History of economic thought
Presentation 9
Petr Wawrosz
Establishing of
modern
microeconomics
Basic characteristic
• Concentration on behavior of individual (a
consumer, a firm)
• Maximalization of utility/profit
• Marginal approach
• General and partial equilibrium
• Description of market structure – perfect and
inperfect competition
• Efficiency and equity
Augustin Cornout (1801-1877)
• French mathemathician
• The first scholar to be interested in the firm as such, to study its
behavior in different market situations and to pose the problem of
the determination of the scale of production.
• He made the first rigorous formulation of a demand function; a
function which he used to determine the price and quantity
produced under monopoly (and duopoly).
• Cornout equilibrium: equilibrium on duopoly market - each firm
makes a series of mistaken assumptions about the behavior of the
other, but the size of these errors gradually diminishes in intensity
until a situation is reached in which the expectations of reciprocal
behavior become correct. At this point the adjustment process
stops.
Jules Dupuit (1804 – 1866)
• He endeavored to study the social benefits
derived from public goods such as canals or
bridges, and, above all, to evaluate the net social
gains generated by variations in tolls and rates.
• He constructed a demand curve, interpreting it in
terms of utility. Then he defined marginal utility
and distinguished it from total utility.
• Dupuit also conceptualized ‘producer surplus’,
which, given an increasing cost curve, is the
difference between the total revenue of the firm
and the overall marginal costs.
Johann Heinrich von Thünen
(1783-1850)
• Publication: The Isolated State in Relation to the
Agricultural and National Economy (1826),
written at German.
• How long to usu land? Marginal productivity of
land equls wage (a farmer cannot influence
wage).
• Which land is used: at first the nearest land to the
town. But the cost of the transport increase with
distance. Farmers with longest distance will
specialize in production with lowest transport
costs.
Hermann Heinrich Gössen (1810 – 58)
• Publication: The Laws of Human Relations and
the Rules of Human Action Derrived Theorem,
1854). Written at Germen, forgotten,
rediscovered at the end of the 1870s.
• Gosen´s law.
Gossen´s law
• Gossen's First Law is the “law” of diminishing
marginal utility: that marginal utilities are
diminishing across the ranges relevant to
decision-making.
• Gossen's Second Law, which presumes that utility
is at least weakly quantified, is that in equilibrium
an agent will allocate expenditures so that the
ratio of marginal utility to price (marginal cost of
acquisition) is equal across all goods and services.
• Gossen's Third Law is that scarcity is a
precondition for economic value.
Ernst Engel (1821 – 96)
• German statistic.
• Income elasticity.
• He explored that income elasticity for the food
is less 1.
• Engel curve.
• Necessities, luxuries, inferior good.
Necessities and luxuries
e>1
Percentage change in
quantity demanded is
higher then percentage
change in income
Luxories
e=1
Percentage change in
Goods with unit income
quantity demanded equals elasticity
percentage change in
income
e<1ae>0
Percentage change in
quantity demanded is
lower then percentage
change in income
Necessities
e<1
Growht of income means
decrease of quantity
demanded; fall of income
means increase of quantity
Inferioor goods
Engel‘s curve
• The relationship among Income (Y, usually
vertical axis) and quantity demanded (Q‘,
usually horizontal axis)
Engel‘s curve for inferior goods
William Stanley Jevons (1835-82)
• Had a formal (university) education at
economist → economist became the science.
• The Coal Question (1862): how to respond to
the shortage of coal
• The theory of Political Economy (1870)
• The Principles of Science (1874)
• Economics must be mathematical science: it
deals wit quantities.
William Stanley Jevons (1835-82)
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Marginal Utility Theory
The Law of diminishing marginal utility
Demand and Price
The Sunspot theory
Carl Menger (1840 – 1921)
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Studied law some time at Prague.
Founder of Austrian School
Publication: Principles of Economics (1871).
The goods of first order (final goods), the goods
of higher order (capital goods, goods that used
for production of final goods)
• Prices of factor of production (goods of highest
order) is derived from the prices of the good
goods of the first order they helped to produce.
Carl Menger (1840 – 1921)
• The Methodenstreit (the dispute about
methodology): which character does have
economic principles:
- Menger: economics principles must be base
on the general principles of human behavior
- German historical school: the economic
principles must be derived from the specific
historical situation and facts
Absolutist versus relativist approach
• Absolutist approach: tends to believe that there are some
objective, absolute “facts or truths” about the perceptions
and patterns of economic behavior that cross cultural,
temporal and social boundaries. These beliefs and patterns
of behavior are perceived as universal. They are believed to
apply in every society at all times in similar ways.
• Relativist approach: holds that what is “true,” or useful, in
one time or place may or may not be useful in some other
time or place. Economic theory is a product of its
environment. The relativist tends to believe that economic
theory is shaped by technology, social and economic
institutions.
• The dispute about methodology is an example which
approach are more important?
Absolutist versus relativist approach
• How to solve the conflict?
• Perhaps a position somewhere between the
extreme relativist and absolutist positions is more
reasonable. There may be universal patterns of
economic beliefs and behavior that span all
societies. However, cultural features, technology
and other factors influence our perceptions,
values and behavior.
• Economic theory is both a determinant and
reflection of the society of which it is a part.
Eugen von Böhm-Bawerk (1851-1914)
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A scholar of Menger
Capital and Interest (1889)
Why the rate of interest is positive?
1. individuals in general expect that more resources (goods)
will available for consumption in the future
• 2. people´s tendency to underestimate future needs
• 1 + 2 → consumers must be compensated for transferring
resources to the future, since they expect resources to be
greater and needs to be less
• 3. methods of production will be more productive when
extended in time. But there must be some factor that
causes producers to stop the process of time extension /to
choose a period of production of finite length).
Eugen von Böhm-Bawerk (1851-1914)
• The theory of discount rate (1/(1 + r))
r = equilibrium price of consumption one
period from now expressed in units of present
consumption
• A critic of the Karl Marx.
Friedrich von Wieser (1851-1926)
• A professor in Prague for some time
• Publications: Natural Value (1889), Social
economics (1914)
• For the first time used term „marginal utility“
• Explanation why socialism cannot be efficient:
it does not allocate resources in such way
when MU1/P1 = MU2/P2 = … MUn/Pn
Leon Walras
(1834 – 1910)
Basic facts
• Professor in Lausanne university in Switzerland
• Publications: Elements of Pure Economics (1874),
Theory of Money (1886)
• The marginalistic perspective was embedded in a
economic view that was comparable to that of classics.
• The price is determined both by marginal utility
(demand) and cost of production (marginal costs,
supply).
• Supporter of using mathematics in economics.
(however economic become unintelligible without
knowledge of mathematics).
The analysis of exchange
• Initial situation: 2 persons and 2 goods, the supply of goods
is fixed.
• How can be characterized the equilibrium of such
economy?
• Walras´ model determines relative prices: the price of good
1 expressed in units of good 2.
• Conclusion: one good can be taken as the unit of account.
All the price can expressed in units of this good ->
numeraire.
• The price of numeraiere equals 1.
• Consumers must compose their consumption in such way
that marginal utility divided by price must be same for all
goods (Gossen´s second law).
General Equilibrium
• Firms supply finished goods that are demanded by consumers.
• In order to produce consumer goods firms demand factors of
productions that are supplied by consumers.
• General equilibrium exists, when:
1. the consumers 'demand is equal to firms´ supply for all consumer
goods.
2. the firms 'demand is equal for all factors of productions.
• Suppose economy with m goods: demand and supply of each
commodity of a function of all prices.
• Walras explain how equilibrium in all markets can be achieve.
• Importance result: if the equilibrium is achieved on m-1 markets,
the last market must be also in equilibrium.
• Money is neutral in his model.
• The model need not have solution (it depends on the equations and
the price can be negative, what is not possible).
The road to equilibrium
• If there is a disequilibrium on some market,
then:
- if demand for the good is higher than supply,
price goes up
- - if demand for the good is lower than
supply, price goes down
• The necessary condition: free entry into and
free exit out of market -> Wallras´ model is the
model of perfect competition.
Alfred Marshall
(1842 – 1924)
Principles of Economics (1890)
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First modern economic text-book.
Supply and demand diagram.
Partial equilibrium.
Price is determined both by marginal cost
(supply) and marginal utility - > although such
results was already discovered by Walras,
Marshal gave the idea clear form.
• Movement along curve versus shift of the curve.
• In SR inelastic (vertical) supply curve.
Demand, Supply, Consumer and
producer surplus
• Diminishing marginal utility. If the price is higher than marginal utility, the
unit is not consumed.
• Income and substitution effect.
• The individual consumer demand curve corresponds to decreasing part of
marginal utility curve.
• Consumer´s surplus.
• Increasing marginal cost. If the price is lower than marginal cost, the unit
is not produced.
• The individual firm´s supply curve corresponds to increasing part of
marginal cost curve.
• Producer surplus.
• The consumer and producer surplus are maximized in the equilibrium.
• Social surplus: (equilibrium price is low (high), producers surplus is lower
(higher) than consumer surplus. Government intervention and change of
surplus.
Partial versus general equilibrium
• Partial equilibrium: Marshall: human intellect
has limited powers so it is necessary to
simplify complex problem in order to
understand and be able to solve them.
• The Principles emphasizes the mutual
interdependencies of economic life but
Marshall himself had not developed a general
equilibrium mode.
Partial equilibrium in perfect
competition
Concept of elasticity
• Price elasticity = how the change of price affects
quantity demanded (price elasticity of demand)
or quantity supplied (price elasticity of supply).
• Small change of price can have small or huge
effects of quantity demanded or quantity
supplied.
• Huge change of price can have small or huge
effects of quantity demanded or quantity
supplied.
Price elasticity equation
• Equation:
Price elasticity of demand or supply:
(e)=
percentage change in quantity demanded or quantity supplied
-----------------------------------------------------------------------percentage change in price
• Mathematically:
• Percentage change in quantity demanded
= (𝑄′2 − 𝑄′1 )/(1/2 * (𝑄′1 + 𝑄′2 ))
• Percentage change in price
= (𝑃2 − 𝑃1 )/(1/2 * (𝑃1 + 𝑃2 ))
• e = (𝑄′2 − 𝑄′1 )/(1/2 * (𝑄′1 + 𝑄′2 ))/ ((𝑃2 − 𝑃1 )/(1/2 * (𝑃1 + 𝑃2 ))) =
=ΔQ´/(𝑄′1 + 𝑄′2 ) * ΔP/(𝑃1 + 𝑃2 )
• Usually it is used absolute value in the case of quantity.
Factors market and income
distribution
• Wage:
• Demand: It is profitable to hire more workers
as long as the value of the marginal
productivity exceeds the wage rate.
• The wage rate from producer point of view is
given (stipulated at the market).
• Supply: marginal utility analysis: wage versus
dissatisfaction with work (leisure time).
Factors market and income
distribution
• Capital:
marginal productivity of capital must be
higher or at least equal to the rate of interest.
• Explain why productivity of labor increases
over time:
- higher wages
- investments in human capital (Marshall does
not use the term).
Free market
• Perfect competition maximizes producers and
consumers surplus.
• Such system is good for building character: it
makes a person become hard-working,
conscientious and prudent.
• This would have a long run effect on economic
growth and development.
Francis Edgeworth (1845 – 1926)
Importance
• Marginal utility of income is decreasing.
• Social welferare: the sum of individual utility.
• The concept of inddifferent curve
Vilfredo Pareto
(1848 – 1923)
Basic facts
• A Course of Political economy (1896)
• Manual of Political economy (1909)
• Walras´s successor at University of Lausanne.
• Developed the concept of indifferent curve.
• Reject social welfare as the sum of individual
utility.
• Pareto optimality.
Indifferent curve
• A curve that shows the combinations of
consuming bundles that give the consumer
same utility.
Indifferent map
• Higher indifferent curve
(IC) = higher utility that
bundle of goods brings
the consumer
• Bundles of good lying
on the one IC brings
some utility
Attributes of indifferent curves (IC)
• They are diminish.
• They cannot cross.
• The shape of IC (usually, exceptions are
substitutes and complements) reflects the law
of diminishing marginal utility: for each
additional unit of good that a consumer must
give up (s)he needs more units of remaining
(second) good so that his/her utility stays
some.
ICs for substitutes and complements
Substitutes
Complements
Marginal rate of substitution (MRS)
= the rate telling if a consumption of one good is
decreasing for some units how much the consumer
must increase the consumption of rest good to stay
on the same IC (to keep his/her utility).
= the rate at which a consumer would be willing to
trade off one good for another.
MRS
• How to count MRS:
• Let a consumer decreases the consumption of good Q´1
about 5 units (for instance from 12 to 7 units). If he
increases the consumption of good Q´2 about 10 units
(for instance from 4 to 14 units) and stay on the same
indifferent curve the MRS is 10Q´2 to 5Q´1 = 5 Q´2 to 1
Q´1 .
• Generally:
MRS = change of units of goods whose consumption is
increasing to change of units of goods whose
consumption is decreasing
Importance of MRS
• MRS tell us the relative price (from consumers
point of view): how should be price of unit of
one good in the units of different good.
• Example: If MRS is 5 Q´2 to 1 Q´1 then a
consumer is willing to pay 5 Q´2 units of good
per 1 unit of good Q´1 → the unit of the good
Q´1 is for a consumer five times valuable than
the unit of the good Q´2.
Importance of MRS
• The prices of goods are generally expressed in money.
• If the ratio of monetary prices differs from MRS it is convenient for
consumer to buy the cheaper good.
• Example:
MRS is 5 Q´2 to 1 Q´1 is five times valuable than . The good Q´1 must
cost five time more than the good Q´2 so that a consumer would be
indifferent (which good should buy).
a) Let the price of 1 unit Q´2 is 2 CZK the price of 1 unit Q´1 is 10 CZK.
At this case a consumer will be indifferent.
b) Let the price of 1 unit Q´2 is 2 CZK the price of 1 unit Q´1 is 20 CZK
( is 10 times expensive than ). At this case it is more convenient for
consumer to buy 5 units Q´2 than 1 unit of Q´1.
c) Let the price of 1 unit Q´2 is 2 CZK the price of 1 unit Q´1 is 6 CZK (
is 6 times expensive than ). At this case it is more convenient for
consumer to buy 1 units Q´1 than 5 units of Q´2.
Importance of MRS
• MRS can be count at each point of IC as a
slope of tangent at this point.
• IF IC has it standard shape the MRS is different
at each points.
• MRS tells a consumer´s willingness to pay
(how many units of remaining good is
consumer willing for the good (s)he gives up).
• From MRS we can derive marginal benefit
curve.
Edgeworth´s box
Arthur C. Pigou (1877 – 1959)
Basic facts
• Marshall successor at Cambridge University.
• Main topic: welfare economic (publications „Economics
of Welfare“ 1920, „A Study in Public Finance“, 1928).
• He believed that the redistribution in favor of low
income groups increase the sum of utility in society.
• However admitted that such transfer could reduce the
total income of society and thereby weaken the
economic basis for redistribution.
• Trade-off: economic efficiency versus distributive
justice.
Market failures
• Externalities
• Monopoly (the price is higher than marginal
costs of production)
How to designate optimal tax system?
• Almost all feasible taxes involve harmful
effects for the economy
- have incentives on labor supply,
consumption and saving:
• The percentage reduction in consumption and
production ought to be the same for all goods.
• To achieve this: impose the highest taxes
should be imposed on goods with inelastic
demand or supply.
Knut Wicksell (1851-1926)
• Swede.
• Main publication: Value, Capotal and Rent
(1893)• Generalized theory of priduction and firm
behavior.
• Concept of production function.
• Demand for factors of production: the value of
marginal productivity compare to price.
LRAC curve
• Shape of LRAC curve
• Decreasing part of the curve
: increasing returns to scale
• Minimum: decreasing
returns to scale
• Increasing of the curve:
increasing returns to scale.
• In perfect competition Q2 is
optimal quantity produced
by individual firm.
• In the LR there will be
constant returns to scale.
The rates of interests
• The natural rate of interest (rn): determined by real rate
of return on capital. Independent on monetary
relationships.
• Market rate (rm): determined by banking system.
• If rm = rn the price level wil be stable and the rate of
inflation will be 0
• If rm < rn the demand for capital increases -> a positive
rate of inflation. Inflation continues till:
- banks increase the rm,
- the natural rate falls as a result of decreasing rate
return on capital.
• Wicksell favors zero inflation (stable price level).
Theory of taxation
• Benefit principle: an indivual´s tax payment ought to
reflect his/her benefits from the provision of public
services.
• The principle of ability to pay? The taxes should be paid
by people who have money to pay them - > progressive
taxation.
• Wicksell favor benefit principle: projects financed by
taxes should give people some benefits.
• How to achieve this: The public projects must be
approved by democratic institutions on the basis of
unanimity.
• Unanimity is not necessary in case of redistribution.
Irving Fisher (1867 – 1947)
• An American economist.
• Founder of Econometric society.
• For the first time draw a figure showing:
- optimal bundle of consumed goods
- optimal combination of factor of production
minimizing cost of production for given level
of output.
Optimal bundles of goods
• The bundle where the
budget line touchs a
indifferent curve.
• Why?
• A consumer
- maximizes his utility.
- cannot find better
combination (bundle) of
good
Saving and Investment
• Fisher Chart – how to
allocate resources
between present and
future consumption: the
consumer's marginal rate
of of substitution
between present and
future consumption must
be equal to the rate of
discount (1/(1 + r)), r =
interest rate.
Saving and Investment
• How much iti is rational to invest in real
capital?
• The amount maximizing present value of the
investment. The point where the marginal
productivity of the capital is equal to the rate
of interest.
The quantity theory of money
• The equation: M*V = P*Y
Y = real GDP (given), V = velocity of money: determined
by institutional arrangements.
• Results: The price level is determined by quantity of
money.
The amount of money determined absolute price level.
The real side of economy is guided by relative process.
• Fisher favors stable price level.
• He defined real and nominal interest rate. Real:
- backward and forward looking.
• Explanation of Great depression: real interest rate
continued to stay at very high level.
Edward Chamberlin (1899 – 1967)
• An American economist. Previous described economists looked on the
market as a perfect competitive one. However reality is different.
• Many firms have (for a long time) increasing returns to scale (and
decreasing AC and MC curve).
• Main publication: The theory of monopolistic competition – reality is
between monopoly and perfect competition.
• Not homogenous product – each producer is a monopolist with respect to
the sale of his own good, but his monopoly position is relatively weak,
since he must pay attention to the competition from those who produce
goods that are closely related to his own.
• The demand curve faced by the single producer is therefore not
horizontal, as under perfect competition, but in comparison to the
monopoly case is relatively flat: if the firms raises its price, it will lose
many customers who will switch to the commodities offered by its
competitors.
• Chamberin expected free entry into industry.
• Firms try to strengthen its position (specialization in product, advertising
…)
Edward Chamberlin (1899 – 1967)
Short run firm´s equilibrium
Long run firm´s equilibrium
Joan Robinson (1903 -83)
• The Economics of Imperfect Competition
(1933) – published similar results as
Chamberlin.
• The imperfect competition on the market for
factors of production. Monopsony.
• The owners of the factors of production are
paid less than value of their marginal product.
• Price discrimination.
Other economists interesting in
imperfect competition
• Harold Hotelling (1895 – 1973). An American.
• Some firms decision in imperfect competition can be
convenient for the firms but are not convenient for the
consumers.
• Where new firms starts to sell its product (near the shop of
first producer), which product firm choose to sell (very
often very similar to the first one).
• Heinrich von Stackelberg (1905 – 1946):
• Theory of duopolistic competition: one firm is a leader,
second one is the follower.
• Frederik Zeuthen (1888 – 1959). A Danish economists.
• The role of bargaining in imperfect competition.