Tag Archives: Microeconomics

Alfred Marshall (1842 – 1924)

Alfred Marshall made lasting contributions to economics. No economist will question that. However, his precise contributions to economics are often forgotten. In a way, the microeconomics that we learn and apply today has strong Marshallian foundations. This post draws on Peter Groenewegen’s excellent (concise) biography of Alfred Marshall (2007) which has been published as part of the Great Thinkers in Economics Series published by Palgrave Macmillan.

Marshall is most famous for his Principles of Economics first published in 1890; the definitive eighth edition was published in 1920. In addition, he wrote Industry and Trade (1919), Money, Credit and Commerce (1923) and Economics of Industry (1879) which he wrote along with his wife, Mary Paley Marshall. Besides these, he also printed and privately circulated his work entitled The Pure Theory of Foreign Trade. The Pure Theory of Domestic Values (1879). Overall, he taught for more than forty years in Bristol, Oxford and Cambridge. The most notable among his students are John Maynard Keynes and Arthur Cecil Pigou.

He took German lessons in order to read Kant in the original. Hegel’s Philosophy of History had a strong influence on his thought. Marshall commenced his study about economics with a close reading of John Stuart Mill’s Principles of Political Economy. He also read the methodological works of Mill on logic and particularly criticised Mill’s conception of the individual as a ‘self-seeking, wealth-maximising homo economicus’. His other economics readings included Smith’s Wealth of Nations, Ricardo’s Principles and Marx’s Capital. Other important influences were Cournot’s Mathematical Investigations in the Theory of Wealth and von Thunen’s The Isolated State; they motivated Marshall’s use of diagrams.

For Marshall, ‘the proper work of economic science…was solving economic problems’. ‘The necessity of economic theory, the importance of facts and continual striving to keep economic analysis relevant and practical were all crucial parts of Marshall’s promise to devote his professional life to the improvement of economic science’ (p. 74). It is also quite well known now that, for Marshall, the ‘mecca of the Economist lies in Economic Biology rather than in Economic Dynamics’ (p. 106).

Groenewegen informs us that Marshall had a personal dislike of the use of textbooks in university teaching (p. 77). Not surprisingly, ‘[t]he Principles of Economics remained a leading textbook on the foundations of economics not only during the life of its author, that is, from 1890 to 1924, but for the next quarter century as well, that is, until the early 1950s’ (p. 111).

The use of mathematics in the Principles has garnered lot of attention since he ‘banished’ all equations to the appendix. In any case, Marshall considered economics as ‘form of reasoning’. Perhaps, given the use of mathematics during his time, his relegation of equations to the appendix might have been appropriate. I quote an interesting letter Marshall wrote to his student Bowley: ‘(1) Use mathematics as a shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples which are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This last I did often’ (p. 114).

Marshall identified time to play an important role in the theory of value. He developed the concepts of the short and long period. He paid particular attention to ‘elasticity’. Besides these, he laid the foundations for the theory of the firm, use of offer curves or reciprocal demand curves in international trade and distinguished internal and external economies.

This post has only very briefly touched upon the way Marshall viewed economics, especially his use of mathematics and his evolutionary notion. We have not detailed his precise contributions to economics. This post serves the purpose of being a very short introduction to Marshall. As students of (micro)economics, it will be fascinating to read Marshall’s works, especially his Principles.

The Politics of Microeconomics

Recently, some students walked-out from the lecture of the exceedingly famous economist, Greg Mankiw, who teaches EC10, Introduction to (neoclassical!) Economics at Harvard University. He is, perhaps, more known for his best-selling textbooks. This post was drafted for a different purpose almost a year ago. However, given the relevance of the essay/post, I decided to publish it here.

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“Students, economics is divided into microeconomics and macroeconomics,” says the professor. This classification dominates economics teaching at all levels – from schools to post graduate studies. What is not mentioned is that, this classification is a characteristic of a particular kind of economics – neoclassical economics. The introductory chapters of microeconomics textbooks teach us that there are two kinds of economics, namely, positive economics and normative economics. With this distinction students are led to believe that microeconomics is objective, scientific and apolitical. Such arbitrary and artificial characterization, I argue, is an important way in which neoclassical economics perpetuates its dominance both in academia and in the arena of policy making. However, the “politics” of microeconomics comes to the fore when one closely examines its history. This essay will closely examine the concepts of factors of production and marginal product.

The so-called objective and scientific microeconomics treats all factors of production (land, labour and capital) on an equal footing. In particular, the roles of labour and capital are depicted as symmetrical. No mention is made of their particular social and historical characteristics. Land, as we know, cannot be treated on par with labour in any unique way. At this juncture, let us recall the objective of economic theory and policy – to improve the conditions of human life. However, such a human-centric objective must not be taken to imply complete disregard for animals or for the environment. Given this, what is the rationale for employing the concept of factors of production in economic analysis? One wonders whether it is to depoliticize economic theory. The earlier economists (classical economists and Marx) had employed the concept of social classes to understand the working of the economy. In their analysis, society was divided into landowners, workers and entrepreneurs. This division was necessary to develop a theory of income distribution. That is, it is the division of the society into ‘social classes’ or ‘factors’ which provides the foundation on which the theory of income distribution is erected. In the former structure, landowners received rents, workers earned wages which were often at subsistence level and entrepreneurs received profits. Whereas, according to microeconomic theory, the rewards accruing to the factors of production are as follows: land earns rents; labour earns wages; capital earns interest and entrepreneur/organization earns profits.  In the latter case, one notices that a distinction has been made between the “agent” and the “factor” of production. Notwithstanding this, the apparent objectivity of microeconomic theory crumbles and arbitrariness enters once we ask: what are the units for measuring capital? Land, as we know, can be measured in hectares, acres, square feet, etc. Similarly, labour can be measured in head count, man hours, man days, etc. But, how is capital measured? In fact, even before posing this question, we need to ask: what is capital? Why is capital, which is produced by labour acting on raw materials, considered a a factor of production? There appears to be no clear reason or rationale behind this. It seems that such an arbitrary concept was introduced to remove “politics” and “conflicts” from economic theory. Even the nomenclature “factors of production” appear significantly distanced from society vis-a-vis that of social classes, which was conceptualised taking into account the conflicts, especially over the means of production, prevalent in the society. Employment of “factors of production” in economic analysis presented a harmonious view of the society as opposed to the conflicts in income distribution which was pointed out by the classical economists.

Next, we briefly discuss the role of the concept of marginal product in microeconomics. In simple language, marginal product measures the contribution of one unit of the factor of production to the production process. Marginal productivity theory is a widely taught concept in graduate programs in economics and business. It is this concept which links factors of production to a theory of income distribution in neoclassical economics. Clearly distinguished “factors” of production is a prerequisite for the theory of marginal productivity. As pointed out in the previous paragraph, the owners of means of production do not find any explicit mention. Microeconomics teaches us that, in conditions of perfect competition, labour and capital get (monetary) rewards in proportion to their contribution to the production process. In other words, wages paid to labour equals marginal product of labour and interest paid to capital equals marginal product of capital. But, note that marginal product can only be computed by considering ‘potential change’, which is computed with the aid of differential calculus. What we do not pay adequate attention to, is that the origins of marginal analysis are to be found in the differential rent theory of Ricardo. Land, owing to technological constraints generated output at a diminishing rate as more and more labour and machinery were applied. This was because of the characteristics particular to land. Neoclassical economists extended this notion of diminishing marginal returns in land to other “factors of production” such as labour and capital. Such a generalisation has been shown to be inadequate on logical and historical grounds. Today, microeconomics textbooks and microeconomics professors hardly mention the historical origins of marginal productivity theory.

Neoclassical economics, as we have seen, misguides economic policy making by projecting a harmonious view of the society, comprising financiers, rentiers, entrepreneurs, wage labourers, salaried workers, etc. This is mainly done through the conceptual apparatus of “factors of production”. The idea of symmetry is introduced through this manoeuvre. Neoclassical economics also teaches students that a state of perfect competition is desirable because each “factor of production” will get what they deserve (their marginal product) as incomes. This, as indicated above, is a misinformed generalization of the rent theory of Ricardo. In fact, through the theoretical apparatuses of factors of production and marginal productivity theory, neoclassical economics tries to be objective, scientific and apolitical. However, as this essay has shown, most concepts of neoclassical economics have been devised in order to mask the conflicts and politics involved in economic phenomena.

Utility in Microeconomics: Outdated?

This post clarifies the concept of a utility function, which occupies a very significant position in neoclassical microeconomics. Advances in neuroeconomics and related fields of behavioural economics is constantly challenging the conventional assumptions of microeconomics. This post takes up one such insight by Stephen B Hanauer which was published in Nature in March 2008.

A utility function can be understood in the following way:

U=f(x,y,z) where U is the utility derived from the consumption of x, y and/or z. Alternatively, a utility function transforms combinations of various goods into a single value. Note that x,y and z refer to ‘quantities’ of goods/services consumed.

Suppose, consumer A has the following utility function: U=x+y+z; arbitrary values of x,y and z would result in the following values of U.

x y z U
0 0 0 0
1 0 0 1
10 10 0 20
6 6 8 20
0 10 10 20
10 10 10 30

That is, microeconomics teaches us that the utility of the consumer is determined by the quantity of goods consumed. An common assumption is that ‘more is better’, which implies that the consumption of more goods gives the consumer more utility. The point to be noted is that microeconomic theory teaches us that utility is strictly a function of quantities. The question posed in this post is whether utility is ‘only’ a function of quantities. What happens if utility is also a function of prices? At this juncture, we need to recollect the objective of utility functions. From the utility function, we derive indifference curves and marginal utilities. Utility or use value of the good or service forms the basis of the demand function, which along with the supply function determines the value/price of a commodity or service. Thus, the use value was employed so as to arrive at the exchange value/relative price of the commodity.

What happens if utility (or experienced pleasantness) is influenced by “changing properties of commodities, such as prices”? That is, can neoclassical microeconomics accomodate the following utility function:

U=f(x,y,Px,Py)

And research in behavioural economics and related areas suggest that prices exert a significant influence on utility and hence on choice and demand. However, if we accept such a utility function, it can no longer be used to explain exchange values/relative prices. Another implication is that prices are no longer determined by the interaction of demand and supply. And the statement that ‘consumer is the king’ no longer holds. Also, producers can adjust prices in such a way as to affect consumers’ utilities. We know that high prices are often associated with better quality and hence higher utility.

x y Px Py U
0 0 10 10 0
10 10 10 10 200
10 10 5 10 150
10 10 4 4 80

The above table can be explained by the following utility function: U=x.Px + y.Py

In this case, a higher price gives more utility to the individual. The maximum utility is when x=y=10 and Px=Py=10.

The other extreme case is when high prices are detested by the individual. For instance, consumers with low incomes will get more utility from consuming goods which are priced less. Their utility function could be represented as follows: U=x.-Px + y.-Py

In which case, the consumers utilities based on the previous values of x,y,Px and Py will be 0, -200, -150 and -80. And the consumer’s utility is maximum when he/she consumes x=y=10 when Px=Py=4.

Empirical evidence suggests that utility is equally influenced by prices of commodities as well. Does this threaten the core of neoclassical microeconomics? This is problematic because neoclassical economics assumes the following to be given: 1) tastes and preferences of individuals, 2) endowments of goods and 3) constant technology. It if from these ‘givens’ that prices and quantities (demanded and supplied) are arrived at through the mechanism of demand and supply/competition/market forces. How can we include the recent findings pertaining to consumer utility and satisfaction in a consistent manner?

Update

The link to the reference was embedded in the authors name. However, because of the comment by Dr. Thomas Alexander, the reference is prrovided below. Also,I acknowledge him for bringing this article to my notice.

Hanauer, S (2008), ‘Experienced Pleasantness,’ Editorial, Nature Reviews Gastroenterology and Hepatology 5, 119 (1 March 2008).

Sraffa: Production as a Circular Process

This is the second in the series of posts on Sraffa. The objective of this post is to clarify the assumption of scarce resources made frequently in neoclassical economics. This is then contrasted with the notion of mass-production in capitalist economies. This facet of capitalism is understood by concepts such as ‘circular production’ and ‘production of commodities by means of commodities’ in Classical Economics.

A brief look at the history of micro and macroeconomics becomes essential. Elements of Marshall and Walras are found in modern microeconomics. Specifically, partial equilibrium analysis comes from Marshall; whereas, Walras contributed ‘general equilibrium analysis’ to economics. Usually, emergence of macroeconomics is considered to have originated with the work of Keynes. This has been contested and it has been shown with considerable evidence that William Petty (1623-1687) was the first macroeconomist. [See Murphy 2009] And that economists like Adam Smith, David Ricardo and Karl Marx were talking about macroeconomics when they discussed production, distribution and accumulation. Neoclassical macroeconomics can be loosely said to comprise New Classical Economics, Neo-Keynesian Economics, variants of Computable General Equilibrium Models (CGE), etc. One of the unifying features of the above mentioned neoclassical schools/models is the assumption of ‘scarce factors’. It is owing to the assumption that factors are scare, that optimization is carried out.

Lionel Robbins defined economics as “the science which studies human behaviour as the relationship between ends and scarce means which have alternative uses.” Here, scarce means refers to scarce factors of production – land, labour and capital. Yes, land can be considered scarce in an economy where the pressure of population is high (or for environmental reasons). But, wouldn’t labour be scarce in some countries and abundant in others? Now for the tricky ‘capital’. Capital is understood as produced means of production. That is, tools, machinery, plants, conveyor belts, electrical appliances, tractors, etc are ‘capital goods’. Are they scarce? They would be scarce if nobody produced them. Usually, in a capitalist or quasi-capitalist economy, capital goods are produced by the private sector, the government and often, imported from abroad. Therefore, a priori, we have no reason to maintain that capital is a scarce factor. Or for that matter, even labour.

Marshall provided a theoretical partition through which one could say that factors are scarce. He introduced the concept of ‘short period analysis’. Till Marshall, the early classicals and neoclassicals analysed economies using the ‘long period method’. Through the short period, Marshall introduced an imaginary period wherein one factor is fixed (usually, capital) and the other factor (labour) is variable. In this period, it is as if one factor is scarce. In a later post, it will be shown that this sort of analysis is an improper generalisation of Ricardo’s theory of rent.

Sraffa’s Production of Commodities by Means of Commodities deals with ‘value and distribution’. That is, he focuses on the relationship between relative prices, wages/profits and technique of production. Throughout the whole analysis, output/quantity is treated as given. This is in tune with the ‘sequential analysis’ of classical economics. Value & distribution is one level of analysis or the ‘core’, as was popularised by Garegnani. Once, the foundation is well-established, the next level is growth & accumulation. In the first level, quantities are treated as given and in the second level, prices are assumed to be given. This is done keeping in view the complexity of the economic processes. Whereas, as we know, in neoclassical theory of general equilibrium, there is a simultaneous determination of quantity, price, wage rate, employment, rate of interest and quantity of capital. That is, all kinds of prices and quantities are simultaneously determined.

A set of equations from classical and neoclassical production theory is given below. This is so as to bring out the differences in a clear way.

Production function: Ya = f(La, Ka)

Sraffa’s equations:
(AaPa + BaPb + … + KaPk) (1 + r) + LaW = APa
(AbPa + BbPb + … + KbPk) (1 + r) + LbW = BPb
. . . . . .
(AkPa + BkPb + … + KkPk) (1 + r) + LkW = KPk

where A, B …. K are the output produced in various industries, L is the labour employed in each industry, Pa refers to price/value of output A and Pk refers to value of output K, r is the rate of profit. [As these are for purposes of illustration alone, some conditions have not been mentioned]

In the first case, it represents the transformation of inputs – labour and capital into an output Y. Let me reproduce what Sraffa writes about his particular conception of production: “It is of course in Quesnay’s Tableau Economique that is found the original picture of the system of production and consumption as a circular process, and it stands in striking contrast to the view presented by modern theory, of a one-way avenue that leads for ‘Factors of production’ to ‘Consumption goods’.” [Sraffa 1960, 93]

The concept of circular production also brings to the fore the web of connections between different production structures. Both classical and neoclassical economics attempts at reducing the complexity of economic phenomena. Neoclassical economics, at the outset abstracts away from interrelated production structures through the concept of ‘representative firm’ in microeconomics. In a similar way, in the area of consumption, man as a social being is reduced to man as an individual whose utility does not depend on that of others. Classical economics carries out its analysis by taking prices as given so as to analyse interrelated production structures.

References

Sraffa, P (1960), Production of Commodities by Means of Commodities, Cambridge: Cambridge University Press.

Murphy, A (2009), The Genesis of Macroeconomics: New Ideas from Sir William Petty to Henry Thornton, New York: Oxford University Press.