1. Neoclassical Revival 1920s and “Empty Economic Boxes” debate Developments in the 1930s –Demand Theory –Theory of Production and Cost –Welfare Economics –Theories of Imperfect Competition –Theories of money and business cycles Neoclassicism became more than just a theory of perfect competition

2. Developments in Demand Theory John Hicks Value and Capital 1939 Built on the work of Pareto, Edgeworth, and Slutsky Ordinal utility measure Preference functions—the axioms of choice Indifference curve analysis Consumer optimum where MRS equals the price ratios Derivation of the demand curve

3. Demand Theory Income and substitution effects –Hicks definitions –Slutsky definitions Giffen good case Ordinary and compensated demand curves Compensating and equivalent variations and consumer’s surplus

4. Theory of Production and Cost Jacob Viner (1931) complete set of short run and long run cost curves for a firm Viner’s famous mistake Hicks—isoquant analysis of production functions Cost minimization in long run where MRTS equals factor price ratios

5. Welfare Economics: Externalities Debate over Marshall’s concept of external economies and diseconomies—what is a genuine externality? Pigou extended Marshall’s concept to all divergences between private costs and benefits and social costs and benefits Many costs not included in private decisions Externalities are grounds for government intervention

6. Externalities Example of the two roads –Road 1 poor quality but wide –Road 2 high quality but narrow –Road 2 increasing cost conditions due to congestion –Private users equate private costs but do not consider costs imposed on other users –Congestion externality justifies tax on use of the better road Knight’s critique of Pigou— externality caused by absence of private property rights

7. Externalities Pigou’s example of damage to crops caused by sparks from railway engines (steam) Coase’s later (1960) criticism of Pigou –If transactions costs are zero parties will negotiate –If transactions cost are high the right should be allocated so as to max the value of output

8. Pareto and Welfare Optima General Equilibrium Approach Ordinal utility and no interpersonal comparisons of utility Pareto improvement—make at least one person better off and no one worse off Pareto Optimum—cannot move without making at least one person worse off

9. Conditions for a Pareto Optimum Formalization of the conditions for a Pareto optimum done in the 1930s by Hicks, Lerner, Bergson, Lange. Optimum condition in exchange: MRS between any pair of goods must be the same for all households that consume both Optimum condition in production: MRTS between any pair of factors must be the same for any firm that uses both

10. Pareto Optimality Optimum condition for composition of output: MRT between any pair of goods must equal the MRS between them in households y x Slope of the production poss curve is the MRT = ratio of marginal costs

11. Pareto Optimality and Competition Competitive equilibrium will lead to a Pareto Optimum First Theorem of Welfare Economics This assumes no externalities, public goods, or common property If all consumers are price takers then the MRS between any pair of goods will be the same for all households (utility max)

12. Pareto Optimality and Competition If all firms are price takers then the MRTS between any pair of factors will be the same for all firms (cost min) If all output markets are competitive then prices will equal MC of production: MRT = the ratio of marginal costs = the ratio of prices = MRS

13. Pareto Optimality I II y x x y 1 2 3 4 5 1 2 3 45 Contract curve or efficiency locus

14. Debates In Welfare Economics The adequacy of Pareto criteria –No unique optimum, will depend on initial endowments –The utility possibility frontier and the limits of the Pareto criteria UIUI U II a b c d

15. Debates in Welfare Economics Concept of Potential Pareto Improvements Compensation Criteria Does compensation have to be paid? A. Bergson and social welfare functions (1938) Arrow and the Impossibility Theorem (1950s)

16. Debates in Welfare Economics The Socialist Planning Debate –Is competition necessary for Pareto optimum? –Could a planner achieve the Pareto conditions Socialist planning –Barone 1908, Lange 1938 Criticism of socialist planning –Mises and Hayek: based on the ideas of the information produced by markets and the role of the entrepreneur