HISTORY OF ECONOMIC THOUGHT
LECTURE 6
The Marginalist Revolutions
1. The Essential Features of the Marginalist Revolution
There are several economists who in the last third of the 19 th Century contributed to the so called Marginalist
Revolution in economic theory. Among the main contributors were: William Stanley Jevons (England); Léon
Walras (French); and three Austrian economists, Carl Menger, Eugen von Böhm-Bawerk, and Friedrich von
Wieser. At the forefront, however, were Jevons, Walras, and Menger, who incorporated the new theories into
a unified system of economic thought.
There are three crucial features of the Marginalist Revolution—( also called the Neoclassical School):

A more detailed theoretical analysis of the behavior of individual economic agents—firms
(producers) and individuals (consumers);

A greater emphasis on the role of demand in determining relative prices of commodities. Consumers’
utility maximization process plays equal role as firms’ profit maximizing behavior in determining the
price (value) of commodities.

Extension of mathematical concepts of optimization, differential calculus, in economic theory.
Optimization involved balancing costs and benefits of any economic activity, on the part of both
consumers and producers, at the margin, where no additional net gains could be obtained by any
further actions.
With the marginalist revolution, economics became an academic discipline, a special province of professors.
The discipline, with much narrower focus on individual actions, was now called “economics”, replacing the
term “political economy”. There was no reference to subsistence wage of the working class, to rent as the
return to the land owner class, and profit as the earnings of the capitalist class. Economics dealt with
quantities, and anything dealing with quantities could be translated into mathematics.
The narrow focus on the behavior of individuals was based on the argument that every man is pleasure
seeking machine; everyone is a living profit-and-loss calculator. In a world of free competition each person,
each pleasure machine, would achieve the highest amount of pleasure bestowed by the efficient market
system. Discarding the term capitalism, and dismissing the notion of the capitalist system as a product of
historical development of, using the Marxian terms, material productive forces and relations of production,
the market system was envisioned as an ahistorical mechanism set up to allow individuals to maximize their
pleasures.
2. William Stanley Jevons (1835-82)
Jevons was born in Liverpool. He began his university studies in 1852 at University College London, but after
two years he broke off his studies and emigrated to Australia. After working for the Royal Mint in Sydney for
five years he returned to England in 1859 to resume and finish his studies at University College, obtaining an
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M.A. in economics. He then taught at the University of Manchester, where he wrote The Theory of Political
Economy, his main contribution to economic thought.
2.1. The Mathematical Method
Jevons principal preoccupation in the realm of economics was the application of mathematical analysis, a
scientific approach, to human behavior:
It is clear that if economics, if it is to be science at all, must be a mathematical science ... To
me it seems that our science must be mathematical, simply because it deals with quantities.
Wherever the things treated are capable of being greater or less, there the laws and relations
must be mathematical in nature.
Along these lines, Jevons refers to the following quote from John Stuart Mill, where Mills talks about prices
being determined by the mutual adjustment of demand and supply:
The proper mathematical analogy is that of an equation. Demand and supply, the quantity
demanded and the quantity supplied, will be made equal. If unequal at any moment,
competition equalizes them, and the manner in which this is done is by and adjustment of
the value.
In criticism, Jevons states:
Mill here speaks of an equation as only a proper mathematical analogy. But if economics is
to be a real science at all, it must not deal merely with analogies, it must reason by real
equations, like all the sciences which have reached at all a systematic character.
But unlike other sciences, where proof or disproof of a theory can be arrived at under controlled experiments,
social sciences cannot study human behavior in a controlled laboratory environment. Jevons dismisses this
criticism, contending that there are great possibilities for the application of mathematics to phenomena that
are not usually thought of as being measurable. Jevons’ background in empirical and statistical studies
persuades him in his views.
2.2. Marginal Utility Theory
Jevons, actually, is better known as the economist who put marginal utility theory at the center of his
economic theory. He argues that utility, the judgment and attitudes (we now call it “tastes”) of a person
which establishes “what is or is not useful”, is a subjective quantity. In determining what is or is not useful,
the individual takes into account the marginal utility (“the final degree of utility”) of consuming the additional
unit of a good. Marginal utility, in turn, is a decreasing function of the quantity of the good consumed. The
following is Jevons description of diminishing marginal utility.
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MU
80
70
60
50
40
30
20
10
0
1
2
3
4
5
6
7
8
9
10
11
Q
Let us imagine the whole quantity of food which a person consumes on an average during
twenty-four hours to be divided into ten equal parts. If his food be reduced by the last part,
he will suffer but little; if a second tenth part be deficient, he will feel the want distinctly; the
subtraction of third tenth part will be decidedly injurious; with every subsequent
subtraction of a tenth part his sufferings will be more and more serious, until at length he
will be on the verge of starvation. Now, if we call each of the tenth parts an increment, the
meaning of these facts is that each increment of food is less necessary, or possesses less
utility, than the previous one.
Note that Jevons diagram does not include any values for the bars representing marginal utility. The numbers
shown in the diagram above are intended to convey Jevons argument more clearly. The intent is to show the
diminishing marginal utility. We could use any set of values for the marginal utility bars, as long as they are in
diminishing order as Q is increased. Also marginal utility for the first two increments are left open ended on
the top, because, according to Jevons, the first two increments are vital to continued life and, therefore, they
are left undefined.
Jevons’ analysis of marginal utility is the basis for the demand model which is now one of the basic features of
the contemporary economics. His model, however, is incomplete, because he does not adequately show how
supply or cost of production is determined, and what lies behind the price of factor inputs, that is, wages,
interest, and rent. The complete model is what we now recognize as the general equilibrium model. This task
began with Walras.
3. Carl Menger (1840-1921)
Even though there were major contributors to economic theory in the European continent outside Britain,
until 1870’s the main body of economic doctrines were of British origin. Only in Britain had a dominant
school, the classical political economy, won so many adherents. But the British economics never won many
adherents in other countries. Among the Germans, particularly, price theory was in disrepute, and historical
economics dominated the intellectual scene. But beginning in the 1870’s the marginalist revolution had two
significant impacts on economic thought:

The dominance of the classical school of economic thought was significantly challenged in England
itself.
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
In the European continent, particularly in the German speaking world, the marginalist theory of
economics provided the biggest challenge to the German historical economics.
The challenge to the German historical school was spearheaded by a German speaking economist--Carl
Menger, an Austrian, who founded a school of economic thought widely known as the “Austrian School”.
Menger’s status in history of economic thought is basically due to his attempt in launching the new theories in
the German-speaking world, and the controversy about the right approach to economics. In this regard, he
appears as a pure theorist in the conflict over method. The heated, and at times bitter, debate that took place
between Menger and his followers against the historical school is known by the German term Methodenstreit
(pronounced metoden-schtrite)—conflict over method.
Within the historical school, economic theory, as such, was a discredited approach. The historical school was
hostile to the abstract deductive economics of the Ricardians. This was true in the pre-marginalist era, where
economic thought was dominated by ideas of Ricardo and Mills. The historical school was even more hostile
to the marginalist approach. As the term “historical” in the historical school implies, this method considered
economics as the means to explain the very basis of economic existence, rather than the superficial
phenomena like prices and returns to factors of production—that is, value and distribution, which was the
preoccupation of both classical and neoclassical economists. The study of economic laws, according to this
school, must be based on historical studies and careful investigation of empirical relationships. This was an
inductive approach to economics, as opposed to the deductive approach of pure theorists, whose formalized
and abstract theories had dominated economic research.
Historical economists believed that all historical episodes, all empirical data, had to be studied in detail and
interpreted with a view to their unique and particular circumstances. Generalization about economic “laws”,
if at all, had to be derived from these detailed studies.
Menger and the adherents of the Austrian School, in contrast, argued that the crucial weakness of the
research strategy of the historical school was that it did not base its analysis on individual behavior.
Economic analysis begins by first understanding the basic foundations of decision-making by rational
individuals—how individuals make choices among different “economic goods” when faced with limited
economic resources.
3.1. Utility Maximization, the Unifying Element in Economic Theory
Menger’s book, Principles of Economics, was published in 1871. Although the arguments were in essence
similar to those of Jevons, Menger’s approach was completely nonmathematical. His illustrations were simple
and numerical. To begin with, Menger classifies economic goods according to the directness with which they
satisfy human needs. Goods of the “first order” satisfy the consumer needs or desires immediately (bread);
goods of second order (flour) and higher (wheat) satisfy these need indirectly. An object does not assume the
character of economic goods— “goods character”, according to Menger—at a higher stage unless those goods
were essential for the production of goods of lower order. For example, cotton would not be an economic
good if it were not used to produce cotton cloth. Thus, the goods character of higher order goods is derived
only from the goods character of goods of lower order. In this way, all factors of production and raw
materials used in the production process derive their values from value of the first-order goods they produce.
How do consumer choose among the different goods of first-order? According to Menger, economic
rationality implies making choices, and choice is balancing at the margin. The effort to select the needs
(choose the goods) which one wishes to satisfy out of scarce resources defines the term “economizing”. The
value of goods included in the basket of economic goods, from which choices are made, is determined by how
far they go in satisfying individuals needs and wants.
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“The value of goods arises from their relationship to our needs, and is not inherent in the
goods themselves. With changes in this relationship, value arises and disappears.”
Satisfactions, Menger argues, differ in their importance. The continuance of life depends on the gratification
of some needs. Other satisfactions serve less important purposes. But, different quantities of the same item,
whatever its significance to continued life, impart different levels of satisfaction (Menger does not use the
term utility):
Further attempts to satisfy the same need will bring at first a greater and then smaller
enjoyment, until eventually a point can be conceived, for each person, at which the further
employment of available accommodations would become a matter of complete indifference
to him, and finally even burdensome.
Here is Menger’s own numerical example. The individual is facing a basket of goods but with limited
endowments. How does the individual allocate his limited resources among these goods? In the following
table ten goods, each costing one dollar ($1), are ranked in descending order of importance in satisfying
needs. Assume the individual has $10 as endowment. The numbers in the table represent different levels of
satisfaction received from each good, as we move to right in each row, and the satisfaction obtained from
different quantities of the same good, as we move down in each column.
Diminishing levels of
satisfaction from each
additional unit of the good
⟶
Diminishing levels of satisfaction received from different goods
⟶
Food
Tobacco
I
II
III
IV
V
VI
VII
VIII
IX
X
10
9
8
7
6
5
4
3
2
1
9
8
7
6
5
4
3
2
1
8
7
6
5
4
3
2
1
7
6
5
4
3
2
1
6
5
4
3
2
1
5
4
3
2
1
Measures (indices) of utility
4
3
2
1
3
2
1
2
1
1
The process of allocation among these goods does not take a straight line path from good I to good X. That is,
the consumer does not spend the first dollar on good I, the second on II, ... The choice, rather proceeds
according to the amount of satisfaction received from consuming incremental units of each good, or, put more
precisely, according to the satisfaction received from each additional dollar spent on that good. Clearly, the
consumer will spend the first dollar on food, good I, because he gets the highest satisfaction. For the second
dollar, he would be indifferent between I and II. With three dollars he would consume two units of I and one
unit of II. With four dollars he could either consume three of I and one of II, or two one I and two of II.
Following the same line of argument, with $10 he would consume four of I, three of II, two of III, and one of IV.
This way he has maximized his utility. No other allocation of his $10 would yield a higher level of satisfaction.
The important point to note here is that the optimum allocation involves equal marginal satisfaction per
dollar (7) for all for goods.
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With Jevons and Menger the analytical core of economics, the determination of value and distribution,
experienced a revolution. The revolution centered in the rise of the marginal utility theory of value. This was
a new psychological theory of value which also provided the tools for explaining the distribution of income
among individuals, who own the factors of production. Since goods were exchanged in the market according
to the utility received from the use of the marginal unit, then use value determined the exchange value of a
good. Thus marginal utility analysis created an analytical tool of general applicability to economic problems.
In Menger’s scheme “goods of higher order”—factors of production—are “economic goods” that yield indirect
consumer satisfaction. Therein, lies their use value. They acquire their indices of economic significance and
hence their exchange values from the same marginal utility principle that determines the exchange value of
consumer goods. The exchange value of goods of higher order, in turn, constitute the cost of production for
firms that use them in the production process. Thus, in the final analysis, the use value, the marginal utility
principle, determines the cost of production and, as a result, how scarce resources are allocated.
The whole body of economic theory is thus explained in light of a single principle: marginal utility.
4. Léon Walras (1834-1910)
Walras was the son of an economist, but economics became his profession only after going through several
failed attempts at other professions. After flunking the examination for École Polytechnique, he finally
entered the École des Mines. But he gave that up also, turning to literature, writing novels which were also
failures. He then spent the next twelve years as journalist, clerk, editor and public lecturer. After all this, at
his father’s suggestion he turned to economics. In 1870 he was appointed to the newly created chair of
economics in the faculty of law of University of Lausanne, Switzerland. He retired from that position in 1892.
His masterpiece, Éléments d’Économie Politique Pure (Elements of Pure Economics), to some the towering
achievement of all economics, was published in 1874, three years after Jevons’ and Menger’s books.
Amazingly, all three developed the marginal utility theory of value independently and almost simultaneously.
But Walras’ achievement is considered to surpass his two contemporaries. Built on the foundation of
marginal utility, rareté as he called it, he developed the general equilibrium theory, according to which, in a
system of pure competition, the equilibrium values of all economic variables, including relative prices of all
final goods and factors of production, and quantities of these goods, are determined in an integrated and
interrelated mathematical model in terms of solutions to a system of simultaneous equation.
4.1. General Equilibrium and Walras Law
We can use a much simplified model than Walras’ own to show his general equilibrium theory and what is
known as Walras Law. Consider a system with 𝑚 goods, hence 𝑚 markets, one market for each good. For
simplicity, let 𝑚 = 3. Buyers and sellers are engaged in transactions in these three market.
The buyers side can be represented by the following three demand equations:
𝑄1𝐷 = −𝑎11 + 𝑎12 𝑃2 + 𝑎13 𝑃3
𝑄2𝐷 = 𝑎21 − 𝑎22 𝑃2 + 𝑎23 𝑃3
(𝐼)
𝑄3𝐷 = 𝑎31 + 𝑎32 𝑃2 − 𝑎33 𝑃3 }
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Note the following regarding these equations:
𝑄𝑖𝐷 = Quantity of good 𝑖 demanded.
𝑖 = 1,2,3
𝑎𝑖𝑗 = Change in quantity of good 𝑖 demanded in response to a change in price of good 𝑗 in market 𝑖:
𝑎𝑖𝑗 = ∆𝑄𝑖𝐷 ⁄∆𝑃𝑗 . For example, 𝑎13 indicates the quantity of good 1 demanded in response to a change in
the price of good 3. The " + " sign indicates that the goods 1 and 3 are substitutes: if 𝑃3 rises, quantity
demanded of good 1 will increase.
𝑃1 = 1 The model is set up to determine the relative prices of the three goods. For this purpose, one of the
goods is chosen as the numéraire so that its price can be set equal to 1.
The sellers (supply) side are represented by the following three supply equations:
𝑄1𝑆 = 𝑏11 − 𝑏12 𝑃2 − 𝑏13 𝑃3
𝑄2𝑆 = −𝑏21 + 𝑏22 𝑃2 − 𝑏23 𝑃3
(𝐼𝐼)
𝑄3𝑆 = −𝑏31 − 𝑏32 𝑃2 + 𝑏33 𝑃3 }
Note that, for example, the coefficient 𝑏13 = ∆ 𝑄1𝑆 ⁄∆𝑃3 < 0. This means that if the price of good 3 goes up the
quantity of good 1 offered will decrease.
The condition of general equilibrium requires that the total value of goods demanded be equal to the total
value of goods offered or supplied:
𝑄1𝐷 + 𝑃2 𝑄2𝐷 + 𝑃3 𝑄3𝐷 = 𝑄1𝑆 + 𝑃2 𝑄2𝑆 + 𝑃3 𝑄3𝑆
(𝐼𝐼𝐼)
Given this, we can now determine the equilibrium price and quantities in the markets for goods 2 and 3.
Equilibrium in these two markets require that
𝑄2𝐷 = 𝑄2𝑆
𝑄3𝐷 = 𝑄3𝑆
Substituting for these quantities the right-hand-side from the price-quantity equationss in 𝐼 and 𝐼𝐼 above, we
have,
𝑎21 − 𝑎22 𝑃2 + 𝑎23 𝑃3 = −𝑏21 + 𝑏22 𝑃2 − 𝑏23 𝑃3
𝑎31 + 𝑎32 𝑃2 − 𝑎33 𝑃3 = −𝑏31 − 𝑏32 𝑃2 + 𝑏33 𝑃3
From which we obtain,
(𝑎22 + 𝑏22 )𝑃2 − (𝑎23 + 𝑏23 )𝑃3 = 𝑎21 + 𝑏21
−(𝑎32 + 𝑏32 )𝑃2 + (𝑎33 + 𝑏33 )𝑃3 = 𝑎31 + 𝑏31
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Here we have a system of two equations with two unknowns 𝑃2 and 𝑃3 . Using the solutions for these two
prices, we can find the corresponding equilibrium quantities for 𝑄2 and 𝑄3 . Then from the general
equilibrium condition we can observe that once the two markets are in equilibrium, the market for good 1
must also be in equilibrium.
Let’s use a simple numerical example by assigning numeric values to the coefficients 𝑎𝑖𝑗 and 𝑏𝑖𝑗
𝑄2𝐷 = 𝑄2𝑆
2 − 1.5𝑃2 + 𝑃3 = −1.5 + 1.5𝑃2 − 𝑃3
𝑄3𝐷 = 𝑄3𝑆
0.5 + 2𝑃2 − 1.5𝑃3 = −1.5 − 𝑃2 + 2.5𝑃3
From which we obtain the following system of two equations with two unknowns
3𝑃2 − 2𝑃3 = 3.5
−3𝑃2 + 4𝑃3 = 2
From which, we have 𝑃2 = 3 and 𝑃3 = 2.75. The equilibrium quantities are obtained by plugging in the prices
in either the demand or supply equations in markets for goods 2 and 3. Now that we have found price and
quantities that set markets for goods 2 and 3 in equilibrium, the market for good 1, according to equation 𝐼𝐼𝐼,
will also be in equilibrium.
𝑄1𝐷 + 𝑃2 𝑄2𝐷 + 𝑃3 𝑄3𝐷 = 𝑄1𝑆 + 𝑃2 𝑄2𝑆 + 𝑃3 𝑄3𝑆
(𝐼𝐼𝐼)
𝑄1𝐷 − 𝑄1𝑆 = 𝑃2 (𝑄2𝑆 − 𝑄2𝐷 ) + 𝑃3 (𝑄3𝑆 − 𝑄3𝐷 )
Since, according to the equilibrium conditions in markets 2 and 3, (𝑄2𝑆 − 𝑄2𝐷 ) = (𝑄3𝑆 − 𝑄3𝐷 ) = 0, then, 𝑄1𝐷 −
𝑄1𝑆 = 0.
In short, Walras showed that, using one good as the numéraire, one of the 𝑚 equilibrium conditions could be
derived from others, so that we have only 𝑚 − 1 independent equations to solve for 𝑚 − 1 prices relative to
the numéraire. Walras Law thus provides that: If 𝑚 − 1 of the m markets are in equilibrium, the last market
must also be in equilibrium.
Given the model, then what is the process or mechanism by which markets arrive at a general equilibrium
state? Walras’ explained this mechanism as the process of tâtonnement, literally meaning “groping”, which
implied a process of trial and error by which markets adjusts toward equilibrium. Imagine an auctioneer
calling out prices for all goods are subject to trade. At these prices buyers and sellers submit the quantities
that they would be willing to transact to the auctioneer. The auctioneer would then adjust, cry out, new
prices, calling for lower or higher prices depending on whether there is, respectively, a surplus or excess
supply in any given market, or a shortage or excess demand. The tâtonnement proceeds until all markets are
cleared.
Walras did not intend to use the general equilibrium model to compute the actual prices to would bring about
equilibrium in all markets. He wanted to show that the theories of individual market behavior could be
organized into a unified, logically consistent, system which describes the functioning of a competitive
economy.
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