The Transition to Neoclassical Economics – “Second Generation Marginalists” Chapter 9

Second Generation Marginalists We use this term because they added to the “first generation” by considering supply as well as demand factors in value theory (price determination) Applied marginal analysis to the supply side – marginal productivity analysis Explains the forces determining the prices of factors of production and the distribution of income

Deficiencies of “First Generation Marginalists” Assumed that supply was given and that the economic problem was simply one of allocating this fixed supply No explanation of factor prices – wages, interest, rent and profit No explanation of distribution of income No analysis of the firm (supply)

Marginal Productivity Theory Based on Diminishing Returns Ricardo did use this concept with respect to agriculture

Definition of Diminishing Returns (Columbia Encyclopedia) Law stating that if one factor of production is increased while the others remain constant, the overall returns will relatively decrease after a certain point. Thus, for example, if more and more laborers are added to harvest a wheat field, at some point each additional laborer will add relatively less output than his predecessor did, simply because he has less and less of the fixed amount of land to work with. The principle, first thought to apply only to agriculture, was later accepted as an economic law underlying all productive enterprise. The point at which the law begins to operate is difficult to ascertain, as it varies with improved production technique and other factors. Anticipated by Anne Robert Jacques Turgot and implied by Thomas Malthus in his Essay on the Principle of Population (1798), the law first came under examination during the discussions in England on free trade and the corn laws. It is also called the law of decreasing returns and the law of variable proportions.

Impact of Diminishing Returns Upward sloping supply curve Why do producers have to have a higher price in order to produce more?  Because of increasing marginal cost, which is based on diminishing returns (diminishing marginal productivity) 

Impact of Diminishing Returns Downward sloping demand for inputs (factors of production) As the marginal product of a factor declines, it is worth less to the firm, and so the firm is willing to pay less for the input.  This results in a downward sloping demand curve for the input.  In a competitive market, factors of production will receive a payment equal to their marginal revenue product, that is, they will receive a payment equal to what they are worth to the firm.

Product Exhaustion Product exhaustion refers to the idea that payments to factors of production based on the value of their marginal product will exhaust (use up) all of the total product.  Ricardo’s theory of distribution concluded that all total product will be used up, or paid out to landlords or workers.  In the Marginalist theory, this is not always the case.  It depends upon the property of the production function

Constant Returns to Scale What do we mean by CRS? Production function is homogeneous to the degree one When ALL inputs are doubled, output doubles; when inputs are tripled, output triples, etc. Therefore, average cost is constant and equals marginal cost

Product Exhaustion and CRS If inputs are paid their MRP, then all revenue is “used up” as factor payments Assume perfect competition ATC = MC and MC = MR This means that ATC = MC = MR, so there are no (economic) profits

Decreasing Returns to Scale What do we mean by DRS? Production function is homogeneous to a degree less than one When ALL inputs are doubled, output less than doubles; when inputs are tripled, output less than triples, etc. Therefore, average cost is increasing and MC > ATC

Product Exhaustion and DRS In this instance there are economic profits – therefore no product exhaustion

Increasing Returns to Scale I leave it to you to make this analysis

Product Exhaustion So, the Second Generation Marginalists realized that product exhaustion would not always occur in the short run But, it would occur in the long run under perfect competition WHY?

Ethical implications of marginal productivity theory Is the distribution of income that results from marginal productivity theory (and based on perfect competition) a “just” or “fair” distribution?

John Bates Clark Said “yes” because perfect competition rewards the factors of production according to their economic contribution Rent, interest and profit are not “unearned” income – they are a return to the contribution of scarce factors of production But what about conditions of less than perfect competition???

Marginal productivity as a theory of employment At the micro level, a firm will hire workers up to the point where. . . Marginal Revenue Product (or value of marginal product) = wage The demand for labor depends upon the marginal revenue product Why is the demand for labor curve downward sloping? Diminishing marginal product

Marginal productivity as a theory of employment What about the macro level? Unemployment results from disequilibrium in the labor market Excess supply of labor Can be corrected via falling wages

Criticism of Marginal Productivity Theory Impossible to measure the marginal product of a factor of production What is the marginal product? The additional to output as a single factor changes – all other inputs remain constant How can we measure the contribution of one factor independent of others?

Factor payments (review) Labor – wages Land – rent Capital – interest (remember this is real capital, not financial capital) Entrepreneurship - profit

Marginalists were concerned with factor payments Factor payments determine income distribution

Second generation Marginalists and wages Demand for labor is downward sloping – diminishing marginal productivity See figure 9.2 on page 250 If wage rate is OD, then total wages are equal to the wage rate of OD times the quantity of labor hired of OC which is equal to the area of OCBD.

Second generation Marginalists and rent Demand for land is downward sloping – diminishing marginal productivity See figure 9.2 on page 250 If Oh units of land is used, then total rent is equal to the area of OHGI Wages then become the residual

Profits and Interest Classical writers failed to distinguish between the two In part this is because the typical firm during this time did not separate ownership from management The capitalist (provider of funds) and entrepreneur (risk taker) were the same person

Profits and Interest Second generation Marginalists recognized a difference Interest is the return to capital and profit is the return to entrepreneurs

Second generation Marginalists and profit To the Marginalists, in competitive markets all factors will be paid the value of their marginal product which is equal to opportunity cost Normal profit is the amount needed to keep the entrepreneur in business – alternatively, it can be seen as the opportunity cost of the entrepreneur

Second generation Marginalists and profit What about economic profit (excess profit, pure profit)? An excess that occurs when competitive markets are not in equilibrium OR When markets are not competitive Economic profit in competitive markets is not a return (payment) to a factor of production but a windfall associated with dynamic elements in an economy For example, in a competitive market, demand may increase in an industry resulting in higher output prices – new firms enter and drive prices down and eliminate economic profits

Second generation Marginalists and interest Interest as a return to capital is still not a settled issue We can look at theories that examine the reasons for the existence of interest (Theories of Interest) Or, we can examine theories of the rate of interest

The “Problem” of Interest Interest is a return to real capital But real capital is manmade machinery that incorporates other factors of production – it is not an “original” factor of production like land and labor But capital receives a return above its initial price (or cost of production) – there is a net return

The “Problem” of Interest Capital appears to be unique among the factors of production in that it creates a surplus value that flows to its owner in perpetuity (Textbook, p. 264) If product exhaustion occurs, then how can there be interest paid to owners of capital into the future?

Interest and time preference People prefer the present over the future A good available now has a different value than the same good available at a later date; value has a time as well as a quantity dimension

Interest and time preference Because of this time preference, factors of production will receive the discounted value of their marginal products The difference between these discounted values and the value of the marginal product when the final goods are produced is equal to interest

Looked at another way The supply curve of loanable funds is upward sloping because people require some payment for deferring consumption into the future The demand for loanable funds is downward sloping because of diminishing returns to capital