Reading Summary: Marshall and Partial Equilibrium PDF

Marshall's book "principles of Economics" developed method of partial equilibria and shapes idea of economic as the science of supply and demand (not only idea, but multiple) Causes for success of the idea: - Easy teachability of supply-and-demand theory - He maintained that everything that c...

Marshall's book "principles of Economics" developed method of partial equilibria and shapes idea of economic as the science of supply and demand (not only idea, but multiple) Causes for success of the idea: - Easy teachability of supply-and-demand theory - He maintained that everything that can be explained with maths, must be expressible in words, otherwise it is not good - Cheap -- access for students and practitioners - Did not present the theory as innovation, but as continuation of classical tradition Partial Analysis ================ Due to the fact that economy is closed off to controlled experiments against the long chain of general equilibrium theory (few long reasonings), but advocate of multiple short reasonings **"Method of partial equilibria":** - Study individual markets on assumption that the prices off all other goods and services are given and constant - Focused on case of perfect competition - Strict conditions under which partial equilibria methods may be applied: 1. Demand-and-supply curves need to be independent of each other 2. Only small changes in price or quantity are allowed for 3. Adjustments triggered by some change must be restricted to the market under observation and must not influence noticeably the situation in other markets - If these are disregarded huge overestimation of explanatory power of the method Period Analysis =============== Marshall's way to address the problem of the determination of prices and quantities in this way = extremely short-run view: **supply is fixed & demand determines market price** **Short run:** - supply can be varied within certain limits by changing capacity utilization of machines and intensity of work - demand & supply affect short-run normal price - perfect competition: maximization of profit when marginal costs = price **Long run:** - production apparatus and employment can be varied - number of firms in market can change - supply is more influential for determining normal price than demand - **Very long / secular run:** - technological and organizational changes may happen - concept of normal price: similar to the classical -- uniform rate of return on capital in competitive market - demand curve: - individuals have need and wants which can be satisfied with different combinations of goods (substitution same utility) - demand decreases with rising price - intersection: equilibrium price and quantity - long term equilibrium: minimum of average costs - what does the long-term equilibrium of an industry look like? - Depends on how production costs develop along with changes in the production volume of an industry - Ideally, all productive factors are variable no fixed factors - Firms can adjust their productive capacity to match the quantities they want to bring to the market (decreasing, constant or increasing returns to scale) - Constant costs per unit: - Supply curve is a straight line parallel to the quantity axis - Demand determines only the volume produced by industry, but not price - Falling marginal and average costs at rising production volume -- Marshall distinguished between economies of scale that are internal to the firm and economies that are external to the firm - Internal to firm: economies apply only to single firms, not industry as a whole monopoly forms - External to firm: industry as a whole benefits from larger output levels - Positive external effects: - Growth of industry and lower average costs , improved level of information Sraffa's Critique: ================== 1. It cannot be rules out that a change in the production volume of an industry with variable costs simultaneously changes the costs of firms in other industries - Incompatible with independence of supply functions in different industries - Only compatible if variable costs are internal to the industry unrealistic - Variable costs are either incompatible with assumption of competition or fall out of the scope of partial analysis 2. Interdependencies between industries - Impossible to change price of just one input or output at a time and analyse the effect of such a change in a single market as if in a vacuum - There are always repercussions within the economic system that may affect quantitatively and qualitatively the result 3. Partial equilibrium analysis should be employed with great caution and only after careful examination - Schumpeter and Morgenstern support this view Possible reaction to this critique: 1. Abandon method of partial equilibrium, but stick to demand-and-supply approach in conditions of perfect competition general equilibrium framework must be adopted in which interdependencies among agents and industries are taken into account 2. Abandon both and return to surplus approach of classical economics 3. Give up assumption of perfect equilibrium and preserve partial equilibrium framework Economics Evolving: Chapter 8 Fundamental change in economic theory during 1870s - Affected content and style of theory - Very sudden and dramatic "revolution" - Happened in English-, German- and French-speaking world simultaneously - England: Jevons - Austria: Menger - French Switzerland: Walras - Nature of the Marginalist Revolution: 1. A stronger emphasis on erecting economic analysis on the foundation of theories of behaviour for individual economic agents, in other words, firms and consumers 2. Increased focus on the demand side of consumer goods markets and on the supply side of factor markets, accompanied by a critique of the classical labour theory of value. Marginal utility became a new and central concept of economic theory. 3. More reliance on mathematical formalization, above all through the use of the differential calculus. Producers and agents are agents who want to achieve the best possible outcome (profit and utilization) need to balance benefits and costs such that no additional gains could be made by any further action (first derivative condition) Not first people to have this approach: already some classical economists (Ricardo's theory of rent, Mill's theory of demand and price formation **William Stanley Jevons** ========================== - Born in Liverpool to parents with strong intellectual interests - Father: ironmonger, but firm went bankrupt, mom: died when he was ten - Studies: University College London 1852 natural science - Broke off after 2 years due to economic reasons and immigrated to Australia - Worked at The Royal Mint in Sydney and then went back to finish studies in logic & economics He is the first economist with a formal university education in the subject ***Notice of a General Mathematical Theory of Political Economy:*** presented to a meeting of general academic forum, but not met with much interest ***The Coal Question:*** turned attention towards applied problems - Became a best seller - Caused a great stir by predicting England's demise as an industrial nation through the depletion of its coal reserves - He related the problem to Malthus's analysis of the population question - Economic development of England was exponentially in industries that depended on coal as a source of energy, but the coal could not be extracted in a speed the growth required it - lack of coal would act as a brake on economic growth need to rethink the nation's strategy - discussed in parliament and he was invited to a personal conference with Prime Minister Gladstone - in judgement of posterity not very impressive achievement ***The Theory of Political Economy:*** - **he decided to make a career in academic life and wrote this in a small college in Manchester** - **became known as his main work** **contribution to empirical economics: works on construction of price indices and business cycles and labour economics** ***The Principles of Science:* 1874, worked on logic and philosophy of science** **Moved to London and became professor at University College** The Mathematical Method ======================= **Jevons had openly and strong opinions against Ricardo and especially Mill** **In the introductory chapter, he makes economics a mathematical and quantitative science** **He accuses Mill of not having realized the importance of mathematical models in economics** **He had little mathematical training himself, which can be seen in The Theory of Political Economy** Marginal Utility Theory ======================= **Utility is a property that commodities possess, but it involves judgement and attitudes of an individual person utilis is subjective and not an intrinsic quality of commodities** **Distinction between total utility and marginal utility, which he calls the final degree of utility** **Marginal utility = a decreasing function of the quantity consumed** **Graph:** - **illustration of Law of the variation of utility** - **height shows utility attached to successive increments of consumption -- sum of all columns = total utility** - **law of decreasing marginal utility must hold no matter how small the increases are continuous function** - **marginal utility only depends on quantity consumed (not in line with Jevons's claim that utility is not an intrinsic quality of commodities)** - **= Gossen's first law** **Gossen's 2^nd^ law** - Not found in The Theory of Political Economy - Come close to it in Jevons's discussion on the problem of allocating a given quantity of a commodity between 2 alternative uses utility maximization implies that marginal utility must be the same for both uses - Special case of the law Demand and Prices ================= Theory of demand for consumer goods (incomplete) is related to the theory of consumer decisions Jevons emphasises the importance of marginal utility **Tabular Form:** Cost of production determines supply; Supply determines final degree of utility; Final degree of utility determines value. Result: circular statement that needs further explanation Ambition: price theory where cost of production as well as consumer demand play equivalent roles -- he had no clear understanding of how to formulate a general equilibrium theory in which supply and demand are determined by prices, which are determined by the condition that supply must equal demand in all markets Jevons was unsuccessful in making such a model in the modern sense **Model of market equilibrium in an exchange economy:** - 2 consumers "trading bodies" - Who trade 2 commodities, corn and beef - Supply is given - Rate of exchange in quantity terms (ratio between number of units of corn and beef exchanged in the market) must be equal to ratio of marginal utilities for consumer A and ratio for consumer B - 2 equations with 2 unknowns (traded quantity of corn and beef) - Contains some paradoxical features: - Model said to explain prices, but includes no prices and determines quantity model determines relative prices, not absolute prices - Limited to situation of pure exchange where there is no production cannot tell anything about role of production costs in explanation of prices The Sunspot Theory ================== Jevons was pioneer of **empirical economics** - E.g. study of the long-run development if the price level - Remarkable for the originality of design of price indices and systematic collection of data - Most famous: "*The Solar Period and the Price of Corn*" - Observed changes between good and bad times in business cycle - Causes for these must be sought in exogenous factors (outside the economic system) Hypothesis: **the periodic changes of economic activity could be traced to the periodicity of the sunspots** (became his stupidest idea) - Sunspots = areas of sun with especially strong magnetic fields -- more sunspots colder earth's climate - Fluctuations in temperature affect agriculture crops in India, then spread to other sectors of the economy and countries **Carl Menger** =============== - Born in part of Austria that now belongs to Poland (1840 -- 1921) - Son of a lawyer - Studied law in Vienna and Prague - Mainly self-taught as an economist - Began to work as an economic journalist and later as an economic analyst in the prime minister's office - Had to follow and analyse price movements in particular commodity markets - Had little help with the price theory that was founded on the labour theory of value - Attempt to work out an alternative theory most famous book: *Principles of Economics (Grundsätze der VWL)* - Became professor at University of Vienna in 1879 - Plan: extend the *Grundsätze* by several volumes that would as a whole represent an integrated view of the whole field of economics -- never achieved The Theory of Value =================== Aim: develop a general theory of value that is capable of explaining all prices, both commodity and factor prices, on the basis of the same principle Similar to the hypothesis of diminishing marginal utility - If a limited number of units of a commodity can be used for different purposes, they will be allocated among these in such a way that every need that is satisfied is more important than any need that is not satisfied - Value of a satisfied need: loss it would entail if a unit of the commodity had been removed - Concept of marginal utility lies below, but is not expressed - Put forward: the subjective value of a unit of a good decrease the more one consumes of it (= Gossen's 1^st^ law - Did not formulate 2^nd^ law - = consumer's optimal allocation of his income between alternative uses - He does realize the importance of this problem - Closest to the law: analysis of the optimal allocation of the same good to the satisfaction of several needs - Marginal utility is the same in all uses of the good - Failed to solve the problem just like Jevons - Factor prices = higher order prices - Could be derived form prices of the good of first order - Value of factor of production = reduction in the value of the finished good that would result if the supply of the factor of production were to be reduced by one unit, given that the other factors of production were optimally reallocated - Results in an early version of the marginal productivity theory of the prices of factors of production The Methodenstreit ================== As a theorist, Menger is not as important as many others, but still mentioned a lot because... 1. He was seen as a pioneer in launching new theories in the German-speaking world although Thünen and Gossen already presented versions of marginalist approach which were more advanced than his 2. After his death, his claim to be considered one of the founders of the new theory was strongly advanced by a successor in Austrian economics, Eugen Böhm-Bawerk 3. Controversy in German-speaking academic world about the right approach to economics Merger appeared as the theorist he really was = opponents of Menger Were adherents of **German school**: - Founder: Wilhelm Roscher (1817 -- 94) - Study of economic laws must be carried out on the foundation of historical studies and careful investigations of empirical relationships - Economics had become more of an inductive and less of a deductive science - Appreciated abstract theory as exemplified by Ricardo, but warns against application - Menger was a fan of Roscher - Gustav Schmoller (1838 -- 1917) - Took a less positive view of the role of theory - Formalized and abstract theory were too important in his view - Menger wrote book to him - Critiqued weakness of the research strategy of the historical school as it did not base its analysis on individual behaviour - Schmoller replied with a critical review of his book lead to Methodenstreit - Very heated and personal in tone - Both became more extreme than they actually were **Methodenstreit:** - Became long-lasting conflict concerning research methods between German and Austrian economists who supported Menger or Schmoller - Actually stupid: difficult to argue that economics should either be theoretical and deductive or empirical and inductive - Should not be an either or question, but a balance between both approaches **Ernst Engel** =============== May be natural to classify under the historian school, but did not participate in Methodenstreit Statistician and became place in economics due to his empirical studies **Engels Law:** - Found as Belgian statistician carried out a detailed investigation of the household budgets of Belgian working-class families - Engel made hypothesis: there is a law regarding the composition of consumption at individual and national level - = expenditure on food as percentage of income falls as income increases - Income or Engels elasticity of food \< 1 - Confirmed in a long series of budget studies for different countries and time periods - Not derived from his own studies! Common misunderstanding **Value of Man:** - Engel presented empirical estimates of the value of man - Calculated expenditure of training a boy to practice his father's profession in different socioeconomic groups - Expenditure increased with father's income and decreased with family size **The Austrian School: Eugen von Böhm-Bawerk and Friedrich von Wieser** ======================================================================= Partly as a result of Methodenstreit: Menger and Austrian school economists came to appear as a particular school of economic research Considered an own school **Böhm-Bawerk:** - Was educated in law and political science but became interested in economics due to Menger - Was in ministry of finance and e times minister - Famous for this theory of capital and interest - Question: why the rate of interest is positive - Answer known as "Böhm-Bawerk's 3 reasons i. Individuals generally expect that more resources will be available for consumption in the future ii. Undisputable fact that people systematically tend to underestimate future needs iii. Advantages of "roundabout protection": methods of production will be more productive when extended in time -- if production per worker increases with length of period of production some factor that causes producers to stop the process of time extension (choose a period of finite length) positive interest rate (lower rate -- longer period)\ negative relationship between rate of interest and capital intensity in production - Became a general equilibrium perspective - Interest rate as one of prices - Discount rate (defined as [1/(1 + *r*)]{.math.inline} with r as interest rate,) is the equilibrium price of consumption one period form now expressed in units of present consumption - Weak point: not formulated as mathematical model - Prominent person as a politician, academic and contributor to public debate - As a polemicist: showed considerable ability to express himself clearly and to the point - Author of classical critiques of Karl Marx's economic theories - Less willing to admit to shortcomings in his own theories **Friedrich von Wieser:** - 1851 -- 1926 - Studies law but was captured by Menger's Grundsätze and found interest in economics - Succeeded Menger as a professor in University of Vienna and was minister of trade for a short time - Books: *Der natürliche Wert* and *Grundrisse der Sozialökonomie* (textbook exposition of the principles of economics as seen by the Austrian School - Remembered for 2 reasons - Invented the word marginal utility in German (tried to translate "final degree of utility") - Theory of relationship between commodity and factor prices - Value of a factor of production in principle could be computed as the decrease in the value of a commodity that would follow from a small decrease in the input factor - principle might imply that the total value of the factors of production might exceed the value of a commodity (little sense) - alternative method for imputation of values to factors of production that took account of the constraint that for each commodity the valeu of the inputs must be equal to the value of output Chapter 9: Leon Walras Menger, Jevons & Walras: - Walras had the greatest direct influence on development of economics - Menger & Jevons - Pioneers in directing attention to consumer side of markets and introducing marginal utility - Neglected some important elements: - Role of cost of production for formation of prices - Broad view of the economic system as a whole **Walras:** - Born in Normandy, France (1834 -- 1910) - Father: economist who wrote on theoretical problems without making any contributions of his own - Was an engineering student, but never passed his exams or practiced the profession - Conversations with his son were very important - Tried many jobs, but never succeeded - His father said there were 2 tasks that remained for intellectuals to achieve during the 19^th^ century:\ a) establish history on a scientific footing\ b) lay foundations for a science of society, especially of its economy - He took on the last task - Referred to this as "the most decisive moment of my life" - 1860 - Participated in a taxation congress and left good impression - I - In general 1860s were disappointing as his attempts to obtain a position in the French university system were unsuccessful (mainly due to his lack of formal academic qualifications) - Started to work in a bank and wanted to give up - 1870 - University of Lausanne -- new chair of economics was created - Committee: 4 politicians and 3 professors - Walras was ranked 1^st^: 3 votes (1 politician, 2 professors) against him, 4 in his favour - Professors who voted against him: saw socialist leaning - Wrote his most famous books: - Elements of pure economics - Book about monetary theory - Articles about applied economics and economic policy - Wanted, but never did: 2 volumes about applied and social economics - Resigned from professorship in 1892 - Continued to be active in research and writing Questions of Method =================== Believed in the advantages of the mathematical method of economic analysis Goal of his life: prove the superiority of this method He was not very trained in mathematics and sought help of mathematicians "Mathematical method is not an experimental method; it is a rational method" Illustration of ideal types with reference to geometry: - Only ideal case triangle has a sum of angles equal to 180° - In practice, the sum comes close to ideal number, but never exactly - Same applies to economic theory - Ideal prices are determined by ideal supply and ideal demand "Applications should wait until theory is fully developed" - How to know when this is the case? - Possible interpretations: - Walras believed that science was fully developed with his Elements - There ought to be a theoretical foundation for any economic analysis of a practical problem Employment of mathematical methods: - Right use makes it easier to follow a piece of theoretical reasoning - Why use of everyday language to explain things in the most cumbrous and incorrect way can be stated more succinctly, precisely and clearly - Became the dominant conviction among academic economists - Could not be read by people without knowledge of mathematics far above elementary level - Opened a divide between scientific literature of economics and type of exposition that could be read by the enlightened public The Analysis of Exchange ======================== Beginning of Elements: analysis of a problem similar to Jevons: How can one characterize the equilibrium of an economy with 2 persons and 2 goods whose supply is fixed **Findings:** - The model determined the ratio between quantities traded of the 2 goods - Since value of the quantity sold by one individual must be equal to the value of the quantity purchased by the other individual, the ratio of prices must be equal to the inverse ratio of the quantities - Model determines only relative prices - Numeraire = to express the price, we may choose one commodity as a unit of account and state all other prices in units of this commodity - Absolute price only meaningful once a decision is mad eon a unit of account, either in form of a regular good or one that has its main purpose to serve as means of payment (= money) **Consumer as a utility maximizing agent:** - Discussion far clearer than Menger and Jevons - Assumes that utility is a magnitude that is attached to the consumption of each commodity separately - To obtain maximal utility: - Rediscovered Gossen's 2^nd^ law - Marginal utility / rarete divided by price must be same for all commodities - Consumer's marginal utilities of the different goods determine prices in an exchange economy General Equilibrium =================== Walras was careful to specify the structure of the interrelationships between markets or the economic circulation in society Firms supply finished goods to consumers firms demand factors of production, labour that are supplied by consumers **General equilibrium:** 1. Consumers' demand is equal to firms' supply for all consumer goods 2. Firms' demand for factors of production is equal to consumers' supply for all factors of production **Equations:** - [*m*]{.math.inline}... commodities & prices - We have m markets and hence m equations (= number of unknowns) - Constructing a mathematical model of economy that determines all prices as result of decentralized decisions about consumption and production by a large number of firms and consumers - Problem: - Theory only determines relative prices - Price of one commodity (numeraire) must be set equal to 1 - Now we have m equations to determine m-1 relative prices one equation too much & an over determinate system - One of the m equilibrium conditions could be derived from the others Value of what individual consumer buys = value of what s/he sells - Must also be true in the aggregate: value of total sales = value of total purchases - If m-1 of m markets are in equilibrium, the last will be so as well - = **Walras's Law** Extension of theory to an **economy with production** - Assumption: there are fixed coefficients in production - Generalized analysis to the case where the marginal productivity of the factors of production varied with amount of input and where factor substitution was possible - Nominal price level cannot be determined until considering monetary factors - Walras was a quantity theorist in this regard - Theory started from assumption that the agents of the economy faced a lack of synchronization of income and expenditure payments - Function of money was to bridge the liquidity problems that this entailed - Conclusion: money is neutral with respect to the real economy - Doubling of money doubling of all nominal prices no effect on relative prices = *the classical dichotomy* **Theory of general equilibrium:** - Major step towards the theory of price formation in competitive markets - Mathematically abstract -- barely anyone understood it - Those who could doubted whether it could become significant - Based on misunderstandings rather than facts - Aim: show that theories of individual market behaviour could be fitted together to an integrated whole, a logically consistent description of the functioning of a competitive economy - Did not provide much opportunity for practical application to problems - Was seen as a general reference for future developments of the theory - Has been further developed also by other economists The Road to Equilibrium ======================= **The Theory of Tatonnement:** - Walras was not satisfied with the internal consistency of his theory - Claimed that model could say something about real world need to explain how the market mechanism arrived at the equilibrium as it cannot explain itself - Tatonnement ("Groping"): extension of description of equilibrium by a dynamic theory of the movement towards the equilibrium - Theory of market adjustment must be seen on background of his methodological argument about the necessity of reasoning by means of idealized concepts - Market with auctioneer or administrator - He begins by crying out random prices for all commodities that are subject to trade - Consumer & firms write down quantities they wish to buy and sell - Auctioneer collects this information for each individual market - If demand ≠ supply cries out new set of prices - Increases price if demand \> supply - Decreases price if supply \> demand - Same procedure again until market mechanism is stable **The Problem of Existence:** - Walras did not take this issue up - He assumed that the model was logically consistent because it contained the same number of equations as unknowns - Still, we cannot assume that the model has a solution because of this - Solutions also need to be meaningful from an economic point of view - E.g. prices cannot be negative