ECON 307
Outline Nineteen: The Road to Neoclassical Economics
After the Marginal/Subjectivist Revolution - Austrian Economics was born was so was Neoclassical Economics (which became the mainstream).
The main changes that occurred were:
Utility, not labor, finally becomes the basis of value: rejects Smith, Ricardo, Marx (although neoclassical economics continues to "model" utility in a less than subjective sense).
Exchange, rather than production, the basis of analysis.
Individual behavior, rather than society, focus of analysis (except in much of neoclassical macro analysis - and "welfare" economics).
Static methodology (by default), rather than dynamic:
“If we wished to have a complete solution … we should have to treat it as a problem of dynamics. But it would surely be absurd to attempt the more difficult question when the more easy one is yet so imperfectly within our power.” [Jevons, Theory of Political Economy, Ch. 4]
Physics Envy
Desire to copy the success of physics via "formalization" of method.
“Economy,..., has always of necessity been mathematical in its subject, but the strict and general statement, … has been prevented by a neglect of those powerful methods of expression which have been applied to most other sciences with so much success.” [Jevons]
“Scarce and scarcity… are given scientific meaning like the word velocity in mechanics and … heat in physics.” [Walras]
Theory a combination of Bentham’s utilitarian philosophy and mathematical static optimization techniques of 19th century physics.
Marginal analysis completely supplants the classical approach
Two streams to analysis:
General equilibrium analysis (Walras)
Partial equilibrium (Jevons)
• Some things held constant (“ceteris paribus”);
• Analysis of isolated markets (Marshall);
• Neoclassical “macroeconomics” (Hicks)
A Re-definition of Economics
Classical School definition focus on growth and distribution of output questions
cost of production focus on price determination
Neoclassical re-definition focus on
Utility-maximization as function of economy
Utility explanation of price determination
In fact - "economic growth" and "economic development" became two separate areas.
Summarized in Lionel Robbins’ (1898-1984) definition of economics:
“Economics is the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses.” (p. 16). From his most famous book: An Essay on the Nature and Significance of Economic Science (1932).
Besides this famous definition, this book also known for Robbins' definitions of positive vs. normative economics: positive issues are questions about what is; normative issues are about what ought to be.
And also: Robbins’s third major thought is that economics is a system of logical deduction from first principles. He was skeptical about the feasibility and usefulness of empirical verification. In this view he resembled the Austrians —not surprising since he was a colleague of F. A. Hayek whom he had brought from Vienna in 1928 (to the London School of Economics)
The Robbins Definition
Ends
Economics neutral about specific ends:
“in so far as the achievement of any end is dependent upon scarce means, it is germane to the preoccupations of the economist. Economics is not concerned with ends as such.” (24)
Means
Resources for satisfaction of ends
Inadequate to meet all ends
“The services which others put at our disposal are limited. The material means of achieving ends are limited. We have been turned out of Paradise.” (15)
Alternative uses for means and ends of different importance
The Economic Problem: rank ends, allocate means to efficiently meet them in order of priority until resources fully employed.
For most neoclassical economists, the market is the best ranking/allocation mechanism. But the "why" was and is to a great degree - ignored in the analysis (commentary).
Professor of Political Economy at the University of Cambridge from 1885 to 1908, he was the founder of the Cambridge School of Economics .
A.C. Pigou and J.M. Keynes were among his students.
Marshall's magnum opus, the Principles of Economics was published in 1890 and went through eight editions in his lifetime. It was the most influential treatise of its era and was for many years the Bible of British economics, introducing many still-familiar concepts – textbooks never seem to change!! But he wrote many other books as well.
The Supply and Demand Model you are all familiar with is credited to Marshall: Qd = f(Price) and Qs =f(Price)
Competitive Equilibrium:
Marshall is also famous for deriving the long run competitive equilibrium of a firm in an industry:
Where MIN LRATC = PRICE (or AR).
Graphically:
Consumer and Producer Surplus: Marshall’s benefits from trade on the supply and demand model.
Consumer Surplus:
Producer Surplus:
Following Walras:
Vilfredo
Pareto (1848-1923)
Italian economist Vilfredo
Pareto was one of the leaders of the Lausanne School of Economics (in
Switzerland).
A follower of Walras, Pareto
viewed economics as part of the broader science of sociology, extending
Walrasian analysis to say that society at large is an equilibrium system.
This view influenced the modern
course of the “social sciences’, in which quantitative techniques have
become standard analytical tools.
In 1906, Pareto published his Manual of Political Economy, his magnum opus on pure economics. The Manual concentrates on presenting pure economics in an explicitly mathematical form.
The Walrasian equations are still there, but the focus is on formulating equilibrium in terms of solutions to individual problems of "objectives and constraints”.
"We will say that the members of a collectivity enjoy maximium ophelimity [maximum optimality] in a certain position when it is impossible to find a way of moving from that position very slightly in such a manner that the ophelimity [optimality] enjoyed by each of the individuals of that collectivity increases or decreases. That is to say, any small displacement in departing from that position necessarily has the effect of increasing the ophelimity [optimality] which certain individuals enjoy, and decreasing that which others enjoy, of being agreeable to some, and disagreeable to others."
So Most Known for Pareto Optimality - the idea that a society is enjoying maximum optimality when no one can be made better off without making someone else worse off.
So a “Pareto Optimal Move” with respect to policy or trade or whatever would be one where someone is made better off, but no one is made worse off.
"The Pareto optimum has gone into the textbooks. Because of the opportunities it offers for mathematical manipulation, great castles of theory have been built upon it." (John Hicks, 1975, "The Scope and Status of Welfare Economics", Oxford EP)
This was incorporated into welfare economics as a notion of efficiency.
Subjectivist Critique: How can we know if someone is made worse off? How do we measure the costs and benefits? Is this in any way operational when looking at an economy (or even a smaller organization)?