Alfred Marshall and Neoclassical Economics Chapter 10

Alfred Marshall British, initially wanted to be a clergyman Wanted to make economics more mathematical, more rigorous, more “scientific” Principles of Economics, published in 1890 Brings the ideas of supply and demand, marginal utility and costs of product into a coherent whole Father of neoclassical economics

Framework of Analysis What are the questions that Marshall is asking? How can economics be used to improve the lot of the poor? He was trying to develop an “engine of inquiry” – a way of analyzing the world to arrive at “the truth” He was a microeconomist

Framework of Analysis What are the assumptions that Marshall is making? Diminishing returns Perfect competition

Framework of Analysis What is the economic/political/cultural/ social environment of Marshall (1842-1924)? Heyday of capitalism, free markets, Industrial Revolution Victorian age Lots of wars

Framework of Analysis What is the economic/political/cultural/ social environment of Marshall (1842-1924)? (continued) Continued attacks on Classical economics Laissez-faire under attack because of dreadful living conditions for people in factories

Framework of Analysis What is the role of the market? Entire analysis based on competitive markets – micro level

Framework of Analysis What is the role of government? He was interested in analyzing government action affected economic welfare

Marshall's definition of economics He equated political economy with economics. It is the “Study of mankind in the ordinary business of life” Includes analysis of individual and social (in part government) action

Marshall and Time Marshall had four time periods Market period – supply inelastic Short run – upward sloping supply curve – can change level of output but not plant capacity; prime costs and supplementary costs Long run – can vary output and plant capacity Secular period = very long run – technology and population can change

Marshall and Time (continued) In modern microeconomics, there are two time periods, short run and long run – the definitions are about the same as Marshall’s prime costs = variable costs and supplementary costs = fixed costs

Price Elasticity The price elasticity of demand measures the percentage change in quantity demanded divided by the percentage change in price.  It is a measure of the slope or steepness of the demand curve.  It is important in measuring the incidence of a tax how total revenue of a seller changes when price changes

Price Elasticity (continued) the price elasticity of demand is affected by: the availability of substitute goods the proportion of income spent on the good the time elapsed since a price change

Marshall’s Demand Curve The amount of a good demanded varies inversely with the price of the good due to the substitution effect and the income effect

Substitution Effect The substitution affect always yields a downward sloping demand curve because, for example, as the price of a product falls, consumers will substitute more of this (relatively) in lieu of other products

Income Effect The impact of the income effect depends upon the type of good in question.  Normal good - lower price will increase the real income of the consumer and he/she will purchase more of the produce Inferior good - lower price will increase the real income of the consumer and he/she will purchase other more desirable products and less of the inferior good.  In this case if the income effect is greater than the substitution effect, then the demand curve will be upward sloping!  Then we  have problems with unstable equilibrium.  These types of goods are called Giffen Goods To deal with this possible problem Marshall assumed that the income effect was small

Welfare Economics It is not the study of government “welfare programs”

Welfare Economics (continued) Welfare analysis is a systematic method of evaluating the economic implications of alternative allocations It answers the following questions: Is a given resource allocation efficient? Who gains and who loses from different resource allocations?

Welfare Economics (continued) Microeconomic approach to analyzing efficiency and equity effects of particular actions May be used to develop criteria for government intervention in markets

Consumer Surplus Gain to consumers that occurs because they are willing to pay higher than market price for initial units of a good Consumer surplus exists because of the concept of diminishing marginal utility and a downward sloping demand curve.  The first unit of a good is “worth” more to a consumer than subsequent good (or services).

Consumer Surplus and Taxes Marshall compared the loss in consumer surplus to the gain from tax revenue The gain or loss from the tax depends upon the elasticity of the supply curve

Marshall’s Contribution to Cost Analysis - Supply Short run v. long run Fixed cost v. variable cost - A firm will continue to operate in the short run as long as it is covering its variable cost Internal economics of scale – forces internal to the firm – affects costs  If there are internal economics of scale (advantages to being big) then there will be decreasing costs; internal diseconomies of scale (disadvantages to being big) result in increasing costs External economics of scale – can explain falling prices in an industry over the long run – think of personal computers and other electronic goods

Marshall’s Quasi-rent Are payments to factors of production (e.g., wages, profits) price determined or price determining? Classicals believed them to be price determining – that is, the price of the final product depended upon the price of the factors of production (inputs) used to produce the final product.  (supply oriented)  An exception was rent, which was price determined since it was fixed in supply. Marginalists said that payment to factors of production were price determined – that is, the price of the final product determined the factor payments (demand oriented) Marshall said “it depends.” 

Upon what does “it depend”? Land rent is price determined from the perspective of the entire economy but price determining from the perspective of the individual farmer.  To the individual farmer, rent is a cost of production Under some circumstances, however, rent can be price determining from the perspective of the economy as a whole.  For a country that has unsettled land, the supply curve of land is upward sloping, therefore higher prices of land will cause more of it to be developed. In the short run wages are price determined (inelastic supply) but in the long run they are price determining (more elastic supply)

Is price a dependent or independent variable? Conventional mathematical analysis places the independent variable (X) on the horizontal axis and the dependent variable (Y) on the vertical axis. Marshall’s analysis had price as the dependent variable and quantity as the independent variable  P = f(Q) Walras and modern economic theory places price as the independent variable and quantity as the dependent variable. Q = f(P).  Therefore, adjustments to get to equilibrium occur via changes in price.  Interestingly enough, modern supply and demand models that you see in principles of microeconomics are drawn with price as the dependent variable (like Marshall) even though it is the independent variable in modern analysis.