Alfred
Marshall (1842-1924) was the major figure in English economics for over three
decades, from around 1890 until the 1920s.
His major work was the Principles
of Economics, first published in 1890.
Marshall had worked out all the major elements of the Principles much earlier. He was, in his own mind and probably objectively,
a co-developer with Jevons of marginal utility analysis in the early 1870s.
However, he did not publish on the subject until 1890, thus losing
claim to priority. In fact, Schumpeter, who judges Marshall very
highly, concludes that Marshall had objective
claim to very little in economic theory.
He adds, “According to what I believe to be the ordinary standards
of scientific historiography, such merit as there was in the rediscovery of
the marginal utility principle is Jevons’; the system of general equilibrium
(including the theory of barter) is Walras’; the principle of substitution
and the marginal productivity theory are Thünen’s; the demand and supply curves
and the static theory of monopoly are Cournot’s (as is the concept, though
not the word, price elasticity); the consumers’ rent is Dupuit’s; the ‘diagrammatic
method’ of presentation is also Dupuit’s or else Jenkin’s.” Yet Marshall has been given credit by many later writers for all
or most of these developments. Why?
Marshall, while citing many of the authors just mentioned, typically failed
to give them their due. He frequently
cited them in relation to other (or minor) elements of their work, ignoring
their major contributions. Furthermore,
Marshall was extremely generous in lavishing praise on Ricardo and Mill, and
saw himself as a direct descendant of Adam Smith.
He is reputed to have said, “It’s all in A. Smith.” From Marshall’s viewpoint, this is natural.
He was a superior mathematician, and much of what he did would have
seemed to him to be nothing more than formalizing and making precise what
Mill had said.
Schumpeter
said that “nobody knows Marshall who only knows the Principles.” He also published
Industry and Trade (1919), Money,
Credit and Commerce (1923), Pure
Theory of Foreign Trade and Pure Theory of Domestic Values (1879), and with
his wife, Mary Paley Marshall, Economics
of Industry (1879). Collected
volumes of his papers were published after his death. Although the Principles
is primarily theoretical, much of the remainder of Marshall’s work is applied.
He was famous for his detailed analysis of particular markets and industries.
Schumpeter said that Marshall “understood business, business problems,
and businessmen better than did most other scientific economists, not excluding
those who were businessmen themselves.”
Marshall’s
overriding motivation for doing economics was to improve the condition of
the common people. He was a humanitarian
at base, having studied for the ministry before his interest in social issues
led him into economics. He did not
write theory for theory’s sake, but sought to understand the basic principles
of social behavior so that society might be reformed (at the margin) to make
people’s lives better.
Marshall said that “political economy or economics is the 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 use
of the material requisites of well-being.”
To Marshall, economics was a science of human behavior. He sought to bring to light such regularities or patterns of orderliness
as are inherent in economic phenomena. These regularities are expressed as generalizations or laws. The aim of the Principles is to study the economic aspects of human behavior in order
to derive the laws governing the functioning of the economic system.
Marshall
regarded competition as, in general, a good thing. In this he followed Smith. Competition
forces individuals to become more rational in their goals and decision making
and more socially conscious of their behavior. The study of economics contributes to this
by deriving solutions to both individual and social problems.
Marshall was concerned to work with variables that were statistically measurable. Although he himself was not a statistician,
his mindset paved the way for statistical work in economics–econometrics. Because goods and services traded for money
are more easily measured than other variables of concern to people, Marshall
concentrated his attention on commodity and factor markets.
Marshall developed the theory of competitive markets, although he was not
always careful to state the exact assumptions under which he worked. However, his analysis applied to industries that were small relative
to the entire economy, were composed of many demanders and suppliers, and
produced and sold output that was homogeneous. This is approximately what modern economists mean by pure competition. The more rigorous concept of perfect competition also requires perfect
information and perfect factor mobility.
Although Marshall’s theory is static, he nevertheless has an appreciation
for the importance of time. He analyzed the behavior of markets during
different periods, a trait that led to vast improvements in the theory of
supply.
Marshall based demand on utility, lauding Jevons’s work on the theory of marginal
utility. His translation from utility
to demand was informal, but nevertheless shows that Marshall thoroughly understood
the issue. [See Principles, III.III.2,
pp. 94-95.] Unlike Jevons, Marshall
did not believe that marginal utility was the most important determinant of
value. Marshall placed more emphasis
on costs of production, following Ricardo in this.
Marshall carefully laid out the concept of a demand schedule, used it to draw
a demand curve, then derived the law of demand:
“Thus the one universal rule to which the demand curve conforms is
that it is inclined negatively throughout
the whole of its length.” [Principles, III.III.5,
n. 2, p. 99] P. 96 of the Principles illustrates his construction
of a demand schedule and demand curve.
Marshall recognized that the slope of a demand curve was an inappropriate measure of the sensitivity of price to changes in quantity (as he put it, price being the dependent variable in Marshallian economics). A change in the units of measurement changes the slope of a demand curve, without changing the true relationship between price and quantity demanded. Marshall overcame this problem by deriving the concept of elasticity of demand:
Since the demand curve is always negatively sloped, the elasticity measure is negative. However, by convention the negative sign is dropped.
Marshall conceived of four different periods of production. The market period is a
period so short that the quantity of output brought to market cannot be altered
except by sale or destruction. In
the market period, the supply curve is perfectly inelastic. In the short
run, some but not all factors of production can be varied. In the long
run, all factors of production are variable. In the secular period,
even technology and population are variable.
• Law of diminishing returns. Marshall worked this out for agriculture, following the classical tradition. He understood that the addition of any variable factor to a fixed factor of production leads to diminishing marginal returns, however.
• Principle of substitution. A firm maximizes its profit by minimizing the cost of production of any given output. To minimize costs, the firm should substitute cheaper for more expensive inputs. The optimal input combination represents an application of Gossen’s second law to production theory. Combine inputs so that
Factor demands are derived from the marginal revenue products of factors. The quantity of a factor demanded is determined by equating MRP to the factor price. Marshall’s marginal productivity theory was mainly a theory of factor demand; it served as a theory of income distribution only in the short run.
Marshall identified three possible patterns that might result as an industry
expands in the long run: constant
returns, increasing returns, and diminishing returns.
His theory of returns to scale was tied closely to the concepts of
external and internal economies. External economies result from “the general
progress of the industrial environment” and enable all firms in an expanding
industry to experience decreasing costs. Better transportation and marketing systems and improvements in
resource-producing industries might produce external economies. Internal
economies are gained by a particular firm as it enlarges its size to achieve
greater advantages of large-scale production and organization. Increasing returns to scale that are internal
in origin can lead to the monopolization of markets, as large firms develop
lower cost structures than smaller firms, driving smaller competitors out
of business. External economies are
not, however, anti-competitive. Marshall
believed that limits to internal economies existed, that managerial and organizational
problems would eventually lead to internal diseconomies that would increase
costs. Therefore, he believed that
long-run increasing returns were likely to be caused by external economies.
Marshall examined both the real and money costs of production. Real costs derive from the disutility of labor and abstinence. Money costs derive from the necessity of paying
a price that will “call forth an adequate supply of the efforts and waitings
that are required” to produce goods and services. Included in the money cost of production is
a normal rate of profit that is
earned by entrepreneurs to repay them for the effort and waiting of the labor
of enterprise.
Prime costs – variable costs.
Supplementary cost – fixed cost.
Marshall understood that profit maximization requires producing where MR = MC. In the presence of diminishing marginal productivity, this implies producing on the upward-sloping portion of the marginal cost curve. Industry supply curves are summations of individual firms’ supply (MC) curves, hence are positively sloped in the short run.
In the short run all factors of production are in relatively fixed supply. The incomes earned by these factors are determined
by the interaction of demand and supply. Demand for factors derives from marginal revenue product. Hence, if supply is perfectly inelastic, marginal
productivity determines factor payments.
The
price received for a factor in the short run may not equal the cost of reproducing
the factor. If the price is above
the cost of production, the factor earns a quasi-rent. This is the excess
above what is required to induce factor suppliers to produce additional units
of the factor. Quasi-rents tend to
be eliminated in the long run by competition.
Marshall carried out his long-run analysis in terms of a representative firm. Such
a firm “has had a fairly long life, and fair success, which is managed with
normal ability and which has normal access to the economies, external and
internal, which belong to that aggregate volume of production.” Marshall examines the long-run industry supply
curve by referring to the costs of the representative firm.
Marshall believed that competition and internal diseconomies would prevent
individual firms from becoming unduly large over time.
In his view, an expansion in industry output over time was accomplished
by adding more firms to the industry, rather than by initial firms growing
larger.
Although Marshall was not the first to draw demand and supply curves and use them to determine equilibrium price and quantity, he nevertheless is regarded as the pioneer in their use. Marshall claimed to be developing the Ricardian tradition, and in a sense he was. Unlike Jevons, Marshall placed appropriate emphasis on cost of production as a determinant of supply and hence of price. However, he went far beyond Ricardo in his treatment of demand, basing it on utility as had Jevons. Ricardo understood that market prices are determined by demand and supply, but he failed to analyze demand in a thorough manner.
Marshall argued that the role of demand in price determination was greater
in the short run than in the long run. In
the market period, demand determines price (and thus marginal utility determines
price), because the quantity supplied is inelastic.
In the short run, the supply curve is positively sloped, so marginal
utility and marginal cost each have a role to play. In the long run, price equals marginal cost. If returns to scale are constant, marginal
utility plays no role in price determination.
Of course, it continues to play a role if returns are increasing or
diminishing.
Marshall
examined two other cases (besides the market period) in which demand determines
price. The first is the case of joint production. When two products are jointly produced, it
is impossible to determine the marginal cost of either product in isolation.
For example, the production of beef and cattle hides is joint production.
The price of a particular joint product is governed, even in the long
run, by the relative intensity of market demand rather than by cost of production.
Whenever a change in the demand for one joint product induces a change
in their joint supply, their prices vary inversely with one another.
Marshall’s
third case of demand-determined price is the case of monopoly. A profit-maximizing
monopolist equates marginal revenue with marginal cost, as Cournot understood.
Marshall discussed the issue in terms of demand
price and supply price, but
reached the same conclusion. Marshall
argued that monopolists attempt to maximize monopoly
net revenue. They do this by subtracting
the supply price from the demand price; the difference is monopoly net revenue.
The object is to select the volume of output that, given the demand
for the product, maximizes aggregate net revenue.
Graphically, the triangle defined by the price axis and the marginal
revenue and marginal cost curves (which Marshall concentrated on) equals the
rectangle defined by the difference between price and average cost multiplied
times quantity (which Cournot concentrated on).
Jules Dupuit discovered the concept of consumer surplus before Marshall was
born. However, Marshall gave the concept
its name and applied it to more problems than Dupuit did. Marshall defined consumer surplus as the monetary value of the utility a consumer
gains when the price at which a good can be purchased is lower than the price
an individual would pay rather than go without it. When the price of a product changes, the change
in the consumer surplus is measured in terms of a sum of money that will offset
the gain or loss resulting from the price change. Marshall used the concept to analyze the welfare
effects of taxes and subsidies.
Two problems reduce the usefulness of consumers’ surplus. First, applying the concept to a market demand curve requires interpersonal utility comparisons, an impossibility. Second, changes in market price also change real income. Unless the marginal utility of income is constant, the effect on an individual’s utility of a price change is uncertain. Marshall combatted the second problem by applying the concept only to products whose purchase was a minor part of an individual’s budget, thereby limiting the income effect.
The prices in factor markets are at the same time costs of production to entrepreneurs
and incomes to the factors. Marshall
tied value theory to distribution theory by working out a theory of factor
pricing linked to final product markets.
Demand for factors is derived demand. It is based on the marginal revenue product
of factors. The market demand curve
for a factor is less elastic than an individual firm’s demand curve, because
an increased supply of final output reduces the price at which the output
sells, thereby reducing the marginal revenue product of factors. Mathematically, in a competitive market a firm’s
demand for factor inputs is MPP.P, where P is taken as given by
the firm. The market factor demand
curve is MPP.MR, where MR is declining as output increases. MRP declines because MPP falls as output rises
anyway. When MR also falls, MRP falls
more sharply yet.
Marshall
treated supply of productive factors much as he treated supply of final output.
In the short run, the supply of factors is highly inelastic.
As a result, the factors may earn quasi-rents.
However, there exists a “reflux influence of remuneration” that operates
to increase the quantity of a factor supplied over time if positive quasi-rents
are earned in the short run. Labor
moves into those specialities which pay better. Capital flows into the types of production that are most remunerative.
Marshall’s
theory of factor supply and his focus on individual markets led him to reevaluate
Ricardo’s theory of rent. Ricardo
had argued that rent is price-determined
rather than price-determining. Price is determined by the cost of production
of food on marginal land that pays no rent. The excess earnings on better-quality land
(rent) are determined by the price. Marshall
showed that for individual entrepreneurs, who could use land for a variety
of purposes, rent is a cost of production. Land has alternative uses and will be used
in an income-maximizing manner. Rent
is thus a competitive price that must be paid to acquire a factor of production.
Marshall
distinguished between interest and
profit.
Interest is earned on capital. The
interest rate is determined by the demand for and supply of loanable funds.
Profit is the remuneration for enterprise, the organization and management
of production. Firms earn only normal profits in the long
run, since excess profits attract competitors who drive down market price
and reduce profitability.