7. NEOCLASSICAL ECONOMICS 1. The marginalist revolution 2. General equilibrium and welfare 3. Monetary theory 4. A benchmark model The classical economists were concerned with the big questions. The neoclassical economists focused on the microeconomic analysis of the behavior of economic agents. The neoclassical economists by and large retained the skepticism of classical economists with regard to an interventionist role of government in economic life. The limited role for government action proposed by economists is to be seen against the background of the political environment in the 19 th century. These were times before the franchise had been widened and in which only a privileged elite had serious political influence. These were not conditions in which government could be expected to pursue the truly general interest or social welfare of the population as a whole. 1

1. The marginalist revolution Ricardo’s theory of rent was based on the assumption of a declining marginal productivity of land. Nevertheless, William Stanley Jevons and Carl Menger have come to be identified as the key initiators of the so called marginalist revolution. Alfred Marshall explained pedagogically the determination of the equilibrium price as determined by supply and demand in a partial equilibrium framework (roughly as still presented in economic textbooks, cf. figure 5). Demand was based on the assumption of a declining marginal utility in consumption, while supply was based on the assumption of a given stock of capital and a rising marginal cost or a declining marginal product of labor. Marshall also pointed out that the individual consumers demand curve would correspond to his marginal utility curve. Similarly, the producer surplus, the difference between revenue of the supplier and the cost of production, is the area above the supply curve but below the price (the area BAC). It is easy to see that the equilibrium at point A, the competitive equilibrium in this market, is the amount of transactions or consumption and production that maximizes the sum of the consumer and producer surplus (the social surplus). 2

The consumer and producer surplus 3

2. General equilibrium and welfare Leon Walras focused on the general equilibrium of the economy as a whole. His model basically determines relative prices, but he could transform these into money prices by introducing an equation representing the quantity theory. Walras (as many of his followers) gave some weight to the aesthetic appeal of his theory: “The law of supply and demand regulates all these exchanges of commodities just as the law of universal gravitation regulates the movements of all celestial bodies. Thus the system of the economic universe reveals itself, at last, in all its grandeur and complexity: a system at once vast and simple, which, for sheer beauty, resembles the astronomical universe”. Walras also concerned himself with the question of how equilibrium would be arrived at. He did so with his famous theory of the so called ‘tatonnement’. WaIras) thought that the market mechanism served the public interest, though he did not clearly formulate how the public interest should be interpreted. For Francis Edgeworth the appropriate objective of policies was “the greatest happiness for the greatest number”. He assumed that all members of society have the same utility function and that the marginal utility of income is decreasing. Neglecting differences in capacity to work and incentive effects, the appropriate (and radical) solution would then be to aim at a complete equalization of income. Vilfred Pareto developed a quite different criterion (Pareto-optimality; cf. L4). 4

3. Monetary theory Eugen von Böhm-Bawerk was one of the first economists to answer the question why the interest rate is (mostly) positive. His answer in three parts was that individuals mostly expect more resources to be available in the future, that people tend to underestimate future needs (myopia), and that time-consuming processes would be more productive (such as trees producing more timber if they are, up to a point, allowed to grow larger and older). Knut Wicksell similarly demonstrated how the rate of interest would affect the capital intensity of production. The neoclassical economists retained the quantity theory of money as set out by David Hume. Like most classical and neoclassical economists, Böhm-Bawerk strongly supported a stable currency linked to the gold standard (and balanced budgets). The quantity theory of money gives expression to a dichotomy, according to which relative prices are determined by the general equilibrium theory, while nominal magnitudes like prices are determined separately by the quantity of money. Wicksell made an original attempt at explaining the causality from monetary factors to the real economy. He distinguished between the natural rate of interest and the market rate of interest. The former is determined by the rate of return on capital in production, while the latter is determined by monetary policy and the banking system. Wicksell argued that a market rate of interest which is below the natural rate (which was not easy to identify) would increase the demand for capital and initiate a cumulative process of inflation, while a market rate above the natural rate would similarly cause deflation. 5

Neoclassical economists William Stanley Jevons ( ), one of the first economists with a university education in the subject, set out his marginalist thinking in his ‘The Theory of Political Economy’ (1871). Posterity remembers him also for his much ridiculed sunspot theory of the business cycle. The Austrian Carl Menger ( ), worked out an alternative to the labor theory of value in his ‘Grundsätze der Volkswirtschaftslehre’ (1871). Alfred Marshall ( ), professor at Cambridge (UK), wrote a long-standing textbook in Economics, ‘Principles of Economics’ (1890). The Frenchman Leon Walras ( ), according to Joseph Schumpeter “the greatest of all economists”, wrote the important two-volume ‘Éléments d’économie politique pure’ (1874 and 1877). Francis Y. Edgeworth ( ) in 1877 published ‘New and Old Methods of Ethics’ (in which he used a lot of quotations in Latin and Greek – without translation). Vilfred Pareto ( ), the successor of Leon Walras as professor at the University of Lausanne, wrote a large number of books and articles in economics and sociology, including ‘Manuel d’économie politique’ (1909). The Swede Knut Wicksell, in many ways a radical, and he deviated from other neoclassical economists in emphasizing the role of interest rate policy for monetary stability. He was also member of the ‘Stockholm school’ that had a macro-oriented view of economics (arguably similar to Keynes’ macroeconomics). 6

4. A benchmark model Sir John Hicks in 1937 famously formulated a simplified model of the classics (in the sense of Keynes, including both the classical and the neoclassical economists). First, the quantity theory of money can be used to determine the price level. Given V and Y, the price level is proportional to the stock of money. Output is a function of employment, which itself is fixed at the full employment level by flexible wages. 7

Benchmark model (cont.) The rate of interest is in this model independent from the stock of money. It is determined in the market for loanable funds so as to create balance between saving and investment. What are the effects of an increase in public spending? Assume first that the increased public spending ΔG is financed by higher taxes. This would reduce household disposable income and ‘crowd out’ private consumption (possibly also increase private saving). Alternatively the increase in public spending could be financed by government borrowing. In this case it would be reflected as an increase in demand for loanable funds, which would raise the rate of interest and crowd out private investment (but would also increase private saving). 8

Benchmark model (cont.) Another useful way to look at the classical model is to start from the national income identity, according to which the following follows by definition of the national accounts: (1)Y = C + I + G + X - M, Defining saving S as the difference between disposable income (income less taxes) and private consumption: (2)S = Y - T - C, gives (3)(I - S) + (X - M) = (T - G). This equation states the simple fact that an excess of private investment over private saving must be financed by borrowing from abroad (importing more than exporting) or by drawing on a financial surplus of the public sector. Another useful statement, similarly true by definition, is that a budget deficit (excess of G over T) must have a counterpart either in an excess of private saving over private investment (used to finance the government deficit) or a trade deficit (borrowing from abroad). 9