The Classical Background “Classical Economics” 1776-1870s: Adam Smith, David Ricardo, J. S. Mill Concerned with issues of long run growth and of maintaining growth Consequences of growth for distribution of income Policy concern with removing barriers to growth created by unwise government legislation

Major Components of Classical Economics Theory of exchange value based on labour time or cost of production. Water diamond paradox; use values not comparable. Theory of Natural and Market Price and adjustment to Natural Price Wage Fund Theory of Labour Demand Population theory of labour supply and the subsistence wage

Major Components of Classical Economics Theory of Rent and diminishing returns in agriculture Ricardo’s corn model of falling rate of profit and eventual stationary state Say’s Law Tendency to equilibrium at full employment Monetary factors as disturbing causes Theory of gains from trade Comparative advantage Terms of trade

Challenges to Classicism: Internal Weaknesses Theory of exchange value Problems of cost side theories J. S. Mill—cost of production of the most costly portion Wage Fund Theory J. S. Mill’s “recantation” of the wage fund theory New Issues Economies of scale and growth of industry Business Cycles

Challenges to Classicism: German Historicism Reaction against the non-historical nature of Ricardian economics Different principles apply to different times and places Evolutionary and theories of economic stages Organic analogies Importance of institutions, law, and ethics

German Historicism National policy and role of the state Historicism a major influence in Germany, America, and to a lesser extent in England Historicism was a major influence from 1860-1880s Economic History, empirical studies, social reform

Challenges to Classicism: Marxism Marx used the labour theory of value to argue that profit came from the exploitation of labour Labour was paid less than the value of its output Elements of Classical economics used to cast a very negative light on capitalism Marxism became influential in the 1880s, Socialist parties, labour unrest

Challenges to Classicism: Romanticism The “romantic” critics of economics included Carlye and Ruskin Saw economics as concerned only with material ends and not with anything “higher” or more spiritual--a narrow economic man Concerned only with market valuations Carlye and Mill and the “dismal science”

New Techniques: Forerunners of the Marginal Revolution Marginalist ideas and analysis were being developed in Europe well before 1870 and the Marginal Revolution Daniel Bernoulli (1700-1782) Diminishing MU of income and the analysis of expected utility William Gossen (1810-1854) Gossen’s “First Law”: law of satiable wants. Implies diminishing MU Gossen’s “Second Law” conditions for a utility maximum

Forerunners of the Marginal Revolution: Dupuit Jules Dupuit (1804-1866) Measurement of the utility of public works Different people have different valuations of a good Willingness to pay and consumer’s surplus Setting of tolls to finance public utilities

Dupuit P Consumer’s surplus P Willingness to pay Q Q Toll T x Q = cost of project CS = benefit CS T Q Q

Forerunners of the Marginal Revolution: Cournot Augustin Cournot (1801-1877) Early pioneer of the mathematical approach Law of demand expressed as a general mathematical function: D=F(P) D varies inversely with P Continuous function Analysis of monopoly, marginal revenue and profit maximization

Cournot Cournot’s analysis of duopoly Each firm sets an output given the output of the other Reaction functions leading to an equilibrium Cournot equilibrium is where each firm is doing the best it can given the other firm’s output Example of two mineral springs with zero production costs Market demand function P=100-Y where Y is total output of both firms Profit for firm 1 = PxQ1 or Q1(100-Q1-Q2) Profit for firm 2 = Q2(100-Q1-Q2)

Cournot P 100 50 MR D 50 100 Monopoly solution: Q1=50; P=50; Profit=250 If second firm enters and takes Q1 as given It will produce where it max Q2(100-50-Q2) Which is at Q2=25. Given Q2=25 firm 1 will adjust in order to max Q1(100-Q1-25)= 37.5 These reactions continue until an equilibrium is reached

Cournot Reaction functions and Cournot equilibrium Q2 100 Q1 given Q2 50 Cournot equilibrium 33.3 Q2 given Q1 33.3 50 100 Q1

Reasons for the Marginal Revolution Decay of Classical economics New techniques of marginal analysis An answer to Romanticism Utility maximization can accommodate ends other than purely material ones An answer to Historicism Menger and the “Methodenstreit” An answer to Marx Marginal productivity theory Analogy to physics and use of calculus