1. The Classical Background
“Classical Economics” s: 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

2. 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

3. 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

4. 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

5. 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

6. 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 s
Economic History, empirical studies, social reform

7. 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

8. 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”

9. 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 ( )
Diminishing MU of income and the analysis of expected utility
William Gossen ( )
Gossen’s “First Law”: law of satiable wants. Implies diminishing MU
Gossen’s “Second Law” conditions for a utility maximum

10. Forerunners of the Marginal Revolution: Dupuit
Jules Dupuit ( )
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

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

12. Forerunners of the Marginal Revolution: Cournot
Augustin Cournot ( )
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

13. 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)

14. 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( 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

15. Cournot Reaction functions and Cournot equilibrium Q2 100 Q1 given Q250
Cournot equilibrium
33.3
Q2 given Q1
33.3 50
100 Q1

16. 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