Download Neoclassical Economics

History of Economic Thought Lec :8
Neoclassical Economics
Alfred Marshall:(1842-1924)
Synthesizer of Neoclassical Economics
Major Contributions
Marshall was a highly skilled mathematician, but he was dismayed as higher level mathematics was
increasingly integrated into economics. Marshall noted that mathematical proofs sometimes yield erroneous
conclusions, and viewed math as often obscuring important economic concepts.
Marshall is considered to be one of the most influential economists of his time, largely shaping mainstream
economic thought for the next fifty years, and being one of the founders of the school of neoclassical
economics. Although his economics was advertised as extensions and refinements of the work of Adam
Smith, David Ricardo, Thomas Robert Malthus and John Stuart Mill, he extended economics away from
its classical focus on the market economy and instead popularized it as a study of human behavior. He
downplayed the contributions of certain other economists to his work
Marshall's influence on codifying economic thought is difficult to deny. He popularized the use of supply and
demand functions as tools of price determination (previously discovered independently by Cournot); modern
economists owe the linkage between price shifts and curve shifts to Marshall. Marshall was an important part
of the "marginalist revolution;" the idea that consumers attempt to adjust consumption until marginal
utility equals the price was another of his contributions. The price elasticity of demand was presented by
Marshall as an extension of these ideas. Economic welfare, divided into producer surplus and consumer
surplus, was contributed by Marshall, and indeed, the two are sometimes described eponymously as
'Marshallian surplus.' He used this idea of surplus to rigorously analyze the effect of taxes and price shifts on
market welfare.
Marshall’s theory of production carefully distinguished between the impact of scale and location on the cost of
production. Size would generally elicit lower production costs over time. Marshall’s discussion embodied static
and dynamic elements, as well as factors incompatible with perfect competition, such as marketing and
advertising expenses (Stigler 1941, pp. 77–83). Moreover, by dwelling on the locational advantages for firms as
parts of industrial districts—the geographical concentration of industry—Marshall linked scale advantages to
the size and concentration of an industry, as well as to the individual firm.
Marshall Distinguished Three Different Periods of Analytical Time for Production
Marshall wove time into economic analysis:
1. The long run: The long run (LR) is an analytical period of sufficient duration to make all feasible resource
adjustments to any event, although, for convenience, technology is usually assumed constant for purposes of
long-run analyses. Fixed costs are zero in the long run.
2. The short run: The short run (SR) from a microeconomic perspective is an analytic period of time in which
at least one resource is fixed so that firms can neither enter nor leave the marketplace--a firm can shut its
plant down, but it cannot leave the industry.
3. The market (intermediate) period is so short that firms cannot adjust output. Because nondurable goods
cannot be inventoried and must be sold immediately, their supply curve is vertical and the price of the good
is determined by demand during that period.
Instructor:Izzah Taimur
1
History of Economic Thought Lec :8
Elasticity of Supply: Supply elasticity depends on time available to producers to respond to a price change
•
•
•
•
Market period: perfectly inelastic supply, price is determined entirely by demand in the case of perishable
goods and by expected future prices in the case of durable goods.
Short run: rising supply curve, price is determined by both supply and demand, usage levels of some
resources are fixed
Long run: usage levels of all resources are variable, supply could be a falling curve
Very long period: changes in knowledge, population and capital cause long run prices to change gradually
Marshall Formalized the Use of Partial Equilibrium Analysis
Partial equilibrium: is a method of economic analysis which looks at the direct effects of some chosen
variables on others, assuming all other influences constant. This technique relies on the ceteris parebus (all
else held constant) assumption.
In partial equilibrium analysis, some potential influences on relationships are held constant.”
Example: hold everything constant except for price and examine the effects of price on Qd or Qs.
The partial equilibrium method, enabled him to concentrate on the key variable that explained a particular
concept, while holding other less important variables constant. For example, his exposition of demand theory is
presented primarily as a function of price, other things being equal, including the purchasing power of money,
money income, prices of related commodities (substitutes or complementary goods), the time element in the
analysis, and tastes, habits, and fashions. This approach simplified functional relationships considerably.
However, the complexity of what was impounded in “the pound of caeteris paribus” made the method difficult
to use in practice, contrary to Marshall’s intentions.
Marshallian Quantity Adjustments: Perhaps again unconsciously following the pioneering assumptions of
Cournot, Alfred Marshall theorized that economic agents adjust quantities (rather than prices) to clear
competitive markets that are out of equilibrium. Disequilibrium exists if, at the current quantity being sold, the
supply price differs from the demand price so that a market experiences a surplus or a shortage. In a Marshallian
adjustment, the quantity supplied will adjust until demand and supply prices are equal. Quantity increases in
response to a shortage, and decreases in response to surpluses. NOTE: Contrast this with the Walrasian
adjustment mechanism, which posits that the market price will fall if the quantity supplied exceeds the quantity
demanded, and that the market price will rise if the quantity demanded exceeds the quantity supplied.
Competitive Equilibria: Marshall identified a competitive equilibrium as occurring when economic profit is
zero, and identified the entry of new firms as driving prices down and resource costs up as potential
mechanisms to drive down profits in a profitable industry, and rising prices and falling resource costs as
mechanisms that eliminate losses as firms exit an industry in which economic profit is negative.
Elasticity: Following some ideas expressed by John Stuart Mill, Marshall mathematically specified elasticity as
a measure of the sensitivity of one variable relative to some other variable.
The responsiveness in supply and demand of a commodity to changes in price was classified by Marshall in
terms of their degrees of elasticity. Where responsiveness is proportionately equal to the price change, unitary
elasticity applies. When responsiveness is less than the price change, the function exhibits inelasticity ; if
greater, it is described as elastic. Elasticity was an important, novel, and enduring feature of Marshall’s price
analysis.
Instructor:Izzah Taimur
2
History of Economic Thought Lec :8
Internal Economics of Scale: These are gains in productivity and reductions in cost inside a firm due to
expanded production.
External Economics of Scale: These are gains in productivity and reductions in cost outside the firm. These
are usually gained in the industry due to expansion of that industry. An example would be the massive
expansion of the highway system that has reduced the cost of transportation for each company in the trucking
industry.
Increasing Cost Industry: An industry in which expansion through the entry of new firms increases the prices
firms in the industry must pay for resources and therefore increases their production costs.
Decreasing Cost Industry: An industry in which expansion through the entry of firms decreases the prices
firms in the industry must pay for resources and therefore decreases their production costs.
Quasi – Rent: A quasi-rent is a transitory surplus, often associated with previous investments in physical or
human capital. These surpluses are ultimately dissipated by, e.g., depreciation, or by rent-seeking initiated by
other parties
Consumer Surplus: The gain consumers derive from differences between the amounts of money they would
willingly pay to consume alternative quantities of a good and the smaller payments required for them to
consume those quantities of the good. Graphically, this is the area below consumers’ demand curves but above
the price line
The Marshallian Industrial District
A concept based on a pattern of organization that was common in late nineteenth century Britain in which firms
concentrating on the manufacture of certain products were geographically clustered. The two dominant
characteristics of a Marshallian industrial district[6] are high degrees of vertical and horizontal specialisation and
a very heavy reliance on market mechanism for exchange. Firms tend to be small and to focus on a single
function in the production chain. Firms located in industrial districts are highly competitive in
the neoclassical sense, and in many cases there is little product differentiation. The major advantages of
Marshallian industrial districts arise from simple propinquity of firms, which allows easier recruitment of
skilled labour and rapid exchanges of commercial and technical information through informal channels. They
illustrate competitive capitalism at its most efficient, with transaction costs reduced to a practical minimum; but
they are feasible only when economies of scale are limited.
Instructor:Izzah Taimur
3