Chapters 12, 13, and 14
Study Guide by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Oser Summary Main Page
Chapter 12: The Rise of the Marginalist School: Gossen and Jevons
The Marginalist school was developed by a number of economists in different countries working independently. Some of the pioneers include Herman Heinrich Gossen in Germany, Carl Menger in Austria, Leon Walras in Switzerland, and W. Stanley Jevons and Alfred Marshall in England. Marginalism became the dominant school for microeconomic or partial analysis, and almost every elementary college economics textbook uses it to analyze the firm, individual production and consumption activities, the market for individual products, and the formation of individual prices. It remained supreme in Western economics until Keynesian macroeconomics appeared in 1936. Today both types of analysis continue to flourish side by side.
Overview of the Marginalist School
The Social Background of the School
Various problems (e.g., widespread poverty, extreme uneven distribution of income and wealth, business fluctuations, industrial accidents without adequate workman's compensation, long work days in dangerous and unhealthy conditions, monopolistic business, insecurity in old age, etc.) caused people to seek solutions beyond the narrow concepts of classical economic thinking. The European trends in seeking solutions included socialism, trade unionism, and government regulation to eliminate abuses and redistribute income. The marginalist economists opposed those trends, defended laissez faire, denounced socialism, discouraged unionism, and were critical of government intervention. The early marginalist viewed classical economics as unacceptable because it appeared to conclude that rent was unearned income, and that labor created all values.
The Essence of the Marginalist School
1. The marginalist concentrated on the margin where decisions are made to explain economic phenomena extending the marginal principle in Ricardo's theory of rent to all economic theory.
2. The marginalist approach was microeconomic rather than macroeconomic, i.e., they considered individual decisions rather than the aggregate economy, market conditions and prices for a single product etc.
3. Their method was abstract and deductive.
4. Their environment was mainly pure competition (many buyers and sellers, homogeneous products, uniform prices, no advertising, no individual or business with economic power), with an occasional monopoly.
5. They viewed demand as the primary determinate of price. Alfred Marshall synthesized the classical emphasis on supply with the marginalist emphasis on demand into what economists refer to as neoclassical economics.
6. Marginalist school economics is subjective and psychological. Demand depends on marginal utility, a psychic phenomenon, and the costs of production involves sacrifices, i.e., the pains related to working, managing a business, and saving money.
7. The marginalists believed that the economic forces worked towards balancing opposing tendencies, or equilibrium.
8. The marginalists theory generally included land with other capital goods and combined rent to the landowner with interest theory refuting the implication in the labor theory of value that rent was unearned income.
9. Men were assumed to be rational in balancing pleasure and pain, the present against the future, and in their understanding of the marginal utilities of different goods. Men were also assumed to be hedonistic in maximizing pleasure and minimizing pain.
10. The marginalists continued the classical school's defense of laissez faire as the most desirable policy to generate maximum social benefits.
What Groups of People did the Marginalist School Serve or Seek to Serve?
Marginalist economic theory benefited those who favored the status quo, including employers, landowners, and the wealthy. They were conservative in that they opposed unions, defended landowners against Ricardo's rent theory, and were opposed to government intervention.
How was the Marginalist School Valid, Useful or Correct in its Time?
The school developed new tools for analysis such as geometrical diagrams and mathematical techniques making economics more of an exact science. They gave demand more importance in determining prices, emphasized the forces that shape individual decisions, and made assumptions related to economic activity that were not considered or clearly stated in classical thinking. The method of partial analysis is useful in that it allows the investigation of complex phenomena by allowing one variable to change at a time, while assuming everything else remains constant. Introducing additional variables allows the analyst to approach more realistic situations.
How did the Marginalist School Outlive its Usefulness?
Marginalism has been modified since 1930, but it has not outlived its usefulness. It has weaknesses such as the famous fallacy of composition (i.e., what is true for the part is assumed to be true for the whole) that has led to erroneous conclusions. For example, Lionel Robbins wrote as late as 1934 that wage reductions were one of the necessary cures to overcome the great depression. Another weakness was the assumption of pure competition. Although the assumption was reasonable in the 1870s, it is irrelevant in large sections of the economy today. The equilibrium approach also has serious weaknesses in that an individual's work day, for example is determined more by historical and institutional factors (time clock, union collective agreements) than by the individual's attempt to balance the pleasure derived from wages against the pain associated with work. Individualism remained a dominant concept in economic theory in spite of the growing effects of collective action.
The early marginalist believed that laissez faire would produce the best results possible and that government intervention was undesirable since the economy was supposedly self-regulating. What was good for business was assumed to be good for the country, the same idea promoted by the classical economists. They also assumed that individuals preferred present spending to future spending (a positive time preference). Individuals viewed interest as the reward for abstinence, therefore underestimating their future needs by refusing to save unless they received a monetary inducement. Other reasons for savings (accumulation of wealth for power and prestige etc.) were overlooked. If, as the marginalist believed, interest is a reward for abstinence, then there should be no unemployment because as soon as unemployment appears, interest rates would drop, wealthy individuals would increase their consumption spending, and this would offset the decline in economic activity. But the system does not work this way.
The marginalist condemned Ricardian rent theory (see Chapter 6) and failed to consider the alternative point of view. Rent was viewed as unearned income because land costs society nothing. Their analysis was originally static, timeless, and unhistorical. They ignored business cycles believing that Say was right that supply creates its own demand, and that full employment was the normal outcome. In addition, they failed to explain economic growth, and floundered during the great depression of the 1930's, finally merging with the Keynesians.
Gossen
Herman Heinrich Gossen (1810-1858) published Development of the Laws of Exchange Among Men (translated from German) in 1854, and it was reprinted in 1889 after Gossen's death. Gossens economic system was based on hedonism and included three principles or laws:
1. The law of diminishing marginal utility states that the marginal utility of a commodity for an individual diminishes with every increase in the amount he already has. This law provides an explanation for how an exchange of equivalents between two individuals can increase the utility for both people.
2. The second law relates to a rational man's inclination to spend on each commodity up to the point where the last unit of money spent on any good is equal to the satisfaction of the last unit of money spent on any other good.
3. The utility of any product must be estimated after deducting the pains of labor it required to produce. A person will labor to the point where the utility of the product (i.e., earnings) equals the pain of the effort in production.
Jevons
William Stanley Jevons (1835-1882) was a professor of logic, political economy, and philosophy at Manchester, and later at University College, London. He published several books on logic and invented a logic machine that could provide a conclusion from any set of premises. He was also a famous historian and contributed to the development of index numbers. Jevons referred to Ricardo as "that able but wrong-headed man" who pushed the car of economic science into the wrong lane. Mill, according to Jevons, pushed it further toward confusion.
In The Theory of Political Economy published in 1871 Jevons wrote that "value depends entirely upon utility." Jevons theory of value was formulated as follows: The cost of production determines supply, supply determines the final degree of utility, and the final degree of utility determines value. In dismissing the labor theory of value, Jevons argued that the value of labor was determined by the value of the produce, not the other way around.
The theory of exchange is stated as "The ratio of exchange of any two commodities will be the reciprocal of the ratio of the final degrees of utility of the quantities of commodity available for consumption after the exchange is completed." Two traders, one with only corn and another with only beef, will trade until, at the margin the amount of corn exchanged has as much utility as the amount of beef exchanged. From the work perspective, a laborer will work until the pleasure or utility of earnings is equal to the pain or disutility of work. The graphic below illustrates the idea.
The utility or pleasure derived from work (earnings) is down sloping because of diminishing marginal utility (line pq). The line reflecting disutility or pain (ud) is up sloping at first, and then down sloping because laborers find work more annoying at the beginning of the day, adjust to it later, and then experience pain as the workday continues. Points b and c are where there is no pleasure or pain, and between those points there is pleasure from working. Beyond point c the pain increases. At point m the pleasure of earnings (point q) is equal to the pain of work (point d) and the worker will stop working.
Jevons' law of diminishing marginal utility solved the paradox of water and diamonds. Adam Smith thought that utility had nothing to do with the amount of exchange because water was more useful than diamonds, but diamonds were more valuable than water. However, the principle of diminishing marginal utility shows that the marginal utility of diamonds is far greater then the marginal utility of water, although the total utility of water is greater than the total utility of diamonds. Jevons used the same reasoning to show that gambling does not pay, but insurance does. For gambling, the marginal utility of money lost is greater than the marginal utility of an equal amount of money won. In the case of insurance, the marginal utility of premiums paid for insurance is less than the marginal utility of the large amounts we may lose without insurance.
Jevons did not fully develop a general theory of distribution, or explain the law of diminishing returns underlying the theory, but he did provide the basic ideas. He said there were three components of profit, including interest, wages of supervision, and insurance against risk. Interest rates were determined by the diminishing returns to capital. Since additional units of capital investments are less productive than earlier units, the rate of profit and interest tends to fall as output per unit of capital decreases.
Jevons accepted Ricardian rent theory based on marginal analysis, and believed sun spot cycles influenced the weather that in turn affected the size of crops. He favored free public museums, concerts, and education, and government regulation of child labor, health and safety in factories, and the greatest happiness principle.
Chapter 13: The Marginalist School: The Austrians and Clark
Menger
Carl Menger (1840-1921) was a professor at the University of Vienna. In Principles of Economics published in 1871, Menger illustrated diminishing marginal utility in a table comparing the marginal utility of food and tobacco, and eight other unnamed products. Menger used the term satisfaction of the marginal unit, rather than the term marginal utility. He identified exchange value with total utility, unlike Jevons who equated exchange value with marginal utility. Menger also originated the idea of imputed values in the pricing of goods used in production. The idea is that although the concepts of marginal utility and total utility refer to consumer wants, the prices of goods used in production are based indirectly on what helps provide satisfaction to consumers directly (the theory of imputation). For example, according to Menger, a consumer's marginal utility for a piece of iron is determined by the marginal utility of the final product that is made from the iron. Imputation extends the principle of marginal utility to the whole area of production and distribution. A landowner's rent is determined by the utility of the products grown on the land. The present value of the means of production is equal to the value of the consumer goods that they will produce, less the interest for the use of capita, and a reward, or profit for the entrepreneur. In considering the problem of monopoly, Menger wrote that a monopolist will raise his price if he believes he can obtain a greater economic gain from selling a smaller quantity of a monopolized good for a high price. He will lower his price if he believes he can make more from selling a larger quantity at a lower price. A monopolist will price his product to obtain the maximum profit.
Wieser
Friedrich von Wieser (1851-1926) taught at the University of Prague and later at the University of Vienna. He introduced the term "marginal utility," although others developed the concept earlier. Wieser wrote that value in use measures utility, but exchange value is a combination of utility and purchasing power. Natural value is determined by the quantity of goods and their marginal utility. Exchange value is determined by marginal utility and purchasing power. Luxuries are high in price because of the purchasing power of the rich, while common goods are low in price because of the purchasing power of the poor. Where needs remain the same for a commodity and the supply increases, the marginal utility decreases (the law of supply). Where needs increase for a good and supply remains the same, the marginal utility increases (the law of demand). He agreed with Menger that the marginal utility multiplied by the number of units available determines the total utility of a good. This produces "the paradox of value." Since each additional quantity of goods has a lower utility value, at some point marginal utility multiplied by the quantity of goods gives a declining total value (Wieser didn't use the term, but this is where demand becomes inelastic). Their total value is zero when there are no goods, or when the quantity of goods is superabundant. Wieser believed that economic systems would stay in the range where increasing supplies of goods would increase both exchange values and total utilities (i.e., where demands are elastic).
Wieser is famous for his doctrine now referred to as the opportunity cost, or alternative cost principle. In producing a commodity for the market, the entrepreneur gives up the opportunity to produce and sell alternative commodities. This principle has wide applicability in economics, but it does not contribute toward explaining value and market prices.
Bohm-Barwerk
Eugen von Bohm-Barwerk (1851-1914) was the third member of the group who founded the Austrian marginalist school. His major contribution was the analysis of time as an element in influencing values, prices, and incomes. The concept of time was used in his famous theory of interest which was based on three arguments. Goods are more valuable in the present than in the future. Consumers underestimate future wants, and are willing to pay interest for present rather than future goods because they expect to be better off in the future. The process of production is lengthened when more capital goods are used in production and this increases the physical product more than proportionally. Interest is a premium placed on the value and price of present consumer goods. Workers and land owners receive the value of their services, but the value is discounted to the present time. Interest can be paid by the entrepreneur because the lengthened production process is more efficient. Interest must be paid because people prefer present to future consumption. He agreed with Menger and Wieser that the total utility of a commodity is the marginal utility multiplied by the number of units, and that the value of the means production depends on the marginal utility of the final goods. However, the value of the final product is greater than the value of the services that produce it by an amount of interest over the period of time that elapses, i.e., time is a variable. Bohm-Barwerk accepted Say's analysis that the economy would tend toward full employment, perhaps as a reaction to Marxism. He published a criticism of Marx in 1896 published in English as Karl Marx and the Close of His System.
Clark
John Bates Clark (1847-1938) represents America's contribution to marginalist economics. He apparently worked out the concept of marginal utility and its relationship to exchange value independently around 1880. Clark invented the term marginal productivity, and in The Distribution of Wealth published in 1899, he presented the clearest analysis of the marginal productivity theory of distribution which is based on the law of diminishing returns. The law states that as more of any variable factor of production is added to fixed factors, the output increases less than proportionally. For example, if capital, land, and entrepreneurship are kept constant while labor is added to production, average output per worker will decrease even though total output continues to increase. Increasing returns to the variable factor might occur at first if the additions caused a better distribution of labor, or a more perfect organization of work. Additional units of the variable factor will be employed until the range of diminishing returns has been entered. Equilibrium will occur where the marginal productivity of the variable factor is equal to the cost, or earnings of the factor.
Clark wrote that the gross earnings of society include three shares: wages, interest, and profits. Rent is merged with interest, and profits are the residual after wages and interest are paid according to the marginal productivity of labor and capital. Capital is productive, and paying interest is buying the product of capital, just as paying wages is buying the product of labor. In a perfectly competitive society, profits tend to disappear.
Clark relied on the method of comparative statics. Studying static laws separately allows the analyst to understand what happens in a dynamic society. The fact that the world is dynamic does not invalidate the conclusions of a static theory. He believed the division of the social income into wages, interest, and profit was, in principle, equitable. Private property is justified because it is based on an ethical distribution of income. In his Essentials of Economic Theory published in 1907, he favored government regulation of monopolies, and was optimistic about the outcome if monopolies could be curbed. He saw five trends: population was increasing, capital was accumulating, technological processes of industry were improving, modes of organizing labor and capital were becoming more efficient, and the wants of mankind were becoming multiplied and refined. His conclusion was economic harmony would prevail.
Chapter 14: The Marginalist School: Alfred Marshall
Alfred Marshall (1842-1924) was the most influential economist in the marginalist school and the most influential of his generation. He was the founder of modern diagrammatic economics which helped clarify certain fundamental principles. Marshall is also known as the great synthesizer because he combined the best of classical economics with marginalist thinking to form neoclassical economics. In Principles of Economics published in 1890, Marshall wrote that economists seek knowledge about cause-and-effect relationships or economic laws that are statements of tendencies that relate to human conduct where motives can be measured by a money price. Marshall was mainly interested in the actions of individuals and small firms, and ignored business cycles or aggregative economics.
Marginal Utility and Demand
Demand is based on the law of diminishing marginal utility and balancing marginal utilities, pleasures and pain, desires and aspirations measured with money. Money measures utility at the margin. A unit of goods has more utility to a poor man than a rich man, and money has greater marginal utility for poor people than for the wealthy. So to generalize about progress, happiness and the effects of taxation, we take a cross section of income groups in society, and money becomes an acceptable measure of the strength of motives. Marshall, unlike the Austrian marginalists, stated that total utility of a good was the sum of the successive marginal utilities of each additional unit. The satisfaction one gets from the total purchases of a good exceeds what he pays for the goods which represents the consumer's surplus. An individual's consumer surplus is approximately equal to his current savings.
The only universal law related to a person's desire for a commodity is that it diminishes with every increase in the amount that he has. Therefore he will buy more at a lower price, and less at a higher price. This causes the demand curve to be down sloping to the right. Elasticity indicates whether the decrease in desire is slow or rapid as the quantity increases. The coefficient of the elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in price. If the coefficient is greater than 1, demand is elastic. If the coefficient is less that 1, demand is inelastic, i.e., low responsiveness to price changes.
Supply and Market Prices
Marshall viewed supply as a curve rather than a point, or a series of quantities that would be provided at a series of prices. The supply curve will slope upward and to the right assuming the efficiency of production depends on labor, with larger quantities supplied at higher prices. The classical economists said supply (i.e., labor time) determines the price, while the marginalists said demand determines the price. Marshall said, like the blades of a pair of scissors cut a piece of paper, both supply and demand determine the price. Supply is based on cost, and demand is based on utility and diminishing marginal utility. The shorter the time period, the greater the influence of demand on value. The longer the time period, the greater influence of the cost of production. The reason is that supply cannot be suddenly increased in response to a sudden increase in demand, or decreased in response to a sudden decline in demand. If the commodity is perishable the supply curve becomes a vertical straight line. If it is not perishable the supply curve slopes upward and to the right until it reaches the total quantity on the market, then it becomes vertical because no additional quantity can be made available during the market period. Therefore, in the short-run, demand is the most important determinant of price.
Marshall made the distinction between prime cost (variable costs) and supplementary costs (constant or fixed costs) noting that not all cost have to be covered in the short run, but they do in the long run if the firm is to continue in business. Therefore, in the long run, the cost of production is the most important determinant of price and value, and it determines the location of the supply curve. In a changing world, where adaptations to change take time, both demand and supply are important. The long-run price is the price that would exactly balance supply and demand, and would be equal to the long-run total cost of production.
Distribution
The distribution of income in a laissez faire economy is determined by the pricing of the factors of production including, wages to labor, interest to capital, and profit to entrepreneurship. Considering the possibilities of substituting one factor for another, the entrepreneur must estimate the value that each addition will make to the value of the total product. Each factor will be employed up to the margin where its net product no longer exceeds its price. Wages measure, and are equal to the marginal productivity of labor, given the supply of labor, and employers will vary the number of workers until that point is reached. Interest is the price of capital, and is based on the diminishing marginal productivity of capital as more units are acquired. This causes the demand for capital to be down sloping to the right. The supply of capital is determined by savings which depends mainly, but not entirely on interest. The rate of interest is determined by the intersection of the demand and supply curves. Normal profits include interest, the earnings of management, and the price of business organization, or the reward to entrepreneurship.
Land is just a particular form of capital, and land and man-made capital goods are similar because the supply of both are fixed. Therefore, the return to old capital is similar to rent, or quasi-rent.
Increasing and Decreasing Cost Industries
Marshall introduced the concept of a representative firm to illustrate the normal cost of producing a commodity, to show that industry could be in long-run equilibrium even as some firms were growing while others were declining, and that a firm could experience decreasing costs of production as the industry expanded. Internal economies are determined by the efficiencies introduced by an individual firm, while external economies are determined by the general development of the industry and are available to all firms in an industry. He thought increasing returns would occur in industry, but he did not believe this would lead to monopoly because business firms would not last long enough to realize all the benefits of an ever increasing scale of production. Diminishing returns would occur in agriculture where man relies heavily on nature. An industry of increasing returns, especially in a new country, would be able to produce more cheaply if it had tariff protection (the infant industry argument). Industries with diminishing returns should have their products taxed to subsidize the industries with increasing returns. These taxes and subsidies would benefit consumers. This argument reflects Marshall's recognition that competitive prices and laissez faire do not necessarily result in the maximum satisfaction to the community.
Marshall is viewed by most economists as one of the greatest members of the classical and marginalist schools along with Adam Smith, David Ricardo, and John Stuart Mill. When Marshall died in 1924, John Maynard Keynes declared him the "greatest economist in the world for a hundred years."
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Go to the next Chapter. Chapter 15: Mathematical Economics (Summary).
Go to Chapter 1 and the links to all Chapters. (Summary).
Related summaries:
Martin, J. R. Not dated. A note on comparative economic systems and where our system should be headed. (Note).
Milanovic, B. 2019. Capitalism, Alone: The Future of the System That Rules the World. Harvard University Press. (Summary).
Piketty, T. 2014. Capital in the Twenty-First Century. Belknap Press. (Note and Some Reviews).
Porter, M. E. and M. R. Kramer. 2011. Creating shared value: How to reinvent capitalism and unleash a wave of innovation and growth. Harvard Business Review (January/February): 62-77. (Summary).
Thurow, L. C. 1996. The Future of Capitalism: How Today's Economic Forces Shape Tomorrow's World. William Morrow and Company. (Summary).
