The marginalist revolution
From 1870s, classical economics has been slowly declining. During the last three decades of 19th century a new set of economic techniques had been developed that helped transform classical economics into new current of economic thought - the so-called neoclassical economics.
As you can deduce from the name of the new current `neo-classical economics' is to some extent an extension of classical economics, it is in many aspects similar to classical economics, but since it is “neo-classical” it is also in many respects different.
The most important new economic technique that helped to create neo-classical economics was marginal analysis - that is the analysis of marginal economic variables, such as MU, MP, MC, marginal revenue and the like.
Beside its obvious usefulness in economic theory, marginal analysis is an important development in the history of economics, since it initiated a significant increase in the use of mathematics in economics.
Since 1870s, economics began to be slowly, but continuously, transformed into mathematical science.
The acceptance of marginal analysis in economics and the realization of its all implications did not occur fast; it took about 30 years from about 1870 to 1900.
The first application of marginal analysis was to the theory of demand.
In the early 1870s, three economists independently applied marginal analysis to demand theory and developed the concept of MU. Later they and their followers applied marginal concepts to other parts of economic theory.
So from 1870 to nineteen hundred almost all economic theory was transformed, and many postulates of classical economics were rejected or highly modified. What is equally important, marginal or neoclassical economics has focused almost exclusively on microeconomic problems. And since it had the dominant position in economics from 1870s to 1930s, macroeconomic questions of economic growth, distribution of income and the like, were largely ignored, not discussed in economics in this period.
So the whole body of economic theory was more or less transformed and that's why we say that the year 1870 is the end of classical economics period and the beginning of a quite new era of economic thinking - neoclassical economics.
In fact, marginal analysis had many precursors, who used the notion of MU in their writings before 1870s. Some English, German and French economists earlier in 19th century explicitly used marginal concepts, especially the concept of MU, but they did not discover all implications of this concept and what's more important they did not influence subsequent writers.
So, it is generally accepted that the introduction of marginal analysis into economics has been the effect of three works published between 1871 and 1874. In those works, the concept of MU was developed and applied to the theory of demand.
The authors of these works were:
William Stanley Jevons (1835-82), Theory of Political Economy, 1871 (English economist)
Carl Menger (1840-1921), Principles of Economics, 1871 (Austrian economist)
Leon Walras (1834-1910), Elements of Pure Economics, 1874 (French economist)
As you can see those economists were of different nationality and it is accepted that they did not know about their respective works, so the introduction of marginal analysis to economics was done by them independently.
Walras, Menger and Jevons agreed that marginal analysis is a very important tool of economic analysis; they differ however on many economic issues, for example, the proper methodology of economic science - Walras advocated that economics should be a mathematical science; Jevons wanted more empirical work in economics, while Menger suggested abstract and deductive, but not mathematical, approach.
Moreover, Menger had contributed to the establishment of the so-called Austrian school of economics, a heterodox approach to economics, which was quite important in the development of economics in 19th and 20th century, we will discuss it shortly later.
And Walras, who is definitely the most important thinker all of three of them, created also general equilibrium theory, the most important tool of economic analysis in 20th century, so he was the greatest theoretician among them and his influence on subsequent economic thought is tremendous. We will discuss his contribution to the GET in one of the following lectures.
However, ignoring all those differences, we call them all - marginalists, since their views on the demand theory were very similar.
All three of these economists, working independently, were convinced that they had developed a unique, revolutionary analysis of the forces explaining the determination of relative prices; that is they thought that they had produced new, revolutionary theories of value, theories of relative prices.
They claimed that value (or price) of a unit of any given good depends entirely on marginal utility from the consumption of this unit.
As you know MU is the increase in utility as a result of consuming one more unit of the good.
Notice here the difference with classical theory of value, which is value theory of classical economists. In general, (beside Ricardo who held labor theory of value) they claimed that value is determined by the cost of production of a good.
In general price equals the sum of wage, profit and land rent paid during the process of production of the good (P=w+pi+r).
According to marginalists, it is a wrong explanation. Price and value do not come from the past, from the costs of production advanced in past to produce goods, price comes from the future; from the utility consumers expect to receive from consuming the good.
Therefore, it does not matter whether the good was costly to produce or not, high production costs may not result in high price - it all depends on how consumers estimate the utility from consuming the good.
Therefore, the marginalists theory of value claims that value (price) depends solely on the marginal utility received from the consumption of the good.
It explains prices from the demand, consumer side of the market (utility of consumers determines prices), while classical theory of value explains prices from the supply side of market (price is determined by the cost of production, costs made by suppliers, producers).
The difference between those two theories of value should be now clear to you. It is revolutionary, as their inventors thought, in that it finds completely different factors explaining prices, than any previous theory of value.
Marginalists claimed that classical theory of value, cost of production theory of value is not sufficiently general because it fails to explain prices of some goods.
As you should remember, classical theory of prices (cost of production theory) does not explain prices of goods, which have a fixed supply (the case of perfectly inelastic, vertical, supply curve). In this case, price is determined by demand, and does not depend on the cost of production (that is supply curve) - you cannot change the supply of these goods.
Examples of this kind of goods include: land, rare coins, paintings or wines.
Therefore, they claimed classical theory of value lacks generality and therefore should be replaced by their theory of value based on the concept of MU. According to them MU determines the demand curve for goods, and therefore marginal theory of value can explain prices of goods, if the supply of goods is fixed.
Hence, it is more general, better theory of value.
All of them thought that utility can be measured without problems and assumed that the principle of diminishing marginal utility is working - which states that as the consumption of a good increases its marginal utility decreased.
To formulate a new theory of value, marginalists applied the concept of MU to the demand theory, to discover the relation between utility and demand.
They assumed that the utility an individual receives from consuming a good depends exclusively on the quantity of that good consumed - it does not depend on the quantities of other goods consumed.
Using modern language of economics they assumed that there are no relations of complementarity or substitution between goods - goods do not have complementary or substitute goods.
It is a very restrictive assumption, but you have to remember that we are talking about the beginnings of modern microeconomic theory; the analysis had to be simple.
Using the abovementioned assumptions (utility can be measured, there is diminishing marginal utility and there are no complementary or substitute goods) they were able to formulate verbally and mathematically (especially Walras), the condition that must be fulfilled if a consumer maximizes his or her utility.
That is the income must be spent in such a way that the last unit of money spent for any particular good yields the same marginal utility as the last unit of money spent on every other good, which may be formally stated as:
MUa/Pa=MUb/Pb=…MUc/Pc.
Moreover, Walras was able to show mathematically, what is the relationship between MU and the exchange of goods in the market and also to prove that the MU is the main force determining demand, and that the demand curve, for most of goods is negatively sloped.
Therefore, these are the most important contributions of marginalists to the demand and exchange theory, but you should notice that those developments were made under restrictive assumptions (for example there are no complementary and substitute goods).
Evaluation of the value theory of marinalists or marginal theory of value.
In the case of goods with fixed supply, we have stated that marginal theory of value is correct MU and demand solely determine the value of goods.
In the case of perfectly elastic supply, demand does not play any role in determining the price, which is explained solely by the supply side, the cost of production.
Therefore, as you can see the theory of value suggested by marginalists is incorrect, and it cannot be said that it is a more general theory of value than classical theory.
Therefore, against the claim of marginalists, value or price does not depend entirely upon utility or demand. In different cases, value depends on demand or supply, and in general case it depends on both demand and supply.
Marginalists' theory was incorrect, because marginalists wanted to find a single factor determining prices, while as it was settled later there is no such a factor.
In fact cost of production, supply, demand, MU and price are interdependent and mutually determine each other. However, only Alfred Marshall in works published later in 19th century gained this understanding of interdependence of all those economic variables.
It was Marshall, who formulated another theory of value - neoclassical theory of value, which builds up, which is synthesis of classical and marginal theory of value, and which correctly stresses the interdependence of price, supply and demand. We will get back to this issue.
The summary of the contribution of marginalists.
They influenced heavily views on the proper subject and method of economics. They were concerned mainly with microeconmics and the following generations of economists accepted this as the most important subject of economics and during the period from 1870 to 1930s economists turned from the long-term and macroeconomic issues that Smith, Ricardo, Mill or even Marx, were interested in and focused on microeconomic issue of how price system works to allocate resources in market economy.
They have provided a new theory of value and demand, which was incorrect as we have seen but the theory have turned the attention of later economists to the neglected demand side in explaining prices - and this remains the important contribution of marginalists.
Finally, they applied the marginal analysis in economics and thanks to this marginal analysis had been extended to cover almost all areas of economic theory. In this way, the mathematization of economics has started, and marginalists are the persons responsible for the beginnings of the 20th century process of mathematization of economics.
The so-called second generation of marginalists.
The first generation of marignalists, Jevons, Menger and Walras introduced marginal analysis to economics and applied it to the theory of value and demand.
The second generation of marginalists consisted of the followers of Jevons, Menger and Walras, who from late 1870s to 1890s have applied marginal analysis to other parts of economic theory, notably to the theory of production, production costs theory, prices of factors of production and the distribution theory. The second generation of maginalists consists of various writers from Austria, England, Sweden and the United States; we do not have to present their names.
Some of the achievements of the second generation of marginalists.
First, in the theory of production and the theory of the prices of factors of production they have established that the firm optimally will hire the factors of production up to the point at which its marginal product multiplied by the price of output (good produced by firm) equals the price of the factor.
For example: w=MPL*p (w - wage rate, price of labor)
The same optimum condition holds for other factors of production.
Notice, this is not only a condition explaining the prices of factors of production, but also a condition determining the functional distribution of income in the society, because it specifies the prices of factors of production, and knowing the amount of aggregate labor and capital, we can calculate how much income goes to the labor (wL), how much to the capital (piK) and the like.
Therefore, this condition and similar conditions for other factors describe also the marginal productivity theory of distribution. In the theory, the prices of factors of production are proportional to the marginal productivity of these factors.
Moreover, they proved that the general rule for employing several factors of production is that
MPA/PA=MPB/PB=… = MPN/PN.
These developments allowed also marginalists to derive formally the demands functions for factors of production.
One of the most important marginalists, American economics John Bates Clark, (he was the first American economist to make an important contribution to the economic theory), gave an interesting interpretation of marginal productivity distribution theory, that is the theory in which the prices of factors of production are proportional to the marginal products of the factors of production.
In 1899, he published a book under the title, Distribution of Wealth, which contains an extensive analysis of ethical implications of marginal productivity theory of distribution.
According to Bates Clark, under perfectly competitive markets, each factor of production would receive a return equal to the value of its marginal product [let's see that (w=MPL*p) - MP - it's the quantity of marginal product, multiplied by the price of the final good, it gives us the value of MP].
Then the return to factors of production measures the contribution (value of marginal product) of a factor both to the particular product being produced in the firm and to society and its wealth.
The return to capital is justified ethically by the fact that capital is productive (its MP is greater then zero), the return to capital is not robbery or theft, but honest, fair and just.
The same applied to land and labor.
Clark's conclusion is that the distribution of income in capitalism (with competitive markets) is an ethically correct distribution in that it rewards the factors of production according to their economic contribution to the social product.
His interpretation was explicitly aimed at Marx's theory of exploitation, Marx as we have learned tried to prove that in capitalism, workers are exploited by capitalists, he thought that capital is not productive it itself.
Clark was interested in marginal productivity theory mainly because he wanted to give an answer to Marx's charge of exploitation under capitalism.
In John Bates Clark's vision, capitalism is non-exploitative and just economic system. He thought that Marx's theory of exploitation was incorrect, because Marx could not understand how market forces work, especially in distributing product in proportion to the marginal productivity of the factors of production.
How can we treat Clark's claim that competitive markets result in ethically desirable distribution of income from modern perspective?
First, his claim violate scientific premise that we should not draw ethical conclusion from non-ethical analysis. According to modern standards, you cannot prove any ethical statement (just distribution of income) from purely scientific (economic) analysis. Therefore, Clark's thesis is not scientific from this point of view.
Second, the thesis concerns only functional distribution of income. It is silent on the more important question whether capitalism results in just distribution of personal income.
Third, Clark assumed perfectly competitive markets, while in real economies we have to deal with monopolies, firms with market power, labor unions and the like, so his conclusions have little relevance for real societies.
Marginal productivity theory was also used by second generation of marginalists as a theory of employment of labor.
Many economists, especially American economists, in the beginning of the 20th century, used this theory to describe labor market in competitive setting.
Those economists concluded that unemployment (exceeding frictional unemployment, that is excluding people who change their jobs) was caused by wages being higher than the equilibrium level. If the wages are flexible, than market system will automatically correct the unemployment, as wages will fall to the equilibrium level.
From this analysis a number of policy conclusions have been drawn:
the wages should be kept flexible and that obstacles to flexible wages such as union contracts, long-term wage contracts, minimum wages legislation are not desirable.
Unions and minimum wage legislation cause unemployment
The best policy to reduce unemployment is to keep government out of the economy and let the market work the way to the full employment by lowering wages.
This was the most popular view on the problem of unemployment in the first three decades of 20th century in mainstream economics. There is no long-term, involuntary (to use later phrase) unemployment of labor in capitalism, the main reason for unemployment are labor unions and minimum wage legislation, and the best policy against unemployment is to free the economy from unions and government legislation.
All this changes during 1930s, during the days of the Great Depression. In mid-1930s these views were very seriously criticized by John Maynard Keynes, who formulated his own theory of employment and tried to prove that long-lasting, involuntary unemployment is possible in capitalism. We will discuss this while reviewing the economics of Keynes.
Beside all those contributions, there were also some developments in the theory of interest made by the second generation marginalists, but we will not discuss them.
Summary.
In 1890s, we had many important contributions in microeconomic theory. Marginalists, the first and the second generation, have applied marginal analysis to demand theory, production theory, distribution theory and other areas of economic science. So the whole microeconomic part of economics has been transformed in a mathematical fashion.
However, all these developments were only an input to the new era of economic thinking - neoclassical economics. Neoclassical economists had synthesized marginalists' contributions in a complete theory of markets. In other words the founders of neoclassical economics integrated the work of marginalists on both the supply and the demand side of markets to build complete theories of market functioning.
We can treat marginal revolution as a transitory period between classical economics, which ends in early 1870s and neoclassical economics which starts in, let's say 1890. Neoclassical economics, especially in microeconomics ruled in economics until 1930s, and there are some economists who claim that modern mainstream economics can still be rightfully called neoclassical economics. We will talk about this issue later.
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