1st Problem definition
2nd The most important representatives
3rd Household demand for consumer goods
4th The concept of consumer surplus
5th The supply of goods by a company
6th The aggregation of supply and demand
7th The equilibrium theory of the market
8th The concept of elasticity
9th Short and long-term offer
10th The marginal productivity theory
11th The theory of work suffering
12th The exhaustion theorem
1st Problem definition
In this chapter we will deal with the third variant of neoclassical theory, the Cambridge school. Of all three variants of neoclassical theory, the Cambridge school still adheres most to the ideas of the older classical school. Together with the classics, above all David Ricardo, the representatives of the Cambridge School also assume that the value of goods is determined by the supply side and that costs are therefore a major determinant of the long-term prices of goods.
Unlike the older classics, however, these neoclassics are based on the conviction that demand factors as well as supply factors also determine the price. The scissors example by Alfred Marshall, the main founder of the Cambridge School, is famous: Marshall compares the price formation with a cut using scissors; both sheets of scissors would make the cut of a paper. One could, of course, hold one sheet in thought and then conclude that the other sheet had made the cut.
If we continue to spin this beautiful picture of the scissors' cut, it can be seen that, although in general both blades, i.e. supply and demand, determine the price, under special circumstances situations are conceivable in which the market results are almost exclusively determined by one side of the market only, so that the other side of the market can be neglected. In this sense, the Keynesian theory can be understood as a theory that attributes unemployment solely to deficiencies in demand, just as the anti Keynesian theory is understood as a theory that attributes unemployment primarily to supply factors.
Just like the Vienna School, the Cambridge School is largely limited to the analysis of individual markets, this is especially true of Alfred Marshall, less so of Stanley Jevons, who, like Leon Walras, was very much concerned with problems of a mathematical system of equations for the entire economy.
We will begin our analysis of the neoclassical theory of this third variant by asking on which determinants the demand of a household for consumer goods depends. In this context, the concept of consumer surplus developed by Marshall and others is also discussed. In a next step, we then examine the question of which determinants are responsible for the supply of goods by a company.
In a next step, the demand decisions of all households as well as the supply decisions of all enterprises are then summarized with regard to a single good and the question is answered on which determining factors the price and the quantity at which the individual market is cleared depend. The concept of elasticity introduced by Marshall must also be considered. The distinction between a short-term and a long-term supply curve should also be addressed in this context.
Next, we turn to factor markets. Here, too, we start with the individual company and ask ourselves on which determinants the equilibrium factor price depends. With regard to the factor supply of a household, we then want to deal with the special theory of the labor trait, which was developed by Jevons and completes the marginal utility analysis of the Viennese School. Finally, the exhaustion theorem will clarify whether, in the case of an equal remuneration of all factors of production, the sum of these factor remunerations corresponds precisely to the value of the entire product.
2nd The most important representatives
The most important representatives of the Cambridge School are Alfred Marshall and Stanley Jevons, as well as Philip-Henry Wicksteed and Francis Ysidro Edgeworth, whose most important works we have included among the representatives of the Lausanne School and will therefore not discuss here.
Alfred Marshall lived from 1842 to 1924. He was a British economist and the main founder of the Cambridge School, one of his major works: Among his major works are 'The Pure Theory of Foreign Trade' (1879), 'Principles of Economics' (1890) and 'Some Aspects of Competition' (1891).
His analyses were essentially limited to a partial analysis. As already mentioned, Marshall brought the scissors example, according to which supply and demand determine the price like the two blades of scissors. He endeavored to complete the beginnings of a marginal analysis in the classics.
He also showed how the individual decisions of households and firms can be aggregated to form an overall demand and supply curve of a single market. He introduced the concept of elasticity for a more in-depth analysis of market developments.
Alfred Marshall became known above all in the field of foreign trade through the development of the exchange curves. However, we will only discuss this theory in the second part of this lecture in the context of foreign trade theory.
Stanley Jevons lived from 1835 to 1882, he was the main English representative of the neoclassical school alongside Alfred Marshall. His main works are: 'Notice of a General Mathematical Theory of Political Economy' (1862), further: 'Theory of political economy' (1871), finally: 'The Periodicity of Commercial Crises and its Physical Explanation' (1878). In contrast to Marshall, we find in Jevon's marginal utility considerations as in the Viennese School, he primarily applied marginal analysis to the factor labor, whereby the marginal costs of labor represent the labor suffering, which increases with increasing labor input and seeks a balance with the marginal utility that is achieved with the consumer good acquired through labor income. Furthermore, his sunspot theory for the explanation of economic cycles is well known.
Philip-Henry Wicksteed lebte von 1844 bis 1927 und war neben Jevons britischer Neoklassiker. Zu seinen Hauptwerken zählen: 'An Essay of the Co-ordination of the Laws of Distribution' (1894), weiterhin: 'Common sense of political economy including a study of the human basis of economic law' (1910).
Its exhaustion theorem is particularly well known: If all factors are remunerated according to the marginal product, the total product is fully exhausted, the pure profit becomes zero.
Enrico Barone lived from 1859 to 1924 and was an Italian economist in the tradition of the Cambridge School. Among his major works are: 'Studi sulla Distribuzione' (1896), 'Studi di economia finanziaria' (1912) and 'Grundzüge der theoretischen Nationalökonomie' (1927). He succeeded in integrating the theory of marginal productivity into the Walras system. He also demonstrated a new method of deriving industry cost functions by plotting the average costs of individual suppliers on the abscissa in order of height, thus creating a staircase-shaped total cost curve. Finally, he demonstrated that efficient price calculation is also possible in a state-planned economy.
John Bates Clark lived from 1847 to 1938 and was the American representative of the Neoclassical period. His major works deal with distributional issues: 'Distribution as Determined by a Law of Rent' (1891) as well as: 'Distribution of wealth' (1899) and: 'Wages and Interest as Determined by Marginal Productivity' (1901).
Instead of the Vienna Scholls's attempt to assign the total value of production directly to the individual factors of production, Clark developed a functional distribution theory that sought to link marginal utility theory with objective Cambridge theory. According to this theory, the supply of production factors is considered to be constant. The level of the factor price is determined by the level of the marginal utility of this factor, whereby the marginal utility itself depends on the amount of factor demanded. Clark also attempted to prove in the framework of the exhaustion theorem that if the factors of production were remunerated according to the marginal product, the sum of the factor incomes for labor, capital, and land would correspond to the total domestic product, so that the pure profit would become zero.
3rd Household demand for consumer goods
First of all, we ask about the determinants of a household's demand for individual consumer goods. This does not take into account the problem that at least a large part of the households consists of several persons, i.e. that the demand should be based on the benefit expectations of the individual family members and that this demand should then be combined to a collective demand of the household. However, Neoclassicism generally assumes a single individual who makes these demand decisions alone, whether the household actually consists of only one person, whether the family father or even the housewife decides for themselves which goods are in demand, or whether, finally, the needs of the individual family members are so similar that one can assume a uniform, identical structure of needs.
Let us now look at the demand of a household for a single consumer good. In order to understand the determinants of this demand, Marshall introduces the concept of a demand curve that is derived from the consumer's perception of the benefits. In a diagram, we plot the quantity of a consumer good in demand (X) on the abscissa, while on the ordinate we plot the price of this good on the one hand and the household's estimates of the value of this good (the marginal utility) on the other.
According to the results of the theory of marginal utility, the price that the household is prepared to pay for a very small quantity (for a single quantity) is very high, since the benefit that the household expects from this unit of good is also high. Although Marshall refers to subjective ideas of benefit, he nevertheless summarizes the value attitudes of the household in objective monetary values. Based on the subjective evaluation, the consumer is prepared to pay a maximum of one sum of money for the purchase of this good. This maximum amount of money to be paid is determined in such a way that with the same sum no greater benefit would have been possible with an alternative decision, i.e. with the purchase of a second best good.
We can now ask at what maximum price the consumer is prepared to pay if a second, third, umpteenth good is under discussion. Since we assume that the law of diminishing marginal utility of income applies, the maximum price at which the consumer is willing to buy another unit will decrease. We receive in this way a negatively inclined demand curve, which is often linearly represented also for simplification reasons.
Instead of asking with Marshall what the maximum price a household is prepared to pay for a certain quantity, i.e., seeing the price as a function of the quantity demanded, we could of course also assume that the price for the consumer is considered to be predetermined and that by constructing a demand curve we can check what quantities of goods this household will demand at alternative prices. In this case the demanded quantity of goods is thus seen in dependence of alternative prices.
So while this second interpretation gives us an answer to the question of the amount of goods a household is willing to pay for alternative prices, the first approach chosen by Marshall explains the maximum price a household is willing to pay for alternative quantities of goods. However, both approaches refer to the same context.
In the same way, we can derive a demand curve for all consumer goods that our household demands. These demand curves all have the same shape, it applies:
for Ni: demand for good Xi pi: price of good Xi
However, it is assumed that both income and prices of all other consumer goods in demand are taken for granted. It is assumed that due to the law of diminishing marginal utility, demand curves normally show a negative slope.
4th The concept of consumer surplus
Based on the demand curve, we can depict the concept of consumer surplus developed by Marshall. It should only be noted that this concept was also developed much earlier by Arsene Juvenal Dupuit.
Starting point is the above developed diagram of a demand function. It is assumed that the household under investigation demands the quantity of goods X1. With this demand, a price of p1 appears on the market. If the household is to benefit from the last unit just purchased, the current price must not be higher than the maximum price for this quantity. Otherwise it would be more advantageous for the household to stop asking for the last unit and to use the money saved for the purchase of another good.
At the same time, the law of indiscriminateness applies on free markets, according to which only the same price can be charged for one and the same good. However, since the household under study would be prepared to pay a higher maximum price for the goods, with the exception of the last unit, it receives a benefit in the form of a pension based on the law of indiscriminateness in price. In our diagram, this corresponds to the green area under the demanded quantity of goods X1.
5th The supply of goods by a company
In the development of the supply of goods curve, we proceed analogously to the development of the demand curve. Just as the maximum price for a certain amount of goods offered by the household depends on the level of marginal utility at this amount, we can also assume that for a certain demand for goods, the entrepreneur is only willing to make the additional offer if he achieves a minimum price that corresponds to the marginal costs. Therefore, we have to start from the costs that a company incurs in connection with the production of goods when developing the supply curve.
Here it is important to differentiate between different types of costs. In general, a distinction is made between fixed and variable costs. Fixed costs are those costs that are incurred regardless of whether and how much goods are produced. A typical example of fixed costs is machinery, for which depreciation is incurred in each period, regardless of whether and how much is produced.
Variable costs, on the other hand, are those costs that are incurred in connection with production and are usually also dependent on the quantity of goods produced. The wage and material costs usually represent such variable costs.
In addition, a distinction is usually made between total costs, unit costs and so-called marginal costs, whereby it makes sense to differentiate between variable unit costs and total unit costs, which also include fixed costs.
The course of the individual costs depends now crucially on the underlying production function, whereby a production function shows the relations between output quantity and the production factors used with production. The connection and difference between cost and production function consists of the fact that in both cases it is examined, how with a change of the production quantity either the quantities of the assigned production factors are changed - and this is the question posed with a production function - or the cost sums are changed, which result for their part from the product from factor quantity and price of this factor.
In general, two different production functions are assumed in the literature. In the case of the classics, it was generally assumed that if production volume increased, marginal costs would first decrease, then reach a minimum, and from then on rise as production increased. In the so-called Cobb-Douglas production function, which was repeatedly empirically tested by Cobb and Douglas, it is assumed that from the outset marginal costs increase with increasing production.
Let us first look at the course of a total cost function. On the ordinate axis we plot the total costs, on the abscissa axis we plot the respective production quantity. The fixed costs determine how high the total costs are as long as production has not yet started. The cost function begins at the intersection with the ordinate and reaches the level of the fixed costs here.
If we assume a Cobb-Douglas function, the total costs immediately rise disproportionately with increasing production. But if we were to assume a classical function, the total costs would initially rise disproportionately from a certain critical quantity to a turning point, and the curve would show a disproportionate increase from a certain quantity to a turning point.
Let us now look at the corresponding course of the marginal cost curve and the curves of the two unit costs. On the ordinate, marginal costs and unit costs are now deducted. Assuming a classical function, the marginal costs and with them the variable unit costs would first decrease, then reach their minimum at a critical production quantity and increase from then on. With a Cobb-Douglas function the marginal costs would increase from the beginning.
The unit cost curve shows a similar course, since the changes in unit costs can be attributed to changes in marginal costs. Take the case of a Cobb -Douglas function. If we move on to produce one more unit of goods, the marginal costs are assumed to increase. However, in unit costs, this cost increase is distributed over the quantities of goods already produced, so that the unit cost curve rises more slowly than the marginal cost curve.
If we compare the variable with the total unit costs, we find that the total unit costs do not increase as fast as the variable unit costs, since the fixed unit costs by definition decrease with increasing production.
Now what is true for the course of marginal costs and unit costs if we assume a classic production function? Marginal costs first decrease with increasing production, reach a minimum with a certain production quantity, and then increase with increasing quantity. For the variable unit costs, the reduction is again less than for marginal costs, since the cost savings are now allocated to the goods already produced. Thus the curve of the variable unit costs reaches its minimum only after the minimum of the marginal cost curve. From the minimum, the considerations we made for the Cobb-Douglas function apply. For total unit costs, the costs up to the minimum fall even more than for variable unit costs, since the unit costs not only fall because the marginal costs initially fall, but also because the fixed costs are distributed over more and more units of goods.
After we have clarified the relationships between the cost curves and the quantity of goods as well as the relationships between marginal costs, variable unit costs and total unit costs, we want to restrict ourselves in the further course of the analysis to the curve of marginal costs. It is the cost increases, thus the marginal costs, which decide on it, which minimum price an entrepreneur must require, in order to extend production by a unit. The respective marginal cost level thus coincides with the required minimum price. Since again the law of the price indiscriminateness applies, thus all goods of same quality are sold also at the same price, on the other hand however the entrepreneur is ready for the extension of production only if he obtains the minimum price (which is determined again by the marginal costs), the offer curve of the entrepreneur coincides with its marginal cost curve, at least if on the rising marginal cost branch one produces. The supply curve provides an answer to the question how many quantities of goods an entrepreneur offers at alternative prices.
Also within the business theory it has to be taken into account that it was only reasons of simplification that led us to see the goods offer only in dependence of the respective goods price. With Walras we will have to assume in reality always that the offer of any good depends in all rule on all commodity prices as well as the remuneration rates of all assigned production factors.
To be continued!