History of Economic thought II

Econ 3142

CHAPTER 1
NEOCLASSICAL SCHOOL OF
THOUGHT

1
1. 1 Neoclassical School introduction
Neoclassical economics is an approach to
economics that essentialize interaction of
demand and supply sides as tool of analysis in
economics.
The determination of economic outcomes (output,
prices, income distributions, etc) is made by markets
through interaction of demand and supply sides.
This is mediated through a hypothesized
maximization of utility by income-constrained
consumers and of profits by firms facing production
costs and employing available information and
factors of production.

2
1. 1 Neoclassical School Introduction

Neoclassical economics is the

dominant approaches of
microeconomics.
Neoclassical economics can be
viewed as synthesis of supply side
economics of classical school and
demand side of the marginal school.
In neo-classical economics, the focus
of analytical attention was directed
to the process through which a
market system allocates resources. 3
1. 1 Neoclassical School introduction
While classical school gave paramount
concern with inter-relationships between
long-period dynamic change and the
distribution of income among various
orders of society.
The main classical theories used to
justify this views were:
• Free market
• Say's Law of the market
• invisible hand and principles of laissez
fair
• self interest maximization
4
1. 1 Neoclassical School Introduction
On the other hand in 1870s a new approach was
introduced by marginal school. This new set of
analytical tools helped to transform classical
economics into neoclassical economics.
Early marginalist used the concept of marginal
utility to determine value of goods from the
demand side.
Neoclassical school integrate the classical supply
with marginalist‘ demand side through which
economic decisions made through the interplay of
demand and supply.

5
1. 1 Neoclassical School Introduction
Methodologically the neoclassical school
extended the marginal approach to other
economic concepts and theories such as marginal
productivity, marginal revenue, marginal cost,
marginal profit, etc.
Marginal analysis became a defining element of
neoclassical economics. The significance of
many economic ideas and theories made clear.
Neoclassical economics is characterized by
several assumptions common to many schools of
economic thought. There is no a complete
agreement on what is meant by neoclassical
economics, and the result is a wide range of
neoclassical approaches to various problems and
domains.
6
1. 1 Neoclassical School
Introduction
The central assumptions of Neoclassical:
1. Agents are rational. People have rational
preferences between outcomes that can be
identified and associated with values. Neoclassical
economics conceptualized economic agents,
households and firms as rational actors.
2.Agents are optimizers. Agents were modelled
as optimizers who behave rationally to optimize
their objectives/self interest.
Consumers have well defined
objective,that is, to maximize utility
firms objective is to maximize profit.
3. Agents act independently (autonomous) on the
basis of full and relevant information.
7
1. 1 Neoclassical School
Introduction
4. Flexibility of wages and prices
5. Full employment equilibrium – the economy
operate at full employment
6. Money is neutral – it has no real effect
7. Perfect information
8.Perfect competition
For neoclassical the level of employment of a
factor determined by the inter play of
demand and supply in the factor market. The
level of output also determined in the same
way.

8
 1. 1 Neoclassical School Introduction
From these assumptions, neoclassical
economists have built a structure to
understand the allocation of scarce resources
among alternative ends. The term
‘Economics’ itself is defined in terms of
scarcity.
From these basic assumptions of neoclassical
economics comes a wide range of theories
about various areas of economic activity.
• The derivation of demand curves leads to an
understanding of consumer behavior
• Supply curve allows an analysis of the
factors of production and production
decisions 9
1. 1 Neoclassical School
Introduction
Important devices of neoclassical market
analysis are graphs depicting supply-and-
demand schedules. These schedules are
taken to reflect the behavior of individual
buyers (agents of demand) and individual
sellers (agents of supply) who interact with
one another on markets. These schedules
used to depicted both for final goods and
factors of production.
The interactions of demand and supply
determine the market prices of of goods and
services and prices of factors of production.
the Market supply and demand for final goods
10
1. 1 Neoclassical School
Introduction
Although early marginalist (Jevons and Menger)
contributed significantly to the development of
microeconomic theory applying marginal analysis,
the content of their theories was deficient in a
number of ways.
Marginal school exclusively to restricted only to
demand and ignored supply side .
More specifically, marginal theory has the
following limitations :
• it has no explanation about forces that determine
prices of variable factors of production
• no explanation of forces determining the
distribution of income
• no significant analysis of the economics of the firm
11
1.2 Neoclassical Major
Contributors
• Alfred Marshall (1842-1924) from England
• Leon Walras (1834-1910), Neoclassical of
Lausanne
• John Bates Clark (1847-1938) from American
neoclassical
• Eugen von Bohm-Bawerk (1851-1914) from
Austrian Neoclassical School
• Knut Wicksell (1851-1926) from Swedish
Neoclassical school

12
 Alfred Marshall (1842 – 1924)
Alfred Marshall ( 1842 – 1924) was one of the most
influential economists of his time and founder of
Neoclassical school. He was born in London, England.
Alfred Marshall was an English economist and the true
founder of the neoclassical school of economics, which
combined views of classical school with the marginal
School.
works of Alfred Marshall includes:
•1879 – The Economics of Industry (with Mary Paley
Marshall)
• 1879 – The Pure Theory of Foreign Trade: The Pure
Theory of Domestic Values
• 1890 – Principles of Economics
• 1919 – Industry and Trade
• 1923 - Money, Credit and Commerce
13
Alfred Marshall (1842 – 1924)
Alfred Marshall while he was professor at Cambridge
University wrote a famous book entitled “Principles of
Economics”, 1890. This book was the dominant
economic textbook in England for many years.
Alfred Marshall Was known as one of the key founders of
neoclassical economics.
His book Principles of Economics established his
worldwide reputation and decisively shaped the teaching
of economics in English-speaking countries.
Major contributions were: theories of demand and
supply, concept of elasticity, consumer surplus,
concepts of increasing and diminishing returns,
theory of costs, concept of short and long runs, etc.
His approach is referred as partial equilibrium
microeconomic theory.
14
 Alfred Marshall (1842 – 1924)
Marshall concentrated on reconciling the classical
labour theory of value, which had concentrated on
the supply side of the market with marginalist
theory that concentrated on the consumer demand
side.
Marshall's graphical representation of supply and
demand graphs referred as the "Marshallian cross".
He insisted, it is the intersection of supply and
demand that produce an equilibrium price in a
competitive market.
Among Marshall’s contributions to the development
of economics, we should also recall his role in the
transformation of the economist into a profession,
with specific autonomy in the areas of research and
teaching.
15
Alfred Marshall (1842 – 1924)
He noted that, in the short run, supply cannot be
changed and market value depends mainly on
demand. In short run, production can be expanded
by existing fixed facilities; since their costs are
fixed and have little influence on price of the
product. Marshall pointed out that it is variable
costs are more important in short run.
This classification of costs into fixed and variable
costs and the emphasis given to the element of
time into long run and short run represent one
of Marshall's chief contributions to economic
theory.
16
1. Marshall and The Theory Of Price

Alfred Marshall was the first to develop the

standard supply and demand graphs
demonstrating a number of fundamentals about
supply and demand. Including :
• the supply and demand curves
•market equilibrium, partial equilibrium
•the law of marginal utility
•the laws of diminishing and increasing returns,
•The concept of elasticity
Marshall's model allowed a visual
representation of complex economic ideas and
theories. These models are now critical
17
throughout the study of economics as it allow
1. Marshall and The Theory Of Price

For Marshall analysis of the functioning of a market

system began with the behavior of consumers and
producers.
Throughout the discussion assumed that agents acted
rationally in pursuit of their own advantage.
Consumers were held to seek maximum satisfactions;
similarly, suppliers of productive services were
expected to seek maximum rewards, profit.
1)Demand analysis - Marshall's
formulation of the concept of demand
• He is responsible for developing Cardinal
Theory of Consumer Behavior.
Marshall referred 'demand’ as relationship
between quantity demanded and prices. it 18is
1. Marshall and The Theory Of Price

These relation between price and quantity

depicted in graph (curve) representing price on
vertical axis and quantity on a horizontal axis.
Marshall regarded demand schedules as
indicating maximum price individuals are
willing to pay for a given quantity of a
commodity. Quantity is thus independent
variable and price is dependent variable.
In classical school, consumer preferences
(demand) has no effect on price.
19
1. Alfred Marshall and The Theory
Of Price
In neo-classical economics, the determination
of market prices became a major problem and
the concept of demand as a schedule of price
- quantity relationships was crucial to its
solution. The concept of marginal utility
central to Marshall in developing the theory
of demand(cardinal theory of demand).
In Marshall's formulation, the construction
of such a demand schedule proceeded in
two stages:
• individual demand and a notion of
'diminishing marginal utility’ and Derivation
of a market demand schedule /curve for20 a
1. A. Marshall and The Theory Of Price
i) The first concern, individual demand and a notion of
'diminishing marginal utility’. The concept of utility,
more specifically, diminishing marginal utility is key to
demand analysis by Marshall.
Consumer purchases commodities in order to acquire
satisfactions (or utilities) from consumptions. The
amount of satisfaction obtainable from a unit of
commodity was closely related to the number of units
consumed.
With additional unit consumed, it could be expected that
increment in total satisfaction (marginal utility) would
decline. Rational consumer would thus be prepared to
pay less for the last unit than for the preceding ones (as
its extra utility decreases) and a reduction in price
would be necessary to induce him to buy more.
21
 1. A. Marshall and The Theory Of
Price
The full derivation of a market demand curve for a specific
commodity involved further step; the law of DMU is at the
heart of it.
The concept of Diminishing marginal utility implies that marginal
utility and quantity consumed are inversely related. From this it
can be inferred the law of demand which state about the inverse
relation between price and quantity. Hence, the demand curve
derive to represent to reflect this law of demand.
Demand curve relate prices and quantities of a commodity that
can be bought by a potential buyer at a given point in time,
other factors being constant.

22
 1. A. Marshall and The Theory Of Price
ii) In practical situation consumers have more
than one goods to purchase. If they were to
maximize utility obtainable from a given income
they should adjust their spending (income
allocation) patterns to ensure that no gain in
satisfaction would be possible from an alternative
allocation of their incomes.
The optimum result would be obtained when the
last money spent on any of the goods in question
added an identical amount of satisfaction.
Otherwise, a different allocation of expenditure
would increase the consumer's total satisfaction.
In equilibrium, the consumer will spend in such a
way that the last dollar spent for any final good
will have the same marginal utility as that spent
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for any other good.
1. A. Marshall and The Theory Of Price

2) Supply side analysis

Firms require productive inputs to produce
goods and these inputs are available at cost.
• It was assumed that firms could obtain
greater quantities of productive inputs only at
rising costs : total, average and marginal
costs.
It followed that firms expand their outputs only
when they expected higher prices. In short, it
was postulated that firms normally operated
under conditions where marginal costs
associated with additional output produced
were rising.
• The structure of marginal costs, in turn, 24
1. A. Marshall and The Theory Of Price

• The supply curve of the firm in the short run in a

perfectly competitive industry, therefore, is
equivalent to that portion of its marginal cost
curve
• As such the supply curve relate quantity supplied
with price from the perspective of firms /suppliers.
The supply schedule/curve reflect capacity and
willingness of firms to supply at a given price.
Just as the market demand for a particular product
was derived by aggregating the demands of
individual consumers, a market supply curve could
similarly be arrived at by consolidating the supply
curves of firms producing identical outputs.

25
1. A. Marshall and The Theory Of Price
The classical school’s trend of reducing costs
into labour inputs now vanished from the
scene. In neoclassical scheme the primacy of
labour in the explanation of costs was
completely eliminated.
With his concepts of supply and demand,
Marshall had the tools he needed for his
explanation of price. It was at the point of
intersection between these two curves that
the equilibrium price (i.e. the price towards
which the market would naturally tend to
gravitate) was established.
He popularized the use of supply and
demand functions as tools of price 26
 1. A. Marshall and The Theory
Of Price
• For Marshall, equilibrium is unique and
stable, because any displacement from
equilibrium position trigger forces that
readjust the market.
Marshall likened these two curves to the
blades of a pair of scissors- of called Marshall's
scissors. By combining demand and supply,
that is utility and costs, effectively replace
labor cost theory of value by the theory of
price.
• While the term "value" continued to be
used, for most people it was a synonym
for "price" . Prices of a product is
determined by interaction between 27
demand and supply.
 1. A. Marshall and The Theory Of Price

3. Partial Equilibrium.
Marshallian approach of price determination or
market equilibrium is called Partial
Equilibrium Analysis.
It is so called because the analysis was made
using ceteris paribus assumption, that is,
market price of a commodity was
determined through market demand and
market supply in isolation from markets for
other commodities or by ignoring
interdependence between markets of different
products.
The fundamental framework of present-day 28
 2. Marshall and Theory of production
Neo-classical production theory addressed
itself to two principal issues.
• The first concerned with the manner in which
any producer combine productive factors.
• The second dealt with the adjustments of
production - producer might be expected to
make adjustment when market conditions
altered.
The first of these could be handled quite
straightforwardly with the aid of analytical
tools where individual business men were
regarded as rational, seeking to maximize
their profits.
29
 2. A. Marshall and the Theory
of production
Technically, a number of possible
combinations of various productive factors
could produce whatever volume of output
might be desired. The rational manager would
naturally select the least-cost
combination.
Adjustment process of production - The
analysis of the producer's response to a
change in market circumstances was more
intricate. In particular, it presented the
problem of time which Marshall described as
'a chief cause of those difficulties in economic
investigation.
30
To address the problems caused by
2. A. Marshall and the Theory
of production
i) 'the short run’ – a period where output
can change by changing some factors –
variable factors, however, plant size can’t
change. These adjustments, however,
associated with increasing
employment of variable factors and
accompanied with rising costs (short run
marginal cost).
Here , we have concepts of marginal
product of variable factor and how it affect
total output.
Optimization of short run output depends
on the positive contribution of the extra
31
variable factor employed (marginal
 2. A. Marshall and the Theory of
production
Synonymously, short run marginal cost
concept was introduced to analyze how
costs of production is affect as short run
output changes. From the concept of
marginal cost supply curve of a firm is
derived which indicate production decision
of a firm as per market prices.
In the short run, the total costs of the firm
can be divided into two components: costs
that vary with output, variable costs and
that which remain constant, fixed costs.
The distinction between variable and fixed
costs in the short run was evidently drawn32
 2. A. Marshall and the Theory
of production
ii) long run – a time horizon where firm’s size /plant
size can vary and all costs become variable; firms
are able to make full adjustment to changing prices
by altering plant size.
The 'long run’ is time span sufficient to
accomplish adjustments in the scale of plant
necessary to produce new market equilibrium.
In practical case, the length of this period would
depend on the circumstances of individual firms and
industries.
In long-run - when the scale of plant altered and
utilization of all productive factors varied. Changes in
scale of plant associated with change in costs: rising,
declining, or constant unit costs.
The most interesting case was one in which average
costs declined with increase in plant scale; this 33
2. A. Marshall and the Theory of
production
By and large the classical economists had
anticipated that 'constant returns to
scale' would normally prevail.
For Marshall, increasing returns to scale
associated with technologies is possible.
Economies of scale implied that a small
number of large producers could operate
with lower unit costs than could a large
number of small firms.
Marshall’s time periods are not measured in
days but refer instead related to pattern of
supply adjustment for the firm and the
industry.
34
Marshall believed that a correct
2. A. Marshall and the Theory of production

The demand curve for final goods

slopes downward as individuals will buy
larger quantities at lower prices. The
shape of supply curve depends upon
the time period under analysis. The
shorter the period, the more
important the role of demand in
determining price; in the long run
period, the more important the
role of supply.
35
3. Marshal and Price elasticity of demand and supply

Price elasticity of demand was presented by

Marshall as an extension of his demand
analysis.
His most important contribution to demand
theory was his clear formulation of the
concept of price elasticity of demand.
The degree of relationship between change
in price and change in quantity demanded is
disclosed by the coefficient of price
elasticity. Because price and quantity
demanded are inversely related, the
computed price elasticity of demand
coefficient would be negative.
Knowing price elasticity of demand enable36
 Leon Walras And The Neo-classicism Of Lausanne

Leon Walras (1834-1910), a Frenchman who spent his

professionally most productive years in Switzerland,
approached the neo-classical problem along a path quite
different from the one Marshall had chosen. Walras served as
professor of economics at the University of Lausanne,
Switzerland.
Walras published his book ‘Elements of Pure Economics’ in
1874 where he discussed about marginalism and model of
General Equilibrium.
Besides his contribution to marginalism, Leon Walras major
contribution to economic analysis was his Theory of General
Equilibrium.
Walras had been one of important contributors to marginal
analysis. His work on marginalism was in many ways more
sophisticated than that of Jevons and Menger.
His conceptualization of the interdependence between sectors
and markets in the economy, called General equilibrium
approach, was by far the most his important contribution.
37
Leon Walras And The Neo-
classicism Of Lausanne
General equilibrium theory is an analysis of the economy in
which all sectors, markets and prices are considered
simultaneously. Thus, one considers both the direct and the
indirect effects of any shock to the system, and the cross-
market effects simultaneously with the direct effects. This
approach formally recognized intercedence between different
sectors, markets and prices in an economy.
This interrelationship of the sectors of the economy is relatively
simple to conceptualize, but it is an enormously complicated
idea to put it down formally in equations.
His General Equilibrium theory had an enormous impact on the
economics profession, particularly at higher level of studies, his
general equilibrium approach is more important than Marshall’s
partial equilibrium.
• In Partial equilibrium analysis only a small number of
variables allowed to vary others kept constant via ceteris
paribus assumption. General equilibrium analysis allows many
more variables to change at the time.

38
Leon Walras And The Neo-classicism Of
Lausanne
• Again Partial equilibrium analysis consider a
market for a commodity considered at a time in
isolation from other markets, he followed the
one-thing at-a-time method. General
equilibrium analysis considers all markets
for all final products and factors of
production simultaneously.
• Walras had perceived the interrelatedness of
households, firms, prices of final goods, prices of
factors of production, and quantities supplied and
quantities demanded of all final and intermediate
goods, expressed it in a system of simultaneous
equations.
• It was Leon Walras who was first able to
give the General Equilibrium vision with
39
clarity and precision through mathematical
 Leon Walras And The Neo-
classicism Of Lausanne
Although the theme of the relationships
among different markets had been studied by
preceding economists, no one before Walras
had managed to construct a general
theoretical structure capable of accounting for
the multiplicity of relationships linking one
market to another.
The actual operation of the forces of supply
and demand in one market depend on the
prices established in several other markets.
The central aim of Walras’s theory is to show
how the voluntary exchange among agents
who are well-informed, self-interested and
rational (each tries to maximize his goals) 40
Leon Walras And The Neo-classicism Of Lausanne
The central question is that could this be achieved through the
coordination of markets. Neither trade unions nor pressure
groups nor cartels nor other types of social groupings are
allowed, as this would violate a fundamental requirement of
the general-equilibrium model, that of perfect competition.
The unknowns determined simultaneously by the market and
given by general equilibrium solutions are:
• The prices of final goods
• The prices of factors,
• The quantities of final goods supplied and quantities
demanded
• The quantities of factors supplied and quantities demanded.

41
 Leon Walras And The Neo-classicism Of Lausanne
Is there only one set of prices and quantities that will result in single
equilibrium for the entire economy, or are there multiple equilibria?
Walras recognized the possibility of Multiple General Equilibria and
general equilibrium analysis still must contend with it. This was not
possible in Marshallian approach which yield unique equilibrium.
Walras examined the case with a simple economy of two commodities (x
and y).
This procedure also had an important recommendation in that it
emphasized the interdependence of all prices within the economic
system.
At the same time, Walrasian General Equilibrium dissolved the
standard lines of demarcation between micro- and macro-
theory. Activities of households, firms and industries could not be
understood in isolation from one another or when detached from the
economy as a whole.

42
Leon Walras And The Neo-classicism Of Lausanne
General equilibrium analysis was, of course, built on important
practical restrictions of the following:
• the whole argument rested on the assumption of full
employment
• The general equilibrium solution could be reached only when
it could be supposed that all income was spent; otherwise
the total interdependence between supply and demand could
not be asserted.
• Nor was Walras's system equipped to handle the case of
increasing returns to scale. If such production conditions
prevailed, a determinate set of equilibrium solutions could
not be reached

43
 Leon Walras And The Neo-classicism Of Lausanne
price or quantity which one is independent variable ?
For Marshall quantity demanded was considered independent while
price ids dependent. While Walras follow a different set of behavioral
postulates with that of Marshall in analyzing market forces. Walras
regard price as independent variable while quantity as dependent.
For Walras, Demand schedules show the quantities individuals are
willing to buy at various prices, and supply schedules indicate the
quantities sellers are willing to offer at various prices. The Walras
approach is accepted in contemporary economic theory.
It is true that Walras and Marshall reached the same conclusions since
the demand curve is downward-sloping and the supply curve is
upward-sloping.

44
 Leon Walras And The Neo-classicism Of Lausanne
Leo Walras and the articulation of economic science
Walras’s impact on the evolution of economic science has been
enormous. No other economist before him had managed to construct a
theoretical model and an analytical method which was so vast and
versatile.
He believed that pure science had nothing to do with value
judgements: ‘The distinguishing characteristic of a science is the
complete indifference to consequences, good or bad, with which it
carries on the pursuit of pure truth’ .
Walras added: ‘From other points of view the question of whether a
drug is wanted by a doctor to cure a patient, or by a murderer to kill
his family, is a very serious matter, but from our point of view, it is
totally irrelevant. So far as we are concerned, the drug is useful in both
cases, and may even be more so in the latter case than in the former’.

45
 Leon Walras And The Neo-classicism Of Lausanne
He completely expelled the classical school notion of natural law from
economics. He never believed that, beyond observable facts, there could
be a structure of economic laws capable of mirroring some natural order.
Walras was a severe critic of the classical dichotomy between natural and
market prices and of everything derived from that distinction.
Walras and economic policy
Walras put forward numerous articulate recommendations for economic
policy.
•He favored nationalization of natural monopolies
•the stabilization of prices by the monetary authorities
•the capital market, whose efficiency and reliability should be ensured
by the State
•the acquisition of land by the State and its concession in use to private
agents in order to increase government revenues

46
Leon Walras And The Neo-classicism Of Lausanne

He believed that economic analysis could not have any intrinsic

connection with the measures of economic policy; he always
kept the normative and positive analyses clearly separated.
Walras divided economics into three different fields:
• Pure Economics, which is based on facts, and concerned with
the relationships among things;
• Applied Economics, Which is based on the principle of utility
and concerned with the relationships between persons and
things; and
• Social Economics, which is based on the principle of justice
and concerned with the relationships among persons.

47
 Vilfredo Pareto (1848-1923)
Vilfredo Pareto (1848-1923) was an Italian engineer,
sociologist, economist, and philosopher who succeeded
Walras as professor of economics in University of
Lausanne (Switzerland). He was, after Walras, the second
most important economist in the early development of
General Equilibrium Theory.
Pareto improved Walras’s model in some respects, and
developed his own original theories. He agreed with
Walras that the scope of pure economic theory is limited
to facts and relationships regarding which free will does
not play a part. He believed that methods of positive
science should be used in the study of all aspects of
economics and of human behavior generally.

48
Vilfredo Pareto (1848-1923)
He Also made several important contributions to
economics:
• The concept of Pareto optimality which provides criteria
for efficient allocation of resources, production efficiency,
efficiencies in exchange. A Pareto-optimal allocation of
resources is achieved when output in one sector (of
product) can’t increased by decreasing output in other
sectors (other products). That is, when reallocation of
resources across products or sectors can’t increase total
out put, it can be said optimum allocation is achieved.
Pareto’s analysis of economic efficiency was powerful and
general because he took account of the conditions for
maximum efficiency in markets for all types of
commodities, and in exchange, production, consumption,
and capital formation.
49
 Vilfredo …..
• He introduced the ordinal /indifference curve
approach in the study of consumer behavior. For
marginalist and Marshall follow Cardinal approach where
utility is some how measurable. He made important
contribution to the theory of demand by introducing ordinal
(ranking) approach rather than cardinally theory. He argued
that the assumption that utility from goods can actually be
measured is not necessary to derive demand theory.
He showed ranking (Ordinal approach) preference is enough
for consumer to make decision. So he replaced the
Marshallian cardinal approach by the ordinal approach,
on which the indifference curve analysis was used in utility
ranking and develop demand theory.

50