Alfred Marshall and Neoclassical Economics

 

I.       Life and Times

 

        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.


II.      Principles of Economics

 

         Objectives

        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.

 

         Methodology

        Marshall pioneered the use use of partial equilibrium analysis.  The economic system is too complex to comprehend in the whole, so it is necessary to devise an analytic technique for simplifying it in order to study the operation of particular parts of the economy.  Marshall introduced the method of abstraction to single out one market or one variable at a time.  He assumed that the behavior of a particular market has negligible effects on the rest of the economy, so that feedback effects from the economy can be neglected.  He impounded all the features of limited importance to a market in a ceteris paribus clause. 

 

        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.

 


III.    The Theory of Demand

         Utility and Demand

 

        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.

 

         Demand Schedules and Curves

 

        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.

 

         Price Elasticity of Demand

 

        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.

 

IV.    The Theory of Production

 

        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.

 

         Laws of Return in the Short Run

 

           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.

 

         Laws of Return in the Long 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.

 

V.     Costs of Production and Supply

 

        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.


         Diminishing Returns and Short-Run Cost Behavior

 

        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.

 

         Long-Run Cost and Supply Curves

 

        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.

 

VI.    Theory of Price Determination

 

        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.

 

VII.     Prices That Deviate from Cost of Production

 

        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).

 

         Consumer Surplus

 

        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.

 

VIII.  Pricing Productive Factors

 

        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.