Chapter 9: The Transition to Neoclassical Economics

Chapter 9: The Transition to Neoclassical Economics Questions for Review, Discussion and Research 1, 2, 3, 4, 7, 8, 9 The full importance of the discoveries” of Jevons, Menger and Walras eluded the first generation Overhead pp. 244

Marginal Analysis Extended • Early neoclassical writers applied marginal analysis almost exclusively to the theory of demand • The supply of factor inputs was exogenous so resource allocation was to assign them to alternate activities

Marginal Productivity Theory • Recall Ricardo’s earlier contribution to the concept of diminishing returns in agriculture • Q = f[T, L, K, R] (L, K in fixed proportions and technology constant) • Doses of labour and capital inputs applied to fixed quantities of land will result in diminishing marginal productivity

Ricardian Theory of Income Distribution • It is a “residual” theory where…Rent – The residual after wages and profit are deducted from total (revenue) product Profit – The residual after determined by the Malthusian population doctrine, are deducted from wages and profit • Classical writers did not fully appreciate the significance of marginal analysis and it was left to the second generation of

neoclassical economists to apply it to marginal productivity Austria – Bohm-Bawerk, Weiser Sweden – Wicksell U.S.A. – J.B. Clark Britain – Wicksteed, Edgeworth

Textbook Illustration of Optimal Purchase of a Variable Input Using Micro Theory

Textbook Illustration of Optimal Purchase of a Variable Input Using Micro Theory • VMPL = P x MPPL = Additional revenue derived from output generated from the hiring of additional labour

Development at the Neoclassical Theory of Distribution • Wicksteed published a pamphlet in 1894 claiming that factor prices would equal their marginal productivity when input and output markets are competitive • Review by Flux showed that “product exhaustion would only exist when productions had mathematical properties identified by Euler, a Swiss mathematician

Development at the Neoclassical Theory of Distribution Cont’d • When Production functions are homogeneous of degree one, constant returns to scale exist so Q = f [T, L, K, R] Q = δQ * L + δQ * K + δQ * R δL δK δR

= MPPL * L + MPPK * K + MPPR * R so P * Q = [P*MPPL*L] + [P*MPPK*K] +[P*MPPR*R] P * Q = [VMPL*L] + [VMPK*K] + [VMPR*R]

Development at the Neoclassical Theory of Distribution Cont’d Total Revenue = Total Payments for Factor Inputs • This equality does not hold when production functions are • Decreasing returns to scale

II. Increasing returns to scale • In all circumstances the optimal decision rule for purchasing inputs MPPL = MPPK = MPPR PL PK PR

Wicksell’s Contribution to Production Exhaustion • Made an independent “discovery” of the marginal productivity concept • In 1902 he noted that firms often experience • Increasing returns to scale • Constant returns to scale • Decreasing returns to scale

Wicksell’s Contribution to Production Exhaustion Cont’d

Wicksell’s Contribution to Production Exhaustion Cont’d • Competition in input and output markets will guarantee that the long-run equilibrium will occur when firms experience constant returns Read page 255 to 259 on your own

New marginal productivity theory has many critics such as Taussig • He claimed that final output is a result of the joint effort of land, labour and capital and it is not possible to separate the marginal productivity of each factor input

Wicksell’s Contribution to Production Exhaustion Cont’d • Marshall’s “solution” was to measure the net product of labour by deducting the cost of capital from the value marginal product of last units (dose?) of labour capital • A residual theory (?)

Theory of Profits • Classical theory did not distinguish between interest and profit • Profits were often viewed as a payment for • Use of finance capital • Management services • Business risk

Clark, Marshall and Schumpeter viewed economic profits as a temporary income resulting from dynamic changes

Frank Knight combined both approaches into one theory of profit based on • Risk • Managerial ability • Economic change

Historical Theories of Interest • Monetary Theories • - Prevailed in the mercantilist era from 1500 to 1750 • - Resurrected in 1930’s with Keynes liquidity preference • Non-monetary Theories • - Classical concern with the long-run and neo-classical productivity theory places focus on real sector

3. Synthesis • - Post war interest in general equilibrium framework lead to integration of monetary and real forces based on Fisher’s writings

Problem of Interest • Overhead pp. 264

Bohm-Bawerk Interest Theory • Fundamental reasoning for the existence of interest is that present goods are worth more than an equal amount of future goods • The cause of interest is not found in the institutional structure of society but in technological and economic considerations independent of social forms Overhead pp. 266 – special note

Fisher’s Interest Theory • Agreed that the greater productivity of roundabout methods would not result in a positive rate of interest in the absence of the first two reasons • While adapting some of Bohm-Bawerks concepts he discarded the classification of separate factor inputs and his entire concept of the period of production

All productive agents yielded flows of income over time and two forces determined interest rates in a market economy • Subjective – reflect preferences for present over future goods and services • Objective – available investment opportunities and the productivity to produce final goods

Fisher’s Interest Theory Cont’d • A complete explanation of interest requires both • The supply of savings is a function of the rate of interest while the demand for investment funds is an inverse relationship with interest rates • Factors of production will receive the discounted values of their marginal products

John Bates Clark • First American economist to gain an international reputation and represents America’s greatest contribution to the second generation of marginal analysis • Claims he had independently conceived the influence of marginal utility on exchange value around 1880 • He invented the term marginal productivity and was the most articulate writer on the early neoclassical theory of distribution

John Bates Clark Cont’d • Clark believed that land and capital were not separate factors of production but the same category of inputs • He recognize that his analysis merged Ricardo’s rent with interest and that his theory of distribution was a generalization of Ricardo’s theory of rent

Quotation • Special attention was given to the nature of capital • Profits are also described in terms familiar to first year students

Chapter 9: The Transition to Neoclassical Economics