finalexam

History of Economic Thought

Notes for Week 12

Alfred Marshall (1842 – 1924)

On the whole, Marshall was a conservative thinker, driven by a desire to see an

improvement in the condition of human beings but in ways that harnessed the self-reliant and

competitive spirit of capitalism. He was sensitive to the plight of the poor, saw himself as

interested in issues of social justice, and did not take a dogmatic attitude toward the free market.

As a result, and despite his preference for a system of free enterprise, he was comfortable

exploring the possibility of using government and public policy to improve on the outcomes of

free markets. He was convinced that competition brought salutary effects on the character of the

individual and saw capitalism as a positive evolutionary outcome of western civilization. He was

in favor of private property, markets, and individual initiative; and, like Adam Smith, tended to

focus on the self-regulatory aspects of market systems.

Yet, despite his willingness to explore the welfare losses capitalism can bring about, he

seems incapable of accepting the idea that free competition might not always result in long-run

benefits. Thus, even when he acknowledged the existence of internal economies of scale, which

in turn imply that competitive markets can evolve into oligopoly or monopoly, he continued to

imagine that the long-run outcome of industries subject to economies of scale would be one

where prices continue to hover around the minimum cost of production. He believed that the

presence of increasing returns to scale would not provide a long-term advantage to any one firm,

but rather that all the firms in the market would experience the same reduction in unit cost,

providing no unique advantage to any one firm. All that would happen is that the output from the

industry as a whole would now be sold at a lower price as a result of the lower unit cost brought

on by the increasing returns experienced by all the firms in the industry. The market, in short,

would remain competitive, with little danger of becoming oligopolistic or monopolistic.

Similarly, and despite acknowledging the existence of large corporate institutions, Marshall

insisted on characterizing the economy as though it consisted of a huge number of small

competing firms. The notion that an increasingly large share of the economy might be dominated

by a hand-full of corporate institutions does not enter into his world-view. He tended to see all

industries as consisting of a range of firms of various sizes clustered around a norm set by the

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technology of production. Furthermore, the economy as a whole was seen as populated by an

enormous number of industries, each of which was in turn populated by a very large number of

firms. As a result, and despite living through the first Robber Baron era and the political

economic dominance of corporations, Marshall continued to portray the economy as driven by

the pressures of competitive markets rather than monopolies and oligopolies.

His reliance on partial equilibrium analysis overlaps with his tendency to imagine the

economy as consisting of a huge number of competitive industries and firms. Under these

conditions, it is indeed reasonable to explore the impact of a change in supply or demand in any

one market by imagining that all the other markets remain unchanged. Since each firm and

industry represents a very small proportion of the industry or the economy as a whole, a change

in supply or demand within any one market will have a negligible effect on the demand and

supply of other markets and, consequently, little chance of reverberating back to the original

market. For example, in the kind of partial equilibrium analysis of which Marshall was fond, one

could imagine market supply contracting while market demand remains unchanged. But the only

way this could hold true is if the drop in income, which a reduction in supply implies, will have

little impact on the rest of the economy and, consequently, little impact on the demand for the

good in the original market. This is not an unreasonable assumption if the market in question

represents a small to insignificant proportion of the total economy. But if the market represents a

large proportion of the economy then such partial equilibrium analysis is no longer appropriate.

A change in supply would now have to account for the impact it has on demand, through the

influence changing supply conditions have on national income and consequently consumption.

These latter possibilities become much more common in economies dominated by large

corporate businesses operating in oligopolistic and monopolistic markets, which is the context of

contemporary advanced capitalist economies.

One of the major contributions Marshall made was to wed the classical and neoclassical

traditions by placing their respective theories of value within the context of time. The Classicals

focused on labor as the determinant of value, while the Neoclassicals focused on utility. By

placing these arguments in the context of time, he showed that utility is the primary determinant

of price in the very short run, what he called the market day; while labor, or more broadly cost, is

the primary determinant of price in the long-run. But, in the short run, the context of ongoing

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day-to-day reality, both utility and cost, that is both demand and supply, play a role in

determining the price of a commodity.

The market day referred to a time period in which the product has already been produced

and its amount cannot be changed. The example he used was of a catch of fish that has been

brought to the market and must be sold quickly to avoid the inevitable spoilage. But the idea also

applies to works of art or unique goods that cannot be reproduced. In each case, the basic idea is

that the quantity of the good available is given and its amount can’t be changed. Under these

circumstances, the cost of producing the good has no impact on the price at which it will be sold.

Instead, it’s the degree of desire or utility, on the part of potential buyers, that determines its

price. If there’s intense desire or utility for the good, then buyers will bid against each other

forcing the price upward; and if not, then the price will fall to the level dictated by those whose

desire for the good is relatively modest. In other words, the price at which it will sell will depend

exclusively on the strength of the marginal utility of potential buyers.

The long-run referred to a time period during which the size of the industry is expanding.

The productive capacity of the industry is growing as a result of the entry of more firms. One

could also imagine that the industry is growing as a result of firms getting larger, but Marshall

tended to downplay this possibility and focused instead on the entry of firms. Part of the reason

for this way of conceiving of growth was due to the fact that he thought of all industries, and the

markets through which the output of industries are sold, as consisting of a range of firms varying

in age and size. There was, he imagined, a representative firm which captured the average age

and size of all the firms in an industry. What’s more, because he saw single proprietorships as

the dominant form of business and tended to downplay the role of corporations which can outlast

the lives of their founders, he thought of firms as having a normal life-cycle: birth, youth,

maturity, old age, and death. So, at any one moment in time, there are firms that are being born

into the industry, firms that are in their youth or mature stage, and firms that are dying off. As a

result, he tended to view the size of the representative firm as stable even though individual firms

were growing and shrinking. Thus, while the representative firm might remain the same size, the

industry is growing as a result of a growing number of firms.

Now, in a context of economic growth, the price of a commodity will be determined by the

long- run cost of producing it. The entry and exit of firms into a competitive market will have the

effect of causing the market price to hover around the minimum average cost of production. In

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the extreme, over the very long run, the price will equal the minimum average cost of

production. If, for whatever reason, the demand for the product is momentarily very strong,

forcing the market price to exceed minimum average cost, then the firms will be making above

normal profits and this will induce capitalists in the rest of the economy to invest in the industry

by opening up new firms. As the entry of firms proceeds, however, the supply of the product

begins to grow faster than demand, causing market price back in line with minimum average

cost. A similar process, though in reverse, occurs if market demand happens to be short of

supply. Thus, in the long run, the price of a commodity is determined by its cost of production,

with utility playing no role in its determination. All that utility (demand) does is to determine the

volume of industry output, not its price.

The short run referred to a time period in which the productive capacity of an industry (and

thus market) was stable, but output could be changed in response to changing demand

conditions. The firms respond to changes in demand by hiring more or less labor and the

appropriate complement of necessary raw materials. Under these conditions, the price of a

commodity is determined by both utility and cost, that is demand and supply. Marshall saw this

as the arena wherein both traditions, the classical and neoclassical, are reconciled. But, in fact,

what he managed to do is highlight the differing approaches of both traditions, noting that the

classical tradition focuses on the long run while the neoclassical tradition focuses on the market

day and both traditions have a role to play in the short run.

Growth Equilibrium as a form of Evolution

Charles Darwin’s On the Origin of Species, published in 1859, had a significant impact on

intellectuals of the late 19th century. Indeed, its impact is still being felt to this day. The idea that

organisms evolve as a result of an on-going struggle to adapt and survive was viewed by many as

an appropriate way of interpreting the evolution of society. Both Alfred Marshall and Thorstein

Veblen were influenced by Darwin’s evolutionary notions, but Marshall’s interpretation

(unfortunately) tended to veer in the direction of Social Darwinism and, as such, was never as

robust as the version developed by Veblen. Indeed, Veblen’s interpretation led to the

development of a school of thought, called Institutional or Evolutionary Economics, that exists to

this day. In contrast, Marshall’s interpretation was sufficiently modest that his theories could be

easily explained, indeed that is how they are explained, using non-evolutionary and mechanistic

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concepts of equilibrium. Thus, contemporary students can easily read Marshall’s Principles of

Economics without ever realizing that he was trying to use an evolutionary perspective. That

could not be said of Veblen.

One of the more interesting twists in the development of economic ideas has to do with the

fact that Darwin had been influenced by Thomas Robert Malthus. In the first chapter of his On

the Origin of Species, Darwin credits Malthus’s Essay on Population as responsible for

providing him with the insight of a species (in this case human) struggling for survival in the

face of food constraints. To be sure, Darwin developed this insight in ways that Malthus had not

anticipated, but the overall vision of competitive struggle remained. There is thus an interesting

intellectual thread going from Malthus to Darwin, and then from Darwin to Marshall and Veblen.

It should also be noted that Marx saw his own theory of historical materialism as a version of

Darwin’s theory of evolution. In private correspondence with his friend Fredrick Engels, Marx

claims that his theory of history was consistent with Darwin’s theories.

Here I’ll focus only on Marshall’s interpretation, not necessarily because it’s the most

appropriate, but because it helps us to understand his economics. He was convinced that

economics should model itself on biology rather than physics. Walras, as you may remember,

saw physics as the appropriate analogy. But he wasn’t alone. Indeed, the notion that economics

could be a version of physics had been a feature of the discipline since Adam Smith and is still a

strongly held belief among contemporary economists. But Marshall felt that such an approach

made no sense for a discipline that pretends to understand how society actually works. Society,

and the institutions that make up society, is a historically evolving system; and as such, is always

in the process of changing or evolving. It’s for this reason that Marshall did not put much stock

in formal mathematical modeling. His belief was that such an effort was bound to miss the mark

since the underlying reality, which the formal models are supposed to capture, would inevitably

change as society evolves.

Yet, despite his preference for biological analogies, he nevertheless relied on the

equilibrium ideas of his predecessors, such as David Ricardo and Antoine Augustin Cournot.

But, he did so in a way that he believed incorporated the idea of economic growth and

development. He did this by trying to introduce time into his theories and by imagining that, at

both the level of the economy and the individual or firm, change occurs gradually. It’s for this

reason that he tended to envision the economy as growing in a relatively stable fashion, what

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contemporary economists would call a stable growth equilibrium. It has often been characterized

as a stationary state, where economic growth is non-existent; but a more appropriate

interpretation is that it represents a slowly growing economy which expands gradually as a result

of incremental additions to capital. He imagined that this was consistent with nature and for that

reason was fond of the Latin phrase natura non facit saltum (nature does not make sudden leaps).

Obviously, he thought of capitalism as a fairly stable system that is forever gravitating toward a

GCE. But unlike Walras’s conception of a GCE, Marshall’s version assumed that the resource

base was gradually expanding as a result of the on-going investment decisions of capitalists.

Thus, Marshall’s vision of a capitalist economy overlaps with Smith’s tendency to see free

market systems as bringing about a harmony of interests.

This overall vision influences the way in which he portrays the individual and the firm.

Both agents are perceived as forever making marginal adjustments to their existing condition, in

the hope of maximizing some objective, such as utility or profit. The context is assumed to be

stable while the individual or firm adjusts her/his stock of goods in response to discrepancies

between the amount currently owned or in use and the amount thought to generate a maximum of

utility or profit. Thus, the individual is portrayed as spending her/his income in such a fashion

that the marginal utility per dollar derived from the purchase of any one good would be equal to

the marginal utility per dollar spent on the purchase of all the other goods. In the case of two

goods, A and B, this idea is represented in the following fashion (which should be familiar to

contemporary students)

𝑀𝑈𝑏

𝑝𝑏 =

𝑀𝑈𝑎

𝑝𝑎 .

If the marginal utility per dollar in the consumption of any one good happens to be greater

than the marginal utility per dollar in the consumption of the other goods making up her/his usual

basket of consumption, then the individual will purchase more of that good so as to restore the

balance to the marginal utility per dollar derived from the consumption (ownership) of goods.

And if the marginal utility per dollar in the consumption of any one good happens to be less than

the marginal utility per dollar in the consumption of other goods, then the individual will cut

back on the purchase of that good.

A similar process was claimed to operate at the level of the firm. The owner, he believed,

was searching for a maximum of profits by making marginal adjustments in the use of the

resources needed to produce the firm’s output. The owner of the firm was forever seeking to

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reduce her/his cost of production by using resources in such a fashion that the marginal product

per dollar generated from the use of any one input would equal the marginal product per dollar in

the use of all other inputs. In the case of two inputs, L (labor) and K (capital), this idea is

represented in the following fashion (again, familiar to contemporary students)

𝑀𝑃𝐿

𝑤 =

𝑀𝑃𝐾

𝑣 ,

where w represents the price of L (the wage rate) and v represents the price of the service of K

(the rental rate, which in turn is the sum of the rate of depreciation and the rate of interest).

If the marginal product per dollar spent in the use of labor is greater than the marginal

product per dollar spent on capital, then the capitalist will change the way in which her/his firm

produces the good by using a bit more labor and a bit less capital. And if the marginal product

per dollar from using labor is less than the marginal product per dollar in the use of capital, then

the capitalist will use less labor and more capital.

Beyond the obvious symmetry of this theory (the individual and the firm behave in very

similar ways) there’s the issue of substitutability, namely the idea that wants, needs, and methods

of production, can be met by combining goods in varying proportions to achieve the same end.

Marshall was the first to emphasize this idea and it’s still a prominent feature of contemporary

neoclassical economics. The basic idea is that the individual and the firm are perceived by

Marshall as always having the option of changing the way in which they spend their money to

achieve a particular end. Thus, in her/his search for a maximum of utility the individual will alter

her/his consumption basket in response to changing prices. If the price of one commodity

increases, she/he will be induced to search for another commodity that could provide the same

level of satisfaction but at a lower relative price. Likewise, in her/his search for a maximum of

profits, the owner of a firm will alter the way in which labor and capital are used in the

production of output whenever resource prices change. Thus, if the relative price of labor

increases the capitalist will adjust her/his firm’s method of production to use less labor and more

capital. Central to this way of thinking is the notion that there’s always a range of substitute

goods which the individual or firm can rely upon to consume or produce any one level of output.

In contrast to Marshall, the classicals conceived of subsistence as consisting of a range of

commodities which a typical working-class individual must purchase so as to sustain

herself/himself. This bundle of commodities was thought of as a necessity, things that must be

purchased to subsist and reproduce working class existence. They frequently used corn as the

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primary example of a subsistence good (keeping in mind that the English used to the term corn

as a generic term for all kinds of grains). If the price of corn were to increase, then – over the

long run - the wage rate would also have to increase to keep the worker’s real wage on a par with

the price of corn. Similarly, the classicals conceived of the technology of production, the capital-

labor ratio, as a fixed magnitude determined by the current state of knowledge. They took it for

granted that each industry had an average or normal way of using capital and labor that was

determined by the technology which the capitalist had to use if she/he were to produce and sell

the corresponding commodity.

But Marshall’s focus on substitutability changed this way of conceiving necessities and

technology. If, for example, there are substitutes for corn, then it’s not necessarily the case that

the wage of the worker will have to increase by the same proportion as the increase in the price

of corn. The worker could instead increase her/his purchase of cheaper substitutes while

decreasing the purchase of the now higher priced corn, allowing the worker’s real wage to

remain unchanged (or at the very least decrease by a smaller proportion than the increase in the

price of corn). Likewise, if the wages of labor were to increase, then it’s not necessarily the case

that the capitalist will have to continue using the same number of workers in the production of

the same volume of output. The capitalist could instead decrease his usage of labor (since it’s

now more expensive) and increase his usage of capital. The proportions in which capital and

labor are used in the production of the good can be changed in response to changes in relative

prices.

The concept of substitutability had the effect of diluting the notion of a necessity by

highlighting the possibility that any one need could be met through the consumption of a wide

range of alternative goods. If the price of any one of those goods were to increase the consumer

could find cheaper priced substitutes to fulfill the same need. And if the price of any one

resource were to increase the capitalist could easily substitute some other resource in the

production of the same good. No one good could now be defined as a necessity since substitutes

were, in general, always available. And no one method of production had to be employed in the

process of production since capital and labor are now conceived as substitutes for each other.

But, not only is the capitalist perceived as forever altering his use of capital and labor in

response to changing input prices, she/he is perceived as forever searching for a maximum of

profits by making incremental adjustments to the amount produced. Since, in general, the

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capitalist was portrayed as a price taker, her/his search for a maximum of profits involved an

ongoing comparison of the market-determined price of the product to the marginal cost of

production. If the price of the product exceeded the marginal cost of production, the firm would

produce and sell more of the product. And if the price of the product fell short of the marginal

cost of production, the firm would cut back on the amount produced. In this fashion the firm

would meander its way to a maximum of profits by producing at that point where the price of the

product just matched the marginal cost of production.

Free Markets and Increasing Returns to Scale

Marshall believed that one of the more important benefits of a free market system is that it

ensured that, over the long-run, commodities would sell at prices that equaled their minimum

unit cost. Now, in the case of firms and industries that experience constant returns to scale, free

competition will indeed have the effect of keeping the market price close to the unit cost of

production; in the extreme, the long-run, the market price will be equal to unit cost as well as

marginal cost. But, in the case of firms and industries that experience increasing returns to scale

this is no longer true. The more aggressive firms in such industries will have an incentive to

grow at a faster pace than the competition, allowing them to generate a greater volume of the

product at a lower unit cost. This in turn will have the effect of squeezing out the higher cost

competitors and, over time, transforming that industry into an oligopoly or monopoly. In other

words, free competition in the context of increasing returns to scale will not lead to a situation

where the price tends to bump against unit cost. Instead, since such markets tend to become

oligopolies or monopolies, the price tends to stay above both unit cost and marginal cost.

Marshall believed that market prices would still be close to unit cost and marginal cost

even in the context of increasing returns, because the impact of increasing returns would be felt

by all the firms in the industry, so that instead of one or a handful of firms growing faster than

the others, and squeezing out the competition, they would all experience a similar reduction in

unit cost, ensuring that the market would remain competitive (lots of competing firms) despite

the presence of increasing returns. He was wrong.