Marginalism

From Hobson's Choice

A group of economic hypotheses that marked the transition from classical economics to neoclassical economics.

1 Context
2 Utility
3 Notes
4 See Also
5 External Links & Sources

Context

Prior to 1870, economic orthodoxy was dominated by the classical school of economics, which was largely molded by the writings of Jean-Baptiste Say, David Ricardo, and Nassau Senior. The premises of classical economics were:

Supply creates its own demand
All saving is invested
Markets determine prices based on factor availability and opportunity cost
Labor is a commodity (and ideally, as cheap as possible).

While neoclassical economics departed from the classicals in several matters, it retained these fundamental propositions.

Classical economics had stumbled, however, on several issues of concern to policy makers. One of these was persuasiveness: the rival historicist school had won control of German and US educational institutions, and was aggressively making headway in France and Britain. Classical economic literature often has great literary merit, but it was a field dominated by polymaths and gentleman amateurs.^[1] The new protagonists were keen to apply mathematical methods to economics as a final arbiter.^[2] In order to do this, however, they required a series of propositions that could render fixed answers to mutable questions. The marginalist revolution provided those answers.

The questions were:

What determines the equilibrium price & quantity of each good?
What determines the distribution of income among the factors of production?
Why are there trade (business) cycles?

The classical responses to these questions, if any existed, suffered from being able to explain virtually any outcome that could have existed.

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Utility

Marginalism's contribution was mainly focused on the concept of diminishing marginal effects in economics. Most important to this was the idea that value was determined by its utility, and in particular, its marginal utility. ^[3] Utility had the advantage of furnishing a stable explanation for prices: demand for additional units of a thing tended to diminish with increased consumption. This was not really a psychological notion, as a practical one: a single consumer would allocate a consumer-good among rival needs, and as the consumer allocated more of that good among the same set of rival needs, she would presumably take care of the most urgent needs first. So, for example, if the good is liters of petrol, then the first liter is allocated to the commute, the second to grocery shopping, the third to clothes shopping, and so on, until the last is used on a trip that the consumer really isn't sure she wanted to make.

Humans were assumed to have a utility function U(x₁, x₂,... x_n), where x₁, x₂,... x_n refered to all the various goods one consumed. Proceeding backwards up the production process, the price of each input was established; each input was valued to the extend that it contributed to the supply of utility. So, for example, the production of a liter of petrol requires k capital and l labor (plus the rents on the oil field). While it is not possible to state unambiguously how much satisfaction each unit of petrol provides, or what percentage of one's total life-satisfaction comes from the consumption of petrol, it is possible (in theory) to reach an estimate of (i.e., the increment in total utility caused by an increment in a particular unit of good x_i).

This offered the satisfaction of suggesting a unique solution to the price of commodities. In classical theory, the price of commodities was determined by their cost of production. This led to the problem of ascertaining factor prices, the ambiguity of which was a headache for bourgeois economics. If economics could not explain why labor was paid so little and capital so much, the forgoing mattered little.

The idea that trade followed a cycle was still far off; fluctuations in business activity were perceived as being determined by fluctuations in factor prices, not by anything inherent to the capitalist system.^[4] But with marginalism, it was now possible to incorporate an explanation for such variations in aggregate demand. Using Alfred Marshall as an example, the problem arose from oscillations between allocation of production in capital goods and consumer goods:

When we come to discuss the causes of alternating periods of inflation and depression of commercial activity, we shall find that they are intimately connected with those variations in the real rate of interest which are caused by changes in the purchasing power of money. For when prices are likely to rise, people rush to borrow money and buy goods, and thus help prices to rise; business is inflated, and is managed recklessly and wastefully; those working on borrowed capital pay back less real value than they borrowed, and enrich themselves at the expense of the community. When afterwards credit is shaken and prices begin to fall, everyone wants to get rid of commodities and get hold of money which is rapidly rising in value; this makes prices fall all the faster, and the further fall makes credit shrink even more, and thus for a long time prices fall because prices have fallen.
Principles of Economics, VI.vi

This arose from the concept the economy being an isotropic affair of millions of identical average households. It was actually Friedrich Hayek^[5] who formalized this into a theory that incorporated cycles (Marshall's explanation does not).

According to Hayek, the crisis occurs when the rising factor incomes generated by the previous expansion lead to an increase in consumer demand. In turn, prices of consumer goods are raised relative to prices of specific capital goods. This point is the same in both versions of Hayek's theory. In Prices and Production, increases in the money supply bring about a decrease in market rates. Capital deepening occurs as price margins narrow between stages of production. But factor incomes rise at the same time. Repeated injections of money (in the form of bank credit) may maintain the "lengthened" production structure (that is, prevent capital enshallowing), but once these injections cease or the rate of increase is slowed, market interest rates rise. At the same time a rise in consumer demand causes relative prices to return (approximately) to their pre-expansion values; consumption output increases and the structure of production is once again "shortened."

This was related to the concept of diminishing marginal utility of consumer goods arising as there is a boom in production. Classical economics, which tended to reckon prices as a sum of capital inputs, was left with a strictly exogenous model of the industrial cycle.

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Notes

↑ For example, John Stuart Mill and [David Ricardo], respectively.
↑ An exception to this was the Austrian School, especially Carl Menger.
↑ The dilemma that the utility theory of value is supposed to resolve is often discussed as the "diamond/water paradox": water is essential to life, while diamonds are just a bauble; but diamonds are costly, while water is cheap (Smith, Wealth of Nations, I.xi). The marginalists pointed out that the marginal utility of an additional increment of either was the key; another gram of water was inconsequential, while another gram of diamond is not. See Böhm-Bawerk, The Positive Theory of Capital, III.iv.
. Pearls and diamonds are to be had in such small quantities that the relative want is only satisfied to a trifling extent, and the point of marginal utility which the satisfaction reaches stands relatively high. Happily for us, on the other hand, bread and iron, water and light, are, as a rule, to be had in such quantities that the satisfaction of all the more important wants which depend on them is assured.
↑ There is some dispute over whether or not Marx's Capital stimulated the emergence of marginalist thought; usually, admirers of marginalism/neoclassical economics say this is impossible, on the grounds that Jevon's, et. al., was already working on their major works when Capital was published. While it's unlikely that Capital caused the marginalist movement, it is true that there was a radical left in Europe long before Capital, and this movement often quoted Ricardo. That's why there was so much apologetic literature.

However, by 1885, when the 2nd volume was published, Marx was not obscure at all. Böhm-Bawerk wrote book-length criticisms of Capital(Karl Marx and the Close of His System, 1896), while Marshall (Principles of Economics), the authoritative source on neoclassical economics, mentions him often.

Marx appears to be a pioneer in referring to "industrial cycles," or what we would call a "business cycle" today. All three volues of Capital make mention of it; in 1888, Gen. Walker mentions it in The Wages Question: A Treatise on Wages and the Wages Class, II.xiv, 1876; Sir Robert Giffen, Economic Inquiries and Studies (complete text online), George Bell & Sons (1904); and thereafter, it was a staple of economic literature.
↑ Hayek, "Profits, Interest, and Investment," p. 3.; quoted in Gerald O'Driscoll, Jr. Economics as a Coordination Problem: The Contributions of Friedrich A. HayekKansas City: Sheed Andrews and McMeel, Inc (1977)