ECON 307 - Outline Seventeen
The Subjectivist - Marginal Revolution in Economics
The dating of this "revolution" is basically from 1871-74, with the “discovery” of the notion of utility being subjective – thus the term “Subjectivist.” And with the concept of diminishing marginal utility to describe consumer demand being introduced - thus the term "marginal," by
William Stanley Jevons, Léon Walras, and Carl Menger.
This set the foundations for the theory of value which eventually replaced the "Classical" theory of value of Adam Smith, David Ricardo, John Stuart Mill and Karl Marx.
The essence of the Marginalist Revolution was not really the mathematical concept of the "margin" (or the additional), but rather in the building up of a theory of value which was based on the phenomenon of exchange rather than production and distribution (including labor as the means to valuing that production). The labor theory of value was considered “dead” by all but the Marxists thereafter.
William F. Lloyd’s definition of economics as catallactics - the "science of exchange" - better describes what the marginalist revolutionaries were all about -- the novel idea that the "natural value" of a good is determined only by its subjective scarcity, i.e. the degree to which people's desire for that good exceeds its availability (what eventually became price theory – supply and demand analysis).
So subjective value theory coupled with the understanding of value "on the margin" were the two main leaps forward in this "revolution."
Market prices are determined by the subjective value of the marginal unit employed, not total value. Therefore, they are determined by subjective value relating to scarcity (or supply).
The Diamond-Water Paradox was finally solved!! And the science of economics leaped forward into a whole new realm of understanding – the ideas were truly revolutionary.
This is how Menger explained it (as we have seen before):
Because the value of goods and services resides in the mind of acting individuals (it is subjective), and not the goods themselves, we have a subjectivist theory of value and an ordinal (not cardinal) definition of utility.
But – there were differences in how the theories were explained:
Each of the revolutionaries was very different in his approach to the question of value and marginalism. Therefore, economics split into three separate branches, each following one of the revolutionaries.
The branches of Jevons and Walras became part of “mainstream” neoclassical economics. The branch of Menger became the Austrian school of economics, still considered out of the mainstream.
But many of the theories of the Austrian economists have been brought into mainstream thinking (even if many mainstream economists don’t realize it - *commentary). This has started to change the mainstream (on the margin). The Austrians are the only economists to always hold true to subjective value theory.
1871 – William Stanley Jevons – English (1835-1882) – Theory of Political Economy
1871 – Carl Menger – Austrian (1840-1921) - Grundsätze der Volkwirtschatslehre (Principles of Economics)
1874 – Leon Walras – French (1834-1910)- Eléments d'économie politique pure (Elements of Pure Economics)
Those That Followed:
Jevons Menger Walras
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Wicksteed Bohm-Bawerk/Wieser Pareto
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Partial Equilibrium Theory Market Process Theory General Equilibrium Theory
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Marshall/Stigler/Samuelson Mises/Hayek/Rothbard Debreu/Arrrow
So Partial Equilibrium theory lead to Neoclassical Micro Theory,
Market Process theory (non-equilibrium) lead to the Austrian School and
General Equilibrium theory lead to Mainstream Macroeconomics.
Keynes and Neoclassical Micro Theory - Neoclassical Synthesis with Keynes
(Attempt to understand macro with micro general equilibrium theory)
Monetarists (Friedman) Macro Fragmentation
Macro starts breaking down in the late 1960s, early 1970s with the Phillips Curve trade-off becoming suspect (stagflation). With general equilibrium theory there is no unemployment, inflation, money, advertising, all markets clear.
There is no “general agreement” among economists as to how macroeconomics should be studied or as to what assumptions should be made about the economy in general.
Partial equilibrium theory or price theory pretty much stayed in tact.
Market Process Theory (Austrian) still remains "radical" but the ideas have made many inroads into "mainstream" ideas - especially with F. A. Hayek winning the Nobel Prize in Economics in 1974.
Revolutionary One - William Stanley Jevons, 1835-1882
Born in England, early training was in the sciences. His economic interests ran the gamut from statistical analyses of prices and gold to pure theory and commercial fluctuations, of which his well-known sunspot theory was one.
Although he left no serious students (as a professor) – he was part of the subjectivist or marginal revolution and his method did influence Marshall and others.
Utility Theory: Jevons had faith that in the future of mathematics and statistics as indispensable aids to discovery in economics. Yet he placed subjective – utility – in the starring role in economic analysis. Jevons admitted that the calculus of pleasure and pain had subjective features, although he expressed hopes that the effects of utility might somehow be ascertained (for example, the outcomes of people’s decisions – a price).
Marginal Utility: Following Bentham, Jevons maintained that the value of pleasure and pain varies according to four circumstances:
Diminishing Marginal Utility: Marginal Utility here is a change in total utility. So Diminishing Marginal Utility is described as in modern day textbooks – consuming more of the same good, eventually the marginal satisfaction will begin to decline. The third hamburger does not add as much to total utility as the first hamburger does.
The Utility Function: Wanting to express it all in math terms, Jevons utility function is a relation between the commodities an individual consumes and an act of individual valuation. Utility is not, in sum, an intrinsic or inherent quality that things possess. Instead, utility has meaning only in the act of valuation – subjective value theory.
U = f(X). If X is food, then this is read as “the utility of commodity X (food) is a function of the quantity of X the individual holds.”
Note that all other goods are left out of the picture – either nonexistent or quantities held constant.
The Equimarginal Principle: Jevons presented a clear understanding of the individual’s maximizing behavior in discussing a person’s allocation of any given commodity among alternative uses.
If an individual starts with a fixed stock of S of a commodity X and the uses of that commodity are represented by x and y, then the stock must be divided up between those uses such that S = x + y. Jevons asked: how does the individual decide to allocate his fixed stock among the two uses?
And – how do consumers spend a fixed budget among goods? Remember, as we use an additional unit of any good, the marginal utility declines (diminishing marginal utility) – so we keep using the good that gives us more marginal utility than another, until the marginal utilities are equal – then we are indifferent.
Or MUx = Muy – the equimarginal condition.
If we bring in price, then the principle reads:
MUx/Px = MUy/Py = etc.
We buy until the last dollar spent on each item brings us the same utility.
Jevons also developed theories of exchange, labor and commercial crisis coming from spots on the sun (which economists don’t pay much attention to).
Revolutionary Two - Leon Walras (1834-1910)
French economist (pronounced "Valrasse").
After sampling several careers—he was for a while a journalist, a lecturer, a railway clerk, a bank director, and a published romance novelist—Walras eventually returned to the study and teaching of economics. In that scientific discipline Walras claimed to have found "pleasures and joys like those that religion provides to the faithful."
His greatest work, Elements of Pure Economics, was published in 1874, three years after those of Jevons and Menger.
Walras set forth the new "marginalist" or "Neoclassical" theory in a formal general equilibrium setting and is therefore widely regarded as the father of general equilibrium theory.
There are markets not only for consumers' products but also for land, labor, and capital. Also in those markets the factors of production receive returns equal to their contributions to production. There will be a 'general equilibrium' in the economic system on condition that there is a free market with perfect competition and that the quantities of inputs and outputs and their prices all automatically adjust to their equilibrium values.
This is called Walras Law of Markets.
Walras was the first to describe the entire economic system theoretically in mathematical terms. Walras expressed the view that all markets are related, and that their relationships can be described and analyzed mathematically. These interrelated markets tend toward a “general equilibrium” position, undergoing a constant interactive adjustment process.
His Steps (from your reading):
But Walras was aware that the mere fact that such a system of equations could be solved mathematically for an equilibrium did not mean that in the real world it would ever reach that equilibrium.
Here he came up with what is known as the famous Walrasian Auctioneer: This process he called "tâtonnement" (French for groping). Tâtonnement was a trial-and-error process in which a price was called out and people in the market said how much they were willing to demand or supply at that price – as if there were an auctioneer.
If there was an excess of supply over demand, then the price would be lowered so that less would be supplied and more would be demanded. Thus - the prices "grope" toward equilibrium.
Walras' theories eventually lead to what is now known as IS/LM analysis. Where investment = savings (equilibrium in the goods market), money supply = money demand (equilibrium in the money market) all at the same time. This model was first introduced at the Econometric Conference held in Oxford during September, 1936. Three economists (following Keynes) Roy Harrod, John R. Hicks and James Meade all presented papers describing math models attempting to summarize John Maynard Keynes' General Theory of Employment, Interest, and Money.
Hicks, who had seen a draft of Harrod's paper, invented the IS/LM model (originally using LL, not LM). He later presented it in Mr. Keynes and the Classics: A Suggested Interpretation.
Hicks later agreed that the model missed important points from the Keynesian theory, criticizing it as having very limited use beyond "a classroom gadget", and criticizing equilibrium methods generally: "When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect." The first problem was that it presents the real and monetary sectors as separate, something Keynes attempted to transcend. In addition, an equilibrium model ignores uncertainty – and that liquidity preference only makes sense in the presence of uncertainty "For there is no sense in liquidity, unless expectations are uncertain." A shift in the IS or LM curve will cause changes in expectations, causing the other curve to shift.
Most modern macroeconomists see the IS/LM model as being at best a first approximation for understanding the real world.
Although disputed in some circles and accepted to be imperfect, the model is widely used and seen as useful in gaining an understanding of macroeconomic theory. It is used in most university macroeconomics textbooks.
This model is probably the one most criticized by Austrian economists. (Hicks - not an Austrian, more of a Keynesian - got it right in the quotation above regarding policy- *commentary).
Revolutionary Three - Carl Menger (1840-1921)
Carl Menger was born in Austrian Poland, the son of a lawyer. He studied law at the universities of Vienna and Prague and received his doctorate at the University of Cracow in 1867. Journalist, civil servant, lawyer. Married with children.
Predecessor to Ludwig von Mises and F. A. Hayek, he is known as the founder of the Austrian School of Economics.
Menger became famous for his writings on methodology before his economics proper became appreciated.
As part of the famous “methodenstreit” – battle over methods with the German Historical School which claimed that all “theory” is derived from history and is relative, no absolute economic laws from deduction, only from induction based on historical details).
Menger: “To aim at the discovery of the fundamentals of our science is to devote one’s abilities to the solution of a problem that is directly related to human welfare, to serve a public interest of the highest importance, and to enter a path where even error is not entirely without merit.” (Principles of Economics, p. 46)
Menger wrote to the German Historical School – two main purposes:
1. refute the labor theory of value and replace it with a theory of value centered around valuing individuals
2. to show how this better theory of value could serve as an organizing principle for historical investigation in theory to use with history.
Menger as Alternative "Radical" Theorist – On Method:
He provided a theory of human action to use when doing historical research. The theory came before history.
He rejected the idea of a “natural – scientific method” – should be called the “empirical method.”
The laws of economics are not as strict as those in physics because of non-economic goals of observable human beings. The data economists study – human beings – have individual purposes and therefore will make reality complex and not strict. All sciences have degrees of strictness.
This lead to Mises and Hayek’s dual methodology for the social and physical sciences.
Menger’s subjective value: the source of value is individual valuations of the usefulness of goods for the purpose of fulfilling their ends or needs.
“Value is thus the importance that individual goods or quantities of goods attain for us because we are conscious of being dependent on command of them for the satisfaction of our needs.” (Principles, p. 115).
He proposed that people rank-ordered their needs and applied successive units of goods to satisfying less and less urgent needs. The value of any part of the stock was equal to the least important use to which a portion of the stock was put.
“The value of a particular good or of a given portion of the whole quantity of a good at the disposal of an economizing individual is thus for him equal to the importance of the least important of the satisfactions assured by the whole available quantity and achieved with any equal portion. For it is with respect to these least important satisfactions that the economizing individual concerned is dependent on the availability of the particular good, or given quantity of a good.” (Principles, p. 139)
The diamond/water example we did earlier – can use water for very low valued uses, therefore, every marginal unit of water is valued as the least important satisfied need we are able to attain.