CHAPTER ONE: NEO CLASSICAL SCHOOL OF THOUGHT of FBE/Economics...in history of economics thought....
Transcript of CHAPTER ONE: NEO CLASSICAL SCHOOL OF THOUGHT of FBE/Economics...in history of economics thought....
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CHAPTER ONE: NEO CLASSICAL SCHOOL OF THOUGHT
Introduction
Neoclassical economics emerged as result of gradual transformation of the classical and
marginalism. Neo means new and classical is the orthodox thought; hence neoclassicism implies a
new form of classicism. It is approaches to economics focusing on the determination of prices,
outputs, and income distribution in markets through supply and demand. It is often mediated
through a hypothesized maximization of income-constrained utility by individuals and cost-
constrained maximization of profits by firms employing available information and factors of
production, in accordance with rational choice theory.
The school of marginalists emphasized decision making and price determination at the margin.
However, there are at least three basic differences between the earlier marginalist and the later
neoclassical economics. Firstly, neoclassical thought stressed both demand and supply in
determining market prices whereas, the earlier marginalists tended to stress on demand side alone.
Secondly, several of the neoclassical economists took a far greater interest in the role of money in
the economy than did the earlier marginalists. Finally, neoclassical economists extended the
marginal analysis of market structure besides pure competition, to imperfect competition, pure
monopoly and duopoly. In this chapter we will look at the neoclassical school aspects and their role
in history of economics thought.
1.1. Historical background of school of thought
The period between the passing away of Mill and the advent of Marshall from 17th century to late
19th
century was full of implications as far as the development of economic science was concerned.
During this period, there were many factors which gave rise to neoclassical school of thought.
These include changes in economic structure, technological aspects, form of competition, and
working condition for worker classes and so on. Several changes had taken place in the field of
industrial advancement in technology and physical sciences. There were new inventions and
innovations as well as techniques of doing things which helped capitalist to raise production. The
use of machinery and inventions among people had let large-scale production in size and in capacity
over time result in industrial concentrations. Further more, differences in size of firms were become
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common with capitalism; many small, medium, and large size firms emerged. In addition, new
forms of competition called non price competition emerged in addition to price competitions.
Hence, firms were also influencing market through price determination, and product differentiations
More over, new form of finance and investments system (credit) came into being and enabled the
capitalist to produce more by solving their financial problems (capital). With the credit and
technological advancement, the economy of the west experienced trade cycle’s ups and downs in
business. The occurrence of trade cycles created upheavals in production and consumptions.
Economics became more concerned with a humanitarian interest.
On the other hand, the misery of worker class in terms rewarded /wage, hours of work and
exploitation became more common. To reduce these peoples started forming unions that fight for
the right of the workers. Trade unions were beginning to claim a voice in wage settings. This
change in outlook may be largely attributed to the labor movement, which developed during the
latter half of the 19th century. This was responsible for the downfall of the wage-fund doctrine.
Further more; the German thought had started gaining strength in England. The criticisms of the
historical school were also responsible for shaking the foundations of the classical economics. The
development of the biological sciences and the idea of evolution further accentuated this change.
All these developments led to the inapplicability of the classical economics.
The theoretical criticisms emerging chiefly from within. Classical and marginalist theories were
applied to solve business problem but they were not effective. Attempts were made to broaden the
scope of economic analysis by recognizing the interrelationship of economic and ethical factors
among classical.
Intellectuals were concerned with the choice of theoretical issues and the manner in which they
were treated. Attentions of economic theorists converged to analysis of economic behavior focusing
on its decision making units such as household, firms, and government as opposed to aggregate one.
From the point of view of neoclassical economists the problem deserving study was the functions of
the market system and its role as alligators. These adjustments of analytical priorities had related to
market behaviors. It became very important to understand the factors shaping the price of both
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output and inputs to analyze the behaviors of market system. Hence, a re-statement of economic
ideas was needed and this work was taken up by Alfred Marshall’s. He presented a synthesis of the
classical doctrines and the marginal utility analysis of the subjectivists. His aim was to reconstruct
economic science in the light of the new developments and in the context of the changed conditions.
1.2 Basic tenets, validity, and beneficiaries of neoclassical school of thought
Neoclassical school of thought was the center of every market economy thought as it covers every
thing in economics. It is not one well- defined theory, rather can be regarded as a family of
approaches to economic and material life. It is in many ways more a methodological programme
than a single theory that can be put to empirical test. Neoclassicism is thus a collection of schools
of thought. Some of the features of neoclassical economics are: methodological individualism,
rationality, equilibrium and the importance of the price mechanism, the extent of competition, the
degree of knowledge of economic actors of their environments, and the use of formal modeling.
I. Methodological individualism
This is the methodological position that aims to explain all economic phenomena in terms of the
characteristics and the behavior of individuals. Methodological individualism states that any theory
of how the economy runs should be built upon understanding of how the individuals within it
behave as everything ultimately reduces to what individuals do. It embraces individual units,
specifically firms and households. They argue that there is no such thing as society, just individuals
and families can be seen as a classic statement of the politics. Strictly, it tries to explain how
households and firms behave by analyzing the behavior of the individual people who make up the
household or firm.
II. Rationality
Neoclassical theory assumes that all individual agents behavior is rational. Individuals are assumed
to be self-interested and to have well-identified goals that they pursue in the most efficient way
possible. They maximize something with respect to objective functions. More specifically,
consumers are assumed to maximize pleasure (utility) subject to what they can afford. Firms are
assumed to maximize profits subject to what is technically possible for them to achieve.
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III. Equilibrium
A real world is complex and it is difficult to analyze interaction among economic agents.
Neoclassical simplified the complexities by introducing models and set of assumptions. In order to
build models which reduce the complexity of the real world economy, neoclassical concentrates on
the analysis of equilibrium. These are situations where the one aspect of the economy is at rest in
such way that no individual has any incentive to change what they are doing unless external factors
change. A single market, for example, is in equilibrium when the market price is such that all
buyers can buy as much as they want and all sellers can sell as much as what they want at that
price. This price is then the equilibrium price. In such a situation, no buyer or seller has any
incentive to change what they are doing. The status quo persists, unless external forces alter
something. Hence, much of neoclassical theory is concerned with understanding of the conditions
under which equilibrium exists.
IV. The importance of the price mechanism
The fourth main characteristic of the neoclassical school of thought is the central role it gives to the
price mechanism in connecting economic agents. In neoclassical models the main interaction
between economic agents takes place through the price system. That is, prices contain all the
information needed by buyers and sellers, and that they provide agents with the necessary incentives
to act (buy, sell, and produce). All economists would agree that price mechanism is a very powerful
investment which play a central role in markets. This applies to all kind of markets, irrespective of
the goods and services traded and the type of exchange between buyers and sellers.
V. Competition
A strong assumption of neoclassical economics is that the power of individual economic actors in
influencing the system is quite nil. Individual economic agent is sufficiently small that they can take
their environment as given, without thinking about the effects of their own actions on it.
Specifically, this assumption means that all agents are assumed to be price takers. In real world
markets, many agents have much more power than this and can have significant effects on prices in
the markets in which they buy and sell.
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VI. Agents’ knowledge
Traditionally, in neoclassical theory there is unrealistic assumption about all economic have perfect
knowledge of anything in the past, present or future which might influence their decisions. In
particular, they know all future prices. There are now modified versions of neoclassical theory that
allow for agents being uncertain about the future (absence of perfect knowledge). Because of
uncertainty about the future is about the decisions that other agents will take in the future, then
agents have to act strategically in order to make the most optimum decision as choices and
outcomes are interdependent. This happens, for example, in the case of asymmetric information
when some agents know things that are not known to others.
VII. The use of formal modeling
One of the characteristics of economics as compared with other social sciences is its systematic use
of formal models. Models, that abstract from the complexities of the real world to concentrate on a
few variables at a time, and then investigate very thoroughly the relationships between these
variables. Neoclassical economics, in particular, uses a highly developed set of formal models. In
developing such formal models, certain abstractions have to be made. Some of its abstractions used
mathematical modeling.
VIII. Building up competitive general equilibrium theory
As mentioned earlier, neoclassical economics should be seen more as a methodological programme
of how to do economics than a collection of particular theories. They developed a general
equilibrium model and theory for the economy. Competitive general equilibrium theory examines
the conditions under which a decentralized market economy, in which economic agents follow their
own interests, will reach an orderly outcome that is economically efficient. What is meant by
‘orderly’ is that all markets are in equilibrium and by ‘efficient’ is that nobody’s welfare can be
improved without making things worse for someone else. Competitive general equilibrium theory
represents the neoclassical school of thought in its purest form. Competitive general equilibrium
theory has not only had a great impact on economic theory, but also it has strong policy
implications. The theory of competitive general equilibrium can be seen as the culmination of this
neoclassical programme, building on all its features
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1.3 Neoclassical economics: pure competition
Alfred Marshall (1842-1924)
Marshall was born at Clapham in 1842. He was the son of cashier in the bank of England. His
father forced him to learn subject relevant to minister in Church of England. But his wide range of
intellectual interest which included mathematics, history, utilitarian and Hegelian philosophy and
social Darwinism led him to study the works of Staute Mill on political economy. He attended
Cambridge where he devoted himself to mathematics, physics and later on to economics. He
graduated in mathematics from St. Johns collage, Cambridge and then thought mathematics at
Cambridge for nine years. In 1877, on his marriage he resigned from his position in Cambridge and
went to Bristol’s and worked as principal of university collage till 1881. From 1883 -1885, he
served in Ballion, Oxford. In 1885 Marshal was appointed as the chairman of political economy
and retained his post till his retirement in 1908.
Marshall was the greatest synthesizer, seeking to combine the best of classical economics with the
marginalist thinking, hence producing the neo classical economics. He was the first economist to re-
name political economy as Economics. He was the first who gave greater importance’s to the study
of human wants and consumption. He himself said of his ‘Principles’ that ‘the present treatise is an
attempt to present a modern version of old doctrines with the aid of the new work and with
reference to the new problem of our age.’
His book “Principles of Economics” was the dominant textbook in England a generation later. The
edition came out in 1920 and it had been reprinted eleven times. It is divided into six books; Book-I
deals with preliminary survey; Book- II examines some fundamental notions; Book -III discuses
wants and their satisfaction; Book- IV describes the factors of production; Book -V deals with
demand, supply and value ant Book -VI presents an analysis of national income and its distribution.
His economic ideas
1. Scope Of Economics
Marshall classified human activities into activities that contribute to material welfare and activities
that do not contribute. Marshall shifted the emphasis from wealth to man. He has given primary
importance to man and secondary importance to wealth. Wealth is only means to welfare.
Accordingly, he defined economics or political economics as economics. For him, it is a study of
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man in the ordinary business of life. It is on the one side study of wealth and on the other more
important side, a part of the study of man. It deals with the economic aspect of man and not social
or political or religious aspect of his life. It examines that part of individual and social action which
is most closely related with the attainment of material well being. It explains their ordinary
business life, which consists of earning and spending of money for the satisfaction of their
necessities of life like food, clothing and shelter.
Economics is not a body of concrete truth, but rather an engine for the discovery of concrete truth.
We seek economic laws, like any law of a general preposition or statement of tendencies, which are
more or less certain and definite. Economic laws are the statements of economic tendencies and are
hypothetical. Since economic laws deal with man’s actions which are numerous and uncertain, they
are to be compared with the laws of tides rather than with the simple and exact law of gravitation.
Economic laws are not natural laws that are necessarily beneficent. Economists like other scientists
collect, arrange, interpret and draw inferences from facts. They seek knowledge of the
interdependence of economic phenomena of cause and effect relationships. Every cause tended to
produces a definite result if nothing occurs to hinder it. Economics is less certain than natural
sciences, but progress is made towards a greater precision.
2. Marshall’s Method
As far as the method of study is concerned, Marshall considered both induction and deduction as
useful for economics. Both are needed for scientific thought as the left and right feet are both
needed for walking. Both are complementary to each other. Marshall was the great interpreter of the
method of partial equilibrium. The forces influencing an economic phenomena are too numerous
and it is very difficult to analyze all of them at one and arrive at a complete explanation of the
phenomenon. Therefore, the best method is to keep other forces constant, and study forces
influencing the phenomenon. Thus all the other forces are reduced to inaction by the phrase “other
things being equal’. He also used mathematics in his analysis. He worked out his theories and
arguments in mathematical terms, but relegated the use of mathematics to footnotes and an
appendix.
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3. Rational Consumer Choice
Marshall’s employed the idea of rational consumer choice in his demand analysis. In money
economy, said Marshall, each line of expenditure will be pushed to the point at which the MU of
shillings (dollars) worth of goods will be the same as in any other direction of spending.
4. Utility and Demand
The utility approach of the Marshallian system dealt with pleasure and pains, desires and
aspirations, and incentives to action. According to Marshall we cannot compare the amounts of
pleasure that two individuals derive from eating hamburger nor can we compare the degrees of
pleasure one person gets from eating hamburger at two different times. But we can measure them by
using the measuring rod of utility i.e. money. Money measure utility at the margin or at point where
decision are made. Two people with equal income will not necessarily derive equal benefit from its
use. The amount of money that people of equal incomes gives to obtain a benefit or avoid an injury
is the extent of the marginal benefit or injury. He also added that an increment of money, like any
additional unit of goods, has greater MU to a poor person than to a rich person.
Marshal traced the development of consumer‘s demand over time. He pointed out that in
contemporary economy, consumer‘s demand governs the traders action. Demand is intimately
connected with and based on utility. Here he made famous distribution between total and marginal
utility and law of diminishing marginal utility. He then comes to the crucial stage of translating the
law of diminishing marginal utility into laws of demand.
Marshall takes up the theory of demand to analyze consumer behavior. A rational consumer aims at
maximizing satisfaction from his consumption. The amount of satisfaction is closely related to the
quantity of that commodity consumed by the consumer. Thus demand is based on the law of
diminishing marginal utility. Marshal stated that the additional benefit which a person derives from
a given increase of the store of a thing diminishes with every increase in the stock that he already
has”. The MU of a thing to any one diminishes with every increase in the amount he already has.
Demand refers to the quantity of a commodity demand at a certain price, other things remaining the
same. The individual demand curve can be directly derived from the law of diminishing marginal
utility. Assuming the marginal utility of money to be constant, the price offered to additional units
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will fall MU tend to diminish. Hence the demand curve slopes downwards. The market demand
curve represents the total demand of all the consumers for a commodity at various prices. These
individual demand curves can be added together to get market demand curve.
5. Law of Demand
Marshall’s law of demand follows from his notions of diminishing marginal utility and rational
consumer choice. Suppose that a consumer’s expenditure are in equilibrium such that the last dollar
spent on each of the several products yields identical MU. Only at the margin that price will
generally match a person’s willingness to pay. That is ... NX Y
X y N
MUMU MU
P P P . In doing so
unlike the earlier theorists Marshall successfully tied equi-marginal rule to the contemporary law of
demand. How these consumers react if the price of good X falls while the price of other goods
remain constant? When price of goods falls two effects are at work, income and substitution effect.
Marshall focused on substitution effect.
To Marshall, the rational consumer would buy more of product X, and then the ratio X
X
MU
P will
exceed the MU/Px ratio of other goods. To restore balance of expenditures, the consumer will
substitute more of X for less of Y. As this substitution occurs, the MU of X falls and the MU of
other goods will rise. Thus, the equilibrium will be restored. Therefore, in Marshall’s word the
amount demanded increases with a fall in price, and diminishes with a rise in price.
Marshall illustrated the law of demand with both table and demand curve. He drew his demand
curve by assuming sufficiently short time to justify the ceteris paribus assumption. He pointed out
that he was concerned with the moment in time, which is too short to consider any changes in
character and tastes of particular person as they change overtime. In the long run all the
determinants of demand will change, and hence the demand curve shifts either inward or left ward.
Thus Marshall made clear conception of differences between changes in quantity demanded
(measured along the horizontal axis) and changes in demand (shift of the entire demand curve).
6. Elasticity of Demand
Marshall was superior to his predecessors in handling elasticity of demand. The law of demand tell
us the direction of change of quantity demanded when price changes. It cannot tell us the extent of
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change of quantity demanded. Elasticity of demand tell us the extent of change of quantity
demanded when price changes. It relates the percentage drop in price to the percentage increase in
quantity demand, which is based on the law of diminishing marginal utility of the good. The
numerical coefficient of the elasticity demand (Ed) is the percentage change in quantity demanded
divided by the percentage change in price. Demand in elastic if Ed>1, inelastic if Ed<1 and unit
elastic if Ed=1, expressed in absolute terms. Marshall also discussed what we now call the
determinants of elasticity of demand. These are prices, availability of substitutes and so on. When a
price of good is high relative to the size of the buyer, income elasticity will tend to be great.
7. Supply and Cost
Marshall developed his theory of supply on lines similar to his demand. Supply schemes refer to a
whole series of quantities that would be forthcoming at a whole series of prices not specific level of
supply. Marshall has distinguished between immediate future, short run and long run production
periods. Immediate future is a production period when it is impossible to alter any factor of
production. Immediate present is a time which may be as short as one day. Short run is a time
period when it is possible to vary some inputs but there is impossible to vary all, and long run is a
production period when all inputs are variable. The quantity supplied can not be increased in
response to a suddenly increased demand, nor can the quantity supplied be decreased immediately
in response to a decline of demand.
If a good is perishable, the market supply curve is perfectly inelastic. The firm would rather sell its
fresh fish for a small amount rather than let it spoil. If the good is not perishable, the sellers have
reservation prices below which they will not sell. However, some sellers sell at prices below cost of
production because they have pressing bills to pay. The short run supply curve sloped up ward and
to the right implying the higher the product price, the larger is the quantity supplied (modern
economics view the short run supply curve as MC curve). In the long run, all costs are variable, and
they must be covered if the firm is to continue in business.
According to him, supply mingled on the availability of factor of production and their efficiency;
types of market in being considered. Regarding the market he deals with the relationship between
buyers and sellers of a particular commodity. He limits himself to the competitive market or market
sufficiently closer to competitive market. Supply is governed by cost of production and time
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element jointly. Marshall distinguished between real and money cost of production. Real cost of
production refers to the efforts and sacrifices involved in making a commodity. It includes the
exertion of labor and waiting for saving. Money cost of production indicates the sum of money that
has to be paid for these efforts and sacrifices. Marshall further divided costs into prime and
supplementary costs. Prime cost is variable costs which include wages and raw materials.
Supplementary costs are fixed costs include depreciation, interest on loans, rent and salaries of
executives. In the short run, a firm has to cover its prime costs. But in the long run, a firm must
cover both prime and supplementary costs. A rational producer aims at minimizing costs.
Like the consumer, the producer too has to distribute his resources so that they have the same
marginal utility in each use; he has to weigh the loss that would result from taking away a little
expenditure here, with the gain that would result from adding a little there. Just as the consumers
obtain utilities or satisfaction from the consumption of commodities, it also involves costs. Just as
the marginal utility diminishes when a consumer increased his consumption of a commodity, the
marginal cost rises as the production of a commodity expands.
8. Equilibrium price and Quantity
The doctrine of demand and supply is the pivot on which Marshallian economics revolved. Marshall
has clearly explained the difference between demand and supply. While analyzing the concept of
demand he has made use of the Austrian analysis including the concepts of utility, marginal utility,
law of diminishing utility, demand schedule etc. He then analyzed the concept of supply with the
help of the doctrine of marginal disutility, laws of returns, Malthusian theory of population, division
of labor, industrial organization and management as related to productive efficiency, etc. He then
formulates his theory regarding the determination of equilibrium between demand and supply.
Marshall has also made use of the term ‘cost of production’, meaning collectively the expenses of
production incurred by the entrepreneur and the sacrifices made by the society.
To Marshall, demand is the center of any activity. He has divided markets into two classes: short
period and long period. In the short period higgling and bargaining activities might oscillate about a
mean position and the price co established may be called the short-term equilibrium price. In the
determination of such a price demand proves to be more effective than the supply. This equilibrium
price is affected largely by the position of the stock readily available in the market and by the
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present quantum of demand. The possibility of the supply to increase or decrease in the near future
may have its own effect but in the case of perishable commodities, the cost of production has but
negligible part to play. Marshall also explained about the long-term equilibrium of normal demand
and supply. He has pointed out that much elasticity is found in the use of the term ‘normal’, when
applied by the economists to the causes determining value.
Price of a commodity is determined not by supply alone as the classical economists believed and
not by demand alone as the utility theorists believed but by both demand and supply. Behind supply
there is financial and subjective cost while behind demand there is utility and diminishing marginal
utility.
9. Consumer surplus
Marshall introduced the concept consumer’s surplus to economic literature. Unlike the Austrians,
Marshall asserted that the total utility of a good is a sum of successive MU of each added unit.
Therefore, the price a person pays for a good never exceed and seldom would equal to what person
be willing to pay. To him the excess of price which buyer would be willing to pay over that which
he actually does pay is the economic measure of surplus satisfaction. It may be called consumer’s
surplus”. In other word, consumers are generally prepared to pay a higher price for a commodity.
But they actually pay less for it; as a result the consumer enjoys a surplus satisfaction. The concept
of consumer’s surplus has become the basis of welfare economics.
10. Factors of Production
According to Marshall, land and labor are the two chief factors of production. Man is the central
force behind all activities related to production and consumption, but since his faculties are moulded
by his surroundings and environment, obviously nature plays a highly significant role. Labor and
land are the only primary factors of production: man being active, while nature being passive,
nevertheless, playing an important role in production. Capital is all stored up provision for the
production of material goods and for the attainment of those benefits which are commonly reckoned
as part of income. Capital is a secondary or derived agent of production. Organization is just a sort
of labor.
11. Division of Labor
Marshall held the view that increased demand for particular commodities and the expansion of
market are the two factors which lead to division of labor. Division of labour and improvement of
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machinery go together. It was necessary for utilizing the skill of the workers and the machinery in
the best possible manner that the division of labor should be resorted to. In order to achieve the
maximum in production, each person should be constantly employed in such a way that the best
possible use of his skill and ability may be made.
12. Distribution of Income
According to Marshall, the theory of distribution is essentially a theory of factor pricing. To him,
business people must compare the relative efficiency of every agent of production they employ and
consider the possibilities of substituting one agent for another. In a competitive economy,
distribution of income is determined by the pricing of factors of Production. The price of factors is
determined by market forces, viz., demand and supply. The demand for a factor of production is a
derived demand and depends on its marginal productivity. A producer employs more and more of
factors of production till it’s reward is equal to its marginal productivity. Marshalls theory of
distribution was essentially marginal productivity theory of distribution. Marshall also accepted
Wicksteed’s argument about the exhaustion of product. Marshall believed that the marginal
productivity theory was not a complete theory of factor pricing as it considers only demand,
neglecting the supply side. It should properly considered supplier. The effective supply of a factor
of production at any time depends on the stock of it in existence, and on the willingness of those in
charge of it to apply in production.
13. Quasi-Rent
Marshall introduced the concept of Quasi-rent in economic literature. He incorporated Recardian
theory of rent. According to Ricardo, the term rent is applied to income from land and other free
gifts of nature. The amount of rent itself is governed by the fertility of land, the price of the
produce, and the position of the margin. In the short run, Marshall wrote, land and manufactured
capital goods are similar because the supplies of both are fixed.
Quasi-rent is the income derived from man-made appliances and machines. Therefore, the return to
old capital investment is something akin to rent; Marshall called it quasi-rent. Marshall coined the
term Quasi-Rent for the earnings of such capital goods in the short run. The supply of these man-
made producer goods cannot be increased in the short period even though the demand for them may
increase. Durable factors like machines, ships, house and even human skills are similar to land
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whose supply is fixed in the short-run. When the demand for them increases suddenly, their supply
cannot be increased and they earn a surplus which is not rent but is similar to rent. This is only a
temporary surplus which goes to the owner of capital equipment due to the impossibility to increase
supply of capital equipment in response to increase in demand. This is because the numbers of
machines are fixed in short-run and transfer earnings are zero. In the long-run its supply becomes
perfectly elastic and any number of machine will be supplied and Quasi rent disappears.
For instance, due to increase in urban population the demand for houses increases. But the supply
cannot be increased because of the scarcity of building materials. Their supply is limited as that of
land. There is abnormal increase in house prices and hence earning to owner. This abnormal
increase in their earnings is Quasi-rent. It is not rent proper or pure rent because the supply of
houses can be increased in the long-run. In the long-run the supply can be increased and the surplus
earnings will disappear. It is instructive to analyze quasi rent in the earning of factors like labor,
capital and organization i.e. in wages, interest and profit.
Quasi rent in interest: The term interest is applied to a return on floating capital, while quasi rent
is the return from specialized or sunk. Interest on capital is a cost of production in all period; but
quasi rent is a surplus. Usually interest acts as an incentive to save. The higher rate of interest may
induce only the marginal investors. But there are other investors who will save ever at lower rate of
interest, such as super marginal investors and surplus is the rent element in interest. Thus quasi rent
is determined while interest is price determining. The supply of machine or any other capital
equipment is fixed in the short period. The surplus earnings will continue.
Quasi rent in wages: Labor is heterogeneous. Laborers generally differ in efficiency particularly in
the case of personal efficiency. The more efficient workers enjoy a surplus or extra wage over
marginal workers. This surplus constitutes the quasi rent.
Quasi rent in profit: Entrepreneurs also differ in their ability like laborers. Entrepreneur with his
superior organizing ability is able to produce more at a lower cost compared to a marginal
entrepreneur. Accordingly, he is able to enjoy more profit. This is considered as Quasi rent element
in profit.
Quasi rent in personal incomes: Skilled persons like engineers, lawyers and professors due to
their abilities earn more than others. Their differential income is the quasi-rent.
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14. Laws of Returns
In production theory, Marshall introduced the idea of returns to scale; increasing, decreasing and
constant returns to scale. To Marshall, Law of diminishing returns follow or experience if an
increase in the capital and labor applied in cultivation of land causes in general a less than
proportion increase in the amount of it produce. Marshall believed that agriculture was subject to
the law of diminishing returns in the long. Law of Increasing Returns holds if an increase of labor
and capital leads generally to improved organization which increases the efficiency and
productivity. In other word, an increase in units of labor and capital would result in more than
proportionate increase in production. According to him, in industry with an expansion of labor( with
population growth) and capital and an improvement in organization and efficiency, there is an
increasing return to scale..The Law of Constant Returns experience if the actions of the laws of
increasing and diminishing returns are balanced, we have the law of constant return and an
increased produce is obtained by labor sacrifice increased just in proportion. In advanced country
twice the amount of labor and capital apple to land would double the yield.
15. Marshall’s Contribution to Monetary Economics
Marshall’s book entitled ˝Money, Credit and Commerce˝ appeared in 1923 with idea of monetary
economics. He thought that the value of money, like that of other commodities was a function of the
dual forces of supply and demand. The demand for money (gold) is measured by the average stock
of command over commodities which each person cares to keep in a ready form. He has also
explained the reasons why each individual decides to keep money in a ready form, obviously
because it has greater advantages over other forms of wealth. Marshall has thrown light on the
problem of rising price. He made a distinction between real and money rate of interest. For the first
time Marshall explained the causal process by which an increase in money supply influences prices
and also those part played by rate of discount was explained by him.
Though the purchase power parity theory was associated with the names of Ric and Cassel, it was
Marshall who explained the rate of exchange between countries with mutually inconvertible
currency. Marshall also introduced the ‘chain’ method of compiling in numbers. Marshall also
introduced a proposal of paper turn for the circulation based on gold and silver symmetallism as it
standard. Symmetallism refers to a method in which a bar of 2000 grams of silver is equal to a bar
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of 100 grams of gold. Under this system, the government must always be ready to buy or sell a
wedded pair of bars for a fixed amount of currency. The proposal of paper currency for the
circulation based on gold-and-silver symmetallism as the standard was made by Marshall in his
reply to the Commissioners on Trade Depression in 1866. The proposal was put forward as an
alternative to bimetallism.. Marshall thought that this plan could be started by any nation without
waiting for the concurrence of others.
IRVING FISHER (1867-1 947)
Irving Fisher was a man of diverse interests. He took active part in several activities like campaign
for prohibition, public health, healthy living etc. He was a mathematician, statistician, reformer and
a teacher. Fisher was born in Saugerties (New York). He was educated at Yale, Berlin and Paris. In
1893 he left for Europe for his higher studies in Mathematics. After his return, he taught
mathematics for sometime at the Yale University. From 1895 onwards he was appointed as
Professor of Economics.
Fisher’s main contributions were in the fields of money, interest and capital. Fisher’s writings
include: The Nature of Capital and Income (1906), The Rate of Interest (1907), The Purchasing
Power of Money (1911), Elementary Principles of Economics (1910), The Making of Index
Numbers (1922), The money Illusion (1928), The Theory of Interest (1930), Booms and De-
pressions (1932), Stable Money (1934) and 100 percent Money (1935). He was the first economist
who said that income should not be confused with capital.
QUANTITY THEORY OF MONEY; Transactions Approach
Fisher presented old quantity theory of money. The Quantity Theory asserts that (provided the
velocity of circulation and the volume of are unchanged) if we increase the number of dollars by
debasing coins or by increasing coinage, price will be increased in the same proportion’. In order to
explain the direct and proportionate changes between quantity of money and price level, Fisher gave
equation of exchange. The original equation of exchange is stated as PT= MV (or) P =MV/T in
which P stands for the price level, M quantity of money, T for transactions and V stand for velocity
of money.
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But he later criticized this original version of his theory for not including credit money. According
to him, there are five determinants of the purchasing power of money. Namely: 1) The volume of
currency in circulation 2) its velocity of circulation 3) the volume of bank deposits subject to check
4) its velocity 5) the volume of trade. He presented his equation of exchange by including credit
money as follows. MV+M’V’=PT Where: M-quantity of currency, V-velocity of circulation,
M’-quantity of demand deposit, V’-velocity of circulation (velocity of M’) , P-average level of pries
, T-quantity of goods and services translated or sold
According to him, prices vary directly with the quantity of money (M and M’) and the velocity of
circulation (V and V’) and vary inversely with the volume of trade (T). Fisher based his quantity
theory of money on certain assumptions. He assumed that the velocity of circulation of money and volume of
trade to remain unchanged. Further, he mentioned certain factors that determined the velocity of circulation
of money. These were (1) system of payment (2) development of credit and finance (3) the speed with which
money is transported (4) community’s consumption and saving habits (5) expectation regarding future
incomes and prices of goods and services. Fisher pointed out that in economically backward countries; the
velocity of circulation of money was low. So in order to increase the velocity, people should not hoard their
savings but invest them in productive channels.
He assumed that M’ is fixed as bank reserve are kept in fixed definite ratio to bank deposit, and
individuals, firms and corporations maintain fairly stable ratio between their currency and deposit
balance. If the ration between M and M’ is temporarily disturbed certain factors automatically will
come into play to restore it. That is individual will deposit surplus cash or they disturb the relation
between M and M’ but only temporarily.
For him the sole effect of increase in quantity of money in circulation is to increase in prices. The
transmission mechanism of increase or decrease in M is by changing peoples desire to hold as a
specific quantity of cash balance in relation to their expenditure. The increase in the amount of cash
in the economy disturbs this optimum ratio causing individual to readjust their cash –to –
expenditure ratio by increasing expenditure. This added spending drive up the prices in the same
proportion as the increasing in cash in the economy.
Fisher’s quantity theories of money have been criticized. On many ground .Some of the criticisms
are: (1) It did not explain the changes in the value of money (2) The price level depends on certain
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non-monetary factors (3) The theory did not treat the problem dynamically. (4) The equation did not
differentiate between cash deposits and saving deposits, (5) the theory failed to explain the price
movements in war times.
A. Monetary policy
Like most monetarists, he believed that price fluctuations cause rather than result from business
fluctuations. Thus, stabilizing prices by controlling the quantity of money would eliminate the
business cycle. By strictly controlling the quantity of currency in circulation, the quantity theory of
money offers, a way to stabilize the overall price level and thereby stabilize the economy.
B. Currency Principle
Fisher suggested currency principle for the banks called “100 percent money”. The banks were
required to maintain 100 percent resources against deposits. They could not expand the currency
unless fully backed by cash. But this principle was certain practical difficulties in the
implementation.
C. Theory of Business Cycles
According to Fisher, the main cause for business fluctuations was the changes in credit. He said
business depressions were merely the “chances of the dollar”. Fisher suggested that in order to lift
the economy from depression prompt action in the form of reflation should be taken by central
bank.
1.4. The Neoclassical school: The departure from pure competition
Marshall’s system provided a framework for economic analysis in economics. It provided the
necessary basic ideas for refinements and advancement in economic analysis. In this connection,
we may mention the departure from pure competition (theories of imperfect competition). In
addition to classical pure competition, people came up with new analytical model which treat the
cases of imperfect competition. For instances, the work of Cournot on pure monopoly and duopoly
in 1838 and others.
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The concern in imperfect competition arose owing to three major factors. One was the gap in
economic theory between the pure competitive market model and monopoly. Marshal did not fully
address the market model between the two. The second was failure of pure competition theory to
explain the reality. The pure competition model was found to be applied only in few markets mainly
in agriculture. Even there the theory was becoming less suitable to economic conditions of the time
in area of farm products markets such as tobacco, meat, grain, milk, etc where few firms and buyers
are in the market. In addition, growing government intervention in agriculture reduced the general
usefulness of pure competition. Besides, many economists came to questions applicability of the
theory of the time industrial production and trade. The theory of perfect competition presupposes
many buyers and sellers dealing with homogenous products. But the products supplied were
differentiated in which producers have market power. Third, Marshal’s analysis posed a problem
when he came to deal with the determination of equilibrium of a competitive industry operating
under increasing returns in the long run.
Marshal viewed the economy in biological terms, or as an organic whole. In this economy, even
though the industry as a whole may retain its over all character, individual members of the industry
(the firms) would have a life cycle of its own. They would come into being, grow, become old,
decay and die. The new firms began with a number of diseconomies. But with passage of time they
gather strength and move on the path of increasing return scale. Later, however, these firms came to
be managed by non-energetic routine lover managements. These firms suffer from diseconomies as
compared to young competitors hence decay.
The argument in terms of increasing returns and competitive market in the long run are
incompatible with real world. Economists like chamberline, Robinson and Piero Sraffa criticized
Marshall’s contention than increasing returns and competition could go together. They forwarded
ideas of imperfect competitions that range between pure competition and monopoly. At about the
same time, after the publication of Joan Robinson’s and chamberlin’s works, other writers from
USA and England thrown up new ideas. Paul M.sweezy in United State and Hall and Hitch in
England came out with the theory of kinky demand curve. In this line oligopoly firm came in to
being. In the section that follow we will look contribution of these writers.
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D. Piero sraffa
Piero sraffa (1898- 1983), an Italian economist, studied under Marshall and was the editor of the
definitive edition of Ricardo’s collective works and correspondences.
Economic ideas
A. Non Ricardian value theory
Sraffa criticized the theory of pure competition and increasing returns to scale theory of neoclassical
school specifically that of Marshal. In 1960 he published book “Production of commodities by
means of commodities; A pertudes to a critique of Economic theory”. In this work he reconstructed
Ricardo’s production and value theory in a modern form. To him, the pattern of demand for various
products does not affect the pattern of prices, instead it affect only the scale of output in each
industry. The real value (prices) of goods depends on the shares of other commodities necessary to
produce them. Relative value (prices) and profits (if wages are given) are determined by the
production technique used to produce a composite standard commodity, which consists of the basic
commodities in the economy. These basic commodities are capital goods that appear as input and
outputs. The key feature of the composite standard commodity is that a change in either wages or
profit affects the inputs in the same way it affects outputs. The conclusion is that the level of
domestic output is entirely independent of how it is distributed between wages and profits. Any
distribution of wage and profits should be consistent with a particular level of output.
B. Theory of increasing returns to scale
P.Sraff with his article published in 1926 pointed out that costs of production may fall as firm
increases its scale of production. Unit cost may decrease with internal economies as the firms
expands output, or as overhead cost changes are distributed over larger number of output. This
theory of Sraff was incompatible with pure competition of neoclassical. If the firm becomes more
efficient as its size increases, there will be fewer firms and less competition.
Sraffs work explained the situation with the characteristics of monopoly. There are two conditions
which can break the purity of the market. First, single producers can affect market prices by varying
the quantity of goods it offers for sale. Second, each producer may engage in production under
circumstances of individual decreasing costs. Firms that have monopoly power lower its prices on
all units of output to increase its sales. It has then incentive to curtail its output to keep its prices,
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revenue, and profit high. Besides, as some firms’ experiences declining rather than rising average
costs, they can expand their scale of operations well beyond the small size that is consistent with
pure competition. This contradict with the traditional theory that foreword a firm’s expansion of
output is limited by rising costs/internal condition of productions in their firms/.
But for P.Staff, the chief obstacles do not lie in the cost of production, but in the difficulty of selling
the larger output without reducing prices or without having to face increased marketing expenses.
Each firm enjoys special advantages in its own protected segment of the total market. It would not
lose all its business if it raised its prices and it would not take away all of its rivals business if it
lowered its prices. Therefore, the firm enjoys certain monopoly element even in a market that
appear competitive, and the demand curve it faces slope down. Hence, a firm can lower its prices
there by increase its sales and profits.
II. Edward Hastings chamberlain /1899-2967/
He was born in Washington, and received his degree from the University of Iowa, and earned his
doctorate at Harvard. He wrote “the theory of monopolistic competition” in 1933. In this book he
sought to explain a range of market situations that are neither purely competitive nor totally
monopolistic.
Economic idea
A. The theory of monopolistic competition
Chamberline was nearer reality in his monopolistic competition. He considered imperfection in the
market in which each seller wants to acquire monopoly powers through product differentiation.
Product differentiation is the phenomena in which within the general class of goods, there exist
significant basis for distinguishing the goods and services of one sellers from those of others. But
the goods are close substitutes of each others.
There are two implications of product differentiation. First, each firm’s demand curve is down ward
sloping and hence marginal revenue curve must lie below the demand. Second, product
differentiation necessitates selling expenses. These are expense to advertising, transportation,
packaging etc. To chamberlain, selling expenses in terms of their effect on sales are subject to the
usual laws of increasing, proportionate and diminishing returns. That is, at the beginning, after a
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minimum of selling expense are incurred, there will be more than proportionate increase in sales.
This would be followed by a phases in which sales increase in the same proportionate as the selling
expenses. Then if we have the phases in which sales increasing less than proportionately. The
selling expenses have the effects of shifting the demand curve up and to the right as it increase cost
and hence prices. Chamberline also investigated optimization aspect in monopolistic competition.
The basic principle for objective function optimization/maximization is the same as with pure
competition. Equilibrium is attained at the point where marginal revenue is equal to marginal cost.
B. Excess capacity with monopolistic competition
Chamberlines significant conclusions were that price is inevitably higher and scale of production
inevitably smaller under monopolistic competition than under pure competitions. The result is
excess productive capacity for which there is no automatic corrective. This excess capacity may
develop over long periods with impunity, prices always covering costs, and may become normal
and permanent through a failure of price competition to function.
The excess capacity of monopolistic competition results in higher prices and wastes in economic
welfare in the system. The waste usually referred to as waste of competitions”. This excess
capacity is typical feature in monopolistic competition market, and it is not there under pure
competition. For Chamberline monopolistic competition results in a number of variations of each of
general product, thus enabling consumers to better fulfill their diverse taster. Thus, it provides
positive benefits associated with product variety.
III. Joan Robinson/1903-1983/
Robinson was student of A.Marshall and professor of economics at Cambridge University. She
published book entitled “The Economics of imperfect competition” in 1933 a few month after
chamberlin’s work. She also offered a significant critique of Marxian economics. Robinson made
important contributions in Keynesian and post Keynesian economics in relation to economic
development and international trade. Some of her economic ideas are as follows.
Economic ideas
Monopsony
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Robinson developed monopolistic competition theory. She also added the idea of monopsony: a
situation in which there is either a single buyer in a market or a group acting as one. She analyzed
the outcomes of monopsony buying power in product and resources markets.
1.5 JOHN GUSTAV KNUT WICKSELL (1851-1926)
The Stockholm school also known as the Swedish school founded by Knut Wicksell. E. Lindahl,
B.Ohlin and Gunnar Myrdal were the most illustrious members. The school had its influence in the
Scandinavian countries. Wicksell was the founder of the Swedish School of Economics. He studied
the economic theories of Mill, Karl Menger and Bohm-Bawerk for five years. After obtaining his
Ph.D. degree in 1895, he became the professor of Economics at University of Lund. Wicksell’s
main writings were: Interest and Prices (1898), Value, Capital and Rent (1893), studies in Finance
Theory (1896), Lectures on Political Economy Vol. I & Vol. 11(1906). “Value, capital and Interest”
contains Wicksell’s theories of value and distribution. “Studies in Finance Theory” shows his views
on public finance and “Interest and Prices” deals with his views regarding the relationship between
rate of interest and price level. “Lectures on Political Economy” is a systematic restatement of the
theories of value and distribution and price level.
His Economic ideas
MAIN IDEAS
A. Political economy
Wicksell used the term ‘Political Economy” in a wider sense. It was considered both as a theoretical
and practical science. As a theoretical science, it is a statement of economic laws, based on simple
assumptions. As a practical science, it examines the question of application of these laws to solve
practical problems of real life. It deals with economic policy and its effectiveness in solving real
social economic problems.
B. Competition
Wicksell considered perfect competition as good as far as it leads to an optimum allocation of
resources and reduces the prices of commodities to its marginal cost. Further more, under this form
of market, the rewards of the productive factors should be determined according to their marginal
productivity. At the same time, Wicksell felt that the welfare of the society depends on an equal
distribution of income and wealth if everything is left to the market. In this regard he welcomed
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state-intervention.
C. Economic Policy
Even though most of Wicksell’s writings contained theoretical analysis, he had a definite attitude
towards economic policy. He was a strong socialist. He was of the opinion that the welfare oriented
economic policy must aim for (a) an optimum allocation and full utilization of resources and (b)
equality of income, wealth and economic opportunities. For achieving these, he suggested a
‘revolutionary programme’ should be adopted. This programme includes (a) expansion of public
sector (b) development of trade union, movement and extension of free education facilities and (c)
introduction of progressive tax system and reduction of excise and tariff duties.
D. Production and Distribution
Wicksell in his theory of production analyzed only three factors of production-land, labor and
capital. He left the fourth factor of production namely, organization due to difficulties of
quantitative measurement. Like Bohm-Bawerk, Wicksell also regarded capital as a product of
cooperation of the two original factors-labor and land. Wicksell presented a general marginal
productivity theory of distribution. According to this theory, the reward of each factor of
production is determined according to the marginal productivity of that factor.All the factors of
production are subject to the law of diminishing returns. But Wicksell defined wrongly the law of
diminishing returns. It was considered to be a matter of diminishing average rather than marginal
returns.
E. Theory of Capital
To Wicksell capital was not a separate factor of production rather intermediate good used in
production. Capital is stored up labor and land, or stored up productive power. It is separated from
the current labor and land through time element. In a simple model, we may say that the stored up
land and labor of the previous years are used up with the current supply of labor and land. And out
of the current years resources a part must be saved up for the next year’s capital if continuity is to
be maintained. Now there is a difference between the marginal productivity of current year’s land
and labor and that of the previous years. This difference in productivity, according to Bohm-
Bawerk was due to the time element. But in Wicksell this time element operates through relative
marginal productivities which differ on account of the relative supplies of capital or productive
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power. In the current period, current supply of labor and land is abundant relative to that of stored
up labor and land. The marginal productivity of saved up labor and land is therefore more than the
marginal productivity of current labor and land. Interest in its pure form is this difference though it
may also be taken as the marginal productivity of waiting. Capital received remuneration for its services
in the form of interest. Thus interest was the difference between the value of annual product and profit plus
payment for land and labor. Wicksell distinguished between natural rate of interest and bank rate of interest.
The natural rate was that rate at which the demand for capital and supply of savings are equal. In other
words, at the natural rate of interest, savings and investment would be equal.
F. The Wicksell Effect
The Wicksell effect demonstrated Von Thunon’s marginal productivity principle, which is applicable to
labor and land. Only at the micro level and not at the macro level. At the macro level, when capital increases,
the marginal productivity of capital declines and real savings is absorbed in rising real wages and rent. Thus,
the social marginal productivity of capital is smaller than the rate of interest. However, at the micro level, the
marginal productivity of capital is equal to the rate of interest.
G. Cumulative Process
Wicksell criticized the traditional quantity theory of money and attempted to explain its method of
operation through the cumulative process. Cumulative process is a state of disequilibrium in which
a discrepancy arises between the natural rate of interest and market rate of interest. If the natural
rate of interest is more than the market rate, investment will be more than savings and there will be
a cumulative rise in prices. On the other hand, if natural rate is less than the market rate, investment
will be less than savings and there will be a cumulative fall in prices.
H. Trade Cycle
Wicksell regarded trade cycle as real phenomena, and not a monetary one. According to him the
main cause for trade cycle is the changes in investment and not in prices. In trade cycle theory, the
important contribution of Wicksell is the idea that, “technical progress does not increase in perfect
simultaneously with the increase in population”
Wicksell tried his best to respond for the question why prices collectively rise or fall? To answer this
question, he turned to an analysis of interest rates. He has distinguished between normal rate and the bank
rate. The money (market) rate is to be conceived as the average of rates at which banks are
advancing loans to the potential investors. The natural rate is the measure of expected yield on new
investment, which is therefore equivalent of the marginal efficiency of capital in Keynes and
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marginal productivity of capital in Bohm- Bawerk. Wicksell uses the difference between natural
and money rates of interest for explaining the movement in prices in the economy.
The normal or natural rate of interest depends on supply and demand for real capital that is not yet invested.
The supply of capital flows from those who postpone consuming part of their income and there by
accumulate wealth. The demand for capital depends on the profit that can be realized from its or marginal
productivity. The interaction between demand and supply determines the natural interest rate. The natural or
normal rate of interest applies only to credit between individuals.
Bank rate may be either greater than or less than normal rate.
If Bank rate less than natural rate, saving will be discouraged, and demand for consumption goods and
services will rise. Simultaneously, entrepreneurs will seek more capital investments because of greater net
profit to be realized as the cost of borrowing money falls. This lead to rise in income accrues to workers, land
owners, owners of raw materials, which leads to a rise in price level. If for example, market rate is less
than natural rate, it leads to a greater total expenditure or demand in the economy and prices move
up. The market rate may be kept low, through creation of bank credit or through dishoarding and the
inflationary price rise may be fed on them.
On the other hand, if bank rate of interest is above the natural rate, prices will fall. Because, saving will
increase, and investment spending will decline. The decline in investment will reduce national income, which
will in turn causes the price of consumer good to decline.If these two rates are not equal in the market, a
disequilibria results and a process of adjustment starts.
I. Savings and Investment
Wicksell considers the equality between savings and investment in ex-ante sense. Accordingly, if
savings exceed investment, income is reduced, consumption falls and so do the prices. Just the
opposite would happen if savings fall short of investment. Wicksell believed that this relative
position between savings and investment could be regulated by the use of bank rate. Assuming that
the bank rates sets the level of other market rates of interest, it follows that by keeping the market
rates sufficiently low, investment can be stimulated while savings would be discouraged. Similarly,
a high bank rate should lead to an access of savings over investment. And through trial and error an
equilibrating rate can also be chosen. Wicksell therefore, integrated interest, savings and investment
in his theory and imparted dynamism to it.
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J. Monetary Policy Monetary authorities can play an important role in price stability by changing the bank rate. In order to
equate the market rate and natural rate of interest, bank rate can be manipulated.
Assessment
Wicksell occupies an important position in the history of economics thought. He was not only
provided a representative synthesis of the existing economic thought but also established a ‘School’
on the strength of his economic reasoning and laying the foundations along new lines of
exploration. He was a contemporary of the economists who were making a revolution in economics
through marginalism. Though he covered a wide area in economics theory, he is better known for
his contribution in the fields of capital interest, monetary theory and economic fluctuations.
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Chapter 2: Heterodox Economic Thought
2.1 Early critics’ of neoclassical school of thought
Neoclassical economics is methodologically individualist and tries to rest explanations of
aggregate phenomena on micro foundations of individual behavior. Arguably, a
“macroeconomics is irrelevant. But coherence exists at a higher level of integration than at
individual level.
The treatment of Labor as a regular commodity and erasure(removal) of the labor/labor power
distinction Portrayal of the modern economy as a barter economy
The misuse of Ceteris Paribus (i.e. the holding constant of factors that logically vary when the
target variable is changed, such as the level of aggregate demand when wages fall)
The derivation of real world conclusions from idealized models without rigorous theoretical or
empirical argument.
Failure to acknowledge the difficulties involved with empirical demonstration of neoclassical
claims and misleading assurances that the texts’ conclusions rest on more or less indisputable
empirical results.
Failure to acknowledge well-known problems with neoclassical capital theory.
Use of questionable analogies to make theoretical claims and public policy recommendations.
Interesting things here is the oft repeated claim that because two people benefit from
exchange, so must two nations. The argument ignores distributional issues, the implications of
path dependency, problems of the second best, social externalities, and so on.
The assumptions of general equilibrium theory: Homo Economicus (rational, isolated, self-
interested man), Perfect Information, Perfect Competition, and Says Law (permanent full
employment) is not realistic.
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2.2 The development of Modern Heterodox school
Heterodox is usually defined in reference to orthodox, meaning to be “against orthodox” or non-
orthodox and defines itself in terms of what it is not, rather than what it is. An economist who sees
him or herself as heterodox does not subscribe to the current orthodox school of thought, as defined
by the historian’s classifications.
Heterodox include the following alternative economics:
• Keynesian economics / post-Keynesian economics
• Marxian economics / neo-Marxian economics
• Structuralist economics
• Institutionalist economics
• Ricardian economics
• Feminist economics
Key characteristics found in the writings of heterodox economists
1. Methodology (rather than just method) is important to understand economics.
2. Human actors are social and less than perfectly rational, driven by habits, routines, culture
and tradition.
3. Economic systems are complex, evolving and unpredictable – and consequently equilibrium
models should be viewed skeptically (doubt accepted opinions).
4. While theories of the individual are useful, so are theories of aggregate or collective
outcomes. Further, neither the individual nor the aggregate can be understood in isolation
from the other.
5. History and time are important.
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6. All economic theories are fallible (capable of making mistake) and there is contemporary
(originating at the same time) relevance (appropriate to the matter in hand) of the history of
thought to understanding economics.
7. Pluralism, i.e. multiple perspectives (particular evaluation of something), is advocated
8. Formal mathematical and statistical methods should be removed from their perceived
position as the supreme method – but not abandoned – and supplemented by other methods
and data types.
9. Facts and values are inseparable.
10. Power is an important determinant of economic outcomes.
Heterodox economists as distinct from Neoclassical economics:
• Do not propose that “capitalism” (i.e. “the free market system”) is an ultimately perfect
system of organizing society;
• Unlike neoclassical economists they criticize the shortcomings of the market system to
various degrees;
• Call for government intervention to overcome these shortcomings;
• Emphasize political, social, cultural, historical, structural and institutional factors that
interplay with economic factors.
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CHAPTER THREE: WELFARE ECONOMICS
3.1 INTRODUCTION
Welfare economics analyzes social welfare. Social welfare refers to the overall welfare of society.
Individuals are the basic units for social welfare as there is no "social welfare" apart from the
"welfare" associated with its individual units. With sufficiently strong assumptions, it can be
specified as the summation of the welfare of all the individuals in the society. It uses
microeconomic techniques to simultaneously determine allocative efficiency within an economy
and the income distribution associated with it. Welfare may be measured either cardinally in terms
of "utils" or dollars, or measured ordially in terms of ranking of preferences.
Welfare economics have been evolved over time starting from Adam Smith up to now. There are
many aspect of welfere. One aspect of welfare economics typically takes individual preferences as
given and stipulates a welfare improvement in Pareto efficiency terms from social state A to social
state B if at least one person prefers B and no one else opposes it. There is no requirement of a
unique quantitative measure of the welfare improvement implied by this. Another aspect of welfare
treats income/goods distribution, including equality, as a further dimension of welfare. In this chapter
we deal with welfare economics; more specifically, basic principles of welfare maximaization,
contributions Pigou, Pareto, and others.
3.2. Historical evolution of welfare economics
Concern for social welfare were there in the world starting from ancient period. For instance, the
question as to what exactly was a "good society"? Had figured prominently in the minds of
economists at least since Aristotle and it was not easy to resolve. Historical treatment of welfare
economics began with the classical economists like Smith, Bentham, and others. Classical writers
regarded political economy as a science which deals with valuable things or economic goods (with
wealth). While defining economics as a science of wealth, they proceeded to assert that wealth
promotes the economic welfare of man and that economics should be essentially concerned with
welfare or at least material wellbeing. This peculiar idea of welfare was challenged by later
economists in course. Several subsequent economists of neoclassical like Marshal dealt with the
welfare aspects. Concern about the relationship between the competitive market system and social
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welfare dates back centuries. Of particular concern was whether the outcome of a market economy
as a "good" outcome. The classical economists emphasized production, supply and costs, the
welfare economists lay stress on consumption, utility and demand. England is the home of the
welfare economics, which was a direct refutation of classical economics, especially the laissez-faire
doctrine.
With growth of capitalism the operation of economy in area of production, employment, prices,
economic growths etc were found to be at sub- optimal level. In area of production, employment,
prical, rate of capital accumulation economic growth, reginonal balance and distribution of wealth
and so on. These diverse dimensions are interrelated. Classical economics ignores the
interdependence of diverse dimension of economy and concentrate on one dimension at a time. To
solve these corrective actions were needed and proposed in diverse sphere of the economy were not
effective. With the marginalist the wealth concept and new dimensions of economic ideas that
focus on marginal utility and utility were forwarded. Broadening of the economics of wealth into
economics of welfare was actually effected by the marginal utility school which rejected the
classical wealth oriented definition of economics. Welfare economics has been described as a
tendency to modify the classical doctrines and to make economics to deal with social policies,
directed towards achieving the goal of social welfare. Many of the early Marginalists, like Hermann
Heinrich Gossen (1854), were so entranced by the concept of utility in their economics that they
naturally fell into the trap of arguing that the market yielded this social optimum. According to
Reder, welfare economics is ‘the branch of economic science that attempts to establish and apply
criteria of propriety to economic policies.’
The 20th
Century welfare economics is realistic and pragmatic. Alfred Marshall has been regarded
as the founder of welfare economics. He provided the concepts of consumer’s surplus and
producers’ surplus. He also maintained a policy to augments the two were desirable. It has been
developed further by a host of writers including Henry Clay, R.G Hawtrey, Edgeworth, Vilfredo
Pareto, J. A. Hobson and A.C Pigou.
However with the advancement of capitalism in Western Europe and America economist started
branching in to two distinct lines. On one hand the imperfections of the capitalist system of
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economy were recognized. Scholar started evaluating imperfection with reference to the generally
accepted morns. They seek to pin-point specific causes of maladies (including inequalities of
income and wealth) and to suggest remedial actions which don’t entail changing the basic structure
of the economy including its institutions and productions relations. They did not advocate state
intervention and / or modification of the basic production relationships.
On the other hand, economic analyses tend to become more and more abstract and pure in which the
emphasis was given on the positive dimension of economics. Positive economics tended to judge
the allocation of productive resource as optimum and the working condition of the economy as the
best possible. It conformed to the model of competitive markets and laissez- faire. No value
judgments were expected to be expressed and therefore no policy conclusion was to be drawn.
However, this positive economic found it difficult to keep the normative aspect out of picture.
Modern welfare economics also proceeds along similar lines. Jeremy Bentham and the
utilitarianians had set the dominant interpretation in the late 18th and early 19th centuries. He had
provided a subjective standard for estimating the aggregate satisfaction in the society. This
approach obviously assumed measurability of utility and interpersonal comparison of thereof. It was
also hedonistic in nature as it assume all utility was pleasure and all disutility was pain. For them,
the best criterion for any policy would be to provide the greatest happiness for the greatest number
of people. The social optimum was thus quickly defined as the allocation where the sum of
individual utilities is greatest. Equity became one of the big topics of discussion: by the principle of
diminishing marginal utility, a dollar is worth less to a rich man than it is to the poor, thus an
egalitarian redistribution of income was called for. Of course, this raised the question of what
"equity" meant anyway -- equitable in utility, equitable in income or equitable in means to
income? Furthermore, there was the question of a trade-off between social equity and the
efficiency of an economy. John Stuart Mill (1848) eloquently argued that income could be
redistributed without sacrificing efficiency.
Emphasis of welfare by welfare economists received fillip only after the World War I, mainly
because of the increasing inequalities and the existence of poverty amidst plenty. However, classical
economic thought had maintained that economic welfare would be optimized if the market
mechanism is allowed to function with out intervention - the basic classic position.
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Only in the 1920s a fully self-conscious welfare theory began to be written. This self-consciousness
about its distinct character and even the name welfare economics are due to Arthur Cecil Pigou.
His great book “The Economics of Welfare” was the beginnings of fully self-conscious welfare
analysis. History of economics thought considers views of Pareto as originator of welfare
economics “new welfare economics”, which is rooted in Walra’s general equilibrium.
The "unholy alliance" between neoclassical economics and Benthamite social philosophy persisted
well into the 20th Century. The main problem, of course, is that the utilitarian calculations require
that one must, one way or another, compare utility levels across people. Vilfredo Pareto had
vociferously opposed this notion, arguing that utility was merely an ordinal representation of
personal preferences between consumption bundles. Not only does the "number of utils" not matter
for utility representation for a single person, but they are certainly not available for adding or
comparing across people. This is why he refused to use the term "utility" and replaced it with
"ophelimity".
3.3. Approaches of welfare economics
There are two mainstream approaches to welfare economics: the old neoclassical approach and the
new welfare economics approach. The early neoclassical approach was developed by Edgeworth,
Sidgwick, Marshall, and Pigou. It assumes that:
Utility is cardinal, that is, scale-measurable by observation or judgment.
Preference is exogenously given and stable.
Additional consumption provides smaller and smaller increases in utility (diminishing
marginal utility).
All individuals have interpersonally comparable utility functions.
With these assumptions, it is possible to construct a social welfare function simply by summing all
the individual utility functions. Old welfare economics contained a significant utilitarian (the
doctrine that value is measured in terms of usefulness) heritage: Economists assumed individual
utilities could be summed to calculate total utility in society, and it was accepted to compare the
utility of one individual to that of another.
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3.3.1. Early Neo classical approaches
3.3.1.1. Sidgwick( 1838-1900)
He was among the first to mention the divergence between private and social products. He wrote “principle
of political economy”. In his work he challenged (put reservation) that an individual’s claim to wealth is not
always the exact equivalence of his net contribution to society (social product). He argues that there may be
externalities (positive or negative) associated with economic activities of individuals. Positive externalities
are activities that yield benefit to others for which the individual is not paid. On the other hand, negative
externalities are activities that impose costs on others for which the individual is not charged. He pointed out
the possibility & significance of the divergence. Therefore, he argued, government intervention is necessary
if such divergence prevails.
3.3.1.2. Alfred Marshall (1842-1924)
After Sidgwick, Marshall also raised the possibility & significance of divergence between private & social
product. This possibility, according to him, is associated with the cases of long run increasing & decreasing
cost industries. He argued that there may be a need for government intervention to correct these
divergences. His analysis was based on two assumptions:
1. Marginal utility of real money is constant, implying that demand is independent of income
(only substitution effect is recognized).
2. Utility is measurable (can be quantified) – cardinal utility.
He believed, at equilibrium, .....PYMUyPxMUx This implies the traditional equi-marginal
equilibrium theory. Nevertheless, his contribution was on partial welfare analysis.
3.3.1.3 ARTHUR CECIL PIGOU
Son of an army officer, A.C. Pigou was born in 1877 and educated at Harrow and King's College,
Cambridge. He compiled a brilliant record that included numerous prizes. Pigou was a prominent
member of the Cambridge school and faithful pupil of Marshall. He was Marshall’s student and teacher
of J.M. Keynes. After Marshall, he became the leading neo classical economist. He was the founder of
Welfare Economics. His leading ideas on welfare economics were found in his “Economics of Welfare”
(1920). Prof Pigou popularized the word of welfare and gave a concrete meaning to it. In his book, Pigou
dealt with three things: (1) a definition of economic welfare (2) spelling out the condition under which
welfare is maximized and (3) pronouncement of policy recommendations for increasing welfare.
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He may be credited with establishing a scientific welfare economics. He was the first to put the whole thing
about welfare in to a system. He shifted on to the consideration of national welfare with reference to social
marginal cost and social marginal benefit. He had also suggested that the problem of unemployment could be
solved through the manipulation of wages; but, later on, he appeared to be much nearer to Keynes when he
suggests the manipulation of investment for combating unemployment. For him, the chief aim of economic
science will be unrealistic.
A. Definition of economic welfare
Pigou carried on in Marshall’s tradition with the same attitude, but he was more abstract and
mathematical. Marshall and others had provided what may be called case-to-case studies and the
areas where there was a need for state intervention for improving the welfare of the society. Pigou
was the first to put the whole thing into systems. Like Marshall, Pigou felt that the study of
economics could be justified only as a means of improving human society. Building upon the base
of Marshallian economics, he set out modifying, expanding, and adapting the apparatus so that it
could be directly applied to the exploration of ways and means by which social intervention would
yield benefits in terms of economic welfare.
Pigou carefully analyzed the competitive economic system to find how it falls short of the ideal and
the means by which the ideal can be achieved. Social welfare is the summation of all individual welfare
in a society. He regards social welfare as a sum of individual welfares which depend upon a balance
between individual satisfactions and dissatisfactions. Individual welfare is capable of measurement
through choices expressed in money payments. Thus, he regards welfare as a psychic good rather
than the mere accumulation of material things. He defined individual welfare as the sum of satisfactions
obtained from the use of goods and services. Since general welfare is very wide and complicated, he limited
his study to economic welfare. He defined economic welfare as that part of social welfare “that can be
brought directly or indirectly into relation with the measuring rod of money.” Economic welfare depends
upon the size, the manner of distribution, and the variability of the national dividend.
B. Condition for maximization of social welfare
According to Marshall, the national income represents the general welfare, but Pigou believes that
welfare is not only dependent on the size of the nation’s income but also on the equality of its
distribution, i.e. the more the equality of the distribution of income the higher will be the level of
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welfare. According to him, economic welfare is generally proportional to the size of the national
income, provided the dividend accruing to the poor is not diminished.
Prof Pigou had a dual criterion for detecting the increase in social welfare. First, he measured the
economic welfare of the society in money value and thus, given the supply of resources, an increase
in national dividend meant an increase in social welfare. The other words, Pigou’s concept of
economic welfare is that part of social welfare that can be brought directly or indirectly into relation
with the measuring rod of money. Economic welfare is generally proportional to the size of the
national income, provided the dividend accruing to the poor is not diminished. While advocating, in
the interest of economic welfare, he argued that the state should protect the interests of the poor the
transfer of purchasing power from the rich to the poor. He favored an income equalization policy
and therefore, reorganization of the economy to increases the share of the poor without offsetting
adversely “productive effort enterprise and development of capital equipment was to be taken as a
gain in social welfare.”
Coming to the division of national dividend between members of the society, Pigou makes a
qualified statement that a shift towards equality should enhance economic welfare. In this
connection he first proceeds on the assumption that income enjoying capacity of all the members of
the society is the same. Hence, obviously a reduction in inequalities would increase economic
welfare. But he then refers to the typical objection that some races have low income enjoying
capacity even within a society, the poorer sections may not know what to do with increased income
and may spend the same wastefully and to their disadvantage. Pigou, however, believes that the
solution of this problem is to redistribute income in those manners which would not be quickly
perceived by the poorer sections through price reductions or the process may be completed rather
slowly which would allow the poorer sections to acquire more of income-enjoying capacity.
Similarly, the government may provide more of public goods and “merit goods” which would
naturally enhance their total enjoyment.
He lays down two conditions for the maximizations of welfare: (i) given the taste and income distribution, an
increase in national income represents an increase in welfare. (ii) For welfare maximization, the distribution
of national income is equally important. If national income remains constant, transfer of income from rich to
the poor would improve welfare. With income subject to diminishing marginal utility, transfers of income
from the rich to the poor will increase social welfare by satisfying the more intense wants of the poor. Thus it
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is economic equality that maximizes welfare
C. Difference between social and private benefit and cost
The central concept of his analysis was the distinction between private and social net product
private product being the product that accrues to the individual making a decision concerning
production. Social net product being the net product that accrues to society as a result of the
decision. In a competitive economy, decisions are made in such a way as to maximize private net
product but not necessarily social net product. Appropriate taxes and subsidies could, however,
make private and social net products equal, thus leading each individual to behave in a way that
maximizes social welfare.
The presence of external effects in production was seen by Pigou in the divergence between social
net product and private net product. He defined social net product “as the aggregate contribution
made to the national dividend” and the private net product as the contribution which is capable of
being sold and the proceeds added to the earnings of the person responsible for investment. The
divergence between the two products shows itself in the form of external effects of production
associated with marginal increments of output. In some cases social net product is more than the
private product while in others private product is greater than the social product.
As an illustration he cited the fact that the smoke rising from the chimneys of private factory spoils
the atmosphere of the locality and increases the laundry bills of the people of the neighborhood. But
people are not compensated in any way by the factory owner. He was of the opinion that the state
should equalize the private net product with social net product. If in industry where private net
product is more, it should be taxed and if another industry shows a lesser private net product ought
to be subsidized. Prof Pigou recognized the divergence between private net product and social net
products cannot always be quantified and measured in terms of money.
Pigou has made a distinction between private and social costs. The private marginal, cost of a commodity is
the cost of producing an additional unit. The social marginal cost is the expense or damage to society as a
consequence of producing that commodity. Private marginal benefit can be measured by the selling price of
the commodity. Social marginal benefit refers to the total benefit that society gets from the production of an
additional unit. By making a distinction between social and private valuations of economic activity, he paved
the way for the analysis of external effects or externalities in social welfare economics.
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Pigou lists three groups of divergence between social and private costs and benefits.
1. There is the fact that the tenancy and ownership of certain durable instruments of production
are in effect separated from each other. When the ownership of the instruments of
production is of someone else, the tenant would not use the instruments properly or maintain
them or improve them. This would therefore lead to a less than socially desirable
investment.
2. The source of divergence between social and private measures of marginal benefits may be
put in terms of what we now call the public goods to the principle of exclusion. It means that
in the case of roads, the beneficiaries cannot be fully, identified, and even if they cannot be
charged for the benefits. Similarly, in the case of certain cost or disadvantages, the sufferers
cannot recover damages from the producers. Actually in a number of goods, elements of
externalities exists which can assigned to individuals.
3. Pigou also talks of the elasticity of demand which these specific goods and the criterions as
to whether their consumption is to be encouraged or discouraged. For instance, in case of
increasing returns industries, investment will be less than socially desirable if the elasticity
of demand is high and if consumption is desirable. In such a situation, these industries shot
subsidized.
Prof. Pigou made the first attempt to lay down conditions of social optimum which he termed “the ideal
output” of the economic system as a whole. In his view, the social optimum prevails when marginal social
products are equal in all industries and thus production of real wealth is maximized. Assuming that all the
productive resources are being employed and that there is no cost of movement between different
occupations and places, it can be concluded that the national dividend is the largest when the values of the
marginal net products are equal in all industries. If this arrangement prevails, the society is having its” ideal
output”.
Pigou built his analysis based on the following assumptions like what Marshall did: These were; cardinal
measurement of utility, equal income enjoying capacity of individuals under the same circumstance,
possibility of inter-personal comparison of utility as also possible for commodity, that the society’s welfare
is the sum total of individual welfares. Pigou also believed that the marginal utility of income falls as
money income increases. As a result, the marginal utility of an additional to the income of a poor
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man is compared to the loss of utility from the loss of the same are of income to a rich man.
Their difference lies mainly on the fact that while Marshall’s welfare economics analysis runs in terms of
partial equilibrium in the form of consumers’ surplus and producers’ surplus. Pigou, considered total
welfare. For this, his rule is that the allocation of resources & their utilization in different employments
should be such as to lead to equality between social marginal benefit & social marginal cost. (SMB = SMC).
The crucial thing in Pigou’s analysis here is that, left to it self, the economy is likely to allocate its resources
in a manner different from the one where the marginal social benefit & marginal social cost would be
equated in each line of employment. These divergences ought to be remedied through fiscal & other policies.
He emphasized the fact that the economic system as viewed by the classical & neo classical economists was
not a friction-free phenomenon and these frictions were major sources of the need for state intervention. That
is, for the achievement of this goal of equality of social marginal cost and social marginal benefit, he has
suggested government intervention.
He has suggested that economic welfare could be increased by the transfer of income/purchasing power from
the rich to the poor. Because the transfer of income from a relatively rich man to relatively poor man of a
similar temperament enables more intense wants to be satisfied at the expense of less intense wants. This will
increase the aggregate sum of satisfactions. Therefore, any cause which increases the absolute share of the
real income in the hands of the poor, provided that it does not lead to a contraction in the size of the national
dividend from any point of view, will, in general increase economic welfare..
According to Pigou, ‘Welfare economics is that part of social welfare that can be brought directly or
indirectly in to relation with the measuring role of money.’ Economic welfare is generally proportional to the
size of national income, ‘provided the dividend accruing to the poor is not diminished, increase in the size of
the aggregate national dividend, if they occur in isolation without anything else whatever happening must
involve increases in economic welfare.’ While advocating, in the interest of economic welfare that the state
should protect the interests of the poor, he has suggested that economic welfare could be increased by the
transfer of purchasing power from the rich to the poor. He introduced the concepts of private net products
and social net products. According to him, private net product is ‘the contribution, that is capable of being
sold and the proceeds added to the earnings of the person responsible for the unit of investment,’ while the
social net product is ‘the aggregate contribution made to the national dividend.’ His treatment of short and
long-term effects of government intervention on the distribution of national dividend is quite interesting.
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Evaluation
Pigou provided the first systematic theoretical base of welfare economics and integrated the normative
problems with positive ones. He provided a rationale for state intervention where private and social
net product diverged. But his policy recommendations were all value based. Though Pigous
Economics of Welfare was the first clear analysis of welfare economics, yet the Pigovian conditions
of welfare have been criticized on the following grounds. Pigou lays emphasis on the maximization
of welfare, but he does not clarify the notion of maximization. Pigovian assumption of equal capacity
for satisfaction is scientifically untenable. This represents a broad value judgment favor of equal distribution
of wealth. The capacity for satisfaction of any individual is a subjective thing incapable of “objective
quantification”. Another trouble with Pigovian welfare economics, is the lack of rig our and
operational content in the distinction between private and social products. Pigou seems to have
assumed that the divergence between the two is not inherent in the working of the free enterprise
system. It is traceable to and can be corrected through governmental intervention. In the real world,
structural failures resulting from immobility, indivisibility and imperfect knowledge are so
numerous as to defy correction through social action. The classification of general welfare into
economic’ and ‘non-economic welfare has also hence criticized as too superficial to be made the
basis of all welfare analysis.
The most destructive criticism of the Pigovian welfare economics was the unrealistic nature of the
assumptions of cardinal additively of the individual utility functions to get the social welfare functions.
Economists do not agree with this view because quantitative measurement of utility is not possible. Pigous
welfare conditions are related to national income. But it is not easy to calculate national income.
Again, social welfare does not increase by mere increase in national income. It is possible that
national income may increase due to inflationary rise in prices and poor may become worse off than
before. Welfare economics is closely related to ethic does not clarify it. Welfare economics is
essentially study in which value judgments and inter personal comparisons are made. By not
relating these concepts with his welfare, Pigous economics of welfare is not considering objective
study of the causes of welfare.
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3.4.1.4 Wilfred Pareto Pereto was born in Paris to Italian parents. He studied at the University of Turin in Italy, and later accepted
the chair as professor of economics at the University of Laussanne, Switzerland. There he studied and
expanded the mathematical traditions established by his processor Walras.
A. Pareto Optimality
Pareto refined Walras’s general equilibrium and set forth the conditions for maximum welfare. Paretian
welfare economics assumes that everyone is the best judge of his own interests and that this welfare
depends upon economic variables only and there are no externalities involved in the process.
Maximum welfare, said Pareto, occurs when there are no longer any changes that will make someone better
off while making no one worse off. This implies that society cannot rearrange the allocation of resources or
the distribution of goods and services in such a way that it aids someone without harming someone else. The
Pareto optimum thus implies: optimal distribution of goods among consumers; optimal technical allocation
of resources, and optimal quantities of outputs. Paretian welfare economics rests on the assumed value
judgment that, if a particular change in the economy leaves at least one individual better off and no
individual worse off, social welfare may be said to have increased.
We can demonstrate these conditions by supposing the existence of simple economy containing two
consumers (smith and Green), two products (hamburger and potato), and two resources (labor and capital).
According to Pareto, the following are the conditions of this optimum:
1. Optimal distribution of goods: The marginal rate of substitution between any two commodities
must be the same for any pair of owners of the same two commodities. The optimal distribution of
goods occurs where smith and Green each have identical marginal rate substitution between the two
goods. We express this symbolically as, MRShpS=MRShpG where MRShpS and MRShpG are smith’s
and Green’s MRS of hamburger for potatoes.
2. Optimal technical allocation of resources: The marginal rate of transformation between any factor
and any product must be the same for any pair of producers using the factors and producing the
product. In our two goods, two resources example, and the optimum allocation of resources to
productive uses will occur where the marginal rate of technical substitution between labor and
capital in the production of hamburger and potatoes are equal. This second condition for Pareto
optimality can be shown symbolically as, MRTSLKH=MRTSLKP, where MRTSLKH and MRTSLKP
are the marginal rate of technical substitution labor for capital in the production of hamburger and
potatoes respectively.
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3. Optimal quantities of output: The marginal rate of substitution between any pair of factors
must be the same for any two producers using both, in producing a given product. If
production and distribution meet the conditions of Pareto optimality, then optimum level of
output will be achieved where the marginal rate of substitution of hamburger for potatoes
equals the marginal rate of transformation (MRT) of potatoes for hamburger. This is the rate
at which it is technically possible to transform potatoes in to hamburger. Symbolically,
MRShp=MRTph.
Efficiency
Many economists use Pareto efficiency as their efficiency goal. According to this measure of social
welfare, a situation is optimal only if no individuals can be made better off without making
someone else worse off. This ideal state of affairs can only come about if four criteria are met: The
marginal rates of substitution in consumption are identical for all consumers. This occurs when no
consumer can be made better off without making others worse off. The marginal rate of
transformation in production is identical for all products. This occurs when it is impossible to
increase the production of any good without reducing the production of other goods. The marginal
resource cost is equal to the marginal revenue product for all production processes. This takes place
when marginal physical product of a factor must be the same for all firms producing a good. The
marginal rates of substitution in consumption are equal to the marginal rates of transformation in
production. These are where production processes must match consumer wants.
There are a number of conditions that, most economists agree, may lead to inefficiency. They
include: imperfect market structures, such as a monopoly, monopsony, oligopoly, oligopsony, and
monopolistic competition, factor allocation inefficiencies in production theory basics, market
failures and externalities; there is also social cost, imperfect Price discrimination and price
skimming, asymmetric information, principal-agent problems, long run declining average costs in a
natural monopoly, certain types of taxes and tariffs.
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Assessment
Pareto did much to help economists better understand the conditions for, and the welfare significance of
economic efficiency. However, the central Pareto criterion, “does a change makes someone better off while
making no one worse off?” is not well suited for evaluating public policies. In addition the Pareto criterion
has the following limitations; it fails to address the issue of distributive justice; it is based on static
view of efficiency; it has conflict with social moral values; it is against public policies; his theory failed to
recognize that his definition of optimum distribution of income admitted of a multiple (instead of a
unique) solution. It also leaves out the case where the loss of losers (on account of redistribution of
income) is smaller than the gain to gainers.
3.3.1.5 J.A. Hobson (1858–1940)
Hobson was a prolific writer. He wrote voluminously on issues like inequalities, injustices and
maladjustment of economic society under capitalism. He was also a social reformer. Unlike the
classical economists, he held that competition was often imperfect, and that in the absence of
effective demand, market gluts often occurred. Hobson regarded economics as a qualitative science
of human values. He considered individual welfare as an organic whole which could hardly be
explained in terms of marginal increment of specific commodities. His important works include;
‘The Economics of Distribution,’ ‘The Industrial System,’ ‘Work and Wealth: A Human
Valuations,’ and ‘Economics of Unemployment.’
His economic ideas
A. Criticism of the Classical Economics
Hobson criticized the classical economics on the score of individualism and competition. According to him,
the assumption of free competition is no longer valid. He held that the quantitative approach of the classical
economists was improper and the market price was no index to welfare. By welfare he meant good life. In his
opinion, the entire analysis of the classical economists with its emphasis on production was defective, since it
undermined the importance of consumption. He said that production is meant for consumption, and, hence it
was subordinate to consumption. The result of this wrong approach regarding the relationship between
production and consumption is that an important economic field is left ill-explored. He thought that
economics must be studied from the welfare point of view. To him economic life was a network of business
and trades, but thoughts desires and relation were its spiritual texture. According to him, there are three
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defects in classical economics; an exaggerated stress upon production, reflected in the terminology and
method of the science, with a corresponding neglect of consumption; a standard of values which has no
consistent relation to human welfare; and mechanical conception of the economic system due to the
treatment of other human action as a means to the production of non-humanly valued wealth.
B. Reconstruction of Economic science
Hobson’s attempt to reconstruct economic science appears to be more important than his other contributions.
He wanted to make ‘welfare’ the center of economics, instead of the analysis of value and price, which
according to him was unreal. It is the goal towards which all his writings lead.
Hobson has divided all productive activity into seven classes: art, invention, professional service,
organization, management, labor and savings. He has tried to show that in each of these categories costs and
utility differ. Whereas in each of these activities, economic costs are incurred, there may be activities in
which the human costs may be nil. In short, he concludes that persons receiving the highest pay in society
incur the lowest cost. In laboring class occupations, workers get physically tired. They get involved into
accidents and other nervous disorders. Their energy is dissipated and their morale is very much lowered
down. Again, unemployment and intermittent employment further adds to human costs and force women and
children to take up employment. Further the modern industry, owing to its disruptive and discriminatory
tendencies also increase human costs of production. To him, it is necessary that while determining the values
emanating from the industrial system, human costs must be set against the utilities derived.
C. Social Reforms
For Hobson, despite industrial progress, material welfare has not increased. He, therefore, holds that for
better distribution, intervention by the state is essential. He desired that the costs of production should be
distributed according to the ability of individuals to bear them and commodities should be allotted according
to the capacity of the individual to derive utility from them. Thus, he proposes social reform through
equitable distribution of the surplus produced under scientific process of production on the basis: ‘from each
in accordance with his ability and to each in accordance with his needs.’ He, therefore, suggests the
establishment of social control. Under his scheme, artistic activity and experimental industries should be let
free. New industries would be subject only to laws relating to minimum wages and high taxation of profits.
Professions would be parts of the governmental service. Public utility industries and those tending to
monopolistic position would be socialized. Thus, he proposes a happy blending of freedom and control,
supported by wage and other social legislation.
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E. Evaluation
Hobson’s analysis has been a subject of severe criticism at the hands of professional economists. It
has been pointed out that Hobson failed to provide us with a criterion for the measurement of
human costs. His reform proposal based on the measurement of human welfare can not be adopted
in case the measurement is not possible. Similarly, his contention that the man who enjoys his work
should be paid less than a man who does not enjoy his work. Despite the weakness in Hobsonian
analysis, he was undoubtedly one of the important inspirations to Keynes.
Criticisms
Some, such as economists in the tradition of the Austrian School, doubt whether a cardinal utility
function, or cardinal social welfare function, is of any value. The reason given is that it is difficult to
aggregate the utilities of various people that have differing marginal utility of money, such as the
wealthy and the poor. Also, the economists of the Austrian School question the relevance of pareto
optimal allocation considering situations where the framework of means and ends is not perfectly
known, since neoclassical theory always assumes that the ends-means framework is perfectly
defined. Some even question the value of crdinal utility functions. They have proposed other means
of measuring well-being as an alternative to price indices, "willingness to pay" functions, and other
price oriented measures. These price based measures are seen as promoting consumerism and
productivism by many. It should be noted that it is possible to do welfare economics without the use
of prices, however this is not always done. Value assumptions explicit in the social welfare
function used and implicit in the efficiency criterion chosen make welfare economics a highly
normative and subjective field. This can make it controversial.
3.3.1 New Welfare Economics
A new type of welfare economics quite different from that developed by Pigou and his followers
Vilfredo Pareto and others. Paretian optimality came to the forefront in which optimum decision of
income is the one from which none can gain additional utility or satisfaction through a redistribution
with out some one losing some utility in the process. The Paretian tide of the 1930s rolled in on the
back of the Hicks-Allen ordinal utility function, where the "number of utils" is not clearly a number
at all, much less one that can be ascertained and manipulated by an external observer. This was
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taken up as a direct assault on the old English utilitarianian tradition that had been kept alive by
Arthur C. Pigou and the Cambridge Marshallians. This stand was further refined to bring in a
distinction between efficiency and equity dimensions of redistribution. It has further been extended
by Edgeworth, Hicks, Kaldor, Barone, Scitovsky, etc. The new welfare economics is normative in
character and is free from value judgments and utility measurement.
The one thing that distinguishes “new” from “old” welfare economics is the search for welfare
propositions that do not rest on interpersonal comparisons of utility, happiness or well-being.
NWE emerged in the 1930's as Robbins (1932) argued that interpersonal comparisons of utility are
essentially normative and unscientific. Robbins' critique had a great impact, and old welfare
economics with interpersonal comparisons was transformed into new welfare economics without
interpersonal comparisons. Robbins' main argument was that ''introspection does not enable A to
measure what is going on in B's mind, nor B to measure what is going on in A's.'' He dismissed
cardinal utility outright and argued that the Pigovian defense of "equal capacities for satisfaction"
was not based on any "scientific" fact. Robbins went on to argue that, consequently, social welfare
should not be a subject of economic study at all. As utility is not comparable across individuals,
then the choice of social optimum is necessarily a normative concern, a value judgment and thus it
is not within the scope of economic "science". Economics "is incapable of deciding as between the
desirability of different ends. It is fundamentally distinct from Ethics.". The Paretian welfare
theorems, which rest comfortably on ordinal utility, was deemed the only acceptable criterion.
The Robbins argument troubled some contemporaries. Roy Harrod posed the question as to
whether Robbins' argument would allow any policy recommendations at all. As long as somebody
suffers from a policy measure, Harrod argued, the Pareto-improvement criteria (everyone better off,
nobody made worse off) does not apply and thus, by Robbins's argument, economists are not in a
position to judge such a measure. There are very few, if any instances, where a policy proposal is
clearly Pareto-improving. Harrod proposed an interesting exercise to Robbins: how would one
defend policy measures long advocated by economists, such as the repeal of the Corn Laws or free
trade? "If the incomparability of utility to different individuals is strictly pressed, not only are the
prescriptions of the welfare school ruled out, but all prescriptions whatever. The economist as an
advisor is completely stultified" (Harrod, 1938).
48
His conclusion was that ''There is no way of comparing the satisfactions of two different people''.
However, many Paretians, as could be expected, were dissatisfied Robbins's conclusion and
launched the "New Welfare Economics" movement in 1930s. New Welfare Economics accepted
the argument that utility is not comparable across people, but nonetheless thought that welfare
judgements could nonetheless be made by appropriate modifications of the concept of Pareto-
optimality. Roughly speaking, the Robbinsian, the Harvard, the LSE and the Distributist positions
were the four sides involved in the debate over the New Welfare Economics that raged for over a
decade in the 1940s, a debate whose terms and tone changed considerably after Kenneth J. Arrow's
famous "Impossibility Theorem" (Arrow, 1951). We take up first the L.S.E. theory, and consider
the Harvard theory later. We treat Arrow's theory elsewhere
We can divine two strains of New Welfare Economics, which we shall call the "Harvard" and the
"L.S.E." positions, respectively. The "Harvard" position is associated mainly with Abram Bergson
(1938) and Paul Samuelson (1938, 1947, 1950). Roughly, the Harvard position accepts that
individual utilities are not comparable and also accepts Robbins's contention that the choice of
social optimum is a normative issue. However, unlike Robbins, it does not accept that it lies outside
the purview of economics.
The "L.S.E." position, expounded by Nicholas Kaldor (1939), John Hicks (1939) and Tibor
Scitovsky (1941), is a bit braver. Again, it accepts that individual utilities are not comparable, yet it
does not regard social choice as a normative issue, but rather a clearly positive one. All that is
necessary is to construct the proper criteria for comparison of social situations which does not
involve value judgments of any sort, that one can make the same welfare conclusions regardless of
whether "one is a liberal or a socialist, a nationalist or an internationalist, a christian or a pagan"
(Hicks, 1939).
As it turned out, welfare economics without interpersonal comparisons was still a potent school of
thought. There are three objectives of the new welfare economics:
a. To clarify and express in terms of quantity the vague concepts of riches;
49
b. To clarify what it is that the economists have to say on matters of public policy which are, from the
economic point of view, desirable or not; and
c. To develop those propositions which are scientifically free from ethical considerations and which can
serve as a basis for policy making.
Regarding the first objective economists says that economics is primarily concerned with the material and
immaterial commodities which are produced, distributed, exchanged and consumed, and not with man as a
producer, distributor, exchanger and consumer. In this sense the economic welfare in a country would
increase proportionally with an increase in the national income. The second objective is concerned, it relates
to the social optimum, which is the centre of gravity of welfare economics. By social optimum is meant the
maximum social utility which can be had by adding the utilities of all individuals. With regard the third
objective it includes the following: All taxes should be as far as possible non-marginal or in the form of lump
sum. There should be a perfect market, that is, a market in which price is the same for all individuals. In such
a situation all individuals would be in a position to maximize their profits or satisfaction; and conditions of
social optimum can be fulfilled only under a system of well-planned socialism and not under capitalism in
which the conditions of perfect competition do not exist.
The new welfare economics approach is based on the work of Hicks, and Kaldor. They explicitly
recognize the differences between the efficiency part of the discipline and the distribution part and
treat them differently. Questions of efficiency are assessed with criteria of as Pareto efficiency and
the Kaldor-Hicks compensation tests, while questions of income distribution are covered in social
welfare function specification.
Below is a brief description of the central concepts, tools and results in NWE: Ordinal preferences,
indifference curves, the Edgeworth box, Pareto efficiency and the two fundamental theorems of
welfare economics, the Kaldor-Hicks compensation criteria and the Bergson-Samuelson social
welfare function.
50
3.3.2.1 Basic assumptions and tools to new welfare economics.
I. Ordinal preferences and indifference curves
NWE rests on the assumption of rational preferences. The notion of rationality here essentially only
states that preferences are complete and transitive. Completeness means that for pair-wise
comparisons of all available alternatives, an individual can always state which alternative s/he
prefers the most or state that she is indifferent between the two. Transitivity means that if the
individual prefers alternative a to alternative b, and b to c, then she must also prefer a to c. Rational
preferences can be described by a utility function u, so that u(x) > u(y) if and only if x is preferred
to y. Thus, in NWE the utility function is not a measure of well-being, happiness or welfare: it only
describes the order in which an individual ranks different alternatives.
A graphical way of illustrating preferences is by using indifference curves. Mathematically, these
are the level curves of the utility function. The indifference curve separates preferred from less
preferred alternatives, and the name comes from the fact that the individual is indifferent between
all the alternatives that lie exactly on the curve. An important assumption often made is that
preferences are convex.
II. The Edgeworth box, Pareto efficiency and the two fundamental theorems of
Welfare economics
The Edgeworth box (also known as the exchange box) is a central tool in NWE and it is used in
almost every modern textbook in Economics. It illustrates all possible allocations of two goods
among two individuals whose preferences are illustrated with indifference curves drawn in the box.
Any point in the box represents an allocation of the two goods between the two individuals. Given
any initial allocation of the two goods, it may be possible for both individuals to engage in
voluntary exchange in order to improve their situation. For some allocations, it is not possible to
reach preferred allocations through voluntary exchange. These allocations are called Pareto efficient
or Pareto optimal. The contract curve connects all Pareto efficient allocations. There are drawbacks
of the Edgeworth box, as is the case with all simplified models. Notably, the analysis is static and
there are no transaction costs. On the other hand, the analysis can be generalized to an economy
51
with a large number of consumers and a large number of goods. It can also be extended to
incorporate a production technology that converts certain goods (inputs) to other goods (outputs).
In the two-dimensional version the Edgeworth-box is often used to illustrate the two fundamental
theorems of welfare economics: The first theorem states that any competitive equilibrium is Pareto
efficient.
The second theorem states that any Pareto efficient equilibrium can be reached through an
appropriate redistribution of the initial endowments. Note that both theorems require a number of
assumptions to hold, the second theorem being the more demanding, as it requires convex
preferences and that the production technology does not exhibit increasing returns to scale.
However, the two theorems do not require interpersonal comparisons of utility.
A policy is said to pass the Pareto criterion if it raises the utility of at least one individual without
rendering anyone worse off in terms of utility. Equipped with only the Pareto criterion and the two
theorems, economists are handicapped in two ways. First of all, there may be several allocations
that are all Pareto efficient but no criterion regarding how to chose between these allocations.
There are many combinations of consumer utility, production mixes, and factor input combinations
consistent with efficiency. In fact, there is infinity of consumer and production equilibria that yield
Pareto optimal results. There are as many optima as there are points on the aggregate production
possibilities frontier. Hence, Pareto efficiency is a necessary, but not a sufficient condition for social
welfare. Each Pareto optimum corresponds to a different income distribution in the economy. Some
may involve great inequalities of income. So how do we decide which Pareto optimum is most
desirable? This decision is made, either tacitly or overtly, when we specify the social welfare
function. This function embodies value judgements about interpersonal utility. The social welfare
function is a way of mathematically stating the relative importance of the individuals that comprise
society.
A utilitarian welfare function (also called a Benthamite welfare function) sums the utility of each
individual in order to obtain society's overall welfare. All people are treated the same, regardless of
52
their initial level of utility. One extra unit of utility for a starving person is not seen to be of any
greater value than an extra unit of utility for a millionaire. At the other extreme is the Max-Min, or
Rawlsian John Rawls utility function. According to the Max-Min criterion, welfare is maximized
when the utility of those society members that have the least is the greatest. No economic activity
will increase social welfare unless it improves the position of the society member that is the worst
off. Most economists specify social welfare functions that are intermediate between these two
extremes.
The social welfare function is typically translated into social indifference curves so that they can be
used in the same graphic space as the other functions that they interact with. A utilitarian social
indifference curve is linear and downward sloping to the right. The Max-Min social indifference
curve takes the shape of two straight lines joined so as they form a 90 degree angle. A social
indifference curve drawn from an intermediate social welfare function is a curve that slopes
downward to the right.
The intermediate form of social indifference curve can be interpreted as showing that as inequality
increases, a larger improvement in the utility of relatively rich individuals is needed to compensate
for the loss in utility of relatively poor individuals. A crude social welfare function can be
constructed by measuring the subjective dollar value of goods and services distributed to
participants in the economy.
Secondly, strict Paretian economics can not advocate policies where some individuals are worse off
as a result of the policy. Most actual situations that economist must analyze involve choosing
53
between policies that result in some people being worse off, and thus the Pareto criterion is violated.
For example, mainstream economists today advocate abandoning the common agricultural policy
(CAP) in the European Union. This advice does however not rest on the Pareto criteria. Even if
consumers worldwide and producers outside the EU would benefit from a free trade oriented policy,
it is a fact that there are producers inside the union that would be losers if such a policy were to be
carried out. These two problems illustrate the weakness of the Pareto criterion. This weakness
spawned two different schools of thought in NWE: The Kaldor-Hicks position and the Bergson-
Samuelson position, dealt with in the next section.
3.3.2.2. The Kaldor-Hicks compensation criterion and the Bergson-Samuelson
social welfare function
The Kaldor-Hicks approach to NWE (also called the LSE-position, from London School of
Economics) attempted to show that the choice of social optimum was a positive question rather than
a normative. To determine whether an activity is moving the economy towards Pareto efficiency,
two compensation tests have been developed. Any change usually makes some people better off
while making others worse off, so these tests ask what would happen if the winners were to
compensate the losers. The original Kaldor-criterion amounted to saying that a change that does not
pass the Pareto criteria should still be carried out if it is possible for the gainers from the change to
compensate the losers, and still be better off them selves. Pareto’s stand was modified to say that
income distribution becomes more efficient if, through redistribution, gainers gain more than is the loss of
the losers; in that case the gainers can compensate the losers and still be better off. This had been known as
the Kaldor principle. That is, Kaldor argued in favor of ignoring the equity dimension by pointing out that
the economist should leave the equity decision to the state/legislature. He said that if the gainers can
potentially compensate the losers and still gain after redistribution, the redistribution is welfare enhancing.
Later on, this compensation principle was modified and it was pointed out that the gainers need not actually
compensate the losers.
Hicks proposed a slightly different version, according to which a change should be carried out if it
is impossible for the losers to bribe the winners to abstain from the change. Using the Kaldor
criterion, an activity will contribute to Pareto optimality if the maximum amount the gainers are
prepared to pay is greater than the minimum amount that the losers are prepared to accept. Under
the Hicks criterion, an activity will contribute to Pareto optimality if the maximum amount the
54
losers are prepared to offer to the gainers in order to prevent the change is less than the minimum
amount the gainers are prepared to accept as a bribe to forgo the change. The Hicks compensation
test is from the losers' point of view, while the Kaldor compensation test is from the gainers' point
of view. If both conditions are satisfied, both gainers and losers will agree that the proposed activity
will move the economy toward Pareto optimality. This is referred to as Kaldor-Hicks efficiency or
the Scitovsky criterion.
Seemingly, the compensation criterion solved the problem of for example not being able to
advocate abandoning trade barriers: If the gain from free trade is large enough, the winners can
potentially compensate the losers. Whether compensation actually should take place or not is
strictly a matter of politics, not economics, according to this view. Little (1950) pointed out that if
the possibility of hypothetical compensation is enough to pass a certain policy, then the Kaldor-
Hicks criterion collapses into favoring policies that increase total real income regardless of
distributive considerations. Thus, the compensation criteria expanded the set of acceptable policies
without making the Pareto-criterion any more specific, resulting in increased rather than decreased
indeterminacy.
3.3.2.3. Bergson-Samuelson approach to new welfare economics
The Bergson-Samuelson branch of NWE (sometimes referred to as the Harvard-position) was more
successful in establishing criteria for a social optimum, but also used a more controversial method:
the social welfare function (SWF), introduced by Abram Bergson (1938). It is written
W = f( u, u2, u3…….un )
Social welfare W depends only on the utilities of the n individuals in society (u1... un). The SWF
assigns a value to each possible distribution of individual utilities in society. Depending on the
functional form, the social welfare function will exhibit different normative characteristics. A
particularly convenient form based on the Atkinson (1970) inequality index is
1
11
1
n
i
i
W u
55
Where ρ can vary from 0 to ∞. This specification allows for varying degrees of inequality aversion.
For ρ=0 we get the pure utilitarian case, where society's utility is the sum of all individuals' utility.
As ρ approaches infinity, we get W = min(u1,...,un). It should be noted that neither Bergson nor
Samuelson was clear about the extent to which the SWF requires interpersonal comparisons of
utility. This changed during the debate that followed Arrow's famous theorem, first presented in
Arrow (1951) and then again in Arrow (1963). Arrows result proved the impossibility of
aggregating individual preferences into collective preferences under surprisingly weak conditions.
The reaction from the Bergson-Samuelson school was that this result had no implications for
welfare economics. However, the debate that followed the theorem made it (more or less) clear that
the Bergson-Samuelson SWF must either make interpersonal comparisons or be dictatorial.
However, the utilitarianian did not just evaporate and die but were given a new coat a point and
relabeled as the "Distributists". Ian M.D. Little led the charge against New Welfare Economics.
Specifically, Little argued that individual utilities are comparable in a scientific manner, and thus
the choice of social optimum is a positive issue which economists should, indeed must, analyze.
Little's basic argument, reiterated by Dennis H. Robertson (1950, 1951), is almost "behaviorist" in
tone. We need not worry so much about "utility and all that" but concentrate instead on things we
can empirically see, such as people's reactions to income. We can safely say that a dollar to a poor
man means more than a dollar to rich man. This does not rely on "interpersonal comparisons of
utility" in a formal sense, but it is plain common sense, i.e. an empirically-validated hypothesis.
We should also mention that the old utilitarian "stochastic argument" for equity, that had been
forwarded earlier by Edgeworth was reiterated by Abba P. Lerner (1944: p.24-32). Admittedly,
Lerner argued, we do not know what people's "capacities for satisfaction" are, and thus we have no
way of compare the utility gains of one person with the utility losses of another from a proposed
policy. However, the statistical expression for the term "we do not know" translates itself into
saying that every alternative is equally likely. This is Laplace's principle of indifference.
Consequently, as we do not have any reason to assume Mr. A has a greater capacity for satisfaction
than Mrs. B, then we can do no better than to assume they have equal capacities for satisfaction. It
is in this manner, then, that Lerner drives us right back into the arms of Pigouvian welfare theory
and his famous result that "if it is desired to maximize the total satisfaction in a society, the rational
56
procedure is to divide income on an egalitarian basis" (Lerner, 1944: p.32). [for a critique of Lerner,
see Milton Friedman (1947)].
Finally, we should mention that the Oskar Lange (1936, 1938) and Abba Lerner (1934) also
resurrected the old Pareto-Barone position on the efficiency of a socialist society thus reigniting the
"Socialist Calculation debate" with the Austrian economists.
57
CHPTER 4: THE KEYNESIAN AND POST KEYNESIAN SCHOOL OF THOUGHT
4.1 Keynesian School of thought
Introduction
The Keynesian system of ideas is one of the most significant schools of economic thought in 20th
century. The school begun with the publication of “General theory of Employment, Interest and
Money” of Marald Keynes in 1936, and remains a major thought in orthodox economics today. It
arouses out of the condition of the time such as great depression and failure of the neo classical
school theories. Keynes idea succeeded in short time, in revolutionarizing the entire thinking
process in economics. For this reason it is termed as “Keynesian Revolution”. It is also called as
“New economics” because he integrated the economy as incorporating both physical and monetary
aspects. Further more; he introduced the techniques of presenting economy in terms of international
income and employment and the determinant of demand and supply functions rather than individual
price determination.
The school was criticizing many of principles and theories of neo-classical thought. Keynesian
economics advocates a mixed economy; predominantly private sector, but with a large role of
government and public sector. The school argues that private sector decisions sometimes lead to
inefficient macroeconomic outcomes and hence advocates active policy responses by state. The
policy response includes monetary policy actions by the central bank and fiscal policy actions by
the government with the major emphasis on the latter.
The school of thought served as economic model during the latter part of the Great Depression,
World War II, and the Post-War Golden Age of Capitalism, 1945–1970, though it lost some
influence following the stagflation of the 1970s. As a middle way between laissez-faire capitalism
and socialism, it has been and attacked from both the right and the left. In this chapter, we will see
the works of Keynes and basic historical background of the Keynesian thought.
58
The historical background of the school
Keynesian economic thought was the product of empirical changes experienced from the time of
Adm Smith to early 20th
century mainly the great depression and intellectual works ,which includes
among other, works of Smith, Ricardo, socialist writers, Mitchell, Marginalist writers and
neoclassical writers. The American as well as the world economy was ragged downturn as a result
of many factors before and after 1929. More specifically, the situation of World War I, growth of
large scale industrial production in Western, declining trend in productivity of capital, intense
competition, government intervention schemes and economic conditions during depression, and so
on.
Over a century firms grew to large scale industries and industrial production, and trade. With
growth of industries, competition became intense. The competitions reduced return on the rate of
replacements of old machine with new and better once. As a result of these additional investments
were low and there were growing accumulated deprecations fund from the past investments over
time as they were not spent quickly enough. Further more, the mature private enterprise economies
of the Western World were not growing at a faster rate (rate expected) owing to declining rate of
growth of population, absence of rooms for further geographical expansion as most of the areas
were already colonized. As a result production appeared to outrun consumption as income and
saving rose. It made the economy more susceptible to statistical measurement and control, making
the inductive aggregate approach more feasible than in the past.
On the other hand, in the economies of the Western there were declining trend in huge productive
investments especially in area of infrastructures. There were no new inventions and innovations as
there were loss of incentives. Further more, there were decline in productive investment in
productive sectors like steam engine, the rail road, electricity, automobile that stimulate new and
vast capital investments and induce growth in other sectors of the economy. Besides, WWI
destructed many countries of the Western world. Those war destructed countries of the world
adopted mechanism to rehabilitate their economy through government interventions. The
government interventions enacted recovered economies of those countries necessitated looking at an
overall view of the economy.
59
The Great Depression of the 1930s was the longest, most widespread, and deepest depression of the
20th century that had been experienced by western world and then propagated to the rest of the
world. The Great Depression had devastating effects in virtually every country, rich and poor. But
it drastically affected the economies of USA, Chile, France, Germany, Japan, Latin America,
Netherlands, South Africa, Soviet Union, Canada, Australia, etc. The timing of the Great
Depression varied across nations, but in most countries it started around 1929 and lasted until the
late 1930s or early 1940s.
There were disagreement as to the cause and effects of Great Depressions by scholars: economists,
historians, and scholars. According to historians, the decline in the US economy was the factor that
pulled down most other countries at first, and then internal weaknesses or strengths in each country
made conditions worse or better. Historians most often attribute the start of the Great Depression to
the sudden and total collapse of US stock market prices on October 29th, 1929, known as Black
Tuesday and it was quickly spread to almost every country in the world. There were multiple causes
for the first downturn in 1929, including the structural weaknesses and specific events that turned it
into a major depression and the way in which the downturn spread from country to country.
However, some dispute this conclusion, and believe the stock crash as a symptom, rather than a
cause of the Great Depression. Beginning in the summer of 1930, a severe drought ravaged the
agricultural heartland of the USA.
As a result of series problems, by mid-1930, consumer spending, many of whom had suffered
severe losses in the stock market in the previous year, cut back their expenditures by ten percent;
automobile sales had declined to levels below the 1928. Investments were depressed as interest
rates had dropped to low levels as there was reluctance on the side people to add new debt by
borrowing. Prices in general began to decline, but wages held steady. Farming and rural areas
suffered crop prices fall by approximately 60 percent. Further more, unemployment in the United
States rose to 25% and in some countries rose as high as 33%. Cities all around the world were hit
hard; especially those depend on heavy industry. Construction was virtually halted in many
countries. Conditions were worse in farming areas, where commodity prices plunged and in mining
and logging areas, where unemployment was high and where there were few other jobs. Facing
60
plummeting demand with few alternate sources of jobs areas dependent on primary sector industries
such as cash cropping, mining and logging suffered the most.
Similar situations and economic activities were experienced by other countries mainly in Western
World. For instance, France, Germany. In general in almost all countries as a result of depression
personal expenditure declined, unemployment increased, Poss of incentive on part of business on
productive investment, tax revenue declined, profits and prices dropped, and international trade
plunged by half to two-thirds. Frantic attempts to shore up the economies of individual nations
through protectionist policies, such as the 1930 U.S. Smoot-Hawley Tariff Act and retaliatory tariffs
in other countries exacerbated the collapse in global trade.
People question the neoclassical economic thought on actual observations and historical studies.
Many scholars proposed government interventions through public work programs, deficit budgets
for the federal government, easing of credit by the Federal Reserve System. British economist, John
Maynard Keynes, provided the scientific analytical framework. He wrote a book entitled “The
general Theory of Employment, Interest and Money” in 1936. Rejecting classical approach
Keynes held the view that mal-adjustment in economic system of a country was a normal feature
which lead the national economy to the ravages of trade cycle. He argued that lower aggregate
expenditures in the economy contributed to a massive decline in income and employment that was
well below the average. In such a situation, the economy reached equilibrium at low levels of
economic activity and high unemployment. For the smooth and uninterrupted functioning of the
national economy, he suggested state intervention. More specifically, during times of economic
crisis to pick up the slack by increasing government spending and/or cutting taxes.
Different countries of the world adopted and implemented the policies recommendations of Keynes
and hence recovered their economy. Countries started to recover by the mid-1930s, but in many
countries the negative effects of the Great Depression lasted until the start of World War II. The
common view among economic historians was that the Great Depression ended with the advent of
World War II when nations increased their expenditure on production of war materials. Many
economists believed that government spending on the war caused or at least accelerated recovery
from the Great Depression. The massive armament policies leading up to war helped countries
61
stimulate their economies from 1937-39. In Europe for instance, by 1937 unemployment in Britain
had fallen to 1.5 million. The mobilization of manpower following the outbreak of war in 1939
finally ended unemployment. In the United States, massive war spending doubled economic growth
rates, either masking the effects of the depression or finally eliminated the last effects of the great
depression and brought the unemployment rate down below 10%.
Many factors legitimize the Keynesian economics during this period. One was the advancement in
technology that transformed the nature of economics from theoretical to quantitative helped
Keynesian policies recommendation and complementation. The other was development of national
income accounting (NIA) methods that made economists to get access to macroeconomic data on
output, employment and prices, in addition to the traditional data on interest rate and money supply.
Moreover, the methods devised to compute NIA were based on aggregate quantities of
consumption, investments, and government spending suggested by Keynes. Besides, expansion in
computer sciences and power enabled economists to formally test some of the hypothesis suggested
by Keynes in a more rigorous ways.
Keynes biography
He was born in 1883 in Cambridge, England, to Florence Ada Keynes and John Neville Keynes.
His father was a distinguished writer on political economy and logic, and for many years the
registrar of the Cambridge University. Keynes graduated from Cambridge University in 1905 in the
Mathematical Tripos and then he entered the Indian civil service. In 1909, he became a fellow at
King’s College where he started teaching economics in Marshallian tradition. In 1912, he was
chosen editor of the economic journal and shouldered his responsibility till his death. He was the
leader of the British delegation to the Bretton Woods Conference in 1944 and served as a Governor
of the J.B.R.D. and I.M.F. He served his country in various capacities. In appreciation of his
services to the nation; his government made him the first Baron of Tilton in 1942.
Keynes contributes a lot to the development of economic thought especially after the occurrence of
Great Depression. His publications include: Indian Currency and Finance (1913), The Economic
consequences of the peace (1919), A Treatise on probability (1921), A Revision of the Treaty
(1922), A Tract on Monetary Reform (1923), A Short view of Russia (1925), The Economic
consequence of Mr. Churchill (1925), The End of Laissez Faire (1926), A Treatise on Money
62
(1930), Essays in Persuasion (1931), Essay in Biography (1933), The Means to Prosperity (1933),
The General Theory of Employment, Interest and Money (1936), and How to Pay for the War
(1940). Besides he wrote about 300 articles and about 50 reviews on official and non-official
reports.
He revolutionized economics with his classic book. With the pretentious title of “The General
Theory of Employment, Interest and Money”. Heavily anticipated, cheaply priced and
propitiously timed for a world caught in the grips of the Great Depression. The General Theory
made a splash in both academic and political circles. This is generally regarded as probably the
most influential social science treatise of the 20th
Century. The General Theory is a monumental
work and can easily be grouped with Smith’s “Wealth of Nations”. It has been truly remembered
that “no book in economics has ever made such a stir within the first ten years of its publication as
has the General Theory”.
The general theory of Employment
The most important theory of Keynes was the theory of employment. Keynes criticized and rejected
the classical theory of employment which denied the existence of unemployment or over production
in the economy. The starting point of Keynesian theory of employment is the concept of effective
demand. According to Keynes employment depends on effective demand and hence unemployment
is due to lack of effective demand.
Interest and money
According to Keynes, interest is the reward for parting with liquidity. Liquidity preference is the
preference of the people to keep their assets in the form of money. He argued that saving and
investment are not the main determinants of interest rates, especially in the short run. According to
him, the rate of interest is determined by the supply of money (Central Bank of a Country) and the
demand for money (liquidity preference due to transaction, precautionary and speculative motives).
63
Keynes developed the liquidity preference theory of interest according to which liquidity preference
and supply of money determines the rate of interest.
THEORY OF MONEY AND PRICES
The classical economists had rigidly separated the monetary theory from the general economic
theory. For them, the monetary theory was only the theory of prices. According to them, monetary
expansion led straight to an increase in the price level, without affecting out put, and employment in
existence. It is on this account that they established a direct link between monetary expansion and
the price level. The same thought were there with Keynes before 1930s. Keynesian analysis of price
is quite close to classical analysis. They agree with the orthodox views that increase in the quantity
of money in circulation leads to an increase in the price.
It was in 1930 that his old conception of the monetary theory underwent a change. From a monetary
theory of prices, he shifted to a monetary theory of output. He reformulated quantity theory and
spotlighted the process of causation and the factors determining the value. Keynes has differed from
traditional economists in the process through which this effort is caused. Keynes tried to fill the gap.
He pointed out that there existed only an indirect relationship between price and the quantity of
money. The changes in the quantity of money are influenced by the rate of interest, which in turn,
affected investment, income, output and prices. Monetary expansion led first to an increase in the
output. As the output continues to expand, certain new factors come into existence which leads to a
rise in costs. The rise in costs due to the inelastic supply of certain factors of production. The net
result is that a successful integration of the quantity theory of money with the theory of output and
the theory of value.
According to him, the finding out of the exact process through which the quantity of money affects
the price level, would involve the following measures;
a) Finding the relation between money and aggregate demand
b) Assessing the effect of changes in aggregate demand on output and
c) Taking into account, the change in the wage rates.
Increase in the supply of money is likely to increase the availability of funds to a certain extent, for
64
speculative purposes. An increase in money supply tends to lower the rate of interest and increase
the demand for investment, which ultimately leads to an increase in income, employment and
output. This increased output can only be possible at an increasing cost beyond a contain point.
Wages form the most important constituent of the cost of production. During the period of
expanding output, labor will become increasingly scarce and the wage rates will be depending on
the bargaining capacity of the laborers.
It may be possible that a change in money wage rates may cause a change in the investment. Neo-
classical theory supports that the two main costs that shift demand and supply are wage and money.
Through the distribution of the monetary policy, demand and supply can be adjusted. If there were
more labor than demand for it, wages would fall until hiring began again. If wage rate decline, the
rate of real investment can be affected in three Ways: in the first instance, affect the business
confidence. The individual businessmen may think that a cut in the money wage rate reduces their
costs. On the other hand, a cut in wage rates and prices increase the real burden of the debt of the
entrepreneurs. A cut will stimulate demand for exports and lead to increased consumption of home
goods as compared to foreign goods. This would result in an increase in the real investment and
finally in the real income and total employment in the currently. Similarly, the marginal efficiency
of capital is not changed by a change in money wage rate.
A rise in money wage rates would lead to an opposite situation. It may be possible that these effects
may be neutralized by corresponding change in the wage rates of exchange rates in other countries.
A change in the money wage rates, prices and money incomes brings out a change in the demand
for cash balances for transportation purpose, in the same direction. If the quantity of money in
circulation remains the same, a reduction in the money wage rates would leave a larger supply of
money to satisfy the demand for cash balances. The rate of interest would fall and thus, the rate of
real investment would increase. Like wise, an increase in money rate would increase the interest
rate and diminish the rate of real investment. This is how Keynes could justify the relationship
between money wage rates in a closed economy.
The problem of greater depression was differently interpreted by classical and Keynesian .To
classical theory, economic collapse as simply a lost incentive to produce. To Keynes, the
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determination of wages is more complicated. First, he argued that it is not real but nominal wages
that are set in negotiations between employers and workers, as opposed to a barter relationship.
Second, nominal wage cuts would be difficult to put into effect because of laws and wage contracts.
Even classical economists admitted that these exist. However, to Keynes, people will resist nominal
wage reductions, even without unions, until they see other wages falling and a general fall of prices.
Keynes also argued that to boost employment, real wages had to go down: nominal wages would
have to fall more than prices. However, doing so would reduce consumer demand, so that the
aggregate demand for goods would drop. This would in turn reduce business sales revenues and
expected profits. Investment in new plants and equipment already discouraged by previous excesses
and would then become more risky, less likely. Instead of raising business expectations, wage cuts
could make matters much worse. Further, if wages and prices were falling, people would start to
expect them to fall. This could make the economy spiral downward as those who had money would
simply wait as falling prices made it more valuable rather than spending.
MULTIPLIER
The concept of multiplier was first developed by R.F. Kahn. Keynes borrowed this concept from
him and developed income and investment multiplier. To him, investment multiplier expresses the
relationship between an initial increase in investment and the final increase in national income.
Multiplier is the ratio of a change in investment to change in income. That is K= I/Y and, where
Y= income, K= multiplier I= investment. The value of multiplier depends on marginal propensity to
consume. The ratio between an increment of investment and the resultant increment of the total
income, the creation of one gives rise to a number of waves. Similarly, in economy each injection of
money gives rise to a series of new money. The multiplier is, thus, a number by which the increase
in investment must be multiplied in order to give the resulting increase in income. If investment of
Birr 1 causes an increase in the total income by Birr.3, then the multiplier is 3. In case the increased
income amount to Br 2 is the multiplier is 2. Thus multiplier, in short, is a numerical co-efficient,
indicating how great an increase in income result from each increase investment.
How and why the increase in the total income is more than proportionate to the increase in the
investment? Because, with each investment, the expansion in production and national income is
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much more than the primary investment. A pan of increased income will be spent by the wage
earners and by the recipients of profits and interest. Increase in receipt also increased income to
others in the economy. If the total of these secondary incomes was immediately spent, the increase
in second income would be so rapid at each turn-over that it would result in maximization of
income and full employment. Thus increased income will again be spent and the process will go
on repeating. If the process continues. At each step, the increase in spending is smaller than in the
previous step, so that the multiplier process tapers off and allows the attainment of equilibrium. This
story is modified and moderated if we move beyond a "closed economy" and bring in the role of
taxation. To him tax payments at each step reduces the amount of induced consumer spending and
the size of the multiplier effect.
Keynes explained that neither savings nor investments are functions of interest rate. Savings
depend on the capacity of interest of the people to save and this capacity is determined by income.
So S= f(y) and not interest rate. Just if the rate of interest is high, people will not starve and save
money when their are low. Investment is also not a function of interest rate, the rate of return or
profit which determines the investment. Investment is a function of MEC and not so mere interest
rate flexibility cannot bring about an between savings and investment.
The concept of multiplier establishes a precise relationship between aggregate income and the rate
of investment (which is function of marginal propensity to save), assuming the marginal propensity
to consume remain the same. The multiplier explains the level of employment expected from a
given fluctuation in investment. This concept gives an insight into the working of the economy and
the part played by the psychological desire among men to save or consume. To him, savings during
depression are likely to make depression worst and reduce the level of income. High consumptions
and high investment should, however, go hand in hand and should not compete with each other.
This is why Keynes thought that government spending on productive purposes may produce or
multiplied increase in employment.
To Keynes knowledge of multiplier is of supreme importance not only in analyzing the course of
business cycles but also in devising an ant cyclical policy to smoothen the business fluctuation in
the working of the economy. The concept of multiplier has brought about a revolution not only in
economic theory but also in policy making at the state level.
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The concept of multiplier plays an important role in understanding the nature of cyclical
fluctuations in income and other macro variability, the process of income propagation and policy
making.
KEYNES AND THE UNDERDEVELOPED COUNTRIES
Keynesian economics was primarily concerned with the problem of economically advanced
countries, and therefore said little about the underdeveloped countries. The General Theory is not
general in the sense that it is inapplicable in all places and at all times. It was written in environment
of developed countries, was meant to solve problems of these countries. It can not directly applied
to problems of underdeveloped countries. Because, the root of the problem, the nature of
unemployment are quite different from that prevailing in the advanced countries and with which
Keynes was concerned. Unemployment, in the advanced countries, is due to the deficiency of
effective demand. In a rich country as income and output increases, consumption expenditure does
not increase at the same rate because of high marginal propensity to save.
Effective Demand: Unemployment is caused by the deficiency of effective demands and to get
over it. The concept of effective demand is applicable to those economies where unemployment is
due to excess saving. But in an underdeveloped economy, income levels are extremely low, the
propensity to consume is very high and savings are almost nill. Here, the problem is not one of
raising the effective demand but one of raising the levels of employment, and per capita income in
the context of economic development.
Propensity to consume: One of the important tools of Keynesian economics is the propensity to
consume which highlights the relationship between consumption and income. When income
increases, consumption also increases but by less than the increment in income. This behavior of
consumption further explains the rise in saving as income increases. In underdeveloped countries
these relationships between income, consumption and saving do not hold. Peoples are very poor and
their marginal propensity to consume is very high. The Keynesian economics tells us that when the
MPC (marginal propensity to consume) is high, consumers demand, out put and employment
increases at a faster rate with the increase in income. But in an underdeveloped countries it is not
possible to increase the production of consumer goods due to the scarcity of cooperate factors when
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consumption increases with the rise in income. As a result prices rise instead of rise in the level of
employment.
On the saving side: Keynes regarded saving as a social vice. It is excess of saving that leads to a
decline in aggregate demand. Again, this idea is not applicable to underdeveloped countries because
saving is the panacea for their economic backwardness. Underdeveloped countries can progress by
curtailing consumption and increasing saving, as opposed to the Keynesian view of raising
consumption and reducing saving. To underdeveloped economy saving is a virtue and nor a vice.
Marginal efficiency of capital: According to Keynes one of the important determinants of
investment is the marginal efficiency of Capital. There is an inverse relationship between
investment and MEC. When investment increases MEC falls and vice versa. This relationship is
however not applicable to underdeveloped countries. In such economies, investment is at low level
and MEC is also low.
Rate of interest: of the motives for liquidity preference transaction and precautionary motives are
income elastic and they do not influence the rate of interest in advanced countries. It is only the
demand for money for speculative motive that affects the rate of interest. In underdeveloped
countries, the liquidity preference for transaction and precautionary motives is high and for
speculative purpose is low. Therefore, liquidity preference fails to influence the rate of interest.
The assumption of on which the Keynesian theory was based, are not relevant to the condition
prevailing in under developed countries. The following are the principal tools of the Keynesian
theory to test validity to underdeveloped countries.
These assumptions are:
Involuntary Unemployment: For the efficient working of the multiplier, involuntary
unemployment must exist. Involuntary unemployment means an elastic supply of labor at the going
wage rate. But, in the underdeveloped countries, the unemployment is to a large extent disguised.
An Industrialized Economy. The multiplier prior operates in an industrialized economy
where the supply of output is elastic. The underdeveloped countries are has agricultural
economies where the supply curve of output is more inelastic than that of an industrialized
economy. When investment is increased in a poor country, it raises n income and prices and
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not output.
Excess capacity in the consumer goods industries: The theory of multiplier also assumes
the existence of e capacity in the consumer goods industries so that when in and
consumption expenditure increase as a result of an increase in investment, output of
consumer goods also rises tome increased demand. In the underdeveloped countries,
production is mainly for self-consumption and not for the market. When there is an increase
in income, the high MPC tends to increase the demand for self-consumption and not the
demand in the market.
Elastic Supply of Working Capital: The multiplier effect is only possible when there is
enough supply of the working capital necessary for increased output. The underdeveloped
countries on the other hand are marked by a compares inelastic supply of the working
capital. In the field of economic policy, too, Keynes’ economic policy were not of much
help to the underdeveloped countries.
In the end, the obvious conclusion is that Keynes General Theory has no relevance to the
conditions and problems of the underdeveloped countries. On the contrary, it is the classical
theory with its emphasis on saving and capacity creation, that provides remedy for the
problem of economic development in these countries.
KEYNES VERSUS CLASSICALS
Keynes differs from the classical school in almost all aspects. Keynes school criticized each and
every concept of classical.
The classical said that there exists in the economy a state of perfect competition which
allocates resources ideally and ensures maximization of output and welfare. But Keynes
argued that perfect competition is a myth. Today’s market structure is characterized by
imperfect market which restricts output and leads to wastage of resources, and exploitation
of consumers.
The classical contributions constitute the core of micro economics’. The classical assumed a
fixed quantity of resources and concentrated on ideal allocation among firms, industries and
individual units in the economy. They studied ‘micro elements’ and implicitly believed that
what principles and rules govern, the micro problems are completely valid for macro
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problems also. Therefore no separate theory is required for macro problems. Keynesian
however argued tha, micro problems require one set of policies and for macro problems,
another set of policies is required. The same policy tools or instruments cannot be applied
for both. Macro is not a mere addition of micro elements. The nature, magnitude and
intensity of macro problems vary from that of micro problems.
According to the classical economists there is automatic self adjusting character of the
economy.The classical believed in invisible hand or flexible price mechanism which ensures
maximization in all market and also in allocation of resources and distribution of resource.
There is no such automatic or self adjusting system in Keynesian economics. If such a force
is there, depressions and booms can be easily avoided and fluctuations averted. He said that
private motives do not coincide with public welfare. So there are no invisible hands, or
automatic price mechanism which ensures the welfare of one and all in society. Artificial
hindrances in the price mechanism have led to exploitation, misallocation and improper
distribution of income.
The classical assumed full employment and there is no deviation from full employment.
Even if there are temporary deviations, the economy has the tendency to reach full
employment. Whereas Keynes stated that under employment equilibrium is the reality and
full employment is a distant goal. Achievement of full employment is very difficult and
maintenance of it on a permanent basis is still more difficult.
Wage-price flexibility is advocated by classical for solving unemployment problem. If at
anytime the economy slips down from the level of full employment it can be restored by
cutting down real wages. Since wages are determined by marginal physical product of labor
and MPL is subject to the operation of the Law of diminishing returns, more labor can: be
employed only if wages are reduced. As long as wages are flexible downwards, full
employment can be easily achieved. The classical school assumed that workers will accept a
lower wage. Thus wages are flexible both ways for them. According to Keynes, wage
flexibility is not found in the modern economy, especially downward flexibility of wages.
Modern trade unions never accept wage cut for solving disequilibrium. Keynes has
explained the following consequences if real wages are reduced: In Modern economy where
there are strong trade unions workers will not accept a reduction in real wage. The Union
may restore to strike in which case production will be completed affected.When wages are
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reduced, it may affect the consumption level of workers. A distribution of income takes
place from wage earners, whose MPC is high, to propertied class (low MPC) which means
overall reduction in consumption. Since consumption is an important element of aggregate
demand effective demand will fall short of aggregate supply and employment, instead of
increasing, will decline further.
The classical economists did not integrate the theory of value with the theory of prices or
money. While real interest rate or commodity market affects the money market, back cannot
have any influence on real market. Money is not problem creator, but just facilitates
transactions and apart that has no special significance. By inventing the speculative demand
for money, Keynes successfully interest the theory of value with the theory of prices. Both
money market and real markets are interdependent and not independently causes much
confusion in the economy. Liquidity prefers has a major impact on the level of investment
and other variables in the system. So money plays a very active role and not a role.
Critical estimates of the works of Keynes
Keynesian economics have profound influence on the world. His contribution has the following
point of strength of analysis and theory.
Keynes showed that the inherent weakness of classical economics which assumed self-
adjusting mechanism of the economy for attain full employment.
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4.2 POST- KEYNESIAN DEVELOPMENT
Emergence of the of the school
The modern macro economics field developed in response to the severe depressions, which
occurred throughout the world in 1920s and 1930s.
The “General theory of employment, interest and money” in 1936 had a huge immediate impact
Some of the major changes which necessitated involvement of government were great depression of
1930s, emergence of natural monopoly, imperfect competition, and policies to change the
economies of developing economies.
Furthermore, with Great Depression of 1930’s, scholar basic premise that the government should
intervene in the economy through fiscal policy, monetary policy, income policy to stabilize the
economy. More over, there were theories of economic development implied that government was
the only available instrument for breaking the vicious circle of poverty in developing economies.
Neo Keynesian economics
Back ground of Neo Keynesian economics
The first generation of Keynesian thought that was developed in the post-war period from the
writings of John Maynard Keynes was known by name Neo-Keynesian economics (or neo-classical
Keynesian economics). "Neoclassical-Keynesian Synthesis" was to pervade in America (and
elsewhere) as the dominant form of macroeconomics in the post-war era, particularly in the 1950s
and 1960s. Neo-Keynesian was the immediate followers that contributed to economic theory and
analysis following the publications of the general theory.
A group of economists notably John Hicks, Franco Modigliani, Paul Samuelson and others,
attempted to interpret and formalize idea of Keynes and to synthesize the neo-Keynesian models
of economics. They focused on unifying the ideas into workable paradigms by combining them with
ideas from classical economics and the writings of Alfred Marshall. For instance, these neo-
Keynesians generally looked regitiles at labor contracts as a source of price and wage stickiness to
generate equilibrium models of unemployment. Many believed that if government policy were used
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to ensure it, the economy would behave as classical or neoclassical theory predicted. Their work
has become known as the neo-classical synthesis, and created the models that formed the core ideas
of Neo-Keynesian economics.
Contributions of neo-Keynesian economics
I. IS-LM
It was with John Hicks that Keynesian economics produced a clear IS-LM model which policy-
makers could use to understand and control economic activity. It relates aggregate demand and
employment to three exogenous quantities, i.e., the amount of money in circulation, the government
budget, and the state of business expectations.
The IS-LM model has derived from Keynes’s liquidity preference (transaction motive). The IS-
curve represent all the combination of interest rate and levels of income at which planned
investment equals planned saving. The LM symbolizes equality between the demand for money (L)
and the supply of money (M). The LM-curve is a curve that shows potential points of equilibrium
in the money market. It indicates all combinations of interest rates and the levels of income at which
money supplied equals money demanded.
II. Phillips curve
This curve indicated that increased employment implied increased inflation. Keynes had only
predicted that falling unemployment would cause a higher price, not a higher inflation rate. The use
of Phillips curve to predict unemployment and inflation was forwarded by Phillips of the London
school of economics in 1958. His graphical presentation came to be known as the Phillips curves.
Paul Samuelson and Robert Solow ploted a Phillips scatter diagram for United State from which
they made a eough estimate of Phillips curve facing the economy in 1960.
III. Consumption function
The aggregate consumption expenditures were the relationship between income and consumption
expenditures for durable and nondurable goods. Scholars argued that consumption expenditure was
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not only related to current income but also to income earned in the past. This work was carried on
by James S. Duisenberg and Franco Modigliani who developed their ideas independently during the
late 1940s. In a theory of the consumption function (1957), Friedman distinguished between income
considered as transitory and income considered as permanent by the house holders. He attempted to
demonstrate that consumer spending mainly reflects permanent income, where as transitory income
is saved.
IV. International trade
Following the Second World War that Keynes’ followers entered into active discussion about the
relationship of the new theory of employment to international equilibrium through the Keynesian
multiplier theory. Macroeconomics has been effectively applied in the formulation of policy in the
field of foreign trade and international payments. It is also worth noting that the General Theory did
not influence the theory of international economic relations.
International economic relations were formally included immediately following the Second World
War with active discussion of about the relationship of the new theory of employment to
international equilibrium through the Keynesian multiplier theory. They related the closed economy
model of Keynesian and use open economy with external relations.
V. Multiplier
In area of multiplier, there was great advancement, particularly the means by which changes in one
of the major aggregates are transmitted to the others and to the level of economic activity at a
whole.
VI. Public policy
Public policy was generally connected with three problems. First, the study of short term changes in
the level of economic activity. Second, the ways to get out of a depression and finally, long term
trend of the economic system to wards stagnation. The entire analysis was primarily concerned with
the prevention of short term lapses from full employment caused by changes talking place in other
countries. The major concern of policy makers and economic theorist was with the maintenance of
full employment in a closed national economic system.
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VII. New economics
Another significant development of the period was the emergence of a new branch of economics,
macro economics. Prior to the beginning of the “New economics”, economic thinkers had
concentrated their efforts on the study of microeconomics problems via behavior of the firm’s
individuals. They failed to explain the behavior of the economy as whole.
Post-Keynesian economics
Back ground of post Keynesian economics
Samuelson and others, main stream economics modified Keynesian principles of macro economics
grafted upon new classical principle of microeconomics. Some denied both IS-LM interpretation of
Keynes and standard micro economics. Post-Keynesian economics is a school of economic thought
with its origins in The General Theory but criticize the work of Neo-Keynesian. The post keynsian
critics were from a group of economists at Cambridge, England including; Joan Robinson, Nicholas
Kaldor and Paul Davidson ,Piero Sraffa, Johen K.Galbraith etc that criticize Neo Keynsian theories.
The post-Keynesian school has remained closest to the spirit of Keyne's General Theory.
Post-Keynesian economics argued that Keynes's theory was seriously misrepresented by neo-
Keynesian economics. They dislike nature of Hick’s IS-LM interpretations as it ignores issues of
unstable expectation and uncertainty. They suggested reason for government intervention. The
existence of uncertainty also leads to the demand for liquidity. This implies that focus on
neoclassical static equilibrium situation as in Hick’s interpretation is misleading and irrelevant.
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Major Tenets of post Keynesian
1. Neo-Ricardian views of production, value and distribution
In 1960 Piero Sraffa published book entitled production of commodities by means of commodities.
He reconstructed Ricardo’s production and value theory in modern form. For Sraffa, the pattern of
demand for various products does not affect the pattern of prices, instead affecting only the scale of
output in each industry. The real value (prices) of goods depend on the shares of other commodities
necessary to produce them. Relative values (prices) and profits (if wages are given) are determined
by the production techniques used to produce a composite standard commodity which consists of
the basic commodity in the economy. These basic commodities are goods that enter in to the
production of all other commodities. They are in essence “capital” goods that appear both as inputs
and out puts. Any distributions of wages and profits is consistent with a particular level of output.
According to Sraffa, the composite standard commodity is Ricardo‘s elusive invariable measure of
value or of relative prices.
2. Endogenous money
For Post Keynesians, the stock of money was assumed to be essentially endogenous to the
economy. It changes in response to changes in the level of wages. Wage increases,cause production
costs to rise, creating a greater demand on the part of firms for working capital to finance their more
expensive goods in progress and inventories. Hence, business borrowing rises and money stock
increases. Inflation arises from the fight over the shares of the distribution of income.
3. Markup pricing
For Post Keynesian prices are set by oligopolistic corporations through corporation pricing policies
in product market, trade union, wage bargaining behavior in labor markets, and so on. They
finance investment from retained profits. To achieve the level of profit and investment plans, they
set prices above current costs. Thus, prices do not reflect the current demand condition, but the
funds requirements for planned investment.
4. Pronounced cyclical instability
For post Keynsian, the economy is inherently unstable. Investment must grow sufficiently to keep
national income and output growing at a steady rate do not hold true as periods of altering
environment of business optimism and pessimism. When investment is less than required to
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maintain the steady rate of growth, the economy recedes and unemployment rises.
5. Need for an incomes policy:
Post-Keynesian believes that convectional fiscal and monetary policies could not solve the problem
of inflation. The reason is that inflation is resulting from a more fundamental conflict over, and the
distribution of available income and output is not because of excess demand. The convectional
policy instrument of curtailing the level of economic activity, reducing the amount of output
available for distribution, there by heightening the social conflict underlying the inflationary process
could not solve the problem. Hence the best policy for post-Keynesian is income policy.
In the field of monetary theory, Post-Keynesian economists were among the first to emphasize that
the money supply responds to the demand for bank credit, so that the central bank can choose either
the quantity of money or the interest rate but not both at the same time.
New-Keynesian economics
Back ground of new-Keynesian economics
The advent of stagflation, and the work of monetarists mainly by Milton Friedman, cast doubt on
neo-Keynesian theories and post-Kenysian thought. In the 1970s new classical economists such as
Robert Luces, Thomas J. Sargent, and Robert Barro called into question many of the precepts of the
Keynesian revolution.
The other was Robert Lucas call for micro foundations were as a critique of traditional macro
econometric forecasting models. On the other hand, from within peoples criticize continuous market
clearing in short run by classical. They emphasize the role of quantity constraint and non-clearing markets
due to uncertainty, imperfect information, and imperfect competition. The result would be a series of new
ideas to bring tools to Keynesian analysis that would be capable of explaining the economic events
of the 1970s. The next great wave of Keynesian thinking began with the attempt to give Keynesian
macroeconomic reasoning of a microeconomic basis. This is known as the new Keynesian
synthesis, and currently forms the mainstream of macroeconomic theory.
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Through the 1970s Keynesian macro-economics fell out of fashion as a policy tool, and as a field of
study.
New Keynesian economics is the school of thought in modern macroeconomics that evolved from the ideas
of John Maynard Keynes together with various strands of neoclassical economics. It has been dominant
in mainstream macroeconomics since the 1980s. The label “new Keynesian” describes those economists
who, in the 1980s, responded to this new classical critique with adjustments to the original Keynesian tenets.
The heart of the new Keynesian view rests on microeconomic models that indicate that nominal
wages and prices are "sticky," (i.e., do not change easily or quickly with changes in supply and
demand,) so that quantity adjustment prevails in short run.
In economics, the term micro foundations refer to the microeconomic analysis of the behavior of
individual agents such as households or firms that underpins a macroeconomic theory. Most early
macroeconomic models, including early Keynesian models, were based on hypotheses about
relationships between aggregate quantities, such as aggregate output, employment, consumption,
and investment. Critics and proponents of these models disagreed as to whether these aggregate
relationships were consistent with the principles of microeconomics. Therefore, in recent decades
macroeconomists have attempted to combine microeconomic models of household and firm
behavior to derive the relationships between macroeconomic variables. Many macroeconomic
models, representing different theoretical points of view are derived by aggregating microeconomic
models, allowing economists to test them both with macroeconomic and microeconomic data.
New classical economics relied on the theory of rational expectations Robert Lucas argues that
rational expectations will defeat any monetary or fiscal policy of Keynesian school. But new
Keynesians argue that this critique only works if the economy has a unique equilibrium at full
employment. Due to price stickiness there are a variety of possible equilibrium in the short run, so
that rational expectations models do not produce any simple result.
New Keynesian economist has returned to the IS-LM model and the Phillips Curve as a first
approximation of how an economy works. New versions of the Phillips Curve, such as the "Triangle
Model", allow for stagflation, since the curve can shift due to supply shocks or changes in built-in
inflation. In the 1990s, the original ideas of "full employment" had been replaced by the NAIRU
theory, sometimes called the "natural rate of unemployment." This theory pointed to the dangers of
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getting unemployment too low, because accelerating inflation can result. However, it is unclear
exactly what the value of the NAIRU is or whether it really exists or not.
Basic Tenets of New Keynesian Economics
A. Reject Neo-Ricardian value theory
Modern Keynesians reject the neo-Ricardian value theory and income policies of post-Keynesians.
They focused on the traditional Keynesian question of why recessions occur. According to them,
recession occurs due to a decline in aggregate demand. Decline in aggregate demand leads to a
decline in real output and corresponding increases in unemployment because the price and nominal
wages are inflexible downward.
B. Menu Costs and Aggregate-Demand Externalities
Economists disagree about whether menu costs can help explain short-run economic fluctuations.
Skeptics point out that menu costs usually are very small and are unlikely to explain recessions,
which are very costly for society. Proponents reply that “small” does not mean “inconsequential”.
Even though menu costs are small for the individual firm, they could have large effects on the
economy as a whole. One reason for prices not adjusts it self immediately to clear markets is that
adjusting prices is costly. These costs of price adjustment, called “menu costs,” cause firms to
adjust prices intermittently rather than continuously. Furthermore, some firms must incur costs
when they lower prices in printing a new menu, printing new price lists, communicating with
customers with advertising and so on. When such menu costs are high, firm may be reluctant to
lower their prices even when faced with slack demand.
To understand why prices adjust slowly, one must acknowledge that changes in prices have
externalities. That is, change in prices has effects that go beyond the firm and its customers. For
instance, a price reduction by one firm benefits other firms in the economy. When a firm lowers the
price it charges, it lowers the average price level slightly and thereby raises real income. The
stimulus from higher income, in turn, raises the demand for the products of all firms. This
macroeconomic impact of one firm’s price adjustment on the demand for all other firms’ products is
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called an “aggregate-demand externality.”In the presence of this aggregate-demand externality,
small menu costs can make prices sticky, and this stickiness can have a large cost to society.
C. The Staggering of Prices
For New Keynesian explanations of sticky prices can be explained how the firms adjust their prices.
If all firms are synchronized, all firms can raise prices together, leaving relative prices unaffected.
They argue that not everyone in the economy sets prices at the same time. And, the adjustment of
prices throughout the economy is staggered. Staggering complicates the setting of prices because
firms care about their prices relative to those charged by other firms. Staggering can make the
overall level of prices adjust slowly, even when individual prices change frequently.
D. Coordination Failure
Some new Keynesian economists suggest that recessions result from a failure of coordination. Coordination
problems can arise in setting wages and prices because those who set them must anticipate the actions of
other wage and price setters. Union leaders negotiating wages are concerned about the concessions other
unions will win. Firms setting prices are mindful of the prices that other firms will charge. To see how a
recession could arise as a failure of coordination, consider the following parable. “The economy is made up
of two firms. After a fall in the money supply, each firm must decide whether to cut its price. Each firm
wants to maximize its profit, but its profit depends not only on its pricing decision but also on the decision
made by the other firm. If neither firm cuts their price, the amount of real money (the amount of money
divided by the price level) is low, a recession ensues, and each firm makes a profit of only fifteen dollars.
If both firms cut their price, real money balances are high, a recession is avoided, and each firm makes a
profit of thirty dollars. Although both firms prefer to avoid a recession, neither can do so by its own actions.
If one firm cuts its price while the other does not, a recession follows. The firm making the price cut makes
only five dollars, while the other firm makes fifteen dollars.” The essence of this parable is that each firm’s
decision influences the set of outcomes available to the other firm. When one firm cuts its price, it improves
the opportunities available to the other firm, because the other firm can then avoid the recession by cutting its
price. This positive impact of one firm’s price cut on the other firm’s profit opportunities might arise because
of an aggregate-demand externality.
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E. Efficiency Wages
Normally, economists presume that an excess supply of labor would exert a downward pressure on
wages. A reduction in wages would in turn reduce unemployment by raising the quantity of labor
demanded. Hence, according to standard economic theory, unemployment is a self-correcting
problem.
New Keynesian economists often turn to theories of what they call efficiency wages to explain why
this market-clearing mechanism may fail. These theories hold that high wages make workers more
productive. The influence of wages on worker efficiency may explain the failure of firms to cut
wages despite an excess supply of labor. Even though a wage reduction would lower a firm’s wage
bill, cause worker productivity and the firm’s profits to decline.
There are various theories about how wages affect worker productivity. First efficiency-wage theory
holds that high wages reduce labor turnover. A second, efficiency-wage theory holds that the
average quality of a firm’s workforce depends on the wage it pays its employees. A third,
efficiency-wage theory holds that a high wage improves worker effort. This theory posits that firms
cannot perfectly monitor the work effort of their employees and that employees must themselves
decide how hard to work. The firm can raise worker effort by paying a high wage.
F. Minimum wage legislation
This imposed by the government economic policy with the aim to meet the inevitable well being of
the low income groups or workers. The intension is to avoid unnecessary exploitation of workers by
their employers. But it create market dis equilibrium so that market do not adjust quickly.
G. Imperfect information
Since every change in consumer tests and change in producers plan are not easily observable in the
market and even if it is observable there is information gap. As a result, markets do not adjust
instantly to the equilibrium market clearing wages and prices.
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H. Formal and implicit contracts
They point out that unions often sign long term contracts containing built in nominal wage increase.
When demand declines union leaders often prefer lay aggregate offs the few or reduce labors, rather
than wage costs.
Policy Implications
In new Keynesian theories recessions are caused by some economy-wide market failure. Thus, new
Keynesian economics provides a rationale for government intervention in the economy, such as
countercyclical monetary or fiscal policy. This part of new Keynesian economics has been
incorporated into the new synthesis that has emerged among macroeconomists.
5.5 New Keynesian and New classical
The primary disagreement between new classical and new Keynesian economists is over how
quickly wages and prices adjust. New classical economists build their macroeconomic theories on
the assumption that wages and prices are flexible. They believe that prices “clear” markets and there
will a balance between supply and demand. New Keynesian economists, however, believe that
market-clearing models cannot explain short-run economic fluctuations, and so they advocate
models with “sticky” wages and prices. New Keynesian theories rely on this stickiness of wages
and prices to explain why involuntary unemployment exists and why monetary policy has such a
strong influence on economic activity.
New classical economists criticized this tradition as it lacks a coherent theoretical explanation for
the sluggish behavior of prices. New Keynesian research attempts to remedy this omission.
5.6 New Synthesis
During the 1990s, the debate between new classical and new Keynesian economists led to the
emergence of a new synthesis among macroeconomists about the best way to explain short-run
economic fluctuations and the role of monetary and fiscal policies. The new synthesis attempts to
merge the strengths of the competing approaches that preceded it. From the new classical models it
takes a variety of modeling tools that shed light on how households and firms make decisions over
time. From the new Keynesian models it takes price rigidities and uses them to explain why
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monetary policy affects employment and production in the short run. The most common approach is
to assume monopolistically competitive firms (firms that have market power but compete with other
firms) that change prices only intermittently. The heart of the new synthesis is the view that the
economy is a dynamic general equilibrium system that deviates from an efficient allocation of
resources in the short run because of sticky prices and perhaps a variety of other market
imperfections. In many ways, this new synthesis forms the intellectual foundation for the analysis of
monetary policy at the Federal Reserve and other central banks around the world.
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Chapter 5
The Development of Modern Microeconomic Theory
Neoclassical economics was not a single entity: it was a multidimensional school of thought that
evolved over time. It focused on marginalism, assumptions of rationality, and a strong policy
presumption that markets worked, although that was subject to a number of provisos. The
neoclassical school was quite fluid: as soon as neoclassical economists became the orthodoxy, and
possibly even before, it started to change. Bit by bit economics moved away from its neoclassical
footing. Marginalist calculus was replaced by set theory; rationality assumptions were modified by
insights from psychology; the set of issues to which economic analysis was applied expanded;
evolutionary game theory raised the possibility that individuals exhibit class-consciousness; and
sociological explanations were used to supplement analyses of the labor market. As these and
similar changes occurred, what had been seen as necessary components of neoclassical thought
ceased to be components of modern thought. Our belief is that sufficient components have changed
to warrant a new term to describe modern economics.
Many elements of neoclassical economics still exist within modern microeconomics, but what
distinguishes modern microeconomics is not these elements; it is a modeling approach to problems.
The assumptions and conclusions of the model are less important than whether the model
empirically fits reality.
In this chapter we discuss the evolution of microeconomics from neoclassical to modern. We
trace that path from the 1930s through a highly formalistic stage in which there was an attempt to
tie microeconomics together within a single theory—with little regard for that theory’s empirical
relevance—to its modern state, in which microeconomics consists of a set of models focused almost
entirely on empirical relevance.
We start our story in the 1930s with the fall of Marshallian economics.
THE MOVEMENT AWAY FROM MARSHALLIAN ECONOMICS
Marshall’s engine of analysis, combining supply and demand curves with common sense, could
answer certain questions, but others exceeded its scope. Supply-and-demand analysis was partial
equilibrium analysis applied to problems of relative prices. But many of the questions economists
were trying to answer, such as what determines the distribution of income or what effect certain
laws and taxes would have either introduced problems beyond the applicability of partial
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equilibrium analysis or violated its assumptions. Nonetheless, economists continued to apply partial
equilibrium arguments to such issues, assuming that the aggregate market must constitute some as
yet unknown combination of all the partial equilibrium markets.
Most economists were content with this state of affairs for quite a while. After all, Marshallian
economics did provide a workable, if not formally tight, theory that was able to answer many real-
world questions. It was the middle ground. Marshallian economists were engineers rather than
scientists, and engineers are interested not in pondering underlying forces but in building something
that works. Marshallian economists were interested in the art of economics, not in positive or
normative economics. As Joan Robinson put it, Marshall had the ability to recognize hard problems
and hide them in plain sight.
Marshallian economics attempted to walk a fine line between a formalist approach and a historically
institutional approach. It is not surprising that in doing so it created critics on both sides. In the
United States, a group called the institutionalists wanted simply to eliminate the theory, arguing that
history and institutions should be emphasized and the inadequate theory dropped. Other critics,
whom we will call formalists, went in the opposite direction: they believed that economics should
be a science, not an engineering field, and that if economics were to conclude that the market
worked well, we needed a theory to show how and why it did so. These formalists agreed with the
institutionalists that Marshallian economic theory was inadequate, but their answer was not to
eliminate the theory: they wanted to provide a better, more rigorous general equilibrium foundation
that could adequately answer more complicated questions.
THE FORMALIST REVOLUTION IN MICROECONOMICS
In the late 1930s the formalist research program won and the Marshallian approach started to wane.
By the 1950s the formalists had reformulated microeconomics into a mathematical structure
dependent on Walras, not Marshall. Applications became less important than logical consistency.
The formalist revolution reached its apex in 1959 with the publication of the Arrow- Debreu model.
With the completion of that general equilibrium work, economists turned once again to applied
work. But they did not return to Marshall’s engine of analysis approach, which downplayed the use
of mathematics and stressed judgment. Instead, they integrated policy prescriptions into the
mathematical models. As that happened, the neoclassical era evolved into the modern modeling era.
In the modeling approach, mathematics is used to develop simple models that ideally capture the
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essence of the problem. Then econometric techniques are used to test those models. This
development and empirical testing of models has become the modern economic method.
The Battle over Formalist Approaches
The mathematical approach is rooted in the thought of several nineteenth- and early twentieth-
century figures discussed in our earlier chapters on neoclassical economics. The first of these great
pioneers in stating hypotheses in mathematical form was A. Cournot, who published his Researches
into the Mathematical Principles of the Theory of Wealth in 1838. Cournot expected that his
attempts to bring mathematics into economics would be rejected by most economists, but he
adhered to his method nonetheless because he found the literary expression of theory that could be
expressed with greater precision by mathematics to be wasteful and irritating.
Leon Walras and Vilfredo Pareto, who succeeded Walras as professor of economics at
Lausanne, were other early devotees of mathematical economics. Whereas Marshall had focused on
partial equilibrium, Walras, using algebraic techniques, focused on general equilibrium. His general
equilibrium theory has substantially displaced Marshallian partial equilibrium theory as the basic
framework for economic research. Jevons, in his influential Theory of Political Economy (1871),
also advocated a more extensive use of mathematics in economics.
Jevons was followed by another pioneer in mathematical economics, F. Y. Edgeworth (1845-
1926), who pointed out in 1881 that the basic structure of microeconomic theory was simply the
repeated application of the principle of maximization. This finding raised the question, Why re-
examine the same principles over and over again? By abstracting from the specific institutional
context and reducing a problem to its mathematical core, one could quickly capture the essence of
the problem and apply that essence to all such micro- economic questions. Following this reasoning,
Edgeworth declared that both an understanding of the economy and a basis for the formulation of
proper policies were to be found in the consistent use of mathematics. He accused the Marshallian
economists of being seduced by the “zigzag windings of the flowery path of literature.”1
As this extension was occurring, there was a simultaneous attempted extension of mathematics
not only into positive economics but also into questions of economic policy. Vilfredo Pareto, whose
name is familiar to many students of economics from its use in the phrase Pareto optimal criteria,
extended Walras’s general equilibrium analysis in the early 1900s to questions of economic policy.
Thus, in the push for formalization little distinction was made between positive economics and the
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art of economics, John Neville Keynes’s distinction between the two was lost, and the same formal
methodology was used for both.
Irving Fisher (1867-1947), writing in the last decade of the nineteenth century, was an early
American pioneer of formalism who supported and extended Simon Newcomb’s (1835-1909)
advocacy of increased use of mathematics in economics. The mathematical approach was not well
received in the United States, however, until nearly the middle of the twentieth century. All these
pioneers were, therefore, unheeded prophets of the future. a judicious blend of theory, history, and
institutional knowledge. Unable to compete with the Marshallian approach, early mathematical
work in economics was practically ignored by mainstream economists until the 1930s. Inattention to
their efforts can be attributed partly to the strength of Marshall’s analysis,
In the early 1930s, this situation began to change. Expositions of the many geometric tools that
now provide the basis for undergraduate microeconomics began to fill the journals. The marginal
revenue curve, the short-run marginal cost curve, and models of imperfect competition and income-
substitution effects were “discovered” and explored during this period. Though rooted in Marshall,
these new tools formalized his analysis, and as they did so they moved farther and farther from the
actual institutions they represented. The Marshallian approach to interrelating theory and
institutions had been like a teeter-totter: it had worked as long as the two sides balanced. But once
the theory side gained a bit, the balance was broken and economics fell hard to the theoretical side,
leaving history and institutions suspended in air.
History and institutions were abandoned because the new mathematical tools required stating
precisely what was being assumed and what was changing, and stating it in such a way that the
techniques could handle the entire analysis. History and particular institutions no longer fit in. One
could no longer argue, as in the earlier Marshallian economics, that “a reasonable businessman”
would act in a certain way, appealing to the reader’s sensibility to know what “reasonable” meant.
Instead, “reasonableness” was transformed into a precise concept— “rational”—that was defined as
making choices in conformance with certain established axioms. Similarly, the competitive
economy was defined as one in which all individuals are “price takers.” Developing one’s models
mathematically required noncontextual argumentation, abstracted from any actual setting, in which
assumptions are spelled out.
Though the use of geometry as a tool in Marshallian analysis was a relatively small step, it was
the beginning of the end for Marshallian economics. When geometry disclosed numerous logical
problems with Marshallian economics, the new Marshallians responded with further formalization.
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Thus, by 1935 economics was ripe for change. Paul Samuelson summed up the situation: “To a
person of analytic ability, perceptive enough to realize that mathematical equipment was a powerful
sword in economics, the world of economics was his or her oyster in 1935. The terrain was strewn
with beautiful theorems waiting to be picked up and arranged in unified order.”2
Because many economists had by this time acquired the requisite analytic equipment, the late 1930s
and early 1940s witnessed a revolution in micro- economic theory, which formalism won. Cournot,
Walras, Pareto, and Edge- worth gained more respect, and Marshallian economics was relegated
primarily to a role in undergraduate education.
The first step in the mathematization of microeconomic theory was to extend the marginal
analysis of the household, firm, and markets and to make it more internally consistent. As
economists shifted to higher-level mathematical techniques, they were able to go beyond partial
equilibrium to general equilibrium, because the mathematics provided a method by which to keep
track more precisely of items they had formerly kept somewhat loosely in the back of their heads.
The second step was to reformulate the questions in a manner consistent with the tools and
techniques available for dealing with them. The third step was to add new techniques to clarify
unanswered questions. This process is continuing today.
These steps did not follow a single path. One path had strong European roots; it included
generalizing and formalizing general equilibrium theory. An early pioneer on this path was Gustav
Cassel (1866-1945), who simplified the presentation of Walras’s general equilibrium theory in his
Theory of Social Economy (1918; English versions 1924, 1932), making it more accessible.
In the 1930s, two mathematicians, Abraham Wald (1902-1950) and John von Neumann (1903-
1957), turned their attention to the study of equilibrium conditions in both static and dynamic
models. They quickly raised the technical sophistication of economic analysis, exposing the
inadequacy of much of previous economists’ policy and theoretical analysis. Their work was noted
by economists such as Kenneth Arrow (1921- ) and Gerard Debreu (1921- ), who extended it and
applied it to Walras’s theory to produce a more precise formulation of his general equilibrium
theory. Following Wald’s lead, Arrow and Debreu then rediscovered the earlier writings of
Edgeworth. So impressed were they by these writers that they declared Edgeworth, not Marshall, to
be the rightful forefather of modern microeconomics. The work of these theorists, in turn, has
continued a highly formalistic tradition of general equilibrium theorists.
Some of the questions that general equilibrium analysis has addressed are Adam Smith’s
questions: Will the unfettered use of markets lead to the common good, and if so, in what sense?
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Will the invisible hand of the market promote the social good? What types of markets are necessary
for that to be the case? Because they involve the entire system, these are essentially general
equilibrium questions, not questions of partial equilibrium. They could not, therefore, be answered
within the Marshallian framework, although they could be discussed in relatively loose terms, as
indeed they were before formal general equilibrium analysis developed.
General equilibrium theorists have found the answer to the question “Does the invisible hand
work?” to be yes, as long as certain conditions hold true. Their proof, for which Arrow and Debreu
received Nobel prizes, was a milestone in economics because it answered the conjecture Adam
Smith had made to begin the classical tradition in economics. Much subsequent work has been done
in general equilibrium theory to articulate the invisible-hand theorem more elegantly and to modify
its assumptions, but by first proving it, Arrow and Debreu earned a place in the history of economic
thought.
MILTON FRIEDMAN AND THE CHICAGO
APPROACH TO MICROECONOMICS
The modern modeling approach that has come to dominate the profession has some grounding, too,
in the Chicago approach to economics, which ran counter to the formalist approach from the 1950s
through the 1970s. The Chicago approach was characterized, first, by a belief that markets work
better than the alternatives as a means of organizing society and, second, by its connection to the
Marshallian informal approach to modeling.
Milton Friedman (1912- ) was a counterweight to Paul Samuelson throughout the modern period
of economics. Friedman summarized his Chicago approach as follows: In discussions of economic
policy, “Chicago” stands for belief in the efficiency of the free market as a means of organizing
resources, for skepticism about government affairs, and for emphasis on the quantity of money as a
key factor in producing inflation.
In discussions of economic science, “Chicago” stands for an approach that takes seriously the use of
economic theory as a tool for analyzing a startlingly wide range of concrete problems, rather than as
an abstract mathematical structure of great beauty but little power; for an approach that insists on
the empirical testing of theoretical generalizations and that rejects alike facts without theory and
theory without facts
Friedman’s approach to economics was Marshallian rather than Walrasian. He saw economics
as an engine of analysis for addressing real problems and as something that should not be allowed to
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become an abstract mathematical consideration devoid of institutional context and direct relation to
real world problems.
In his consideration of policy issues, he combined strong beliefs in individual rights and liberty
and in the effectiveness of the market in protecting those rights (see Capitalism and Freedom,
1962). His political orientation was basically pro-market and anti-government. He advocated many
policy proposals that at first were seen as radical but later became more acceptable: financing
education with vouchers, eliminating licensing in professions, and legalizing drugs.
Around 1950, Friedman produced a number of provocative papers on methodology and also a
paper on the Marshallian demand curve and the marginal utility of money. In the late 1950s, he
made contributions to macroeconomics in his Studies in the Quantity Theory of Money (1956). His
column in Newsweek was read by many, and a TV series titled “Free to Choose” gave him greater
notoriety than most theorists. He won the Nobel Prize in economics in 1976.
Even as Friedman was becoming well known, his Marshallian approach was dying. In part, this
was because it was seen by many as ideologically or normatively tainted, causing researchers to
revert to formalism to avoid ideological bias. An example of what some economists considered to
be the normative bias in the Chicago approach to economics can be seen in the Coase theorem,
named for Ronald Coase (1910- ), another influential Chicago economist whose work led to the
recent field of law and economics. The Coase theorem was a response to the Pigouvian approach,
which saw the existence of externalities as a reason for government intervention. In “The Problem
of Social Cost,” Coase argued that in theory, externalities were not a reason for government
intervention, because any party helped or hurt by an action was free to negotiate with others to
eliminate the externality. Thus, if there were too much smoke from a factory, the neighbors hurt by
the smoke could pay the factory to reduce it.
The Coase theorem has been much discussed in the literature. The general conclusion is that in and
of itself the theorem is no more ideological than is the theory of externalities that predisposes one
toward government intervention. Issues involving government intervention are complicated, and
there is no answer that follows from theory; in modern economics, a theory of government failure
exists side by side with a theory of market failure. Which is more appropriate depends upon the
relative costs and benefits, issues upon which individuals may disagree.
Nonetheless, the Chicago approach has stimulated many new ideas, and it, rather than the more
formalist approach, may sow the seeds for major developments in microeconomics in the future.
Among those new ideas that have been stimulated has been Armen Alchian’s (1914- ) and Harold
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Demsetz’s (1930- ) work on property rights as underlying markets. Since the Chicago view is that it
is best to assume that markets work efficiently, much of the discussion of inefficiency in markets
(such as might be produced by monopolistic competition) is misplaced. But markets depend upon
property rights; thus, the study of property rights is of paramount importance to economics. What
are the underlying property rights? How do they develop? How do they change?
The most important follower of Friedman was Gary Becker (1930- ), who won the Nobel Prize
in economics in 1992. He has used microeconomic models to study decisions about crime,
courtship, marriage, and childbearing. Becker has shown that the simple-maximization
microeconomic model based on the assumption of rational individuals has potentially infinite
applications, and recent years have seen it used in widely diverse areas. These incursions of
economic theory into other disciplines have sometimes been treated facetiously by those who claim
that the economic approach is too simple. In one sense, they are right. The ideas and policy
conclusions of the “economics of everything” are often simple. But mere simplicity does not make
them wrong. Market incentives make a difference in people’s behavior, and noneconomic
specialists have often not included a sufficient consideration of these incentives in their analyses.
But analyses can go astray when only economic incentives are considered and insufficient attention
is paid to institutional and social incentives. Unfortunately, given modern economists’ training in
noncontextual modeling, this is often what occurs.
With the retirement of Milton Friedman and his colleague George Stigler and with Gary Becker’s
impending retirement, Chicago economics changed, becoming more mathematical and less
intuitive. Not stopping at simple models, it generalized models along the lines suggested by Varian.
Clearly, Chicago has entered the modern school of economics, and the modern school of economics
has become quite homogeneous. What one learns in graduate programs at Harvard, Chicago, MIT,
Stanford, or any top graduate school, is essentially the same thing.
summary
Modern microeconomics has evolved significantly from its neoclassical roots and is much better
defined by its eclectic formalistic modeling approach than by its beliefs. Its roots are to be found in
Cournot and Edgeworth rather than in Marshall. The movement away from Marshallian economics
started in the late 1930s with the publication of John Hicks’s Value and Capital and Paul
Samuelson’s Foundations of Economic Analysis. Their work was a culmination of many years of
frustration on the part of some economists with Marshall’s avoidance of formalizing economic
theory. Samuelson’s and Hicks’s work was followed by even greater formalization of neoclassical
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thinking in the work of Arrow and Debreu. After that work was complete, modern microeconomics
turned to eclectic applied policy work, in which assumptions could differ from core general
equilibrium assumptions.
The Marshallian approach could still be found in the Chicago school through the 1970s,
although the Chicago brand of Marshallian economics had a strong pro-market bias. With the
retirement of Milton Friedman and the impending retirement of Gary Becker, and the death of
George Stigler, Chicago economics melded into modern economics, becoming more mathematical
and less intuitive.
Modern economics has problems, but they are not the problems of neoclassical economics. Some
present-day economists level their criticisms of economics at neoclassical economics and in so
doing fail to examine the prevailing paradigm that characterizes modern economics.
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Chapter 6
The Development of Modern Macroeconomic Thought
Interest in macroeconomic issues has fluctuated throughout the years, reaching its nadir around the
turn of the nineteenth century. The attitude of the economics profession toward macroeconomic
thought at that time could be characterized as one of benign neglect. The macroeconomic thinking
that did exist, moreover, was somewhat confused. Alfred Marshall, who had codified and organized
microeconomics in his Principles of Economics, always intended to do the same for
macroeconomics, but he never did. He limited his discussion of macroeconomics to a determination
of the general level of prices, as did F. W. Taussig in his introductory textbook.
Growth, which had been the focus of Adam Smith’s work, received only slight emphasis in the
later classical and neoclassical periods. Instead, the profession focused on developing formal
models of allocation and distribution using the static reasoning that Ricardo championed; Smith’s
ambiguities lost out to Ricardo’s more formal models. Business cycles also received only fleeting
reference; the standard assumption of full employment of all resources precluded greater
consideration of them. That full employment assumption was often justified by reference to Say’s
Law, supply creates its own demand.
Analysis that used the full employment assumption and focused on explaining the forces
determining the general level of prices continued until the 1930s, when the Great Depression led to
new work on understanding business cycles. During the period from the 1930s to the late 1970s,
macroeconomics continued to focus on business cycles, an approach that came to be known as
“Keynesian economics.” The classification is not totally correct, since Keynesian ideas quickly
merged with neoclassical ideas; the actual macroeconomics that developed in the texts might more
appropriately be called neo-Keynesian economics. This chapter describes this evolution and its
historical foundation.
The 1970s saw a reaction against neo-Keynesian economics in the form of the new classical
revolution, which moved the focus of macroeconomics away from business cycles and toward
growth. Since the 1990s, the primary focus of cutting-edge macroeconomics has been on growth.
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HISTORICAL FORERUNNERS
OF MODERN MACROECONOMICS
Modern macroeconomics consists primarily of monetary theory, growth theory, and business-cycle
theory. Emphasis on these has fluctuated over the years, in part as the experience of the economy
has changed and in part as techniques have allowed economists to deal with issues that they
previously found unmanageable. We will begin with a discussion of growth theory.
Early Work on Growth Theory
Analysis of economic growth was the primary concern of Adam Smith, who emphasized the
relationships between free markets, private investment spending, laissez faire, and economic
growth. Ricardo refocused economics, turning it away from economic growth and toward the issue
of the forces determining the distribution of income. This change in viewpoint between Smith and
Ricardo concerning the essential subject matter of economics was fundamentally a reorientation of
economics away from the growth macroeconomics of Smith and toward Ricardo’s microeconomic
concerns—what determines wages, rents, profits, and other prices, and thus the distribution of
income. This emphasis on microeconomics, the allocation problem, continued to dominate
mainstream economic thought from Ricardo in the first quarter of the nineteenth century until the
major depression that engulfed the industrialized world in the 1930s.
Joseph Schumpeter, in the discussion of growth in his famous book on the history of economic
thought, distinguishes two types of economists by their thinking about growth: the optimists and the
pessimists. He argues that most mainstream economists fall within the pessimist group, the
strongest pessimists being Malthus, Ricardo, and James Mill. These mainstream economists
strongly emphasized decreasing returns, ever-increasing rent, and the stationary state toward which
the economy was progressing. They did this even as the economy around them was growing at rates
far exceeding those of earlier times. As Schumpeter notes, “They were convinced that technological
improvement and increases in capital would in the end fail to counteract the fateful law of
decreasing returns.”
Somewhat of an exception to this among the major mainstream economists was John Stuart
Mill, who discussed growth and technology more than Malthus or Ricardo did, and who, moreover,
was much more optimistic about the possibility of continued growth. But a close reading of Mill
shows that he did not base his belief so much on the continued growth of technology and capital as
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on his belief that societies would ultimately voluntarily restrict the birth rate and thus slow the
inevitable diminishing marginal returns.
Toward the end of his life, Mill became more of a pessimist. He seemed convinced that the
stationary state was near. However, he did not see this result as necessarily bad. Rather, he saw the
stationary state as a comfortable state in which there was moderate prosperity and reasonable
equality. This followed because he saw the distribution of income as being determined by social as
well as economic forces.
It was left to heterodox economists such as Henry Carey (1793-1879) and Friedrich List to
support the optimist vision. List, discussed in Chapter 12, was part of the German historical school,
which emphasized empirical observation and history over theory. Since he could see that the
economy was growing at a faster rate than it had earlier, it was only natural for him to believe that
growth could continue, possibly indefinitely. Carey was an American economist who deemphasized
theory and emphasized history and empirical observation. This led him to the same conclusion as
List: there seemed no end in sight to the growth of the economy. Given the American experience at
the time, with an expanding frontier and ever-increasing agricultural land, it was natural that
diminishing returns would be less emphasized in the American context.
It is interesting that the optimists, List and 6arey, supported tariffs, whereas the pessimists, such
as Ricardo, generally supported free trade. This difference probably flowed from their view of
theory and use of assumptions. Ricardo’s theoretical comparative advantage model directed
thinking toward the advantages of a policy of free trade. But the static nature of the model also led
to the view that once the gains of trade had been achieved, growth would stop. List and Carey
focused less on theory and more on observation and history. Direct observation of the economy
suggested the importance of technology and the possibility of continued growth. It also suggested
that protecting that technology by tariffs was important. Smith’s argument that trade expands
technology through expanding the division of labor and learning by doing, and therefore can be
beneficial for all, is a much more complicated argument to make; it follows from a dynamic view of
the economy that is difficult to capture in formal models.
Mainstream economists of the time vigorously attacked both List’s and Carey’s views and delighted
in pointing out their theoretical mistakes. But in doing so the mainstream economists failed to grasp
the broader lesson of List’s and Carey’s work that diminishing marginal returns could be overcome,
possibly forever, by technological development. Modern economists were likewise blind to Marx’s
insights concerning growth.
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As neoclassical economics developed, the movement away from a focus on growth accelerated.
The neoclassical, with the possible exception of Alfred Marshall, whose views on growth resembled
Mill’s, focused more on static equilibrium. Both Mill and Marshall held that technological progress
could temporarily create the conditions of growth but that the law of diminishing returns in
agricultural and raw materials would ultimately win out.
For the most part, economists in the first half of the twentieth century did not deal with growth. An
important exception was Joseph Schumpeter, who does not fit neatly into any school.
Quantity Theory of Money
Classical and neoclassical theorists maintained an interest in at least one macro- economic question:
what determines the general level of prices? They addressed this economic question by utilizing the
supply-and-demand approach developed in microeconomic theory. The supply of money was
assumed to be determined by the monetary authorities, so some orthodox economists contended that
the basic issues to be analyzed were on the side of demand. The household and firm are assumed to
be rational and to have a demand for money to be used for various purposes. Walras, Menger, and
others developed a supply-and-demand analysis to explain the value of money, but the most famous
of these theories is probably the one developed by Marshall, which has become known as the
Cambridge cash-balance version of the quantity theory of money.
The first clear statement of the quantity theory of money was made by David Hume in 1752.
This theory, as it came down through the literature, held that the general level of prices depended
upon the quantity of money in circulation. Marshall’s version of the quantity theory was an attempt
to give microeconomic underpinnings to the macroeconomic theory that prices and the quantity of
money varied directly. He did this by elaborating a theory of household and firm behavior to
explain the demand for money. Marshall reasoned that households and firms would desire to hold in
cash balances a fraction of their money income. If M is money (currency plus demand deposits), PY
is money income, and k is the proportion of their income that households and firms desire to hold in
the form of money, then the fundamental cash-balance equation is
M = kPY
Because Marshall accepted Say’s Law, full employment is assumed. An increase in the quantity of
money, assuming k remains constant, will lead to an increase in money income, PY. Because full
employment is assumed, an increase in the quantity of money will result in higher prices and a
consequent increase in money income; real income, however, will not change. Decreases in the
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quantity of money will result in a fall in money income as prices fall; real income again will remain
constant. We shall not examine the many different aspects of Marshall’s formulation; the important
point is that Marshall’s version of the quantity theory made an attempt to integrate the
microeconomic behavior of maximizing firms and households with the macroeconomic question of
the general level of prices.
A group of economists, the most prominent being the American Irving Fisher (1869- 1947),
developed another form of the quantity theory known as the transactions version. However, they
showed little interest in finding a microeconomic foundation for the macroeconomic analysis of the
general level of prices. In this version,
MV = PT
where M is the quantity of money, V is the velocity of money, P is a measure of the price level, and
T is the volume of transactions.
Although these two approaches have important differences, they have one element in common:
they were both designed to explain the forces that determine the general price level. They were not
used to explain the level of real income, which was assumed to be at full employment and fixed by
nonmonetary forces in the economy.
Not all economists were satisfied with this analysis. For example, Knut Wicksell (1851- 1926)
argued that the quantity theory of money failed to explain “why the monetary or pecuniary demand
for goods exceeds or falls short of the supply of goods in given conditions.”7 Wicksell tried to
develop a so-called income approach to explain the general level of prices; that is, to develop a
theory of money that explains fluctuations in income as well as fluctuations in price levels.
Business Cycle Theory
Although fluctuations in business activity and in the level of income and employment had been
occurring since the beginning of merchant capitalism and were acknowledged by orthodox theorists,
economists made no systematic attempts to analyze either depression or the business cycle until the
1890s. Heterodox theorists, the most important of whom was Marx, had pursued these issues with
greater vigor. But Marx’s works were largely ignored by orthodox theory. Thus, until the last
decade of the nineteenth century, orthodox economic the allocation and distribution of scarce
resources, a macroeconomic theory explaining the forces determining the general level of prices,
and a loose set of notions concerning economic growth. Prior to 1890, orthodox “work on
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depressions and cycles had been peripheral and tangential.”theory consisted of a fairly well
developed theoretical microeconomic structure explaining 8
One major exception to this generalization is the work of Clement Juglar (1819-1905), who in
1862, published Des crises commerciales et de leur rétour périodique en France, en Angleterre et
aux Etats-Unis. The second edition of this work, published in 1889, was considerably enlarged with
historical and statistical material. Juglar is a spiritual predecessor of W C. Mitchell in that he did not
build a deductive theory of the business cycle, but rather collected historical and statistical material
that he approached inductively. His main contribution was his statement that the cycle was a result
not of forces outside the economic system but of forces within it. He saw the cycle as containing
three phases that repeated themselves in continuous order:
The periods of prosperity, crisis, liquidation, although affected by the fortunate or unfortunate
accidents in the life of peoples, are not the result of chance events, but arise out of the behavior, the
activities, and above all out of the saving habits of the population, and the way they employ the
capital and credit available.9
Although Juglar’s work initiated the study of the business cycle, the modern orthodox
macroeconomic analysis of fluctuations is grounded in the writings of a Russian, Mikhail Tugan-
Baranowsky (1865-1919). His book Industrial Crises in England was first published in Russian in
1894; German and French editions followed. After reviewing past attempts to explain the business
cycle, he pronounced them all unsatisfactory. The chief intellectual influences on Tugan-
Baranowsky were Juglar and Marx, particularly Marx. Tugan-Baranowsky’s main contribution to
our understanding of the business cycle was his statement of two principles: (1) that the economic
fluctuations are inherent in the capitalist system because they are a result of forces within the
system, and (2) that the major causes of the business cycle are to be found in the forces determining
investment spending. The sources of the Keynesian analysis of income determination, with its
emphasis on the inherent instability of capitalism and the role of investment, run from Marx through
Tugan- Baranowsky, Juglar, Spiethoff, Schumpeter, Cassel, Robertson, Wicksell, and Fisher on the
orthodox side; and from Marx, Veblen, Hobson, Mitchell, and others on the heterodox side.
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Some of the mercantilists, the physiocrats, and a host of heterodox economists who
KEYNESIAN MACROECONOMICS
Keynesian economics is named after John Maynard Keynes, whose father, J. N. Keynes, was an
important economist in his own right. The son’s accomplishments quickly eclipsed his father’s,
however. In this and in several other ways J. M. Keynes’s life is like that of J. S. Mill. Both had
fathers who were contemporaries and friends of brilliant economists: James Mill was a friend of
David Ricardo, and J. N. Keynes was a friend of Alfred Marshall. Both the younger Keynes and the
younger Mill received the high-quality education typically provided to children of intellectuals, an
education that equipped their innately brilliant minds to break new ground and to persuade others
through the force of their writing. Both Mill and Keynes rejected the policy implications of their
fathers’ economics and proceeded in new directions. But here the similarities end, for J. S. Mill was
unable to break completely with the theoretical structure of his father and Ricardo; ultimately, he
constructed a halfway house between classical and neoclassical theory. Keynes’s break with the
past—that is, with the laissez-faire tradition running from Smith through Ricardo, J. S. Mill, and
Marshall— was more complete. Although he was familiar with the basic Marshallian partial
equilibrium analysis, he constructed a new theoretical structure to address the aggregate economy
that had significant effects on both economic theory and policy.
Keynes does not fit the stereotype of the intellectually narrow twentieth- century economist. He
was criticized, in fact, for devoting too little of his time to economic theory and spreading his
interests too broadly. Even as a student at Eton and Cambridge he displayed this proclivity to pursue
a wide range of interests; hence he came to be known as a dilettante. His education completed, he
entered the British government’s India Office as a civil servant, where he remained for two years
before returning to Cambridge. He was never exclusively an academic. His continuing interest in
economic policy led him to take a number of government posts throughout his life. He was active in
business affairs both for himself and as bursar of King’s College, and his ability in business is
manifested by the fact that his net worth rose from near bankruptcy in 1920 to more than $2 million
by the time of his death in 1946. Keynes was interested in theater, literature, and the ballet; he
married a ballerina and associated with a group of London intellectuals known as the Bloomsbury
group, which included such notables as Clive Bell, E. M. Forster, Lytton Strachey, and Virginia
Woolf. His unique mixture of talents enabled him to be an accomplished mathematician as an
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undergraduate, to write a book on probability theory, and to be a powerful and effective prose
stylist, which is evident in the sheer literary mastery of both his Economic Consequences of the
Peace and his essays, collected into two books as Essays in Persuasion and Essays in Biography.
The single most important aspect of Keynes the economist is his orientation toward policy. He
attended the Versailles peace conference as a representative of the British Treasury Department but
resigned abruptly in 1919. He was disgusted by the terms of the Versailles treaty, which imposed on
Germany large reparations that he thought could never be paid. He received international acclaim
for his criticism of the terms of the treaty, published in 1919 in his Economic Consequences of the
Peace. In 1940, he wrote How to Pay for the War, and in 1943, he advanced a proposal called the
Keynes Plan for an international monetary authority to be put into effect after World War II. As
head of the British delegation to Bretton Woods, he was instrumental in the formation of the
International Monetary Fund and the International Bank. But his most important contributions to
policy and theory are contained in his book The General Theory (1936), which created modern
macroeconomics and still forms the basis of much of what is taught in undergraduate
macroeconomics. Paul Samuelson captured its importance when, reflecting on the Keynesian era, he
wrote, “The General Theory caught most economists under the age of thirty-five with the
unexpected virulence of a disease first attacking and decimating an isolated tribe of South Sea
Islanders.”
The Contextual Nature of The General Theory
Possibly no book in economic theory has a more presumptuous first chapter than Keynes’s General
Theory. To be sure, other economists had proclaimed their own originality and brilliance, but
Keynes did it with such force that it seemed convincing. This lack of modesty apparently went back
to Keynes’s youth. When he took the civil service exam upon graduation from college and did not
receive the top score in economics, his response was, “I evidently knew more about economics than
my examiners.”11 While Keynes was working The General Theory, he wrote to George Bernard
Shaw that he was writing a new book that would revolutionize the way in which the world thinks
about economic problems. The first chapter of The General Theory is one paragraph long. Here
Keynes simply states that his new theory is a general theory in the sense that previous theory is a
special case to be placed within his more general framework. By “previous theory,” Keynes meant
both classical and neoclassical economics, which he defined as the economics of Ricardo as it
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pertains to Say’s Law, and of those who followed in this belief: J. S. Mill, Marshall, Edgeworth, and
Pigou. on
Although the single most important aspect of Keynes the economist was his policy orientation,
his most important work, The General Theory, in spite of its policy overtones, is essentially a
theoretical book whose major audience was to be found among professional economists. Keynes
wrote, “This book is chiefly addressed to my fellow economists. I hope it will be intelligible to
others. But its main purpose is to deal with difficult questions of theory, and only in the second
place with the application of this theory to practice.”12
We can reconcile this seeming contradiction by understanding the way in which Keynes used
theory. Many economic theories are what might be called noncontextual; that is, they are developed
in an institutional void. Such theories are best understood by deductive logic; they begin with first
principles from which conclusions are deduced on the basis of carefully stated assumptions. In
making these assumptions, one does not take reality into account but tries instead to understand the
inherent logic of the interactions among the assumptions. Such theories might be called analytic
theories. General equilibrium analysis, done correctly, is an analytic theory. Because the
assumptions are inevitably far removed from reality, drawing policy conclusions from broad-
ranging analytic theories is extremely complicated.
Keynes used a different kind of theory, one that might be called “realytic,” because it is a
compromise between a realistic and an analytic approach. A realytic theory is contextual; it blends
inductive information about the economy with deductive logic. Reality guides the choice of
assumptions. Realytic theories are less inherently satisfying, but because they correspond closely to
reality, it is easier to draw policy conclusions from them. Keynes did not start from first principles
in The General Theory but instead used reality to guide his choice of assumptions. Thus, although
he concentrated on theory, he never lost sight of its policy implications.
An example might make the distinction between realytic and analytic theories clearer. Keynes
assumed prices and wages to be relatively constant without attempting to justify those assumptions.
Although he briefly discussed the implications of flexible prices in The General Theory, arguing
that they do not solve the unemployment problem, a thorough consideration of their implications
was of little concern to him; for the problem at hand— what to do about unemployment—it was
reasonable to assume fixed wages and prices.
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have permitted such assumptions. Keynes left it to others to provide an analytic basis for his theory.
Much of the subsequent development of macroeconomic thinking has been an attempt to provide an
analytic base for macroeconomics. He could do this by using his realytic approach, whereas a truly
analytic model would not
Keynes began working on The General Theory immediately after completing his two-volume
Treatise on Money, which made use of the quantity theory of money to discuss cyclical fluctuations.
In The General Theory, Keynes abandoned this approach, much to the chagrin of his colleague
Dennis Robertson, with whom he had previously worked closely. He adopted instead a simple, new
approach that focused on the relationship between saving and investment. To provide himself with a
heftier target, Keynes lumped together the neoclassical disequilibrium monetary approach and the
earlier classical approach, exaggerated their beliefs, and called them collectively “classical theory.”
In doing so, he created a caricature of classical thought that emphasized its differences from his new
approach but concealed many of its subtleties.
Keynesian economics became embodied in the texts in a variety of models called the multiplier
model (sometimes called the AE/AP model), the IS/LM model, and the AS/AD model. These
models were the core of what was taught as macroeconomics through the 1980s and still appear in
many recently published undergraduate texts. But cutting-edge macroeconomics, for the most part,
went in different directions, as Keynesian economics lost favor.
The Rise of the Keynesian Multiplier Model: 1940-1960
In the 1940s and 1950s, economists explored the multiplier model, developing it in excruciating
detail. It was expanded to include international effects, various types of government expenditure,
and different types of individual spending. Terms such as the balanced budget multiplier became
standard parts of economic terminology, and every economics student had to learn Keynes’s model.
It is interesting to note that the model and the monetary and fiscal policies that were, and are,
generally called Keynesian are not to be found in Keynes’s book. There is not a single diagram in
The General Theory, nor any discussion of the use of monetary and fiscal policy. How, then, did the
multiplier model (done algebraically and geometrically) become the focal point of the
macroeconomic debates of the 1950s? Part of the reason is that it seemed to provide a better
description of current reality than did the alternatives. But other factors were also at work. The
initial policy debates about the validity of Keynesian economics focused on fiscal policy
(government deficits during the war had apparently pulled the Western world out of the
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Depression). Because the multiplier model nicely captured the effects of fiscal policy, it tended to
become the Keynesian model. We suspect that sociological reasons also played a role in both the
initial adoption and long-term acceptance of this model. The need for truth is often tempered by
other needs of the profession—specifically, teaching requirements and the necessity of publishing
journal articles. The multiplier model fit those needs beautifully.
It was in the United States that the multiplier analysis caught on. Paul Samuelson and Alvin
Hansen (1887-1975) developed it into the primary Keynesian model. Samuelson’s textbook
introduced it into pedagogy, other books copied Samuelson’s, and soon the multiplier model was
Keynesian economics. The multiplier analysis had many pedagogical advantages, being easy to
teach and learn. It allowed macroeconomics to develop as a separate field by providing a core
analytical structure for the course, just as supply-and-demand analysis had for microeconomics.
The Depression of the 1930s had changed the context within which society and economists
viewed the market. Prior to that time, the neoclassical arguments in favor of laissez faire had been
based not only on economic theory but also on a set of philosophical and political judgments about
government. The general political orientation of almost all individuals except radicals in the early
1900s was against major government involvement in the economy. Within that context, the
concepts of many government programs that we now take for granted, such as Social Security and
unemployment insurance, would have seemed extreme.
With the onset of the Depression, attitudes began to change. Many people felt that if the free
market could lead to such economic distress as existed during the Depression, it was time to start
considering alternatives. As economists began to analyze the aggregate economy in greater detail,
many became less confident of their policy prescriptions and much more aware of the shortcomings
of neoclassical theory. Consequently, economists began to advocate a variety of policy proposals to
address unemployment that were inconsistent with their mainstream neoclassical views. In the early
1930s, for example, A. C. Pigou in England and several University of Chicago economists in the
United States advocated public works programs and deficits as a means of fighting unemployment.
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Keynesian Policy
Keynesian economics subsumed policy argumentation and developed a model that had built into it
the need for activist government policies. In this model, aggregate demand controlled the level of
income in the economy, and the government had to control aggregate demand through monetary
and fiscal policies.
During the 1950s and 1960s, Keynesian policy came to mean fine-tuning through monetary and
fiscal policy. Abba Lerner (1903-1982) was an influential force in directing Keynesian analysis
toward such fine-tuning. In his Economics of Control (1944), Lerner advocated that government not
follow a policy of sound, finance (always balance the budget); it should instead follow a policy of
functional finance, which considered only the results of policies, not the policies themselves.
Functional finance allowed the government to “drive” the economy; in an oft-repeated
metaphor, monetary and fiscal policy were portrayed as government’s steering wheel. Lerner
contended that fiscal and monetary policy were the tools government should use to achieve its
macroeconomic goals: high employment, price stability, and high growth. The size of the deficit
was totally irrelevant: if there was unemployment, the government should increase the deficit and
the money supply; if there was inflation, the government should do the opposite.
Lerner’s blunt statement of the “Keynesian” argument offended the sensibilities of many
Keynesians and provoked considerable discussion, even causing Keynes to disavow
Keynesianism.13 Evsey Domar, a well-known Keynesian at the time, said, “Even Keynesians, upon
hearing Lerner’s argument that the size of the deficit did not matter, recoiled and said, no he had it
wrong, in no uncertain terms.”14 But Keynes soon changed his mind and agreed with Lerner, as did
much of the economics profession, and it was not long before Keynesian economic policy became
synonymous with functional finance.
Monetary and fiscal policies were, moreover, politically palatable. Many economists and others
believed the Depression proved that the government had to assume a much larger role in directing
the economy. The use of monetary and fiscal policy kept that role to a minimum. Markets could be
left free to operate as before. The government would not directly determine the level of investment;
it could simply affect total income indirectly by running a budget deficit or surplus. For many, the
legitimization of deficits had a second desirable characteristic: it allowed government to spend
without taxing.
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MODERN MACROECONOMICS
Monetarism
Throughout the 1950s and 1960s, the primary foil to the Keynesians was the monetarists. Under the
leadership of Milton Friedman, they provided an effective opposition to Keynesian policy and
theory. The consumption function model used by Keynesians in the 1950s had no role for money,
nor did it consider prices or the price level. This initial lack of concern about money supply and
prices manifested itself in policy based on Keynesian analysis. In an agreement with the Treasury
that developed during World War II, the Federal Reserve Bank agreed to buy whatever bonds were
necessary to maintain the interest rate at a fixed level. In so doing, the Fed relinquished all control
of the money supply. Monetarists argued that the money supply played an important role in the
economy and should not be limited to a role of holding the interest rate constant. Thus, the rallying
cry for early monetarists was that money mattered.
Keynesians were soon willing to concur with the monetarists that money mattered, but they felt
that the monetarists differed from them in believing that only money mattered. The debate was
resolved by means of the IS-LM Keynesian-neoclassical synthesis, in which the monetarists
assumed a highly inelastic LM curve and Keynesians assumed a highly elastic LM curve. Thus, at
least in terms of the textbook presentation, monetarist and Keynesian analyses came together in the
general neo-Keynesian IS-LM model, about which they differed slightly on some parameters.
Modern macroeconomics was a result of economists working through the neo-Keynesian model and
discovering many problems, some purely theoretical, and some becoming apparent as neo-
Keynesian policy failed.
Problems with IS-LM Analysis
IS-LM analysis remains part of most macroeconomists’ toolbox; it provides the framework most
economists initially use in tackling macroeconomic analysis. By the 1960s, however, it had been
well explored in the literature and found wanting in several ways. First, it forced the analysis into a
comparative static equilibrium framework. In the view of many economists, Keynes’s analysis
concerned—or should have concerned—speeds of adjustment. They believed that Keynes was
arguing that the income adjustment mechanism (the multiplier) occurred faster than the price or
interest rate adjustment mechanisms. Comparative static analysis lost that aspect of Keynes.
Second, in IS-LM analysis the interrelationship between the real and nominal sectors had to
occur through the interest rate and could not occur through other channels. Monetarists were
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unhappy with this because they thought money could affect the economy through several channels.
Many Keynesians were unhappy with the framework because it shed little light on the problem of
inflation, which in the 1960s was beginning to be seen as a serious economic problem. Third, the
demand for money analysis used to derive the LM curve was not based on a general equilibrium
model; instead, it was assumed in a rather ad hoc fashion. It had not truly integrated the nominal
and real sectors. Because it did not capture the true role of money and the financial sector, it
trivialized their function. It made it seem as if a fall in the price level could bring about an
equilibrium, when in fact most economists believed that a falling price level would make matters
worse, not better. Nonetheless, the IS-LM model was adopted. It was neat, it served its pedagogical
function well, it was a rough and ready tool, it provided generally correct insight into the economy,
and it was the best model available.
Dissatisfaction with existing analysis, however, led many macroeconomists to turn to other
models in their research. This led to a dichotomy. While IS-LM analysis remained the key
undergraduate model in the 1970s and 1980s, graduate research started to focus on quite different
issues. By the early 1990s the change in focus was filtering down to undergraduate courses. Modern
theoretical debates in macroeconomics have little to do with the shapes of the IS-LM curves.
Instead, they approach macroeconomic issues from a microeconomic perspective, and they deal
with issues such as the speeds of quantity and price adjustment. In a sense, many macroeconomic
researchers in the 1970s and 1980s argued that we should skip the Keynesian IS-LM interval and
return to the macroeconomic debate, as it existed in the 1930s, when issues were framed in
microeconomic terms. Thus, starting in the 1970s, we saw a reaction against Keynesian economics.
The Rise of Modern Macroeconomics
Monetarism’s focus on inflation brought it to the fore in the 1970s as inflation increased
substantially. At this happened, Keynesian policies and theory lost favor. Fiscal policy proved
politically too hard to implement; decisions on spending and taxation were made for reasons other
than their macroeconomic consequences. Monetary policy became the only game in town, but the
Keynesian models did not include the potential inflationary effects of monetary policy and so were
not well suited to dealing with discussions of monetary policy. So there was a movement away from
Keynesian economic models for formulating policy.
Simultaneously, there was a movement away from the Keynesian models on theoretical
grounds. As economists tried to develop the microfoundations for those models, they found that
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they could not do so within the context of the standard general equilibrium microeconomic
approach. This desire for micro- foundations deserves some comment, since it is important in
understanding the movement away from neoclassical economics and into modern formalistic
eclectic model-building economics.
Keynesian macroeconomics does not fit the neoclassical mold, and thus it can be seen as a step
in the direction away from neoclassical and into the eclecticism that characterizes modern
economics. It starts with analysis of interrelationships of aggregates rather than developing these
relationships from first principles. Thus, it has always had a tenuous theoretical existence, its
primary role being as a rough-and-ready guide to policy. Loose micro foundations were added to
macroeconomics throughout the 1950s and 1960s where they seemed to fit, but no attempt was
made to develop macroeconomics models from first principles. Macroeconomics was simply out
there—a separate analysis with little direct connection to the Walrasian theory that was at the core
of theoretical microeconomics.
The Micro foundations of Macroeconomics
In the 1970s, economists, in trying to fix this problem, began to lay the micro foundations of
macroeconomics by attempting to fit the Keynesian models into the neoclassical general
equilibrium model. They did this for two reasons: first, for theoretical completeness and, second, to
be able to expand the model to include inflation in the analysis. As they did so, they discovered that
Keynesian models broke down when normal neoclassical principles were applied to them.
Keynesian macroeconomics, the traditional macroeconomics of the textbooks, was inconsistent with
the microeconomics being taught.
The microeconomic foundations literature established new ways of looking at unemployment.
Whereas Keynesian analysis pictured unemployment as an equilibrium phenomenon in which
individuals could not find jobs, the micro- foundations literature pictured unemployment as a
temporary phenomenon— the result of the interaction of a flow of workers leaving work and new
workers entering. It argued that intersectoral flows were an important cause of unemployment and
that these flows were the natural result of dynamic economic processes. For the new
microfoundations approach to macroeconomics, unemployment was a microeconomic, not a
macroeconomic, issue.
Micro foundations economists argued that to understand unemployment and inflation
economists must look at individuals and firms’ microeconomic decisions and relate those decisions
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to macroeconomic phenomena. Search theory, the study of an individual’s optimal choice under
uncertainty, became a central topic of macroeconomics, as did a variety of new dynamic adjustment
models. As researchers began focusing more and more on these models, they focused less and less
on IS-LM models. The initial micro foundations models had been partial equilibrium models, but
once the micro foundations box was opened, economists needed to derive some method of
combining the various markets. The obvious choice was to use general equilibrium models. Thus,
general equilibrium analysis, which we saw in Chapter 14, had become the central model of
microeconomics, was ushered into macroeconomics along with micro foundations literature.
Micro foundations literature was cemented into the profession’s consciousness in the early
1970s by its accurate prediction about inflation. Advocates of the micro foundations approach
argued on theoretical grounds that the Phillips curve—a curve showing a tradeoff between inflation
and unemployment—was only a short-term phenomenon and that, once the inflation became built
into expectations, the unemployment-inflation tradeoff would disappear. The long- run Phillips
curve would be close to vertical and the economy would gravitate toward a natural rate of
unemployment.
The policy implications of the new micro foundations approach were relatively strong. Its
analyses removed the potential for government to affect the natural rate of long-run unemployment
through expansionary monetary and fiscal policy. Attempts to do so would work in the short run by
temporarily fooling workers, but expansionary policy would simply cause inflation in the long run.
According to the new microeconomics, government’s attempt to reduce unemployment below its
natural rate was the cause of inflation in the late 1970s.
Keynesian monetary and fiscal policies were not, however, completely ruled out. In theory, at least,
they could still be used temporarily to smooth out cycles. Thus, in the early 1970s, a compromise
arose between Keynesians and the advocates of a micro foundations approach to macroeconomics
economics: in the long run the classical model is correct; the economy will gravitate to its natural
rate. In the short run, however, because individuals are assumed to adjust their expectations slowly,
Keynesian policies can have some effect.
The Rise of New Classical Economics
In the mid-1970s the term rational expectations first appeared on the macroeconomic horizon. The
rational expectations hypothesis was a byproduct of the microeconomic analysis of Charles C. Holt
(1921- ), Franco Modigliani (1918- ), John Muth (1930- ), and Herbert Simon (1916- ), who were
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trying to explain why many people did not seem to optimize in the way that neoclassical economics
assumed they would. Their work was meant to explain by means of dynamic models what Simon
called “satisficing” behavior; that is, why firms’ behavior did not correspond to microeconomic
models. John Muth turned that work on its head, writing as follows:
It is sometimes argued that the assumption of rationality in economics leads to theories inconsistent
with or inadequate to explain, observed phenomena, especially changes over time. Their hypothesis
is based on exactly the opposite point of view: that dynamic economic models do not assume
enough rationality.19
Muth maintained that in modeling it is reasonable to assume that because expectations are
informed predictors of future events, they would be essentially consistent with the relevant
economic theory. As Simon wrote, “[Muth] would cut the Gordian knot. Instead of dealing with
uncertainty by elaborating the model of the decision process, he would once and for all—if his
hypothesis were correct—make process irrelevant.”20
With his assumption of a “dynamic rationality,” Muth turned disequilibrium into equilibrium.
Just as neoclassical writers used rationality to ensure static individual optimality or to ensure that
the individual moves to a tangency of his or her budget line and indifference curve, Muth used it to
express “dynamic” individual optimality—to set the individual on his or her inter-temporal
indifference curve. As long as the private actors in the economy are optimally adjusting to the
available information (and there is no good reason to assume the contrary), they will always be on
the optimal adjustment path.
Although Muth wrote his article in 1961, the rational expectations assumption did not play an
important role in economics until it was adopted by Robert Lucas into macroeconomics and
combined with the work being done in micro- foundations of macroeconomics. The rational
expectations hypothesis struck at the heart of the compromise between microfoundations
economists and Keynesians, because it held that people did not adjust their expectations toward
equilibrium in stages. They can discover the underlying economic model and adjust immediately,
and it would be beneficial for them to do so. Assuming that people have rational expectations,
anything that will happen in the long run will happen in the short run. Because in the
microfoundations-Keynesian compromise the effectiveness of monetary and fiscal policy depended
upon incorrect expectations, the rational expectations hypothesis was devastating. In the new view,
if Keynesian policy is ineffective in the long run, it is ineffective in the short run.
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In the mid-1970s, rational expectations caught on in macroeconomics, and there were significant
discussions of policy ineffectiveness and the unworkability of Keynesian-type monetary and fiscal
policy. This developing work in rational expectations soon came to be known as new classical
economics, because its policy conclusions were similar to earlier classical views. By the late 1970s
it seemed to many that the future of macroeconomics lay in new classical thinking and that
Keynesian economics was dead.
One of the lasting influences of the new classicals on macroeconomics was their contribution to
the theory of macroeconomic modeling. As will be discussed in Chapter 16, Keynesians had
developed macroeconomic models to a high level of sophistication in the work of economists such
as Jan Tinbergen (1903-1994) and Lawrence Klein (1920- ). In the 1960s and 1970s, many of these
econometric models were not good predictors of future movements in the economy, and many
economists were beginning to lose faith in them. Robert Lucas, a leader of the new classicals,
specified one reason why these models were poor predictors in an argument that became known as
the Lucas critique of econometric models. He argued that individuals’ actions depend upon
expected policies; therefore, the structure of the model will change as a policy is used. But if the
underlying structure of the model changes, the appropriate policy will change, and the model will
no longer be appropriate. Thus, it is inappropriate to use econometric models to predict effects of
future policy.
The majority response was to change their view of models: models were practical tools that
provided insights into particular policy questions; there could be a number of different models that
could be used whenever they seemed to apply; there was no need to have a broad consistency of all
the models. Thus, modern textbooks present the IS/LM model as a working tool, not as something
derived from strict microfoundations. This approach to modeling differed significantly from the
neoclassical approach, which saw all models as, in principle, developing from the core assumptions
of microeconomics.
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SUMMARY
The history of macroeconomics has been marked by changing interest in growth, business cycles,
and inflation and the determination of the price level. While Adam Smith was primarily interested
in the question of economic growth, later classical economists focused their analysis on the
distribution of income and saw the economy as ultimately being driven to a stationary state by the
law of diminishing marginal returns. They saw prices as being primarily determined by the quantity
theory of money, and they saw that determination as needing to be separated from the analysis of
the real economy. They saw the economy as essentially self-correcting, with little need for
government intervention.
Keynes’s General Theory marked a significant change in the focus of economics from
microeconomic questions of resource allocation to macroeconomic questions of business
fluctuations. It emphasized the short run over the long run. Keynes offered a new analytical
framework to explain the forces determining the level of economic activity. He not only found
capitalism inherently unstable but concluded that the usual outcome of the automatic working of the
market was to produce equilibrium at less than full employment. Following the leads of Marx,
Tugan-Baranowsky, Wicksell, and others, he focused on the role of investment spending in
determining the level of economic activity.
A great deal of literature followed that not only extended and improved the original Keynesian
formulation but also threw into sharper perspective the contrasts and similarities between the
Keynesian and pre-Keynesian models. The Keynesian concepts were in a form that invited
mathematical model building and empirical testing. The theoretical revolution was followed shortly
by a policy revolution as the major industrialized economies began programs and constructed
agencies designed to foster full employment.
The Keynesianization of macroeconomics developed in a rather curious manner: it took the
form of multiplier models advanced by leading Keynesians such as Alvin Hansen and Paul
Samuelson. The close association of the development of Keynesian macroeconomic theory with the
use of fiscal policy as a compensatory action available by government to promote full employment
probably accounts for this focus on the multiplier model. In response to internal inconsistencies in
the pure Keynesian formulation and to issues raised by monetarists concerning the role of money,
the IS-LM model became the dominant macroeconomic model by 1960.
With the formalization of the debate around 1975, however, this model was found to be
unsatisfactory for economic research. Inflation, as well as unemployment, seemed an important
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economic topic. A new literature appeared that tried to uncover the microfoundations of
macroeconomics and in so doing blurred the one aspect of Keynesianism that had divided
economics into microeconomic and macroeconomic spheres. With the rise of the microfoundations
literature, the debates and theoretical developments returned to something closer to the framework
of the early 1930s. The only exception was that general equilibrium analysis was increasingly
replacing partial equilibrium analysis. Initially, macroeconomics was closely associated with
econometrics and the development of large-scale models of the economy. Although numerous such
models exist, their early promise has not been realized. Thus, in the 1980s there was a movement
away from such models and from the focus on purely theoretical issues. Modern macroeconomics is
highly eclectic, and no single approach is accepted by all economists.
It is, moreover, in a period of transition; scholars are carrying on a wide range of research programs
addressing many different questions. The main focus of macroeconomics today is on a new growth
theory that deviates significantly from the earlier classical growth theory, especially in emphasizing
endogenous technology and in not considering the stationary state as inevitable.
The development of econometrics and empirical methods in Economics
There has been a continuous debate in the profession about the proper relationship between
theory and empirical methods
Empirical Approaches
1. Common Sense Empiricism
Relates theory to reality through direct observation with a minimum of statistical aids
Still commonplace in some subjects
History anthropology
Contemporary supporters point to the valuable insights found in
careful observation
extensive field work
case studies
direct contact with institutions
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personal experience “within” an event
2. Statistical analysis
Emphasizes those aspects of an economic event that can be quantified and is therefore
subject to measurement and analysis
Supporters claim that this approach permits a researcher to draw from a large number of
theories and select the most relevant one.
Also claim that it discouraged pre-considered theoretical notions from biasing one’s
interpretation of data
3. Classical Econometrics
- Rigorous defines the relationship between theory and empirical data
- developed in the 1930’s
4. Baynesian Approach
-Directly relates theory and data as above but assumes that no test can provide definite
answers
Does not seek objective laws but subjective degrees of belief
Statistical analysis cannot determine objective truths, but it does add in making
subjective judgments
Recent Developments
1. Computer Technology
2. Agent Based Modelling
3. Calibration: See if data is consistent with a theory
4. Experimental Economics
Neoclassical Era (1870-1950’s) and Empirical Analysis
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There was no accepted test to validate or reject the merits of various theories
This gradually changes as neoclassical theories became more formal and some sought to
make economics an exact science
This resulted in formalizing the approach that economists use in their empirical analysis