their treatment of aggregate variables
(macroeconomics)
• WicksellonPrice level changes (why do prices
collectively change up or down?)
– The rate of interest (normal or natural rate of interest)
depends on supply and demand for real capital that is
not yet invested (this applies only to credit between
individuals)
 .

• Bank rate ( in contrast to natural rate)- may be either less than or

greater than the normal rate of interest.

• Bank rate < natural rate –

• saving will be discouraged and demand for consumption goods
rises.Investment capital demand increases with unchanged or
diminished supply of goods as savings diminished, upward price
movement begins and keep on rising so long as the bank rate of
interest is less than the natural rate

• Bank rate > natural rate –

• savings increase and investment spending will decline reducing
national income, which will in turn cause the price of consumer
goods to decline. Deflation continues with further expectation of
price falls.
• Wicksell’s implication for public policy: Anticipation of
Keynes.
• he was the first economist to advocate stabilizing
wholesale prices by controlling discount and interest rates
• His prescription runs as follows: So long as prices remain
unchanged, the banks rate of interest is to remain
unattended. If prices rise, the rate of interest is to be
raised, and if prices fall, the rate of interest is to be
lowered; the rate of interest is henceforth to be maintained
as its new level until a further movement of prices call for a
further change in one direction or the other.
• Wicksell on forced saving-
• Assuming full employment through a bank loan financing
of a new enterprise, more land and labor would be
employed in producing capital goods. This leaves fewer
resources for consumer goods production. However, the
demand for consumer goods increases rather than
diminish as income from labor and land increases with the
bidding up of prices by entrepreneurs. With the resulting
rises in prices entrepreneurs would acquire fewer capital
goods and consumers restrict their consumption. i.e will
be forced to save.
 .

• Wicksell on Imperfect competition

• Recognized the inadequacy of the purely competitive
model in retail markets
• Anticipated the imperfect competition of Chamberlin and
J.Robinson
• Retailers usually have a fixed circle of consumers and this
enables them to have fixed rather than fluctuating prices.
• With new entrants to the retail activity original shops lose
their customers and without reducing their overhead
expenses they will no more be operating on the lowest
point of their average cost curve. As a result they will be
compelled to raise their prices and at the same time retain
some of their customers.
• Wicksell on phases of returns to scale and
product exhaustion
• A given firm passes through all three phases of
returns to scale first increasing – then
constant-and finally decreasing.
• Product exhaustion occurs when the level of
output reaches at the minimum point of the
long run average cost curve where profit is 0.
 Iriving Fisher

• Fisher’s theory of interest:

• Two factors interact to establish the interest rate
• Impatience rate (subjective valuation of present
consumption to future consumption)
• Investment opportunity rate (real factors)
• The equilibrium interest rate occurs where the
rate of return on investment and the rate at which
society is willing to trade off present for future
consumption are equal.
• Fisher distinguished real rate of interest from
monetary or nominal interest rate.
– Nominal interest rate is the sum of real interest rate
and expected inflation rate. If the expected rate of
inflation is 5% and the real interest rate is 5%, then
the nominal rate of interest will be about 10%.
Lenders demand 10% to ensure that borrowers
return the full purchasing power of the principal on
top of the real interest rate. This effect of inflation
on nominal interest rate is known as fishers effect.
• Fisher’s quantity theory of Money:
• Fisher restated the old quantity theory of money
and amplified it.
• Fisher’s Equation of exchange is of the form
MV=PT where V is the velocity of circulation.
• k in the Marshall’s version is the reciprocal of the
velocity of circulation.
• He saw five determinants of the purchasing
power of money.
• The volume of currency in circulation (M)
• Its velocity of circulation (V)
• The volume of bank deposits subject to check (M’)
• It velocity (velocity of bank deposits) (V’)
• The volume of trade (T)
• MV + M’V’ = PT Where
• P is the average level of prices which vary directly with the
quantity of M & M’
• Monetary policy: strictly control the quantity of currency
in circulation to stabilize price .
 .
• He advocated using paper money redeemable on
demand with a quantity of gold that would
represent constant purchasing power.
• The purchasing power of the money unit would
thus remain constant. That would mean to
abandon gold coin and use gold certificate.

•  
 .

• The scheme for stabilizing

• Increased prices - increase the gold content. Reduced
prices- reduce the gold content.
• If gold comes into circulation- prices go high.
Therefore, reduce the price of gold
• If gold were being exported –prices would fall
therefore raise the price of gold.
• Fisher believed price fluctuations cause business
fluctuations, not otherwise. Therefore, stabilizing
prices by controlling the quantity would eliminate
business cycle.
• After 1929, Fisher saw the greatest cause of deflation
and depression as the growth of debts.
 Hawtrey
• The monetary theory of business cycle
– The vicious circle of inflation and activity _Starting
from bank increased lending and releasing cash,
consumers demand expands.
– Wholesalers order more goods. This in turn
increases economic activities ( production);
increase production activity leads to increased
income to consumers and to more demand and
spending.
– As production grows it approaches its limit.
Producers start asking more and more prices.
– The vicious circle of inflation and activity ensues.
 .

• The vicious circle of deflation and depression: Starting

from bank reduces lending and absorption of cash,
consumers demand shrinks.
• Wholesalers order less and less goods.
• This in turn reduces economic activities ( production);
reduced production activity leads to reduced income to
consumers and to less demand and spending.
• As production declines wholesalers and producers start
expecting further declines and become eager to clear at
lower prices.
• The downward spiralling of prices further reduce
economic activity and lower incomes. The vicious circle
of deflation and reduced activity continues.
• The discretionary Monetary policy
– Central bank open-market operation
– Changes in the discount rate
– Reserve requirements
 THE NEOCLASSICAL SCHOOL-THE DEPARTURE FROM PURE
COMPETITION
• PieroSraffa
• Falling unit cost of production with increases in scale of
production
• Leads to natural monopoly and the break-up of pure
competition
• Even in a market that looks competitive firms enjoy a special
advantage, a certain monopoly elements .they do not lose all
of their business if they individually raise prices. The demand
curve they face is a down ward sloping curve to the right.
• Traditional theory holds that a firm’s expansion is limited by
rising costs. Straffa said this expansion of output is limited
because of monopoly pricing since many firms work under
diminishing costs.
 Chamberlin
• The theory of monopolistic competition
• The key concept is product differentiation
– Assumptions
– Cost curves the same
– Firms charge prices greater than their marginal
costs
– Operate at average costs greater than minimum
– Inefficiency in allocation
 Monopolistic Inefficiency in allocation
• .

MC

P
AC

D=AR

D’=AR
MR’
MR

QM Qc

Q
 Joan Robinson
.
Introduced the nature of monopsony market in product
market and in resource market
MC= marginal wage
MW cost
MC
C AWC= Average wage
S
S=AWC cost
VMP= Value of
P=M WU Marginal product
C WU =wage union
PC WC=Wage competitive
WC
Wm
Wm=Wage monopsonist
PM D=P VMP LeC=Employment
competitive
Lem=Employment Monopolist
PC=Price competitive
PM =Price monopsonist
QeM=Output
LeM Le
monopsonist
QeM QeC
C
QeC=Output
competitive
• Monopolistic competition can only be
eliminated by pure competition
• Exploitation occurs when the worker’s wage is
less than the value of the marginal product of
labor (VMP)
• Remedy by Robinson:
– Trade union or trade board imposing minimum
wage removes monopsonistic exploitation.
 NON MARXIAN HETERODOX ECONOMICS
•  
 THE GERMAN HISTORICAL SCHOOL
 Arose in 1840 with Friedrich List and Wilhelm Roscher and ended in
1917 when Schmoller died.
• Like the socialists, this school is critical of classical economics.
• Historical Background:
• Germany was divided, weak and agricultural
• Nationalism, militarism, paternalism, devotion to duty and hard
work, massive government intervention were the order of the
day.
• Germany was far behind England in industrial development
• Economists in Germany believed government intervention was
necessary to catch up.
• Basic tents of the historical school
• Evolutionary approach to economics
• Emphasis on the positive role of government
• Inductive/historical approach
• Advocacy of conservative reform
• Whom did the historical school benefit?
• Themselves
• Dominant business, financial and landowning class
• Validity of the school
• The perspective of considering changing history and
changing environment is correct
• The evolutionary approach enabled explaining the
departure from laissez-faire in countries like England
• Lasting contribution
• Historical inductive method is generally accepted today.
• The attack on laissez faire as unrestricted free enterprise
does not necessarily produce the best result
•  
 THE INSTITUTIONALIST SCHOOL (THE OLD)

• An American contribution to economic

thought
• Began around 1900 and continues up to date
• The founder was Thorstein Veblen
Historical Background of the school
• In spite of impressive developments of
capitalism, improvements in living conditions of
many workers did not match their expectations.
• Long hours of work, low housing condition,
insecurity at times of sickness, unemployment,
and old age,
• higher education and job security were not
adequate or accessible for most workers.
• Health and safety regulations were non-existent or
inadequate
• Monopoly began, conservative forces predominated
every where, state and federal government were
using the force of the police to solve industrial
disputes, were establishing tariff protection to
businesses.
• The doctrine that minimum government interference
produces the maximum social well-being seemed
untenable.
• There were three methods recognized as
methods of achieving social change
• Reorganize society along socialism
• Promote trade unionism
• Undertake social reform by ameliorating the
conditions through government intervention
and save capitalism
• There was the influence of the German historical
school on American institutionalist school.
• Both share the inductive approach as superior
over the abstract deductive approach.
• Despite the methodological similarity the
institutionalists were not nationalists;
• they were more liberal and democratic in their
outlook.
 Major tenets:-
• Holistic broad perspective- the economy is like a complex
organism
• Focus on institutions- economic life is regulated by economic
institutions, not by economic laws
• Darwinian evolutionary approach – society and its institutions
are constantly changing
• Rejection of normal equilibrium – emphasis on circular
causation and cumulative changes
• Clashes of interests
• Liberal democratic reform
• Rejection of pleasure-pain psychology
 Whom did institutionalism benefit?

• The middle-class, agrarian interests, small

business and labour groups, government
workers, reformers, humanitarians, leaders of
consumer’s organizations, union members,
were attracted to its ideas.
• Non-economist academicians praised the
institutionalist interdisciplinary approach.
 Usefulness and correctness of the school in its time

• The school challenged the rigid orthodoxy in

economic thinking and helped to revise that type of
theory.
• The school added realism to economic analysis by
incorporating the institutional setting the evolutionary
process and by looking at the economy as a whole.
• The school urged closer integration of the social
sciences.
• The emphasis on inductive studies reduced the gap
between economic theory and practice. Gathering and
analysing statistical data become popular and is a
monument to this method.
 Lasting contributions
- The broader perspective
- The reform movement
- The influence on development
economics
Veblen: the founder of the institutionalist
school
•Contributions On
– Behavioural Dichotomy
– Private property
– common man
– The leisure class
 Conspicuous consumption
 Propensity to avoid useful work
 Conservatism
‾ Emulative consumption
– Attacks on Neo-classical economics
•Behavioral dichotomy
– From a social psychological point of view,
• Veblen distinguished individuals and classes
– whose behavior was dominated by the
propensity for exploit, or the predatory
instinct, from those
– whose behavior was dominated by the instinct
of workmanship, the parental bent, and the
development of idle curiosity.
 – From the standpoint of economics,
• Veblen saw the same dichotomy between
–the forces that he referred to as "business"
and
–the forces that he referred to as
"industry."
 (Compare this with the rationality assumptions of Neoclassical
economics )
– From the standpoint of sociology, the dichotomy
was manifested in the differences between
• the "ceremonialism" and "sportsmanship"
characteristic of the "leisure class" and
• the more creative and cooperative behavioral
characteristic of the "common man”.
 On private property
•The natural-rights theory of property makes the creative effort of
an isolated, self sufficing individual the basis of ownership vested
in him.
•But production takes place only in society-only through the co-
operation of an industrial community.
•Since there is no individual production and no individual
productivity, the natural-rights preconception . . . reduces itself to
absurdity, even under the logic of its own assumptions.
•But while production is always social, the laws of private
property, which in capitalism determined the distribution of social
production, were private and individual. 
 .
•All human progress had been achieved through advances in social
production. Such advances were, in general, the result of the
"instinct of workmanship" and the working of "idle curiosity. "
•  Private property was the result of the "predatory instinct" and
stood in opposition to the "instinct of workmanship. "
• Historically, Veblen believed, the instinct of workmanship was
prior to and more fundamental than the predatory instinct.
• A proposition central to Veblen's entire social philosophy was
that "man's life is activity ; and as he acts , so he thinks and
feels.
• " It was not people's ideas and feelings that primarily
determined their activities ; rather their life processes and
activities determined their ideas and feelings.
 The working class and the common man
• It was generally the more economically secure elements of the
working class that constituted a potential threat to the status
quo.
• They had usually been successful in acquiring highly
marketable productive skills.
• This meant that they usually had considerable pride of
workmanship.
• There was a constant danger that the traits associated with the
instinct of workmanship-clear, logical thinking, cooperation,
mutual aid, and general humanitarianism-would increase to a
point where such workers would turn to anarchism or
socialism in order to promote the hegemony of workmanlike
traits over pecuniary, predatory traits.
 The leisure class
 Is characterized by :
o Conspicuous consumption
o Propensity to avoid useful work
o Conservatism
 Attacks on Neo-classical economics
o On consumer sovereignty
o Static system
o Instinct for workmanship
 Emulative consumption
• Emulative consumption was a primary means of reducing the working
class threat.
• Emulative consumption, however, represented a personal treadmill from
which no progress was possible and escape was difficult if not impossible.
 
• The misery of workers, in Veblen's view, arose predominantly from
material deprivation only in the part of the working class that lived in
abject poverty.

• For the remainder of the working class, the misery was caused by both
the social degradation of labor and the "chronic dissatisfaction" associated
with emulative consumption.
•  
 Conservatism

•The abjectly poor, and all those persons whose

energies are entirely absorbed by the struggle for
daily sustenance, are conservative because they
cannot afford the effort of taking thought for the
day after tomorrow; just as the highly prosperous
are conservative because they have small
occasion to be discontented with the situation as it
stands today.
 Wesley Clair Mitchell
•The importance of empirical investigation
•Business cycles : conclusions
- Business cycles arise in a money economy (a society where
economic activities are mainly carried by making and
spending money)
- Business cycles are widely diffused throughout the economy
- Business fluctuations depend on the prospect for profit
- Fluctuation are systematically generated by the economy
itself
•The need for social planning to overcome the worst features of
business fluctuations
 Quasi-Institutionalists:
Joseph Schumpeter

•A “two-structure approach to the mind and society” of

Schumpeter is two systems each consisting of three
layers (Shionoya 1997, pp. 260–265).
- The system of substantive theory, about the economy,
consists of economic statics, economic dynamics, and
economic sociology.
- The system of meta-theory, about economics, includes
the philosophy of science, the history of science, and
the sociology of science.
• These two systems are parallel in viewing
– the economy, on the one hand, and
– economics, on the other,
• from the viewpoints of,
– first, static structure,
– second, dynamic development, and
– third, their activities in a social context.
 .
• The economy: Substantive theory
• Economic statics is applied to:
– the process of circular flow, in which the economy
repeats itself year after year, with its size and structure
remaining constant under given conditions.
– According to Schumpeter, economic growth based on an
increase in population and capital can also be explained
by economic statics because these changes are exogenous.
– By an analogy with economic equilibrium, he assumed the
presence of static order in other areas of social life such as
politics, science, art, and morality and explained static
states by reference to the adaptive behavior of ordinary
people.
• Economic Dynamics
.

– His unique view was that the dynamic phenomenon in the

economic process is brought about by a destruction of the
previous equilibrium by forces from within the economy,
i.e., by the innovations of entrepreneurs.
– He also argued, using an analogy with economic
dynamics, that such dynamic phenomena occur in other
areas of social life, also by innovators’ destruction of the
existing order.
– If innovators succeed in introducing a new way of life
to specific areas, the direction in which the general
public will follow is set, and they become the leaders
in these areas.
 .

•Adaptive behavior is to statics what innovative behavior

is to dynamics;

• just as a static state in any area is characterized by the

average man following conventions and customs, so is a
dynamic state marked by a leader who has enough energy
and will, foresight and creativity to introduce innovations.
 
•The entrepreneur in the economic area is a special kind of
leader.
 .

•Economic sociology
– The logic of economic sociology, the third branch in the system of
theory, consists of an analysis of institutions that are exogenously
given to economic theory and are lumped together to include all
noneconomic factors.
 
– Schumpeter defined economic sociology as “a sort of generalized or
typified or stylized economic history”. It is the concept of an
institutional framework that can generalize, typify, or stylize the
complexities of economic history.
 
– In other words, economic sociology is the generalization,
typification, and stylization of history by means of institutional
analysis.
 Economics :Meta theories
•Schumpeter’s writing is a set of meta-theories with three layers that
can be regarded as the counterpart of his set of substantive theories
on the economy.
•Meta-theory is a theory about theory.
 
•Just as his economic studies contain three layers, i.e.,
• economic statics,
• economic dynamics, and
• economic sociology,
• his studies on science have three parallel layers, i.e.,
• statics of science,
• dynamics of science, and
• sociology of science.
 In the common usage
- the first one( the statics of science)
- is called the methodology of science (or the philosophy of science),
which is concerned with the static structure and rules of science;

- the second,
- the history of science, which deals with the dynamic development
of science; and

- the third,
- the sociology of science, which views scientific activities as social
phenomena.
 .

• It is natural that a strong structural parallelism

exists between the systems of substantive
theory and meta-theory
• because the same methods of observation are
applied to the two areas of social life, i.e.,
economy and science;
• the same methods will permit analysis of static
equilibrium, dynamic development, and
interactions with other social areas,
respectively.
 .

• If we combine the results of Schumpeter’s historical

research on economic development in his Business
Cycles, on the one hand, and the development of
economics in his History of Economic Analysis, on
the other, an interesting picture will emerge.
•According to the Kondratieff framework of long waves
in economic activities, which Schumpeter used for
historical investigation,
– the Industrial Revolution Kondratieff (1787–1843),
– the Bourgeois Kondratieff (1843–1898), and
– The Neo-mercantilist Kondratieff (1898–1950) are
distinguished.
 .

•Similar 50-year cycles are also evident in the

chronology of the history of economics:
– the first classical situation was marked by the
acceptance of Adam Smith’s system of
economic thought around 1790,
– the second by the maturity of classical
economics at John Stuart Mill around 1848, and
– the third by the synthesis of neoclassical
economics by Alfred Marshall and Knut
Wicksell around 1890.
•Although Schumpeter did not . explicitly mention a fourth
period, by following his procedure we can probably define
the fourth classical situation as the establishment of
Keynesian economics around 1950.
 
•The long waves in the history of the economy and
economics, which Schumpeter just suggested, present a
stimulating methodological question concerning the
evolutionary interrelationship between the mind and society.

•  Read on Gunnar Myrdal, John Kenneth Galbraith, The

Austrian School
 The new institutionalist school

- This school is characterized by :

- Market oriented and anti-interventionist
- Emphasis on rational economic decision
making
 Various strands of the new institutionalist
school
• Property rights school
o The role of property rights
• Law and economics
o The relationship between law and economics
• The transaction cost school
o Transaction costs explaining the organization and
behaviour of firms
• Public choice and constitutional economics
o Analysis of rent seeking, interest groups, voting roles
and constitutional economics
 WELFARE ECONOMICS
•Concerns of welfare economics
– Discovering principles for maximizing social well
being(Defines welfare optimality and means of achieving it)
– Identifying factors that impede the achievement of
maximum well-being and means of removing the
impediments
– If the current state of welfare is W and if welfare can be
made larger to W* welfare economics tries to show whether
W<W* and suggests ways of raising W to W* if W<W*
 Measures of welfare improvement
(measures of movement from W to W*)

• Growth of GNP( NNP), GDP(NDP),

• Bentham’s utilitarianism
• Cardinalists criteria
• The Kaldor-Hicks “ Compensation”
criterion
• The Bergson criterion : social welfare
function
• Pareto Optimality criteria ( efficiency)
 Growth of GNP/ GDP/ NNP/ NDP
• Growth increases employment and goods available
– Highlights the importance of efficiency for social
welfare
– Accepts the existing income distribution as ethical or
just
– Critiques
• Social welfare dependence on the amount of goods
and services as well as their distribution
• Efficiency is the necessary condition but not the
sufficient condition to guarantee the maximization of
social welfare.
 Bentham’s utilitarianism
•Welfare is improved when the greatest good is secured for the greatest
number W=UA+UB+UC
–Assumes total welfare is the sum of individual utilities
–Inter personal comparison of individual utilities is possible
•ΔW>0 if (ΔUA+ ΔUB+ ΔUC)>0
•If the welfare increment of any two is greater than the decline in the
third Bentham’s criteria claims total improvement.
•Critiques
•The greatest good and the greatest number may not occur together.
–Take the case of change from W1=100+120+130=350 to
W2=50+125+135=310
–Which state is better?
–The greatest good has not occurred but the greatest number has occurred
 CARDINALISTS CRITERIA
• Uses the law of diminishing utility as the criterion of
welfare
• Transferring income from high income to low income
increases total utility
• Critique
– Assumes individuals have identical utility
function and interpersonal comparison of utility is
possible
– Ignores incentive outcomes of income
redistributions
 THE KALDOR-HICKS “COMPENSATION”
CRITERION

• In an undergoing change if the amount gained

by “gainers” is greater than the amount lost by
“losers” the change constitutes an improvement
in welfare.
• Critiques
– Assumes the marginal utility of money is the
same across gainers and losers
– Ignores the existing income distribution
 THE BERGSON CRITERION : SOCIAL WELFARE FUNCTION

• Social welfare function provides a ranking of social states in

which different individuals enjoy different levels of utility
analogous to consumer’s utility function.
• Each curve is the locus of combinations of utilities of A and B
which yield the same level of social welfare
•  Maximization of social welfare is achieved when Grand utility
frontier becomes tangent to any of the welfare states Wi
• Grand utility frontier is obtained from the various static general
equilibrium states where each state is associated with a set of
utility combinations for the two agents ( A and B) and the
furthest points are taken as points on the grand utility frontier
• The Bliss point
• Tracing back from bliss point to
production possibility frontier, product
mixes, Isoquants and factor allocation
•  
 PARETO OPTIMALITY CRITERIA
()
• Efficiency criteria
– Any change that makes at least one individual
better off and no one worse off is an improvement
in social welfare
─ A situation in which it is impossible to make any
one better of without making someone worse of is
said to be Pareto optimal or Pareto efficient.
─ Does not assume inter personal comparison of
utilities
 Pareto
- Refined Edgeworth’s indifference curve notion as
well as Walras’s general equilibrium analysis
- Arrived at the conditions for maximum welfare to be
Pareto optimality
o Maximum welfare occurs where there are no longer
any changes that will make some one better off
while making no other worse off.
- Pareto optimality implies-optimal distribution of
goods among consumers, optimal technical allocation
of resources and optimal quantities of outputs.
Optimal distribution of goods
• Optimality condition: consumers having
identical marginal rates of substitution between
two goods MRSxy(A) = MRSxy(B),
where A and B are individuals and x & y are goods
Optimal technical allocation of resource
o Optimality condition: MRTSLK(X) = MRTSLK (Y)
Optimal quantities of output
o Optimality condition: MRSXY = MRTXY
 .

•Every equilibrium is Pareto efficient( there will be no

further gain from trade)
– This is the first theorem of welfare economics
•When preferences are convex a Pareto efficient allocation
is
an equilibrium for some set of prices
• This is the second theorem of welfare economics
 Critique
 Assumes endowment under the status quo as ethical
 fails to address the issue of distributive justice,
overall growth of output vs. distributive impacts
 it is based on static view of efficiency
 Pigou :

•Unlike Pareto’s general equilibrium analysis

Pigou relied on partial equilibrium analysis
•Income redistribution-
• greater equality of income could increase economic
welfare
•Externalities:
• spillover effects lead to the divergence between
social and private costs and benefit
Externalities and divergence of social and private costs and
benefits
 Pigou on saving

•People’s telescopic faculty is defective and tend to

devote too much of their resources to present use and
too little to future use.
•Economic outcomes are affected as a result.
– The creation of new capital is checked, and people use up the present
(existing) capital to such a degree that future advantages are sacrificed for
smaller present ones.
•Pigou concluded that, to enhance economic welfare,
 governments intervention that strengthen the tendency to consume at
present should diminish
 taxes on saving, on property, progressive taxes on income be avoided
 put heavy taxes on consumption
 Pigou’s effect: real balance effect of price
falls
•The decline in the general price level accompanying an economic
downturn will increase the real value of people’s assets.
•With increased asset value people will save less and consume more,
thus increasing demand.
•This will restore full employment. The idea served as explanation in
macro economics why the aggregate demand is downward sloping.
•Pigou and price discrimination
• 1st degree – all consumer surplus is taken away
• 2nd degree – block prices charged, taking parts of the consumer
surplus
• 3rd degree -price is charged on the basis of elasticity of demand
 Debates on Welfare under socialism versus
under capitalism
•Ludwig von Mises:
– Consumer goods
 The same types of economic calculation that guide
resources to their highest valued uses under
capitalism must be made by the socialist planner
who desires to maximize consumer welfare.
 Without private owner ship of resources, free
markets and entrepreneurs, such calculation is
impossible to make.
 .

•Capital goods
 Relative prices in market economy reflect scarcities and
productive values.
 Prices of capital goods change quickly in response to
changes in consumer tastes, new technology, entrepreneurial
expectations, etc. Under socialism no such mechanism exists
 the economy is on constant change and continuously
generating new Information. Entrepreneurs are best suited to
and have the ability to anticipate rewards.
 profits and loses select those who can best fulfill wants, they
smarten entrepreneurs
 socialism cannot duplicate the functions of the market
 Oscar Lange:

•Market socialism, would result in economic efficiency and

maximum social welfare
 Market socialism is characterized by
 a) private ownership of consumer goods a
 b) free choice of occupation
 c) state ownership of the means of production.
 There are markets for goods, services and labor but
not for capital and intermediate goods.
 Shadow price, an index of the terms of exchange
between two items, exists rather than market price.
 .

 A central planning board, through trial & error

process can set the prices of capital by adjustment of
price to eliminate shortages & surpluses.
 Workers are paid their market wage plus the social
dividend.
 The trial-and-error process is much the same as that
which occurs under capitalism but can work better
under socialism because central planners have better
access to a greater range of information about
shortages and surpluses than do individual capitalists.
 KENNETH ARROW

 How do we know if we are socially better off as a

result of policy choice?
 Individual choice versus collective choice, how do
they relate?
 Is perfect democracy possible?
 Are there rules for determining what constitutes a just
distribution of income?
 .
•To ascertain the relationship between individual preferences and social
choices through democratic voting, Arrow establishes four minimal
conditions to be met by social choice:
 
 social choice must be transitive : if A is preferred to B and B to
C then A to C
 A group decision must not be dictated by anyone inside or outside
the community
 social choices must not change in the opposite direction of
individual choice
 A social preference made between two alternatives must depend only
on preferences toward these two alternatives and not on people’s
opinions of other options.
 Arrow arrived at his impossibility theorem: that " perfect democracy
is impossible”
 .

Example: suppose a community has three

voters (V1, V2, and V3) and there are three
alternative policies to choose from (A, B, C)

Policy V1 V2 V3
A 1st 3rd choice 2nd choice
choice
B 2nd 1st choice 3rd choice
choice
C 3rd 2nd choice 1st choice
choice
 .

• Comparing policy, A to B, by majority rule, A wins (two

individuals (V1 and V3) have chosen A to be better than
B).
• Comparing the winner A with C, C wins the majority.
• This choice implies that C is better than B if the social
choice respects the transitivity rule.
• But actually, B is observed to be better than C by the
same majority-rule, violating the transitivity principle.
• Thus, decisions on the basis of perfect democracy
(majority rule) do not simultaneously respect the four
principles.
 JAMES M.BUCHANAN

•The public choice perspective

 only individuals know their utility
 individual have different tastes, capacities,
expectations, knowledge but all possess the
commonality - pursuit of self interest
 The pursuit of self interest leads to
spontaneous order through the process of
exchange.
 ‘

 Buchanan extends the assumption of self-interested behavior

to political and public choice roles and explains
o the collapse of communism : Communist leaders promoted
their own interest not the idealized social good
o the rising of public debt in many industrial
nations :Elected politicians will seek any excuse to create
budget deficits to provide public goods & services so that
they stay in power.
o the rent seeking behavior of business & labor groups: they
attempt to persuade governments to limit competition and
create special rules that enhance private profit
o Bureaucracy is endemic to government and tends to beget
more bureaucracy
 .
•Buchanan objects the idea in conventional welfare economics
that:
o advocating ( posing) government officials as agents who can
identify social welfare function, and
• considers them as agents who identify and correct the 'bad'
produced by private sector to enhance society's welfare.
•The reasons for the objection are:
o Utility can be known only individually; and individuals know
their utility preference when presented with real world choices,
which means no one can discern a collective or a social
welfare function
o The government sector consists of people who act on their
own interest that may not align with the social ideal, if at all
that social welfare exists.
 .

•Although Buchanan is pro- individualist, he is not an anarchist.

Individuals understand the need for government to constrain
individual behavior and the need for constitutional rules to
constrain the state.
 
•Mutual consent (unanimity) is desirable in establishing
constitutional rules, but efficiency considerations may necessitate
majority voting rule. Even majority rule is not sacrosanct. An
optimal voting rule is that minimizes the sum of
(a)the costs to those opposing the proposition and
(b)Society bargaining and decision-making costs associated with
gaining greater consensus
 
 MATHEMATICAL ECONOMICS AND EMPERICAL
METHODS IN ECONOMICS
•Mathematical economics refers to the expression of
economic principles and analyses using mathematical
symbols and methods.
• It does not constitute a separate school of economic
thought but a distinct method of expression and analyzing
economic theories, principles and conclusions.
•Algebra, geometry, calculus, difference equations,
differential equations, linear algebra, topology are used in
economic analysis and theorizing.
• 
 Mathematical economics was used in three general ways

(a)to derive and state economic theory

(b)to expose inconsistencies in verbally expressed theories and
corrected logical errors
(c)to develop testable hypothesis
 
•Static and Dynamic Optimization, linear programming, partial
equilibrium, general equilibrium, input output analysis, game
theoretic analysis, are applications of mathematics in economics.
 
•You need to make a brief review Cournot, Walras, Edgeworth,
Pareto, Nash, Von Neuman and Morganstern, Hicks, Leontief,
Samuelson, Fisher with regard to formalization of economics,
Perpetual questions and Issues in scientific investigation

- Is there any way to relate theory to reality?

- If there is a way, is there more than one way? 
•Assessing the reality on the ground to confirm or
refute theories is known as empirical analysis.
• Historically the empirical methods followed to
relate theory to reality were: 
- Common sense empiricism (armchair empiricism)
- Statistical Analysis (measurement of reality without
theory)
- Classical econometric analysis
- Bayesian Econometric analysis
 .

• How are Mathematical Economics, Statistics and

Econometrics related in modern economic science?

 Mathematical economics: - Application of maths to develop

hypotheses and clarify their implications

• Statistics: - Collection of numerical observations and

statistical analysis, use tests derived from
• probability theory to gain insight into those numerical
observations

• Econometrics: -Combination of mathematical econometrical

and statistical analysis
•Read Colander (Pages ) and Stanley L
Brue ( pages 365 to389) on the development
and use of mathematics, statistics and
econometrics in economic analysis
• 
 THE DEVELOPMENT OF MODERN MICROECONOMICS

•Historically Cournot, Walras, Pareto, and Edgeworth unseated

Marshall to become the forefathers of modern graduate
microeconomics, relegating Marshallian economics to a role in
undergraduate education.

• Marshall focused on partial equilibrium. Modern microeconomics

focused on general equilibrium that was pioneered by Walras.

•Though geometry was used in Marshallian analysis to some extent,

it heralded the beginning of the end of Marshallian economics.
 .

•In modern microeconomic after 1930s expositions using

the various geometric tools and mathematical formalizing
intensified.

•History and institutions gave way to argumentations

abstracted from any actual setting.

•Because many economists had acquired the requisite

analytic equipment, the late 1930s and early 1940s
witnessed a revolution in microeconomics, in which
formalization won.
 Formalization of economic theory went through

(1)Extending the marginal analysis of households, firms,

and markets to make it more internally consistent, with
the use of general equilibrium and higher mathematical
analysis.
(2)Reformulating the questions in a manner consistent with
the tools and techniques available for dealing with them.
(3)Adding new techniques to clarify unsolved questions.
This process has continued to date.
 These processes followed different paths  
1)European roots
o Generalizing and formalizing general equilibrium theory.
Arrow & Debru addressing Adam Smith’s question " will
the invisible hand promote social good?”
•  
2) The other path is that of Paul Samuelson which focused on
the implications of economic theory in the following statement
"the existence of analogies between central features of various
theories unifies the existence of a general theory which
underlies the particular theories and unifies them with respect
to those essential features"
 .

 Accordingly, Equilibrium and stability

conditions emerge as the two-part structure
underlying economic theory.
 
 The conditions of equilibrium for
comparatives statics can be put in the
maximization framework. For dynamic
analysis specification of the dynamic
properties are required to assess the stability.
 .

•As advances in mathematical economics and

general equilibrium approach relegated Marshallian
approach to a subordinate level, what happened to
the monopolistic competition theory, which was a
departure from Marshallian economics?

•Monopolistic competition theory failed to be

embraced in the new microeconomics for reasons of
difficulty in formalizing
 .

- Chamberlain’s monopolistic competition analysis was

a Marshallian partial equilibrium analysis, and it was
not amenable to integration in the general equilibrium
analysis that relied on the competitive model
•  
- Monopolistic competition was countered as an
unnecessary appendage. It does not add to pure
monopoly or to pure competition explanations as no
power of prediction as the polar models.
 Topics in modern microeconomics
 Topics in Modern Microeconomics have expanded to two general
areas : i.e., in terms of issues( domains) and methods (techniques)
•  
o The domain of Microeconomics :
 Microeconomics is expanding to other areas, which were
traditionally considered outside the realm of economics, such
as the analysis of decisions of family on the number of
children, marriage, crimes, , social choice and constitutions,
law and economics etc
•  
o The techniques of microeconomics :
 New mathematical tool kits and inclusion of uncertainty and
game theory
Topics in modern micro economics in two specific
areas
o Demand theory:
 Indifference curve approach ( preference based ),
 Revealed preference approach ( choice based )
 
• Critiques on the claims of the law of demand
 The existence of Giffen goods and the counter
explanation
 The argument on Inadequate psychological foundation
of utility maximization as a basis for demand analysis
 .

o Welfare economics
 The fundamental theorems of welfare
economics
 Measures of change in consumer welfare
 Consumer surplus
 Equivalent variation
 Compensating variation
 DEVELOPMENTS IN MODERN MACROECONOMICS
 

•Historical forerunners of Macroeconomics

- MERCANTILISTS
 The possibility of divergence of Actual and Potential
level of output as a result of :
o Private interest leading to monopoly that restricts
output
o Individuals saving and hence deficiency of domestic
demand
o Imports crowding out domestic products
 .

 The accumulation of Gold and silver as the measure of

wealth of a country
 Balance of payments
o The outflow of gold and silver leads to unfavourable
balance of trade
o The need for restriction of imports and promotion of
exports
o 
• Government intervention is required to regulate
domestic and foreign trade and maintain positive
balance of payments
 CLASSICAL
 Invisible hand would lead to attainting the potential output (under lassez
faire)
 A. Smith agreed with Mercantilists on the effects of monopoly but the
method of removal of monopoly is not government but competition.
 Mercantile un-consumption arguments were countered by “Says law ”
 Mercantilist argument for amassing gold was countered by the idea that
a countries wealth is measured not in precious metals but in real output
(under free trade, & foreign competition )
 Markets (even not perfect) worked better than the alternatives
 Classical thinkers’ focus of inquiry shifted from monetary and
financial forces to real forces. The dichotomy between real and
nominal forces was accepted
• Nonmainstream economist such as Karl Marx asserted that the
economy had an aggregate or macroeconomic problem
 NEOCLASSICAL ECONOMICS
 Orthodox economics was interested mainly on one macro
issue- the general price level and to some extent on business
cycles. To explain the forces that determine the general level
of prices, quantity theory of money in the version of
equation of exchange and transaction version were
developed.
•  
• The most famous theory of money, , was developed by
Marshall M = kPY, where M is currency plus demand
deposits PY is money income,k is the proportion
households desire to hold income in the form of money ,
it was known as the equation of exchange version.
 .

•Irving fisher developed transaction version of the, Quantity

theory of money –
• MV =PT, where M- Quantity of money, P- price
level, V=velocity, T transaction level.
• Both assumed full employment
 All attempts to explain business cycle were not successful
because they were based on a solid belief in self
equilibrating properties of the market economy and saw
aggregate fluctuation as temporary co-ordination
problems. No one was able to show that equilibrium was
possible at less than full employment.
 .

• Marshallean framework has problems with macroeconomics because of the partial

equilibrium nature of supply and demand analysis.
• The only way to extend the arguments from partial to general equilibrium is to use
complicated mathematics.
• Early neoclassical economists used little mathematics.
• Few Swedish economists anticipated that the problem to come.
• They argued that a difference between ex ante and ex post savings and investment
affect the aggregate economy.
• These works were ignored until the great depression, after which they were
reconsidered and known as disequilibrium monetary theory.
• British economists influenced by these events maintained that there could be
temporary monetary disturbances in which the flow of savings would not equal the
flow of investment.
• These temporary disturbances would cause fluctuations in real income.
• Ultimately the economy would right itself but there would be a sequence of time
periods with in which the interconnected flows could be in disequilibrium.
• In connection with this theory it was suggested that the velocity of money could
fluctuate in the short run and that there would be temporary unemployment.
 .

• Most neoclassical economists of this period were not disequilibrium monetarist.

• Founded on supply and demand approach in a partial equilibrium framework,
they focused on disequilibrium in labor markets as the cause of extended
unemployment.
• The underlying belief was that wages were above equilibrium wages due to
influences of union’s power.
• To reduce unemployment, it necessitates reducing union power.

• The Depression of 1930’s changed the context under which the market was seen.
• Economists began to analyze the aggregate economy in greater detail becoming
aware of the short comings of neoclassical theory and policy prescription.
• Mainstream neoclassical views became inconsistent to their policy proposals, as
they started deviating from laissez faire and prescribing government intervention
in advocating public works and deficits as a means of fighting unemployment.
•  
 .

• Modern macro economics developed within the contexts of:

 economic upheaval
 concern over unemployment
 Questioning the underlying neoclassical theory
•THE BIRTH OF MODERN MACROECONOMICS
 
– When Keynes (1936) developed a theory, arguing that equilibrium
at less than full employment could exist, a new phase of orthodox
macro theory commenced.

– Keynes broke the laissez faire tradition that was running through
the time from Adam Smith to the time of Marshall 

 
 KEYNES AND KEYNESIANISM
- General theory of Keynes has contextual nature
- It has Analytic VS realytic ( blending inductive
information with deductive logic )
• E.g. – fixed price assumption ( no explanation , or
first principle to start from , is given for why they
are fixed; Its assumed reality is simply taken as a
starting point)
•
 Major Tenets of Keynesian school

 Macroeconomic emphasis concern with total or aggregate

amounts of consumption , saving, income, output and
employment
 Demand Orientation – Effective demand (aggregate
expenditure as the immediate determinant of National income
output & employment. Thus effective demand establishes
actual output when in some cases is less than potential output.
 Instability in the economy – the economy is given to recurring
booms and busts – due to erratic planned investment spending,
which is determined jointly by:
 the rate of interest and
 the marginal efficiency of capital.
 .

• Interest rate depends on:

 people’s preference for liquidity and the
quantity of money while marginal efficiency
of capital depends on :
 expectations of future profits and
 the supply price of capital.
• The expected profits are unstable and the most
important causes of business fluctuations.
 Wage and price rigidity downwards.
 Active fiscal and monetary policies
 .
- Differences of Keynes analysis from classical &
Marshallian adjustment to equilibrium, when applied to
Aggregate equilibrium.
- Discussion of:
- the classical belief of the dichotomy of real and nominal economy,
- Says law,
- equilibrium at full employment,
- Prices do not have equilibrating role at the aggregate level;
- Keynes Criticism of this model that what brings the equality of supply
and demand at times when planned supply is different from planned
demand , at a disequilibrium start? ;
- the alternative path of the adjustment of the aggregate economy by Keynes,
through income ( supply) and consumption (demand) approach, where the
marginal propensity to consume is the link ; the multiplier concept)
 Extensions by other Keynesians
- Extensions by other Keynesians
• The consumption function analysis, which did
not include analysis on the interrelationship
between the financial and real sectors
• Functional Finance (Fiscal policy and
Monetary), where the monetary policy aspect
did not go with the consumption function
model
• The IS-LM Model
• ∆P ∆M ∆r ∆I ∆Y
• Keynes Effect (compare it. with real balance or
wealth effect, or Pigou’s effect). Changes in prices
leading to new equilibrium linking real and financial
side of the economy; however, prices were seen as
rigid.
•Problems of the IS – LM framework :
o Limited the analysis to comparative statics, where the speed of
adjustment was ignored. Keynes believed the multiplier adjustment
mechanism was faster than price mechanism. Is - LM ignored this.
o Believed that the real and nominal sectors were interrelated only
through interest. Ignored the phenomenon of inflation and other
channels of transmission.
o LM analysis was based on demand for money which didn’t use
general equilibrium analysis. It was an adhoc – formulation.
 MONETARISTS
•They argued that output fluctuations are due to monetary
disturbances.
 Monetarists complained that the consumption function
model of Keynesians had no role for money. Later its role
expanded to affecting the interest rate.
 Monetarists argued money matters more than its effect on
interest. The IS-LM framework was a point of concurrence
in this respect but monetarists believed a highly inelastic
LM curve while Keynesians assumed a highly elastic LM
Curve
•  
 THE MOVEMENT TOWARDS MICRO
FOUNDATION

• 

•Macro focuses of the 1930 was an attempt to

explain unemployment Keynes said it is a macro
issue.
• (Absence of jobs due to demand deficiency)
• Micro foundation economists sought the answer
on firm’s decision & search behavior of workers.
• 
 THE NEW CLASSICAL MACROECONOMICS

•A combination of elements of :
•Monetarism,
•General equilibrium theory,
•The rational expectation hypothesis,
•And Policy ineffectiveness

•Eg. Agents anticipate a predictable monetary

policy and thereby neutralize the potential impact on
the real sector.
 KEYNESIAN RESPONSES
•Keynesianism appeared as Neo Keynesians, Keynesians (post Keynesians)
and New Keynesians

•NEO KEYNESIANS (neoclassical synthesis Keynesians, “bastard

Keynesians”) believe that the IS-LM is a fair representation of Keynes ideas

•POST KEYNESIANS do not believe that the IS-LM is a fair representation

of Keynes ideas
o Neo- Ricardian view of production value and distribution
o mark up pricing
o Endogenous money
o pronounced cyclical instability
o Need for an income policy
 NEW KEYNESIANS
•believe that the new classical abstract approach is the right
one but when we make reasonable assumptions about the
macro institutional structure Keynesian results follow.
• Attempts to continue the Keynesian tradition of explaining
less than full employment equilibrium with price rigidities
 Downward price -wage rigidities
 Menu costs
 Formal and implicit contracts
 Efficiency wages
 Insider - outsider theory
THE CONTEMPORARY MAIN TOPICS IN MACROECONOMICS
(Substantive and methodological)

•Substantive
 REAL BUSINESS CYCLE THEORY ( the explanation for aggregate output fluctuations)
• 
 THEORIES OF GROWTH AND DEVELOPMENT
• Historically dominant growth models
• Harrod-Domar
o the capacity - creating effect of investment
o the demand - creating effect of investment
• the requirement for Balanced growth
• Solow growth theory
• Neoclassical growth theory
 Model with Infinitely lived agent (engaged in intertemporal maximization)
 Overlapping generations model
• The latest ones
• Endogenous growth theory
 .
•Methodological
 DISEQUILIBRIUM MACRO ECONOMICS
 AGENT BASED ECONOMICS
• 
•