HISTORY OF ECONOMIC THOUGHT
LECTURE 7
Alfred Marshal
The marginalist revolution is attributed to Jevons, Menger, and Walras, all three publishing in the early 1870’s
what amounts to a totally new approach, compared to the classical political economy, to the theory of value
and distribution. After 1880 a new generation of economists set about completing or modifying the work
started with the above trio of economists. The most prominent among the new economists were Vilfredo
Pareto from Italy, Knut Wichsell from Sweden, John Bates Clark and Irving Fisher from the United States, and
Alfred Marshal and Philip Wicksteed in England. Böhm-Bawerk and von Wieser followed in the footsteps of
Menger in the Austrian School. Among this list, however, Marshal stands as a towering figure in shaping the
modern economic thought, what we study today as economics.
1. Alfred Marshal (1842-1924)
Marshal gave the new marginalist theories a form that made them accessible to both professional economists
and those outside this exclusive circle, and a content which made them far more amenable to applied
economic analysis. Marshal began his studies in Cambridge in 1861, first concentrating on mathematics and
physics, but then gradually moving toward philosophy and economics. His interest in economics stemmed
from his desire to develop conditions to help improve the lot of the poor and working class:
... in my vacations I visited the poorest quarters of several cities and walked through one
street after another, looking at the faces of the poorest people. Next, I resolved to make as
thorough a study as I could of Political Economy,
In 1865 he completed his studies in economics, reading the classical political economy of Ricardo and Mills
and applying his mathematical skills to explain those theories in more precise mathematical form. Upon
graduation, receiving a fellowship, he began teaching economics in Cambridge. After a period spent teaching
at University College in Bristol and then in Oxford, he returned to Cambridge permanently and taught there
for the next 23 years. The publication of his book, Principles of Economics, in 1890 made Marshal the
undisputed leader of academic economics. The book appeared in eight editions and was used as the main
textbook of economics for many decades.
Marshal was critical of Jevons’ use of mathematics, even though himself was quite proficient in that subject.
In fact, he did use math in his theories, but confined mathematical notations to footnotes and appendix. His
Principles was clearly intended as a textbook for students, but it also functioned as a scientific treatise
addressed to economists.
2. Marshal’s Contributions to Economic Theory
2.1. Supply and Demand—The Marshalian Cross
Marshal’s principal contribution to economics was his use of the partial equilibrium approach, the analysis of
the behavior of each industry or market in isolation. How are the equilibrium price and quantity in a given
market determined? The method proposed by Marshal was the supply-demand model. Unlike the early
marginalists, he did not reject the classical economics tools of analysis. He integrated the essential aspects of
the classical theory of value with the marginalist approach.
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The problem with the classical theory of value was not that it was based on cost of production, but rather, it
was its insistence on the difference between use value and exchange value. In the classical theory, the
exchange value of a good was based on how much it cost to produce it, the amount of factor inputs embodied
in a unit of output, which essentially boiled down to labor theory of value. The first marginalists rejected the
classical approach off hand, replacing it with the use value (utility) to the consumer of the final unit of the
good in question. The question of the source of value, thus, became an either-or issue, either cost of
production or utility, but not both.
Marshal was also a marginalist. However, his most important contribution to economic theory was the
synthesis of the cost of production side of value with the marginal utility aspect of it. Marshal developed the
most ubiquitous model in economics, the supply and demand curves, also dubbed by others as the Marshalian
cross, to show that the value, the equilibrium price, of a good is determined both by its use value (utility) to
the consumer, represented by the demand curve, and the cost of producing the good, represented by the
supply curve. The marriage of the classical cost-of-production theory and the neoclassical marginal utility
theory of value was expressed by the intersection of supply and demand curves, where the equilibrium price
and quantity of the good are determined.
Figure 1
Price
Quantity
Marshal used the cutting mechanism of a pair of scissors as a metaphor to explain the role of utility and cost
in determining the price of a good:
We might as reasonably dispute whether it is the upper or the under blade of a pair of
scissors that cuts a piece of paper, as whether value is governed by utility or cost of
production.
The beauty of the supply-demand model is that it can be used, depending on the context, to support both the
classical cost of production theory and the marginal utility theory of value. In the supply-demand framework,
the marginal utility theory of value is represented by a vertical supply curve. According to this theory of
value, the use value of the marginal unit determines the value of a good. For this to be true, the quantity
supplied at any period is fixed. This would be true in the very short-run, when producers are unable to
respond to a change in demand by increasing their output.
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The contrast between the marginal utility theory of value and the classical theory of value is shown in Figure
2. Panel (a) shows the marginalist theory. A rise in the price of the good from 𝑃1 to 𝑃2 is solely due to
demand. Supply is fixed at 𝑄1 . There is no change in quantity. Marshal explains this situation or context as
the market period. In this period producers have no opportunity to respond to a change in demand; the time
is too short. However, if the new demand is maintained at 𝐷2 , with the passage of time (short run) producers
will adjust their production schedule, hire more prime (variable) inputs and increase output. In panel (b)
price and quantity both have increased, albeit, price has increased proportionately more than quantity
(∆𝑃 ⁄𝑃 > ∆𝑄 ⁄𝑄 ). But, as the time horizon expands, firms will adjust their production capacity upward by
expanding their supplementary (fixed) inputs. The supply curve becomes flatter, allowing quantity to
increase proportionately more than price (∆𝑄 ⁄𝑄 > ∆𝑃 ⁄𝑃 ), as shown in Panel (c).
Note that the increase in price has increased profits (above the normal or natural level) for the existing
producers. The excess profits will attract more firms from other markets, further increasing output. The
result is the return of the price to the original level 𝑃1 . This is what classical economists referred to as the
natural price. Thus the classical natural price is represented by the horizontal long run supply curve, as
shown in Panel (d).
Figure 2
(a)
Price
(c)
Price
S
P₂
S
P₂
P₁
P₁
D₁
D₁
D₂
Quantity
Q₁
Q₁
(b)
Price
D₂
Quantity
Q₂
(d)
Price
S
P₂
P₁
P₁
D₁
Q₁Q₂
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S
D₂
D₁
Quantity
Q₁
Q₂
D₂
Quantity
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2.2. Partial Equilibrium versus General Equilibrium
The concept of general equilibrium was Walras’s invention. Marshal’s answer was partial equilibrium, the
study of the behavior of markets, determination of equilibrium prices and quantities, one market a time.
Marshal argued that, even though markets are more or less interrelated, and changes in one market affects
other markets, human ability to recognize these myriads of interrelationships and analyze them was very
limited. Therefore, the general equilibrium theory had very limited applicability to the analysis of real
economic phenomena.
Marshal’s partial equilibrium theory was the ceteris paribus (other things being equal) approach to changes in
economic conditions. What causes a change in the price of a given good? The price change may be due to
changes in demand, changes originated from the consumers side of market for the good in question, or it may
be because of changes in supply, originated from the producers side. In the supply-demand framework,
therefore, we need to consider the factors that lead to changes in demand, and the factors that impact the
behavior of producers, the supply side.
2.2.1. Law of Demand
Marshal’s theory of demand, like that of the early marginalists, is based on the concept of diminishing
marginal utility, that each additional unit of a good consumed adds less utility than the previous unit: “The
marginal utility of a commodity to anyone diminishes with every increase in the amount of it he already has.”
According to Marshal, although utility is a subjective measure and hence is not directly measurable, the
consumer’s marginal utility measure can be indirectly observed as the price he is willing to pay for each
additional unit. This price Marshal calls the demand price. The inverse relationship between the demand
price and the quantity of a good demanded, shown in Figure 3, is referred to as the law of demand. The price
that the consumer is willing to pay for each additional pound of tea consumed in a year (it is important to
specify the time period) decreases, reflecting the fact that each additional pound of tea yields diminished
utility.
Figure 3
Price (shillings per pound)
20
14
10
6
4
3
D
2
0
1
2
3
4
5
6
7
8
Quantity of Tea (pounds per year)
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2.2.2. Utility Maximization Rule
All consumers have a certain amount of income (budget) that they must allocate among various goods. The
allocation is not a haphazard process. It should proceed in a way that the consumer’s total utility is
maximized. The rational resource allocation rule requires that marginal utility per dollar must be equal
across all goods in the consumer’s goods basket. In mathematical symbols the rule is expressed as,
𝑀𝑈1 𝑀𝑈2
𝑀𝑈𝑛
=
=⋯=
𝑃1
𝑃2
𝑃𝑛
Let’s use a numerical example to see why this is the utility maximization rule. Assume Thomas, our
representative consumer, receives a fixed amount of income per period and he must allocate this budget
among three goods such that his utility is maximized. The following table shows Thomas’s total and marginal
utility amounts assigned to each quantity of the three goods.
𝑄
1
2
3
4
5
6
7
8
𝑈₁
19
35
48
58
65
69
70
Total Utility
𝑈₂
36
67
93
114
130
141
147
148
𝑈₃
46
84
114
136
150
156
154
144
Marginal Utility
∆𝑈⁄∆𝑄
𝑀𝑈₁
𝑀𝑈₂
𝑀𝑈₃
19
36
46
16
31
38
13
26
30
10
21
22
7
16
14
4
11
6
1
6
1
The market prices Thomas faces for the three goods are shown in the table below. The table also shows
marginal utility per dollar for each increment. Suppose Thomas’s budget for the period is $50. Clearly,
Thomas would choose good 1 first because it has the highest MU per dollar (9.5). His second choice would be
good 2, 𝑀𝑈2 ⁄𝑃2 = 9, and third choice good 3, 𝑀𝑈3 ⁄𝑃3 = 8.36, and so on. . . When all is said and done, Thomas
will choose four units of good 1, five units of good 2, and four units of good 3. He has exhausted his budget
($2 × 4 + $4.0 × 5 + $5.5 × 4 = $50) and maximized his utility.
𝑃=
𝑄
1
2
3
4
5
6
7
8
$2.0
𝑀𝑈₁/𝑃₁
9.50
8.00
6.50
5.00
3.50
2.00
0.50
$4.0
𝑀𝑈₂/𝑃₂
9.00
7.75
6.50
5.25
4.00
2.75
1.50
0.25
$5.5
𝑀𝑈₃/𝑃₃
8.36
6.91
5.45
4.00
2.55
1.09
Note that, in the above table per dollar marginal utilities for the final units are not exactly equal. The figure
for the fourth unit of good 1 is 𝑀𝑈1 ⁄𝑃1 = 5, while 𝑀𝑈2 ⁄𝑃2 = 𝑀𝑈3 ⁄𝑃3 = 4. But, according to the
mathematical notation, marginal utility per dollar must be exactly equal for utility maximization. This exact
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relationships would always hold, if goods were divisible into very small subunits. For example, instead of
considering marginal utility of a loaf of bread per dollar, we deal with MU of a slice of bread per dollar.
Now assume the price of good 1 decreases to $1. The fall in 𝑃1 will increase the ratio 𝑀𝑈₁/𝑃₁ relative to the
other two goods, inducing Thomas to increase his consumption of good 1 until 𝑀𝑈₁/𝑃₁ comes down to the
same ratio as for the other two goods. Thus, with the lower 𝑃1 = $1 Thomas will consume 6 units of good 1,
as opposed to 4 units at 𝑃1 = $2. This is the process which leads to the law of demand, the inverse
relationship between price and quantity demanded of a good.
𝑃=
𝑄
1
2
3
4
5
6
7
8
$1.0
𝑀𝑈₁/𝑃₁
19.00
16.00
13.00
10.00
7.00
4.00
1.00
$4.0
𝑀𝑈₂/𝑃₂
9.00
7.75
6.50
5.25
4.00
2.75
1.50
0.25
$5.5
𝑀𝑈₃/𝑃₃
8.36
6.91
5.45
4.00
2.55
1.09
2.2.3. Ceteris Paribus
The law of demand operates, according to Marshal, under the ceteris paribus assumption. Marshal describes
ceteris paribus as follows:
The element of time is a chief cause of those difficulties in economic investigations which
make it necessary for man with his limited powers to go step by step; breaking up a complex
question, studying one bit at a time, and at last combining his partial solutions into a more or
less complete solution of the whole riddle. In breaking it up, he segregates those disturbing
causes, whose wanderings happen to be inconvenient, for the time in a pound called Cæteris
Paribus. The study of some group of tendencies is isolated by the assumption other things
being equal: the existence of other things is not denied, but their disturbing effect is
neglected for a time.
In describing the consumers response to a change in the price of the good in question, say tea, we must
assume that other factors besides the price of tea that may impact the consumer’s demand for tea are held
equal or constant. For example, an increase in the price coffee, a substitute for tea, may induce some
consumers to drink more tea. Or, an increase in the price of sugar, a complement for tea, may induce some to
drink less tea. Thus, changes in the price of coffee or sugar, two related goods, impact the demand for tea.
Here the change in demand for tea is not caused by a change in price of tea but by a change in other things.
The other things that may impact the demand for tea also include change in tastes and change in income.
Thus, the law of demand describes a change in quantity demanded of a good in response to the change in the
price of that good, ceteris paribus. This is shown as a movement along the demand curve (Figure 4-a). On the
other hand, a change in other things lead to shift in the whole demand curve. For example, the demand for
tea will increase, shift to the right, if the price of coffee increases (Figure 4-b), or decrease, shift to the left,
when the price of sugar rises (Figure 4-c).
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Figure 4
(a)
(b)
P₁
(c)
P₁
P₁
P₂
D
D₁ D₂
Q₁ Q₂
Q₁
Increase in quantity demanded of tea
due to a decrease in price of tea
2.2.4.
D₂
Q₂
Q₂
Increase (shift to right) in demand due
to an increase in price of coffee
D₁
Q₁
Decrease (shift to left) in demand due
to an increase in price of sugar
Consumer Surplus
Marshal defines the consumer surplus as the difference between the amount the consumer pays (spends) for
a specific quantity of a good and the amount he would have been willing to pay or spend. To explain, consider
the diagram shown Figure 5 below, showing Thomas’s expenditure for tea.
Figure 5
Price (shillings per pound)
20
14
10
P
6
0
1
2
3
4
5
6
7
8
Quantity of Tea (pounds per year)
The heavy horizontal line is the current price of tea, 𝑃 = $6 (the dollar symbol is used to simplify typing!), At
this price Thomas buys four pounds of tea and his total expenditure on tea is $6 × 4 = $24. He is paying $6
for each of the 4 pounds he is consuming. However, note that his demand price, the amount he was willing to
pay, for the first pound was $20, for the second, $14, and for the third, $10. Only for the fourth pound his
demand price is equal to the price he is actually paying. The total amount that he was willing to pay for 4
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pounds of tea is, therefore, $20 + $14 + $10 + $6 = $50. His consumer surplus is thus the difference between
what he was willing to spend on four pounds of tea and what he spends: $50 – $24 = $26.
The consumer surplus for the market as a whole is shown in Figure 6. The area of the triangle 𝐴𝐸𝑃 is the
consumer surplus corresponding to quantity 𝑄. The total amount the consumers are willing to pay for tea is
the area 𝑂𝐴𝐸𝑄, but the amount they actually pay is the area of the rectangle 𝑂𝑃𝐸𝑄. The difference is the
consumer surplus.
Figure 6
Price
A
P
Consumer
surplus
E
Consumer
spending
D
0
Q
Quantity
Marshal also adds the producer surplus to the picture. The producer surplus is the difference between the
price which the producer actually receives for a quantity and the minimum price that he is willing to sell or
offer that quantity. This minimum price is called the supply price, which represents the producer’s marginal
cost. For example, in Figure 7 at the market price of $10 William sells 4 pounds of tea. His total receipt or
total revenue is $10 × 4 = $40. Note that his supply price, his marginal cost, for the first pounds is $1, for the
second pound, $3, and for the third pound, $6. Thus his total cost is the sum of marginal costs, including the
marginal cost of the fourth unit: $1 + $3 + $6 + $10 = $20. Since his total revenue for selling four units is
$40, then his producer surplus is $40 – $20 = $20.
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Price (shillings per pound)
Figure 7
P
10
6
3
1
0
1
2
3
4
5
6
7
8
Quantity of Tea (pounds per year)
For the market as a whole, then the producers’ surplus is the area above the supply curve and below the
price. In Figure 8 producers’ total revenue is the rectangle 𝑂𝑃𝐸𝑄, the producer cost is the area 𝑂𝐵𝐸𝑄, and
the producer surplus is the triangle 𝐵𝑃𝐸.
Figure 8
Price
S
E
P
Producer
surplus
B
Producer
cost
0
Q
Quantity
Putting supply and demand together, the total surplus for all consumers and producers is shown in Figure 9.
The total surplus in this market is the sum of the consumer surplus and the producer surplus. This is the area
of the triangle 𝐴𝐸𝐵. To maximize total surplus, then, market must be at equilibrium, where the marginal
utility of the last unit consumed is equal to the marginal production cost. This Marshal regards as the
“general doctrine” where “a position of (stable equilibrium) of demand and supply is a position also of
maximum satisfaction.” If the market is prevented from reaching equilibrium, either by restricting quantity to
lower than the equilibrium quantity or, fixing the price above, or below, the equilibrium price, total
satisfaction will be less than the maximum.
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Figure 9
Price
A
S
Consumer
surplus
E
P
Producer
surplus
B
D
Producer
cost
0
Q
Quantity
2.2.5. Elasticity
Marshal is credited with developing the concept of elasticity applied to demand and supply. Elasticity is a
mathematical concept which measures the sensitivity of the dependent variable 𝑦 to a change in 𝑥. In a linear
equation or function such is 𝑦 = 20 − 2𝑥, the slope of the function measures the absolute change in the value
of 𝑦 in response to unit change in 𝑥. For example, when 𝑥 decreases from 𝑥0 = 4 to 𝑥1 = 2, 𝑦 increases from
𝑦0 = 12 to 𝑦1 = 16. Thus, the change in 𝑦 per unit change in 𝑥 is: ∆𝑦 ⁄∆𝑥 = 4⁄2 = 2 (with a negative
algebraic sign indicating that 𝑥 and 𝑦 are inversely related). Here we say that the slope of the function or
equation is −2.
𝑆𝑙𝑜𝑝𝑒 =
∆𝑦
∆𝑥
For a linear function the slope remains unchanged for all values of 𝑥.
Elasticity, however, is different. It measures the proportional (percentage) change in 𝑦 in response to a
proportional change in 𝑥. In the example above, when 𝑥 decreases from 𝑥0 = 4 to 𝑥1 = 2, the proportional
change is ∆𝑥 ⁄𝑥0 = 2⁄4 = 0.5, or a decrease of 50 percent. In response, 𝑦 has increased from 𝑦0 = 12 to 𝑦1 =
16, an increase of ∆𝑦⁄𝑦0 = 4⁄12 = 0.33, or an increase of 33%. Elasticity is, therefore, calculated as
50%⁄33% = 1.5, which means for a one percent change in 𝑥, 𝑦 changes by 1.5%.
𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 =
∆𝑦 ⁄𝑦0
∆𝑥 ⁄𝑥0
Unlike the slope of a linear function, however, elasticity does not remain constant for all values of 𝑥. Suppose
𝑥 decreases from the initial value 𝑥0 = 8 to 𝑥1 = 6, a change of 2⁄8 = 0.25 or 25%. In response, 𝑦 changes
from 𝑦0 = 4 to 𝑦1 = 8, a relative change of 4/4 = 1, or 100%. Thus, elasticity is 100⁄25 = 4, or for one
percent change in 𝑥, 𝑦 changes by 4 percent.
In applying the mathematical concept of elasticity to demand, we replace the dependent variable 𝑦 with 𝑄,
quantity demanded, and the independent variable 𝑥 with 𝑃, the price of the good. Thus, the elasticity of
demand indicates the percentage change in quantity demanded per one percent change in price.
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𝐸𝑙𝑎𝑠𝑡𝑖𝑑𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑: 𝜖 =
∆𝑄 ⁄𝑄0
∆𝑃 ⁄𝑃0
There are two attributes of elasticity of demand which make it a very useful concept in explaining the
behavior of different markets. First, elasticity differs depending on the initial price of a good from which a
change takes place. Using the above mathematical example representing a linear demand function, 𝑄 = 20 −
2𝑃, if the initial price is 𝑃0 = $8 and price is reduced by $2 to 𝑃1 = $6, the elasticity of demand is 𝜖 = 4, but
when we start from an initial price of 𝑃0 = $4 and reduce it by the same $2 to 𝑃1 = $2, elasticity is reduced to
𝜖 = 1.5. The economic reason for greater elasticities at higher prices is that, since at higher prices quantity
consumed is low, the marginal utility of each additional unit is much higher than the marginal utility when
price is low. Thus, the consumer is much more responsive to a decrease in price when price is initially high.
At low prices, one can reasonably argue that, since quantity consumed is already high, the consumer is near
satiation, and so he will not be very responsive a further decrease in price.
Second, elasticity is independent of units of measurement. Thus, the use of elasticity allows one to compare
the price sensitivity of demand or supply by a single number that is comparable between different goods,
time periods, and countries.
2.3. External Economies and Diseconomies
In discussing supply, Marshal observed that in the long-run supply becomes very elastic, and in many cases
elasticity approaches infinity, when the long-run supply curve becomes horizontal. The infinitely elastic
supply scenario supports the classical view that the changes in demand only affects the quantity and not the
price (Figure 2-d).
Marshal, however, pointed two other scenarios with respect to the long-run supply curve. He pointed out
that in some situations the long-run supply curve becomes negatively sloped, where an increase in demand
led to lower rather than higher prices as we generally expect to happen.
Figure 10
S₁
S₂
E₁
P₁
E₂
P₂
LRS
D₁
Q₁
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D₂
Q₂
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In Figure 10, starting from the initial market equilibrium 𝐸1 , the demand shifts increases from 𝐷1 to 𝐷2 . In the
short-run the existing producers will expand output in response to the higher price obtained at the
intersection of 𝐷2 and 𝑆1 . In the long-run the existing producers will expand production capacity and new
firm will enter the market, shifting the supply curve to 𝑆2 . The new equilibrium is now established at 𝐸2 .
Basically, the long-run supply traces the various intersection points of expanding short-run supply. When the
short-run supply settles at 𝑆2 , the line that connects 𝐸1 to 𝐸2 is the long-run supply curve. At the new
equilibrium the higher quantity 𝑄2 is sold at the lower price 𝑃2 .
Marshal describes the factors that lead to a downward sloping long-run supply curves as external
economies. These factors are external to the firm, but internal to the industry. The supply curve of an
individual firm is still upward sloping due to rising marginal costs, but the supply for the whole industry
slopes downward. The external economies are the result of improved information and technologies
developed by the firms that are clustered in a geographical area, access to better qualified labor, and the
emergence of specialized support activities. A modern example is the Silicon Valley.
External diseconomies could also occur resulting in an upward sloping long-run supply curve. This could
happen due to bottlenecks created by some scarce inputs or raw materials, or lack of skilled labor.
Figure 11
S₁
S₂
LRS
E₂
P₂
E₁
P₁
D₂
D₁
Q₁
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Q₂
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