Alfred Marshall
There are two fathers or founders of neoclassical economics:
Alfred Marshall (1842-1924), English economist, main economic work - Principles of economics, 1890.
Leon Walras (1834-1910), Elements of Pure Economics, 1874 (French economist)
Walras is treated also as one of the marginalists, but his contribution exceeds only applying marginal analysis in economics, and we will see next week, what are his other contributions to economics, and why he deserved to be named as one of the fathers of neoclassical economics.
Today, we will analyze the economics of Alfred Marshall. Marshall, as one of the founders of neoclassical economics, developed an analytical framework that still serves today as the structural basis of current undergraduate economic theory and much economic policy.
Marshall was an English economist; he studied first mathematics, but later turned to economics. He was a complex person, he was a very good mathematician but shy away from using mathematics in economics, he had very extensive historical knowledge and tried to make use of it in his economics. He was very religious, and thought that reducing poverty is the ultimate aim of economics; he had an optimistic conviction that economics might provide the means of improving the well-being of the entire societies.
He is considered eminent theoretician of economics and a towering figure in the development of economics, but he refused to take rigid, strong or unambiguous positions on many theoretical and methodological issues of economic science.
He attempted to offer balanced judgments on many issues and problems, and because of that, he is sometimes considered vague, indecisive or imprecise.
He often seemed to be saying that it all depends, for example that for one reason Ricardo was right, but for other was wrong, that on the one hand abstract economic theory is good, but on the other it is wrong and the like.
Some economists perceive such flexibility of Marshall as a sign of his wisdom, but others, especially those more mathematically inclined see this only as indecisiveness.
In addition, of course, because of his inclination to formulate balanced judgements, there is now a vast body of literature that tries to uncover what Marshall really meant (but not as vast as in Marx's case for example).
First, let's start with the problem of the proper scope of economics.
What should economists do? What is the proper subject of economics according to Marshall?
Marshall is the economist responsible for the change of the name of our subject. In the title of his main economic work, he preferred to use the term “economics” instead of “political economy”. Most of the previous great treatises in economics were concerned with political economy. But Marshall wanted to disassociate economics from political, normative, philosophical, ethical issues, so he dropped the term political economy in favor of the term economics.
What is ironic about his choice of the term economics is that he, more than almost any of his contemporaries, was engaged in political economy and the economic policy, he focused not on the pure, scientific theory, but on the applied theory and policy.
Marshall defined economics as:
“a 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 with the use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and on the other, and more important side, a part of the study of man”.
It is a very general, loose definition; economics embraces almost all social sciences in this definition.
Marshall suggested that each economist should define the scope of economics to suit his or her personal inclinations, so he was very open-minded and tolerant.
As I mentioned before he thought that the elimination of poverty is the chief task of economists, and he maintained that the key to solving this problem lay in the theories of economics, economists could explain the causes of poverty and give politicians powerful means to increase the well-being of the working class and other low-income classes in the society.
Marshall's views on the proper methodology of economics are again complex.
He was very mathematically gifted, but also he had a wide reading of history. He thought that the proper combination of abstract, mathematical theory and historical analysis is the right approach of economists. Again, he thought that some economists prefer to rely heavily on one single methodology (for example abstract theory) and he did not object to this.
So he thought that many different shades of methodologies can find its use in economics.
His views on the use of mathematics in economics are especially interesting and famous among economists.
Marshall was a gifted mathematician. Yet, he understood not only the power, but also the limits of math when it came to explaining and describing economic reality. Marshall wrote this candidly in a letter to a friend in 1906, as he approached the end of a long teaching career.
"I have a growing feeling that a mathematical theorem dealing with economic hypotheses is very unlikely to be good economics, and I go more and more on the following rules -
1) Use mathematics as a shorthand language rather than as an engine of inquiry.
2) Keep to them until you have done.
3) Translate into English.
4) Then illustrate with examples that are important in real life.
5) Burn the mathematics.
6) If you don't succeed in 4, burn 3. This last I often do."
Marshall Principles includes steps 3 and 4, it is written in a style indented not only for economists, but also for every educated reader. Mathematics is placed either in footnotes or in a mathematical appendix. The seven hundred pages long book is filled with real life examples from current or past economic experience, but also it is based on a strong, highly abstract theoretical structure (but placed in the appendix).
So far, we have said that Marshall was a complex thinker, that he was sometimes accused of being vague, not rigorous, and indecisive.
However, this was not because of his personal character. Marshall had two reasons for regarding the study of an economy as complex and difficult.
First, in the economy everything seems to depend upon everything else, there is a complex and often subtle relationship among all parts of the system.
Second, time is extremely important in the economy and economic analysis, especially because economic causes take time to work out their full effects. Therefore, the economic analysis has to take careful account of the time in which the analysis is performed.
Because of the complexity of the economy and because economic causes need time to work themselves out, Marshall developed a method of analysis which is called partial equilibrium method (or analysis).
In this method, to solve a complex problem, we isolate a part of the economy for analysis (one market for example), ignoring but not denying the interdependence of all parts of the economy. We analyze for example the supply and demand for one good, ignoring for the moment the complex substitute or complementary relations with goods in other markets. One important use of partial equilibrium method is to make a first, inexact but valuable approximation of the likely effects of a given economic cause. It is a method, which gives simple, immediate predictions about various actions in economic policy, for example, the effects of raising tariffs and the like.
Marshall's procedure was to first analyze issues in a very narrow partial equilibrium framework (keeping most economic variables constant) and then to broaden the scope of analysis slowly and carefully to include more and more markets.
To cope with the problem of time in economic analysis Marshall defined four time periods - these are analytical period of time, they are not measured in hours or days, but in the ability of the producer to adjust the supply of the product.
the market period the amount of time for which the supply of a commodity is fixed.
Second, the short period (or short run) is the time in which the supply can be increased by adding labor and other inputs but not by changing plant size or building another plant.
Third, the long period (long run) - here the plant size can vary.
In the market period market (for all firms), supply curve is inelastic perfectly
The supply curve becomes more elastic in the long run than in the short run.
The long run supply curve for an industry can take three forms - upward slopping (increasing costs), perfectly elastic (constant costs of production) or even in some strange situations downward slopping (decreasing costs)
The 4th period, the secular or very long run, permits technology or population changes.
This analytical construction (four time periods) helped Marshall to build a proper theory of value.
As we have seen before in economics before Marshall, we had the controversy between the classical economists and marginalists concerning the relative importance of demand and supply in value theory.
Classical economists claimed that supply determines value, while marginalists hold that the demand is the most important factor explaining values and prices.
Marshall believed that this controversy can only be resolved if we correctly understand the interdependence of economic variables and the influence of time in the economy.
According to him, in general, it is fruitless to argue whether demand or supply solely determines prices.
To quote him in detail:
“We might as reasonably dispute whether it is the upper or the lower blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens."
Marshall maintained that in general case MU, cost of production and value or price of a commodity are interrelated and are mutual causes of each other. There is no single cause for price or value of a commodity. MU, cost of production and price of a good mutually determine their values at the equilibrium point in market.
The shorter the period of analysis, the more important the role of demand in determining prices, the longer the period the more important the role of supply - in general, hoewer, MU (connected to the demand side), cost of production (connected do the supply side) and value (price) mutually determine their values at the margin (that is at the equilibrium point).
This is a correct theory of value as it is today admitted at least on the undergraduate level or introductory level and in partial equilibrium framework.
Marshall also contributed significantly to the theory of demand by introducing the concept of price elasticity of demand - that is proportional quantity change divided by proportional price change.
Several previous authors had come close to the idea, but it was Marshall who first defined it clearly.
Marshall also was able to theoretically derive the demand curve and to prove that the curve is negatively sloped, downward sloping, but only under the assumption that there are no big income effects when the price of a good changes - that is he assumed that there is no income effect of the price change. Anyway, he did not have the theoretical tools to distinguish clearly between the substitution and the income effects of the price change.
He did not notice the theoretical possibility of the positively sloped demand curve - this is the case of inferior goods with strong income effects of the price change - the so-called Giffen goods. However, the theoretical tools for distinguishing between income and substitution effects were not developed yet in economics.
Therefore, Marshall's theory of demand is not complete and based on very restrictive assumptions. We will see later how the theory developed in the 20th century
Another contribution of Marshall is in the field of welfare economics - that is the part of economics that strives for measuring the changes in the individual and social welfare, well-being.
Marshall has shown that price is the measure of consumers' marginal utility. He developed a concept of consumers' surplus - the difference between the total amount consumers would be willing to pay and what they actually pay for the good.
Another Marshall's contribution is to the theory of firm's supply - that is the analysis of the costs of production and supply of the firm.
His analysis is until today accepted analysis of costs and supply in the undergraduate textbooks, so we can be short on this.
In the market period there is no troubles, a firm cannot change the supply.
In the short run, Marshall made the distinction between fixed and variable costs, and showed that firm would continue to operate in the short run even if it was incurring a loss, temporary loss, as long as it was covering its total variable costs - just like you have learn in the introductory microeconomics.
His discussion of the long-run firms' costs is deficient by modern standards, but he identified the long run forces that determine the shape and position of the firms' costs and supply curves.
First, there are forces internal to the firm. As the size of the firm increases, internal economies of scale lead to decreasing costs and internal diseconomies of scale result in increasing costs.
Examples of internal economies of scale would include applying better organizational skills or using more technologically advanced machines
Examples of internal diseconomies of scale would include employing to much management and administration or as company's scope increases, it may have to distribute its goods and services in progressively more dispersed areas. This can actually increase average costs resulting in diseconomies of scale.
However, Marshall thought that the shape by the industry supply curve in the long run depends on the so-called external economies and diseconomies of scale.
These factors are external to the firm and to the industry. If external economies dominate external diseconomies, than supply curve of the firm and industry in the long run is downward sloping - larger quantities are supplied at lower price.
This is a rather strange case, because in most industries industry supply curve is constant or increasing, but Marshall found historical evidence that is some cases costs and prices have decreased over time, so he wanted theoretically explain this fact.
What can be the cause of external economies of scale? According to Marshall, the reductions in costs of all firms in the industry that take place when all firms locate together (in a close distance) and share their ideas about production and management. Close localization brings also cost-saving subsidiary industries (that deliver intermediate products for our industry) and skilled labor has the incentive to locate in the area.
So according to Marshall in the long run industry curve can possess three different shapes - it can be downward sloping (external economies dominate diseconomies), it can be constant (external economies and external diseconomies cancel out each other), or it can be upward sloping (costs are rising, because external diseconomies dominate external economies).
This was discussed further in the early decades of the 20th century and we will get back to this issue.
Marshall also made some advancements in the theory of distribution based on marginal productivity theory and explained in detail the mechanism of reaching the equilibrium in markets and noticed the very theoretical possibility of unstable equilibrium in market, when the supply curve is negatively sloped (the case where external economies of scale dominate external diseconomies of scale).
Marshall was mostly interested in microeconomic theory, but he also contributed significantly to macroeconomics analyzing the economic stability at the macro level and the forces determining the general level of price.
He generally accepted the view of classical economics that the capitalism is stable, that it is impossible to have general overproduction in the economy, the depressions are not very deep and long lasting - so he accepted the Say's Law, that we have elaborated while discussing classical economics.
However, of course, temporary economic fluctuations did happen in capitalism in Marshall's times and he explained them with the reference to the notion of business confidence.
In the boom, when the production is increasing, business confidence is high and credit expands rapidly, during the depression, bussiness becomes pessimistic and credit rapidly contracts.
Marshall suggested that to avoid depressions and unemployment you should do two things.
control credit markets, so that credit is not over-expanded in period of rising business confidence because it may lead to depressions
in depressions, the government can help restore business confidence by guaranteeing firms against risks.
As for his contribution to the theory explaining the general level of price, he advanced the quantity theory of money (which was already in use in classical economics period). We will discuss it in the lectures devoted to the modern macroeconomics.
A short summary of Marshall's thought.
Although over a century has passed since Marshall began his study of economics his contributions to microeconomics - value theory, analysis of firm's costs and supply, partial equilibrium analysis, price elasticity of demand, the concept of consumer's surplus - still provide the basis for mainstream undergraduate theory of microeconomics. On the undergraduate level core microeconomics has not changed much since Marshall, there were some developments in mathematical analysis, but not in the substance of the theory. One exception here is the analysis of imperfect competition markets (oligopoly for example), which was done by later writers.
He did not formulate full system of economic knowledge, since he focused mainly on microeconomics and did not explain the forces determining the levels of national income and employment.
He regarded his work as a continuation of classical economics of Smith, Ricardo and mill, updated to the development made by marginal economists.
He wanted to create purely scientific, positive economic science on the belief that if we understand what the economy is, we could make better choices about what the economy and society should be. In addition, he thought, on the normative, ethical side, that society should help those in lower-income groups.
He was a complex and subtle writer, often taking conciliatory, balanced position on many economic issues. The best example here is his theory of prices - prices are the result of a vast set of complex interacting forces, there is no one single cause explaining prices.
He was a proponent of theoretical analysis in economics, but since economic models are very abstract and describe a very complex reality, he found it necessary to supplement theoretical analysis with descriptive and historical material.
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