NEOCLASSICAL

1. NEOCLASSICAL

2. Marginalist was slowly transformed into Neoclassical economics

3. 3 differences between early marginalist and neoclassical: • Marginalist stress on demand but neoclassical stress on both demand and supply in determining market prices of goods, services and resources. • Took far greater interest in the role of money in the economy. • Extended marginal analysis to market structures besides pure competition, pure monopoly and duopoly.

4. NEOCLASSICAL PURE NEOCLASSICAL MONETARY IMPERFECT COMPETITION MARSHALL WICKSELL SRAFFA FISHER CHAMBERLIN ROBINSON HAWTREY IMPERFECT COMPETITION DIMINISHING MU RATIONAL CONSUMER CHOICE LAW OF DEMAND CONSUMER SURPLUS P CHANGES, FORCED SAVING, IMPERFECT COMPETITION THEORY OF MONOPOLISTIC COMPETITION QUANTITY THEORY OF MONEY AND MP. MONOPSONY, PRODUCT /RESOURCES MARKET MONOPSONY, EXPLOITATION UNDER MONOPOLISTIC COMP. BUSINESS CYCLE AND DISCRETIONARY MP

5. ALFRED MARSHALL (1842-1924) • Greatest figure in neoclassical school. • Popularized the modern diagrammatic approach to economics. • Although he was a mathematician, he was skeptical of the overall value of mathematics in economic analysis. • He seeks to combine best of classical with marginalist and hence producing neoclassical.

6. ALFRED MARSHALL (1842-1924)…CONTRIBUTIONS • Utility and Demand • MU • Rational Consumer Choice • Consumer’s surplus • Elasticity of Demand • Supply • Immediate Present • SR and LR

7. ALFRED MARSHALL (1842-1924)…CONTRIBUTIONS • Equilibrium Price and Quantity • Numerical/ Graphical Presentation • Distribution of Income • Wage • Interest • Profit, Rent, Quasi-Rent

8. ALFRED MARSHALL (1842-1924)…CONTRIBUTIONS • Increasing and Decreasing Cost Industries • Life-Cycle of Business Enterprises • Internal versus External Economies • Increasing/Decreasing Return to Scale • Welfare Effect of Taxes & Subsidies

9. UTILITY AND DEMAND • Demand is based on the law of diminishing MU. • MU diminishes as the amount increases.

10. UTILITY AND DEMAND • He introduced 2 important qualifications: • Time – too short a time will not lead to changes in character and taste • Consumer goods that are indivisible. Small quantity of commodity may be insufficient to meet certain special want; there will be more than proportionate increase of pleasure when consumer gets enough to meet the desirable end.

11. UTILITY AND DEMAND • He suggested that money could be used to measure utility of intangibles. • Money measure utility at the margin – the point at which decisions are made. • Price of money has greater MU to poor person than rich person because poor person has less money initially. • He measured strength of preference or motive by money.

12. Rational Consumer Choice • His demand analysis used the idea of rational consumer choice. • Decision to spend will be done by weighing the MU of 2 different types of expenditures. • Earlier, Jevon and Menger described the process of rational choice. • But Marshall successfully tied this equimarginal rule directly to the contemporary law of demand.

13. Law of Demand • His law of demand follows directly his notion of DMU and rational consumer choice • “The amount demanded increases with a fall in price, and diminishes with a rise in price”

14. Law of Demand • Suppose MUx /Px = MUy /Py … = MUn /Pn • If price of X decline, ratio of MUx /Px > MU/P of all other goods. • To restore a balance of expenditure, a rational consumer will substitute more of X for less of Y,Z and others. • As substitution occurs, MU of X will fall and MU of others will increase until equilibrium is restored.

15. Law of Demand • Illustrated law of demand using table and demand curve. • He focused on substitution effect (relative price effect) and income effect (when consumer experienced gain in purchasing power) • Only later that this 2 concepts became clearer.

16. Consumer Surplus • TU of goods is the sum of the successive MU of each added unit. • Therefore the price a person pays for a good never exceeds or = to what he/she willing to pay. • Dupuit first noted on excess utility over expenditure.

17. Consumer Surplus • But Marshall is credited for using the concept “consumer surplus” and systematically exploring it. • Although there is problem, Marshall’s nation of consumer surplus has proved to be a valuable tool for analyzing several economics phenomena – deadweight or efficiency losses from taxes, monopoly and tariff.

18. Elasticity of Demand (Ed) • Far superior that his predecessors in handling elasticity of demand. • He analyzed the subject verbally, diagrammatically and mathematically. • Law of person’s desire for commodity – other things being equal, it diminishes with every increase in his supply of the commodity. • The lower the price, the more consumers will buy. So the demand curve slopes downward to the right.

19. Elasticity of Demand (Ed) • Ed tells us whether the decrease of desire is slow or rapid as Q increases. • In absolute term, Ed > 1 demand is elastic, Ed < 1 demand is inelastic, Ed = 1 demand is unit elastic. • He also discussed the determinants of demand elasticity. • It is useful for understanding wide range of problem and policies (tax policy)

20. SUPPLY • Supply is governed by cost of production. • He divided time into 3 periods: immediate present, short run and long run. • Immediate Present • Market prices refer to the present, no time allowed for adaptation of the Q supplied to changes in demand. • Market supply curve vertical straight line – perfectly inelastic. Because no matter how high price, quantity supplied cannot be increased.

21. SUPPLY SHORT RUN • To analyze the period he divided costs into 2 types: supplementary costs (fixed costs) and prime costs (variable costs). • SR is a period where variable inputs can be , but fixed cost cannot be changed. • SR supply curve slopes upward and to the right, the higher the price, the larger Q supplied. • Modern view SR supply curve as MC curve.

22. SUPPLY LONG RUN • All costs are variable and they must be covered if firm wants to continue production.

23. EQUILIBRIUM PRICE AND QUANTITY What determines market price? • Classical  Cost of production • Marginalist _ Demand • Marshall: • Both demand and supply • Behind supply – financial and subjective costs • Behind demand – utility and dmu

24. EQUILIBRIUM PRICE AND QUANTITY • Numerical presentation • Using tables to demand and supply and determination of equilibrium price and quantity • Graphical presentation

25. Graphical presentation P SUPPLY C B P DEMAND Q F He incorporate element of time in discussing market price. He explained how time (SR and LR) influence demand and supply.

26. DISTRIBUTION OF INCOME • In competitive economy distribution of income is determined by pricing of factors of production. • Business people constantly compare relative efficiency of every agent of production they employ. • He based his analysis on the diminishing returns

27. Wages • Not determined by MPN alone. • MP is the basis for ND, which depended on consumer demand of the final product. • Wage depends on ND and NS. • It is correct to say wage measures (are equal) to MP with a given supply of labor

28. Wages • Marshall is correct in identifying demand for labor as a derived demand and also discussed the determinants of wage elasticity of labor demand. • Pigou later summarized Marshall’s four laws of derived demand.

29. In modern times, this 4 laws are: • Other things being equal: • The greater the substitutability of other factors for labor, the greater the Ed for labor. • The greater the price elasticity of product demand, the greater the Ed for labor. • The larger the proportion of total production cost accounted for by labor, the greater the Ed for labor. • The greater the elasticity of supply of other inputs, the greater the Ed for labor.

30. Interest • A rise in the rate of interest diminishes the use of machinery, because businessman avoids the use of all machines whose net annual surplus is less than the rate of interest. • Lower interest rate increases capital investment. • Quantity of saving supplied depends on rate of interest, and rate of interest depends of supply of savings.

31. Interest • Motive of saving is the willingness of people to postpone consumption from present to future (inter temporal consumption.) • Fall in interest rate will induce people to consume more in present. • Interest rate will move towards equilibrium.

32. Profits, Rent, Quasi-Rent • Normal profits include interest, earnings of management and the supply price of business organization. • Earning of management are payments for specialized form of labor. • Remaining portion of normal profits, supply price of business organization ia a reward to entrepreneurship.

33. Profits, Rent, Quasi-Rent • Marshall includes Ricardian rent theory. • Quasi-rent return to old capital investment in SR, similar to rent. • Only variable cost influence prices in SR. • Price in turn determined the earnings of the fixed investment.

34. INCREASING AND DECREASING COST INDUSTRIES • His key analytical tool- using concept of “representative firm” – typical 19th. Century sole proprietorship. • The purpose of his abstraction: • He referred the expenses of a representative producer as one who is neither the most efficient not the least efficient in the industry.

35. INCREASING AND DECREASING COST INDUSTRIES • An industry can be in long period equilibrium even though some firms are growing or declining. They all neutralize each other. • Even representative firm may not be increasing its internal efficiency, it can experience falling costs of production as industry expands.

36. The Life-Cycle of Business Enterprise • Took a dynamic view of the growth and decline of business enterprises. • The growth of one establishment and the decline of another balance the economy.

37. Internal versus External Economies • Internal economies – efficiencies or cost savings introduced by the growth in size of individual firm. As firm gets large they enjoy specialization, mass production, using more and better machine and thus powering cost of production. • External economies – come from outside of the firm. They depend on the general development of the industry.

38. Increasing and Decreasing Return to Scale • Increasing return to scale – as N and K expand, organization and efficiency improve. Increased demand will ultimately cause price to fall and more be produced. • If we heavily depend on agriculture we would have decreasing returns to scale. • Constant cost return – an increased demand in product does not affect price in LR

39. Welfare Effects of Taxes and Subsidies • His analysis of constant, increasing and decreasing cost industries led him to conclude: • Either tax or subsidy will reduce net consumer utility in constant cost industry. • Tax may add to net consumer utility in increasing cost industry. • Subsidy may add to net utility in a decreasing cost industry.