Alfred Marshall (1842 – 1924) and Francis Ysidro Edgeworth (1845 – 1926) The two leading late 19 th century British economists 1

Marshall and Cambridge, first professor of economics Always seen as something special: his analysis is easier to follow than, say Walras’, as his approach is ”plain English”. Seen as someone that was the beginning of the Cambridge tradition: Marshall, Pigou, Robertson, Keynes, Sraffa, Austin Robinson, Joan Robinson, Kaldor, Robert Neild, Frank Hahn, Angus Deaton and many, many more. Marshall was a well-trained mathematician. “Burn the mathematics when the analysis is done, then “plain English”. No doubt that his foremost pupil, John Maynard Keynes, thought that Marshall was a giant. In 1933, Keynes wrote an essay on Marshall and his economics – referred to by Sandmo. This essay together with similar articles on other economists are impressively well researched and composed. Moving social profiles. Marshall was a bit strange: very conscious of offering polite words to his colleagues and competitors but often with a tone of jealousy. It took him 20 years to write his main work, Principles of Economics (1890) 2

What did Marshall accomplish? Marshall is the inventor of several important concepts: The Partial Equlibrium Method, elasticity, the interrelation between market equilibrium and social welfare, ceteris paribus and more. He uses supply and demand in the same way as we do. Principles was a textbook – perhaps the first modern one – and it is large (871p); economic theory is in Book 5. 3

The Marshallian cross 1 4 From p. 346 in a footnote! – what is so great about that?

The Marshallian cross 2 Now what is so great about this? Demand based on decreasing marginal utility – as in Jevons and Walras – but much clearer. Supply curve rising due to increasing marginal costs. Very far from the classical conception of a flat supply curve (Labour theory of value, determining the price alone) “We might reasonable dispute whether it is the upper or under blade of a pair of scissors that cut a piece of paper, as whether value is governed by utility or cost of production” (p. 348) – General equlibrium as in Walras? Probably, but illustrated partially, only one market at display. Much easier to understand and makes adjustments clearer. In the short run, supply may be vertical, price increases with demand, but in the longer run supply becomes flatter. As Sandmo explains, this was an important piece of analysis that Keynes took over. 5

Partial or general equlibrium? Walras had a model of all markets; it determines all quantities and all relative prices. Is Marshall doing the same? He invented ceteris paribus to do one market at a time. He also have many remarks on the interrelationships of all markets. Also clear, that Walras’ model could not take into account all the particularities of each individual market. Marshall’s method is very practical – very useful to go from market to market. Ref. i.e. Tobin who talked about monetary theory in his path-breaking 1969-article it was called “A General Equlibrium Approach to Monetary Theory”, but it was partial as only monetary markets were considered. So, it is used a lot. In addition, no one analyzing a small market would try to put it into a complete setting. However, did Marshall really understand interdependencies? Perhaps he did not is Sandmo’s conclusion and that is not so innocent. He understands substitution effects but maybe not income effects. 6

Utility, demand and welfare 1 Marshall understands that a decreasing MU will lead to a decreasing demand curve. Higher price, lower demand. However, a lower price will also increase the purchasing power of the person’s nominal income. The MU of the income increases and we not only have a substitution effect (higher price, lower demand) but also an income effect (a higher real income can buy more of all goods). Now, Marshall assumes this away as he is only referring to a “small” market. 7

Utility, demand and welfare 2 Now add all demand curves to get the market demand for a particular good: 8

Utility, demand and welfare 3 The consumers’ surplus measures the gain to consumers from a fall in price down to equlibrium. They would have been willing to pay more but they do not have to. Similarly, producers enjoy a producers’ surplus. Had the price been lower, their surplus would have been lower et vice versa. The sum of these two surpluses, Marshall calls the social surplus and it proves to be an extremely interesting concept. 9

Utility, demand and welfare 4 “There is indeed on interpretation of the doctrine {social surplus at its maximum in equlibrium} according to which every position of equlibrium of demand and supply may fairly be regarded as a position of maximum satisfaction. For it is true that so long as the demand price is in excess of the supply price, exchanges, exchanges can be effected at prices which will give a surplus of satisfaction to buyer or to seller or to both.” (p 470). All this of great interest to many, many kinds of applications. Market equlibrium is a social optimum, but Marshall is aware that one may – or should – intervene in markets to obtain distributional effects. 10

Elasticities Were invented by Marshall to present a way of giving meaning to reactions or steepness. Of enormous practical use in multiple situations! As you know well! 11

External effects. Marshall analyzing a special case only Can the long run supply curve be downward bending so that price will decrease with an increased demand? Yes, with increasing returns to scale. Costs may go down when production becomes more efficient. Demand for computers have been rising for 30 years and they have become far better – because of much technological progress. Inventions etc. have cut costs. However, also the opposite, ref. Marshall’s example with fishing. Not quite what we would call external effects, but clearly important. He had a “plan” for taxing firms with increasing returns to scale and transferring to money to those with increasing! Taxing Intel and give the money to fishermen . 12

Factor Markets and Income Distribution 1 The Iron Law of Labour does not work anymore! Marshall’s demand for labour: In addition, this is influenced by training (human capital and education). A high wage makes it possible for parents to give their children a good start in life (Marshall’s father persuaded his employer (Bank of England) to pay for Alfred in a fine school!). Moral principles and Christian ideas are somehow behind what men do! “Cambridge is for men with cool heads and warm hearts” Read Sandmo. 13

Factor Markets and Income Distribution 2 Upwards sloping as MU increases as w increases. Much the same for capital, one will be investing (supplying capital) until rate of profit equals interest rate. 14

Monetary Theory 1 Not in Sandmo. Marshall published a Money, Credit and Banking when he was 80! It was a Quantity Theory of Money approach, but He is close to see M as a demand for money function and not the supply of money, later slowly leading up to Keynes’ liquidity preference. Also Interest rate is (as we have seen) something that can differ from the rate of profit. Wicksell made much of that! What about the real rate of interest? 15

Monetary Theory 2 Purchasing Power parity, exchange rates adjust according to inflation differentials and – again – the change of the money supply. In favor of index-linked clauses in long term contracts. Sandmo is not very enthusiastic about his monetary theory – can’t see way! 16

Francis Ysidro Edgeworth (1845 – 1926) Mathematical economist concerned with the interactions between equlibrium and welfare..

What is utility? How to measure it and compare between individuals? We saw that economists from Cournot, Mill etc. discussed utility and that Marshall intuitively argued that marginal utility was negative and (therefore) the demand curve downward sloping. He was also arguing that society would reach a “maximum satisfaction” with regard to one market when it was in equlibrium:

What is utility? However, what is this ”maximum satisfaction? A key to understanding this is Utilitarianism (from Bentham). It can be measured, one can compare between individuals and it can be aggregated! Edgeworth worked with Exact Utilitarianism: “We cannot count the golden sands of life; we cannot number the “innumerable smile” of seas of love; but we seem to be capable of observing that there is here a greater, there a less, multitude of pleasure-units, mass of happiness; and that is enough.” Based on psychology, Edgeworth argued that marginal utility of income must be decreasing.

Social welfare My understanding of this is that Edgeworth in fact did believe that one could compare utility between individuals! This is believe contradicts the quote on the previous slide! Take from a rich person an give to a poor will increase total utility; this is what we call cardinal utility. It obviously has political implications. Social welfare is the sum of individual utility functions. As we will se, Pareto had the opposite opinion while Pigou assumed the same as Edgeworth (even though he did not care too much). This is a very fundamental issue with enormous consequences for politics!

Utility functions Anyway, how do we measure the utility of one specific individual? As we saw, Marshall considered good after good (the partial equlibrium approach): Edgeworth realized that goods may be substitutes (butter and cooking oil); consumption of one good dependent on the consumption of another: More consumption of x, less utility of y. Nevertheless, obviously, it could be the other way round (university class teaching and e-learning). What we now call complementary goods.

Indifference curves Coming so far, Edgeworth is the first to draw the indifference curve (here a series of curves – each indicating a level of individual utility Why must these curves be concave? Starting from a point on one specific curve in the North West corner, one is willing to surrender much y to get extra x et vice versa.

The shape of indifference curves Why must these curves be concave? Starting from a point on one specific curve in the North West corner, one is willing to surrender much y to get extra x et vice versa. Now, an exercise in transactions in a perfect equilibrium with : There are two consumers A and B and two goods X (first axis) and y (second axis). At the beginning, they are in E 1 ; A owns little x and much y and the other way round with B. A’s indifference curves are observed from A and B’s from B. By making transactions both A and B can improve their positions and obviously their utility; both are moving to higher indifference curves. The invisible hand working!

Sketching the perfect equilibrium As Sandmo sketches by increasing infinitely the number of A’s and B’s we end up with an equlibrium that is perfect competition. This is what we call positive or descriptive analysis. Or on YouTube: