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CHAPTER ONE: NEO CLASSICAL SCHOOL OF THOUGHT

Introduction

Neoclassical economics emerged as result of gradual transformation of the classical and

marginalism. Neo means new and classical is the orthodox thought; hence neoclassicism implies a

new form of classicism. It is approaches to economics focusing on the determination of prices,

outputs, and income distribution in markets through supply and demand. It is often mediated

through a hypothesized maximization of income-constrained utility by individuals and cost-

constrained maximization of profits by firms employing available information and factors of

production, in accordance with rational choice theory.

The school of marginalists emphasized decision making and price determination at the margin.

However, there are at least three basic differences between the earlier marginalist and the later

neoclassical economics. Firstly, neoclassical thought stressed both demand and supply in

determining market prices whereas, the earlier marginalists tended to stress on demand side alone.

Secondly, several of the neoclassical economists took a far greater interest in the role of money in

the economy than did the earlier marginalists. Finally, neoclassical economists extended the

marginal analysis of market structure besides pure competition, to imperfect competition, pure

monopoly and duopoly. In this chapter we will look at the neoclassical school aspects and their role

in history of economics thought.

1.1. Historical background of school of thought

The period between the passing away of Mill and the advent of Marshall from 17th century to late

19th

century was full of implications as far as the development of economic science was concerned.

During this period, there were many factors which gave rise to neoclassical school of thought.

These include changes in economic structure, technological aspects, form of competition, and

working condition for worker classes and so on. Several changes had taken place in the field of

industrial advancement in technology and physical sciences. There were new inventions and

innovations as well as techniques of doing things which helped capitalist to raise production. The

use of machinery and inventions among people had let large-scale production in size and in capacity

over time result in industrial concentrations. Further more, differences in size of firms were become

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common with capitalism; many small, medium, and large size firms emerged. In addition, new

forms of competition called non price competition emerged in addition to price competitions.

Hence, firms were also influencing market through price determination, and product differentiations

More over, new form of finance and investments system (credit) came into being and enabled the

capitalist to produce more by solving their financial problems (capital). With the credit and

technological advancement, the economy of the west experienced trade cycle’s ups and downs in

business. The occurrence of trade cycles created upheavals in production and consumptions.

Economics became more concerned with a humanitarian interest.

On the other hand, the misery of worker class in terms rewarded /wage, hours of work and

exploitation became more common. To reduce these peoples started forming unions that fight for

the right of the workers. Trade unions were beginning to claim a voice in wage settings. This

change in outlook may be largely attributed to the labor movement, which developed during the

latter half of the 19th century. This was responsible for the downfall of the wage-fund doctrine.

Further more; the German thought had started gaining strength in England. The criticisms of the

historical school were also responsible for shaking the foundations of the classical economics. The

development of the biological sciences and the idea of evolution further accentuated this change.

All these developments led to the inapplicability of the classical economics.

The theoretical criticisms emerging chiefly from within. Classical and marginalist theories were

applied to solve business problem but they were not effective. Attempts were made to broaden the

scope of economic analysis by recognizing the interrelationship of economic and ethical factors

among classical.

Intellectuals were concerned with the choice of theoretical issues and the manner in which they

were treated. Attentions of economic theorists converged to analysis of economic behavior focusing

on its decision making units such as household, firms, and government as opposed to aggregate one.

From the point of view of neoclassical economists the problem deserving study was the functions of

the market system and its role as alligators. These adjustments of analytical priorities had related to

market behaviors. It became very important to understand the factors shaping the price of both

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output and inputs to analyze the behaviors of market system. Hence, a re-statement of economic

ideas was needed and this work was taken up by Alfred Marshall’s. He presented a synthesis of the

classical doctrines and the marginal utility analysis of the subjectivists. His aim was to reconstruct

economic science in the light of the new developments and in the context of the changed conditions.

1.2 Basic tenets, validity, and beneficiaries of neoclassical school of thought

Neoclassical school of thought was the center of every market economy thought as it covers every

thing in economics. It is not one well- defined theory, rather can be regarded as a family of

approaches to economic and material life. It is in many ways more a methodological programme

than a single theory that can be put to empirical test. Neoclassicism is thus a collection of schools

of thought. Some of the features of neoclassical economics are: methodological individualism,

rationality, equilibrium and the importance of the price mechanism, the extent of competition, the

degree of knowledge of economic actors of their environments, and the use of formal modeling.

I. Methodological individualism

This is the methodological position that aims to explain all economic phenomena in terms of the

characteristics and the behavior of individuals. Methodological individualism states that any theory

of how the economy runs should be built upon understanding of how the individuals within it

behave as everything ultimately reduces to what individuals do. It embraces individual units,

specifically firms and households. They argue that there is no such thing as society, just individuals

and families can be seen as a classic statement of the politics. Strictly, it tries to explain how

households and firms behave by analyzing the behavior of the individual people who make up the

household or firm.

II. Rationality

Neoclassical theory assumes that all individual agents behavior is rational. Individuals are assumed

to be self-interested and to have well-identified goals that they pursue in the most efficient way

possible. They maximize something with respect to objective functions. More specifically,

consumers are assumed to maximize pleasure (utility) subject to what they can afford. Firms are

assumed to maximize profits subject to what is technically possible for them to achieve.

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III. Equilibrium

A real world is complex and it is difficult to analyze interaction among economic agents.

Neoclassical simplified the complexities by introducing models and set of assumptions. In order to

build models which reduce the complexity of the real world economy, neoclassical concentrates on

the analysis of equilibrium. These are situations where the one aspect of the economy is at rest in

such way that no individual has any incentive to change what they are doing unless external factors

change. A single market, for example, is in equilibrium when the market price is such that all

buyers can buy as much as they want and all sellers can sell as much as what they want at that

price. This price is then the equilibrium price. In such a situation, no buyer or seller has any

incentive to change what they are doing. The status quo persists, unless external forces alter

something. Hence, much of neoclassical theory is concerned with understanding of the conditions

under which equilibrium exists.

IV. The importance of the price mechanism

The fourth main characteristic of the neoclassical school of thought is the central role it gives to the

price mechanism in connecting economic agents. In neoclassical models the main interaction

between economic agents takes place through the price system. That is, prices contain all the

information needed by buyers and sellers, and that they provide agents with the necessary incentives

to act (buy, sell, and produce). All economists would agree that price mechanism is a very powerful

investment which play a central role in markets. This applies to all kind of markets, irrespective of

the goods and services traded and the type of exchange between buyers and sellers.

V. Competition

A strong assumption of neoclassical economics is that the power of individual economic actors in

influencing the system is quite nil. Individual economic agent is sufficiently small that they can take

their environment as given, without thinking about the effects of their own actions on it.

Specifically, this assumption means that all agents are assumed to be price takers. In real world

markets, many agents have much more power than this and can have significant effects on prices in

the markets in which they buy and sell.

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VI. Agents’ knowledge

Traditionally, in neoclassical theory there is unrealistic assumption about all economic have perfect

knowledge of anything in the past, present or future which might influence their decisions. In

particular, they know all future prices. There are now modified versions of neoclassical theory that

allow for agents being uncertain about the future (absence of perfect knowledge). Because of

uncertainty about the future is about the decisions that other agents will take in the future, then

agents have to act strategically in order to make the most optimum decision as choices and

outcomes are interdependent. This happens, for example, in the case of asymmetric information

when some agents know things that are not known to others.

VII. The use of formal modeling

One of the characteristics of economics as compared with other social sciences is its systematic use

of formal models. Models, that abstract from the complexities of the real world to concentrate on a

few variables at a time, and then investigate very thoroughly the relationships between these

variables. Neoclassical economics, in particular, uses a highly developed set of formal models. In

developing such formal models, certain abstractions have to be made. Some of its abstractions used

mathematical modeling.

VIII. Building up competitive general equilibrium theory

As mentioned earlier, neoclassical economics should be seen more as a methodological programme

of how to do economics than a collection of particular theories. They developed a general

equilibrium model and theory for the economy. Competitive general equilibrium theory examines

the conditions under which a decentralized market economy, in which economic agents follow their

own interests, will reach an orderly outcome that is economically efficient. What is meant by

‘orderly’ is that all markets are in equilibrium and by ‘efficient’ is that nobody’s welfare can be

improved without making things worse for someone else. Competitive general equilibrium theory

represents the neoclassical school of thought in its purest form. Competitive general equilibrium

theory has not only had a great impact on economic theory, but also it has strong policy

implications. The theory of competitive general equilibrium can be seen as the culmination of this

neoclassical programme, building on all its features

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1.3 Neoclassical economics: pure competition

Alfred Marshall (1842-1924)

Marshall was born at Clapham in 1842. He was the son of cashier in the bank of England. His

father forced him to learn subject relevant to minister in Church of England. But his wide range of

intellectual interest which included mathematics, history, utilitarian and Hegelian philosophy and

social Darwinism led him to study the works of Staute Mill on political economy. He attended

Cambridge where he devoted himself to mathematics, physics and later on to economics. He

graduated in mathematics from St. Johns collage, Cambridge and then thought mathematics at

Cambridge for nine years. In 1877, on his marriage he resigned from his position in Cambridge and

went to Bristol’s and worked as principal of university collage till 1881. From 1883 -1885, he

served in Ballion, Oxford. In 1885 Marshal was appointed as the chairman of political economy

and retained his post till his retirement in 1908.

Marshall was the greatest synthesizer, seeking to combine the best of classical economics with the

marginalist thinking, hence producing the neo classical economics. He was the first economist to re-

name political economy as Economics. He was the first who gave greater importance’s to the study

of human wants and consumption. He himself said of his ‘Principles’ that ‘the present treatise is an

attempt to present a modern version of old doctrines with the aid of the new work and with

reference to the new problem of our age.’

His book “Principles of Economics” was the dominant textbook in England a generation later. The

edition came out in 1920 and it had been reprinted eleven times. It is divided into six books; Book-I

deals with preliminary survey; Book- II examines some fundamental notions; Book -III discuses

wants and their satisfaction; Book- IV describes the factors of production; Book -V deals with

demand, supply and value ant Book -VI presents an analysis of national income and its distribution.

His economic ideas

1. Scope Of Economics

Marshall classified human activities into activities that contribute to material welfare and activities

that do not contribute. Marshall shifted the emphasis from wealth to man. He has given primary

importance to man and secondary importance to wealth. Wealth is only means to welfare.

Accordingly, he defined economics or political economics as economics. For him, it is a study of

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man in the ordinary business of life. It is on the one side study of wealth and on the other more

important side, a part of the study of man. It deals with the economic aspect of man and not social

or political or religious aspect of his life. It examines that part of individual and social action which

is most closely related with the attainment of material well being. It explains their ordinary

business life, which consists of earning and spending of money for the satisfaction of their

necessities of life like food, clothing and shelter.

Economics is not a body of concrete truth, but rather an engine for the discovery of concrete truth.

We seek economic laws, like any law of a general preposition or statement of tendencies, which are

more or less certain and definite. Economic laws are the statements of economic tendencies and are

hypothetical. Since economic laws deal with man’s actions which are numerous and uncertain, they

are to be compared with the laws of tides rather than with the simple and exact law of gravitation.

Economic laws are not natural laws that are necessarily beneficent. Economists like other scientists

collect, arrange, interpret and draw inferences from facts. They seek knowledge of the

interdependence of economic phenomena of cause and effect relationships. Every cause tended to

produces a definite result if nothing occurs to hinder it. Economics is less certain than natural

sciences, but progress is made towards a greater precision.

2. Marshall’s Method

As far as the method of study is concerned, Marshall considered both induction and deduction as

useful for economics. Both are needed for scientific thought as the left and right feet are both

needed for walking. Both are complementary to each other. Marshall was the great interpreter of the

method of partial equilibrium. The forces influencing an economic phenomena are too numerous

and it is very difficult to analyze all of them at one and arrive at a complete explanation of the

phenomenon. Therefore, the best method is to keep other forces constant, and study forces

influencing the phenomenon. Thus all the other forces are reduced to inaction by the phrase “other

things being equal’. He also used mathematics in his analysis. He worked out his theories and

arguments in mathematical terms, but relegated the use of mathematics to footnotes and an

appendix.

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3. Rational Consumer Choice

Marshall’s employed the idea of rational consumer choice in his demand analysis. In money

economy, said Marshall, each line of expenditure will be pushed to the point at which the MU of

shillings (dollars) worth of goods will be the same as in any other direction of spending.

4. Utility and Demand

The utility approach of the Marshallian system dealt with pleasure and pains, desires and

aspirations, and incentives to action. According to Marshall we cannot compare the amounts of

pleasure that two individuals derive from eating hamburger nor can we compare the degrees of

pleasure one person gets from eating hamburger at two different times. But we can measure them by

using the measuring rod of utility i.e. money. Money measure utility at the margin or at point where

decision are made. Two people with equal income will not necessarily derive equal benefit from its

use. The amount of money that people of equal incomes gives to obtain a benefit or avoid an injury

is the extent of the marginal benefit or injury. He also added that an increment of money, like any

additional unit of goods, has greater MU to a poor person than to a rich person.

Marshal traced the development of consumer‘s demand over time. He pointed out that in

contemporary economy, consumer‘s demand governs the traders action. Demand is intimately

connected with and based on utility. Here he made famous distribution between total and marginal

utility and law of diminishing marginal utility. He then comes to the crucial stage of translating the

law of diminishing marginal utility into laws of demand.

Marshall takes up the theory of demand to analyze consumer behavior. A rational consumer aims at

maximizing satisfaction from his consumption. The amount of satisfaction is closely related to the

quantity of that commodity consumed by the consumer. Thus demand is based on the law of

diminishing marginal utility. Marshal stated that the additional benefit which a person derives from

a given increase of the store of a thing diminishes with every increase in the stock that he already

has”. The MU of a thing to any one diminishes with every increase in the amount he already has.

Demand refers to the quantity of a commodity demand at a certain price, other things remaining the

same. The individual demand curve can be directly derived from the law of diminishing marginal

utility. Assuming the marginal utility of money to be constant, the price offered to additional units

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will fall MU tend to diminish. Hence the demand curve slopes downwards. The market demand

curve represents the total demand of all the consumers for a commodity at various prices. These

individual demand curves can be added together to get market demand curve.

5. Law of Demand

Marshall’s law of demand follows from his notions of diminishing marginal utility and rational

consumer choice. Suppose that a consumer’s expenditure are in equilibrium such that the last dollar

spent on each of the several products yields identical MU. Only at the margin that price will

generally match a person’s willingness to pay. That is ... NX Y

X y N

MUMU MU

P P P . In doing so

unlike the earlier theorists Marshall successfully tied equi-marginal rule to the contemporary law of

demand. How these consumers react if the price of good X falls while the price of other goods

remain constant? When price of goods falls two effects are at work, income and substitution effect.

Marshall focused on substitution effect.

To Marshall, the rational consumer would buy more of product X, and then the ratio X

X

MU

P will

exceed the MU/Px ratio of other goods. To restore balance of expenditures, the consumer will

substitute more of X for less of Y. As this substitution occurs, the MU of X falls and the MU of

other goods will rise. Thus, the equilibrium will be restored. Therefore, in Marshall’s word the

amount demanded increases with a fall in price, and diminishes with a rise in price.

Marshall illustrated the law of demand with both table and demand curve. He drew his demand

curve by assuming sufficiently short time to justify the ceteris paribus assumption. He pointed out

that he was concerned with the moment in time, which is too short to consider any changes in

character and tastes of particular person as they change overtime. In the long run all the

determinants of demand will change, and hence the demand curve shifts either inward or left ward.

Thus Marshall made clear conception of differences between changes in quantity demanded

(measured along the horizontal axis) and changes in demand (shift of the entire demand curve).

6. Elasticity of Demand

Marshall was superior to his predecessors in handling elasticity of demand. The law of demand tell

us the direction of change of quantity demanded when price changes. It cannot tell us the extent of

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change of quantity demanded. Elasticity of demand tell us the extent of change of quantity

demanded when price changes. It relates the percentage drop in price to the percentage increase in

quantity demand, which is based on the law of diminishing marginal utility of the good. The

numerical coefficient of the elasticity demand (Ed) is the percentage change in quantity demanded

divided by the percentage change in price. Demand in elastic if Ed>1, inelastic if Ed<1 and unit

elastic if Ed=1, expressed in absolute terms. Marshall also discussed what we now call the

determinants of elasticity of demand. These are prices, availability of substitutes and so on. When a

price of good is high relative to the size of the buyer, income elasticity will tend to be great.

7. Supply and Cost

Marshall developed his theory of supply on lines similar to his demand. Supply schemes refer to a

whole series of quantities that would be forthcoming at a whole series of prices not specific level of

supply. Marshall has distinguished between immediate future, short run and long run production

periods. Immediate future is a production period when it is impossible to alter any factor of

production. Immediate present is a time which may be as short as one day. Short run is a time

period when it is possible to vary some inputs but there is impossible to vary all, and long run is a

production period when all inputs are variable. The quantity supplied can not be increased in

response to a suddenly increased demand, nor can the quantity supplied be decreased immediately

in response to a decline of demand.

If a good is perishable, the market supply curve is perfectly inelastic. The firm would rather sell its

fresh fish for a small amount rather than let it spoil. If the good is not perishable, the sellers have

reservation prices below which they will not sell. However, some sellers sell at prices below cost of

production because they have pressing bills to pay. The short run supply curve sloped up ward and

to the right implying the higher the product price, the larger is the quantity supplied (modern

economics view the short run supply curve as MC curve). In the long run, all costs are variable, and

they must be covered if the firm is to continue in business.

According to him, supply mingled on the availability of factor of production and their efficiency;

types of market in being considered. Regarding the market he deals with the relationship between

buyers and sellers of a particular commodity. He limits himself to the competitive market or market

sufficiently closer to competitive market. Supply is governed by cost of production and time

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element jointly. Marshall distinguished between real and money cost of production. Real cost of

production refers to the efforts and sacrifices involved in making a commodity. It includes the

exertion of labor and waiting for saving. Money cost of production indicates the sum of money that

has to be paid for these efforts and sacrifices. Marshall further divided costs into prime and

supplementary costs. Prime cost is variable costs which include wages and raw materials.

Supplementary costs are fixed costs include depreciation, interest on loans, rent and salaries of

executives. In the short run, a firm has to cover its prime costs. But in the long run, a firm must

cover both prime and supplementary costs. A rational producer aims at minimizing costs.

Like the consumer, the producer too has to distribute his resources so that they have the same

marginal utility in each use; he has to weigh the loss that would result from taking away a little

expenditure here, with the gain that would result from adding a little there. Just as the consumers

obtain utilities or satisfaction from the consumption of commodities, it also involves costs. Just as

the marginal utility diminishes when a consumer increased his consumption of a commodity, the

marginal cost rises as the production of a commodity expands.

8. Equilibrium price and Quantity

The doctrine of demand and supply is the pivot on which Marshallian economics revolved. Marshall

has clearly explained the difference between demand and supply. While analyzing the concept of

demand he has made use of the Austrian analysis including the concepts of utility, marginal utility,

law of diminishing utility, demand schedule etc. He then analyzed the concept of supply with the

help of the doctrine of marginal disutility, laws of returns, Malthusian theory of population, division

of labor, industrial organization and management as related to productive efficiency, etc. He then

formulates his theory regarding the determination of equilibrium between demand and supply.

Marshall has also made use of the term ‘cost of production’, meaning collectively the expenses of

production incurred by the entrepreneur and the sacrifices made by the society.

To Marshall, demand is the center of any activity. He has divided markets into two classes: short

period and long period. In the short period higgling and bargaining activities might oscillate about a

mean position and the price co established may be called the short-term equilibrium price. In the

determination of such a price demand proves to be more effective than the supply. This equilibrium

price is affected largely by the position of the stock readily available in the market and by the

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present quantum of demand. The possibility of the supply to increase or decrease in the near future

may have its own effect but in the case of perishable commodities, the cost of production has but

negligible part to play. Marshall also explained about the long-term equilibrium of normal demand

and supply. He has pointed out that much elasticity is found in the use of the term ‘normal’, when

applied by the economists to the causes determining value.

Price of a commodity is determined not by supply alone as the classical economists believed and

not by demand alone as the utility theorists believed but by both demand and supply. Behind supply

there is financial and subjective cost while behind demand there is utility and diminishing marginal

utility.

9. Consumer surplus

Marshall introduced the concept consumer’s surplus to economic literature. Unlike the Austrians,

Marshall asserted that the total utility of a good is a sum of successive MU of each added unit.

Therefore, the price a person pays for a good never exceed and seldom would equal to what person

be willing to pay. To him the excess of price which buyer would be willing to pay over that which

he actually does pay is the economic measure of surplus satisfaction. It may be called consumer’s

surplus”. In other word, consumers are generally prepared to pay a higher price for a commodity.

But they actually pay less for it; as a result the consumer enjoys a surplus satisfaction. The concept

of consumer’s surplus has become the basis of welfare economics.

10. Factors of Production

According to Marshall, land and labor are the two chief factors of production. Man is the central

force behind all activities related to production and consumption, but since his faculties are moulded

by his surroundings and environment, obviously nature plays a highly significant role. Labor and

land are the only primary factors of production: man being active, while nature being passive,

nevertheless, playing an important role in production. Capital is all stored up provision for the

production of material goods and for the attainment of those benefits which are commonly reckoned

as part of income. Capital is a secondary or derived agent of production. Organization is just a sort

of labor.

11. Division of Labor

Marshall held the view that increased demand for particular commodities and the expansion of

market are the two factors which lead to division of labor. Division of labour and improvement of

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machinery go together. It was necessary for utilizing the skill of the workers and the machinery in

the best possible manner that the division of labor should be resorted to. In order to achieve the

maximum in production, each person should be constantly employed in such a way that the best

possible use of his skill and ability may be made.

12. Distribution of Income

According to Marshall, the theory of distribution is essentially a theory of factor pricing. To him,

business people must compare the relative efficiency of every agent of production they employ and

consider the possibilities of substituting one agent for another. In a competitive economy,

distribution of income is determined by the pricing of factors of Production. The price of factors is

determined by market forces, viz., demand and supply. The demand for a factor of production is a

derived demand and depends on its marginal productivity. A producer employs more and more of

factors of production till it’s reward is equal to its marginal productivity. Marshalls theory of

distribution was essentially marginal productivity theory of distribution. Marshall also accepted

Wicksteed’s argument about the exhaustion of product. Marshall believed that the marginal

productivity theory was not a complete theory of factor pricing as it considers only demand,

neglecting the supply side. It should properly considered supplier. The effective supply of a factor

of production at any time depends on the stock of it in existence, and on the willingness of those in

charge of it to apply in production.

13. Quasi-Rent

Marshall introduced the concept of Quasi-rent in economic literature. He incorporated Recardian

theory of rent. According to Ricardo, the term rent is applied to income from land and other free

gifts of nature. The amount of rent itself is governed by the fertility of land, the price of the

produce, and the position of the margin. In the short run, Marshall wrote, land and manufactured

capital goods are similar because the supplies of both are fixed.

Quasi-rent is the income derived from man-made appliances and machines. Therefore, the return to

old capital investment is something akin to rent; Marshall called it quasi-rent. Marshall coined the

term Quasi-Rent for the earnings of such capital goods in the short run. The supply of these man-

made producer goods cannot be increased in the short period even though the demand for them may

increase. Durable factors like machines, ships, house and even human skills are similar to land

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whose supply is fixed in the short-run. When the demand for them increases suddenly, their supply

cannot be increased and they earn a surplus which is not rent but is similar to rent. This is only a

temporary surplus which goes to the owner of capital equipment due to the impossibility to increase

supply of capital equipment in response to increase in demand. This is because the numbers of

machines are fixed in short-run and transfer earnings are zero. In the long-run its supply becomes

perfectly elastic and any number of machine will be supplied and Quasi rent disappears.

For instance, due to increase in urban population the demand for houses increases. But the supply

cannot be increased because of the scarcity of building materials. Their supply is limited as that of

land. There is abnormal increase in house prices and hence earning to owner. This abnormal

increase in their earnings is Quasi-rent. It is not rent proper or pure rent because the supply of

houses can be increased in the long-run. In the long-run the supply can be increased and the surplus

earnings will disappear. It is instructive to analyze quasi rent in the earning of factors like labor,

capital and organization i.e. in wages, interest and profit.

Quasi rent in interest: The term interest is applied to a return on floating capital, while quasi rent

is the return from specialized or sunk. Interest on capital is a cost of production in all period; but

quasi rent is a surplus. Usually interest acts as an incentive to save. The higher rate of interest may

induce only the marginal investors. But there are other investors who will save ever at lower rate of

interest, such as super marginal investors and surplus is the rent element in interest. Thus quasi rent

is determined while interest is price determining. The supply of machine or any other capital

equipment is fixed in the short period. The surplus earnings will continue.

Quasi rent in wages: Labor is heterogeneous. Laborers generally differ in efficiency particularly in

the case of personal efficiency. The more efficient workers enjoy a surplus or extra wage over

marginal workers. This surplus constitutes the quasi rent.

Quasi rent in profit: Entrepreneurs also differ in their ability like laborers. Entrepreneur with his

superior organizing ability is able to produce more at a lower cost compared to a marginal

entrepreneur. Accordingly, he is able to enjoy more profit. This is considered as Quasi rent element

in profit.

Quasi rent in personal incomes: Skilled persons like engineers, lawyers and professors due to

their abilities earn more than others. Their differential income is the quasi-rent.

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14. Laws of Returns

In production theory, Marshall introduced the idea of returns to scale; increasing, decreasing and

constant returns to scale. To Marshall, Law of diminishing returns follow or experience if an

increase in the capital and labor applied in cultivation of land causes in general a less than

proportion increase in the amount of it produce. Marshall believed that agriculture was subject to

the law of diminishing returns in the long. Law of Increasing Returns holds if an increase of labor

and capital leads generally to improved organization which increases the efficiency and

productivity. In other word, an increase in units of labor and capital would result in more than

proportionate increase in production. According to him, in industry with an expansion of labor( with

population growth) and capital and an improvement in organization and efficiency, there is an

increasing return to scale..The Law of Constant Returns experience if the actions of the laws of

increasing and diminishing returns are balanced, we have the law of constant return and an

increased produce is obtained by labor sacrifice increased just in proportion. In advanced country

twice the amount of labor and capital apple to land would double the yield.

15. Marshall’s Contribution to Monetary Economics

Marshall’s book entitled ˝Money, Credit and Commerce˝ appeared in 1923 with idea of monetary

economics. He thought that the value of money, like that of other commodities was a function of the

dual forces of supply and demand. The demand for money (gold) is measured by the average stock

of command over commodities which each person cares to keep in a ready form. He has also

explained the reasons why each individual decides to keep money in a ready form, obviously

because it has greater advantages over other forms of wealth. Marshall has thrown light on the

problem of rising price. He made a distinction between real and money rate of interest. For the first

time Marshall explained the causal process by which an increase in money supply influences prices

and also those part played by rate of discount was explained by him.

Though the purchase power parity theory was associated with the names of Ric and Cassel, it was

Marshall who explained the rate of exchange between countries with mutually inconvertible

currency. Marshall also introduced the ‘chain’ method of compiling in numbers. Marshall also

introduced a proposal of paper turn for the circulation based on gold and silver symmetallism as it

standard. Symmetallism refers to a method in which a bar of 2000 grams of silver is equal to a bar

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of 100 grams of gold. Under this system, the government must always be ready to buy or sell a

wedded pair of bars for a fixed amount of currency. The proposal of paper currency for the

circulation based on gold-and-silver symmetallism as the standard was made by Marshall in his

reply to the Commissioners on Trade Depression in 1866. The proposal was put forward as an

alternative to bimetallism.. Marshall thought that this plan could be started by any nation without

waiting for the concurrence of others.

IRVING FISHER (1867-1 947)

Irving Fisher was a man of diverse interests. He took active part in several activities like campaign

for prohibition, public health, healthy living etc. He was a mathematician, statistician, reformer and

a teacher. Fisher was born in Saugerties (New York). He was educated at Yale, Berlin and Paris. In

1893 he left for Europe for his higher studies in Mathematics. After his return, he taught

mathematics for sometime at the Yale University. From 1895 onwards he was appointed as

Professor of Economics.

Fisher’s main contributions were in the fields of money, interest and capital. Fisher’s writings

include: The Nature of Capital and Income (1906), The Rate of Interest (1907), The Purchasing

Power of Money (1911), Elementary Principles of Economics (1910), The Making of Index

Numbers (1922), The money Illusion (1928), The Theory of Interest (1930), Booms and De-

pressions (1932), Stable Money (1934) and 100 percent Money (1935). He was the first economist

who said that income should not be confused with capital.

QUANTITY THEORY OF MONEY; Transactions Approach

Fisher presented old quantity theory of money. The Quantity Theory asserts that (provided the

velocity of circulation and the volume of are unchanged) if we increase the number of dollars by

debasing coins or by increasing coinage, price will be increased in the same proportion’. In order to

explain the direct and proportionate changes between quantity of money and price level, Fisher gave

equation of exchange. The original equation of exchange is stated as PT= MV (or) P =MV/T in

which P stands for the price level, M quantity of money, T for transactions and V stand for velocity

of money.

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But he later criticized this original version of his theory for not including credit money. According

to him, there are five determinants of the purchasing power of money. Namely: 1) The volume of

currency in circulation 2) its velocity of circulation 3) the volume of bank deposits subject to check

4) its velocity 5) the volume of trade. He presented his equation of exchange by including credit

money as follows. MV+M’V’=PT Where: M-quantity of currency, V-velocity of circulation,

M’-quantity of demand deposit, V’-velocity of circulation (velocity of M’) , P-average level of pries

, T-quantity of goods and services translated or sold

According to him, prices vary directly with the quantity of money (M and M’) and the velocity of

circulation (V and V’) and vary inversely with the volume of trade (T). Fisher based his quantity

theory of money on certain assumptions. He assumed that the velocity of circulation of money and volume of

trade to remain unchanged. Further, he mentioned certain factors that determined the velocity of circulation

of money. These were (1) system of payment (2) development of credit and finance (3) the speed with which

money is transported (4) community’s consumption and saving habits (5) expectation regarding future

incomes and prices of goods and services. Fisher pointed out that in economically backward countries; the

velocity of circulation of money was low. So in order to increase the velocity, people should not hoard their

savings but invest them in productive channels.

He assumed that M’ is fixed as bank reserve are kept in fixed definite ratio to bank deposit, and

individuals, firms and corporations maintain fairly stable ratio between their currency and deposit

balance. If the ration between M and M’ is temporarily disturbed certain factors automatically will

come into play to restore it. That is individual will deposit surplus cash or they disturb the relation

between M and M’ but only temporarily.

For him the sole effect of increase in quantity of money in circulation is to increase in prices. The

transmission mechanism of increase or decrease in M is by changing peoples desire to hold as a

specific quantity of cash balance in relation to their expenditure. The increase in the amount of cash

in the economy disturbs this optimum ratio causing individual to readjust their cash –to –

expenditure ratio by increasing expenditure. This added spending drive up the prices in the same

proportion as the increasing in cash in the economy.

Fisher’s quantity theories of money have been criticized. On many ground .Some of the criticisms

are: (1) It did not explain the changes in the value of money (2) The price level depends on certain

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non-monetary factors (3) The theory did not treat the problem dynamically. (4) The equation did not

differentiate between cash deposits and saving deposits, (5) the theory failed to explain the price

movements in war times.

A. Monetary policy

Like most monetarists, he believed that price fluctuations cause rather than result from business

fluctuations. Thus, stabilizing prices by controlling the quantity of money would eliminate the

business cycle. By strictly controlling the quantity of currency in circulation, the quantity theory of

money offers, a way to stabilize the overall price level and thereby stabilize the economy.

B. Currency Principle

Fisher suggested currency principle for the banks called “100 percent money”. The banks were

required to maintain 100 percent resources against deposits. They could not expand the currency

unless fully backed by cash. But this principle was certain practical difficulties in the

implementation.

C. Theory of Business Cycles

According to Fisher, the main cause for business fluctuations was the changes in credit. He said

business depressions were merely the “chances of the dollar”. Fisher suggested that in order to lift

the economy from depression prompt action in the form of reflation should be taken by central

bank.

1.4. The Neoclassical school: The departure from pure competition

Marshall’s system provided a framework for economic analysis in economics. It provided the

necessary basic ideas for refinements and advancement in economic analysis. In this connection,

we may mention the departure from pure competition (theories of imperfect competition). In

addition to classical pure competition, people came up with new analytical model which treat the

cases of imperfect competition. For instances, the work of Cournot on pure monopoly and duopoly

in 1838 and others.

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The concern in imperfect competition arose owing to three major factors. One was the gap in

economic theory between the pure competitive market model and monopoly. Marshal did not fully

address the market model between the two. The second was failure of pure competition theory to

explain the reality. The pure competition model was found to be applied only in few markets mainly

in agriculture. Even there the theory was becoming less suitable to economic conditions of the time

in area of farm products markets such as tobacco, meat, grain, milk, etc where few firms and buyers

are in the market. In addition, growing government intervention in agriculture reduced the general

usefulness of pure competition. Besides, many economists came to questions applicability of the

theory of the time industrial production and trade. The theory of perfect competition presupposes

many buyers and sellers dealing with homogenous products. But the products supplied were

differentiated in which producers have market power. Third, Marshal’s analysis posed a problem

when he came to deal with the determination of equilibrium of a competitive industry operating

under increasing returns in the long run.

Marshal viewed the economy in biological terms, or as an organic whole. In this economy, even

though the industry as a whole may retain its over all character, individual members of the industry

(the firms) would have a life cycle of its own. They would come into being, grow, become old,

decay and die. The new firms began with a number of diseconomies. But with passage of time they

gather strength and move on the path of increasing return scale. Later, however, these firms came to

be managed by non-energetic routine lover managements. These firms suffer from diseconomies as

compared to young competitors hence decay.

The argument in terms of increasing returns and competitive market in the long run are

incompatible with real world. Economists like chamberline, Robinson and Piero Sraffa criticized

Marshall’s contention than increasing returns and competition could go together. They forwarded

ideas of imperfect competitions that range between pure competition and monopoly. At about the

same time, after the publication of Joan Robinson’s and chamberlin’s works, other writers from

USA and England thrown up new ideas. Paul M.sweezy in United State and Hall and Hitch in

England came out with the theory of kinky demand curve. In this line oligopoly firm came in to

being. In the section that follow we will look contribution of these writers.

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D. Piero sraffa

Piero sraffa (1898- 1983), an Italian economist, studied under Marshall and was the editor of the

definitive edition of Ricardo’s collective works and correspondences.

Economic ideas

A. Non Ricardian value theory

Sraffa criticized the theory of pure competition and increasing returns to scale theory of neoclassical

school specifically that of Marshal. In 1960 he published book “Production of commodities by

means of commodities; A pertudes to a critique of Economic theory”. In this work he reconstructed

Ricardo’s production and value theory in a modern form. To him, the pattern of demand for various

products does not affect the pattern of prices, instead it affect only the scale of output in each

industry. The real value (prices) of goods depends on the shares of other commodities necessary to

produce them. Relative value (prices) and profits (if wages are given) are determined by the

production technique used to produce a composite standard commodity, which consists of the basic

commodities in the economy. These basic commodities are capital goods that appear as input and

outputs. The key feature of the composite standard commodity is that a change in either wages or

profit affects the inputs in the same way it affects outputs. The conclusion is that the level of

domestic output is entirely independent of how it is distributed between wages and profits. Any

distribution of wage and profits should be consistent with a particular level of output.

B. Theory of increasing returns to scale

P.Sraff with his article published in 1926 pointed out that costs of production may fall as firm

increases its scale of production. Unit cost may decrease with internal economies as the firms

expands output, or as overhead cost changes are distributed over larger number of output. This

theory of Sraff was incompatible with pure competition of neoclassical. If the firm becomes more

efficient as its size increases, there will be fewer firms and less competition.

Sraffs work explained the situation with the characteristics of monopoly. There are two conditions

which can break the purity of the market. First, single producers can affect market prices by varying

the quantity of goods it offers for sale. Second, each producer may engage in production under

circumstances of individual decreasing costs. Firms that have monopoly power lower its prices on

all units of output to increase its sales. It has then incentive to curtail its output to keep its prices,

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revenue, and profit high. Besides, as some firms’ experiences declining rather than rising average

costs, they can expand their scale of operations well beyond the small size that is consistent with

pure competition. This contradict with the traditional theory that foreword a firm’s expansion of

output is limited by rising costs/internal condition of productions in their firms/.

But for P.Staff, the chief obstacles do not lie in the cost of production, but in the difficulty of selling

the larger output without reducing prices or without having to face increased marketing expenses.

Each firm enjoys special advantages in its own protected segment of the total market. It would not

lose all its business if it raised its prices and it would not take away all of its rivals business if it

lowered its prices. Therefore, the firm enjoys certain monopoly element even in a market that

appear competitive, and the demand curve it faces slope down. Hence, a firm can lower its prices

there by increase its sales and profits.

II. Edward Hastings chamberlain /1899-2967/

He was born in Washington, and received his degree from the University of Iowa, and earned his

doctorate at Harvard. He wrote “the theory of monopolistic competition” in 1933. In this book he

sought to explain a range of market situations that are neither purely competitive nor totally

monopolistic.

Economic idea

A. The theory of monopolistic competition

Chamberline was nearer reality in his monopolistic competition. He considered imperfection in the

market in which each seller wants to acquire monopoly powers through product differentiation.

Product differentiation is the phenomena in which within the general class of goods, there exist

significant basis for distinguishing the goods and services of one sellers from those of others. But

the goods are close substitutes of each others.

There are two implications of product differentiation. First, each firm’s demand curve is down ward

sloping and hence marginal revenue curve must lie below the demand. Second, product

differentiation necessitates selling expenses. These are expense to advertising, transportation,

packaging etc. To chamberlain, selling expenses in terms of their effect on sales are subject to the

usual laws of increasing, proportionate and diminishing returns. That is, at the beginning, after a

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minimum of selling expense are incurred, there will be more than proportionate increase in sales.

This would be followed by a phases in which sales increase in the same proportionate as the selling

expenses. Then if we have the phases in which sales increasing less than proportionately. The

selling expenses have the effects of shifting the demand curve up and to the right as it increase cost

and hence prices. Chamberline also investigated optimization aspect in monopolistic competition.

The basic principle for objective function optimization/maximization is the same as with pure

competition. Equilibrium is attained at the point where marginal revenue is equal to marginal cost.

B. Excess capacity with monopolistic competition

Chamberlines significant conclusions were that price is inevitably higher and scale of production

inevitably smaller under monopolistic competition than under pure competitions. The result is

excess productive capacity for which there is no automatic corrective. This excess capacity may

develop over long periods with impunity, prices always covering costs, and may become normal

and permanent through a failure of price competition to function.

The excess capacity of monopolistic competition results in higher prices and wastes in economic

welfare in the system. The waste usually referred to as waste of competitions”. This excess

capacity is typical feature in monopolistic competition market, and it is not there under pure

competition. For Chamberline monopolistic competition results in a number of variations of each of

general product, thus enabling consumers to better fulfill their diverse taster. Thus, it provides

positive benefits associated with product variety.

III. Joan Robinson/1903-1983/

Robinson was student of A.Marshall and professor of economics at Cambridge University. She

published book entitled “The Economics of imperfect competition” in 1933 a few month after

chamberlin’s work. She also offered a significant critique of Marxian economics. Robinson made

important contributions in Keynesian and post Keynesian economics in relation to economic

development and international trade. Some of her economic ideas are as follows.

Economic ideas

Monopsony

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Robinson developed monopolistic competition theory. She also added the idea of monopsony: a

situation in which there is either a single buyer in a market or a group acting as one. She analyzed

the outcomes of monopsony buying power in product and resources markets.

1.5 JOHN GUSTAV KNUT WICKSELL (1851-1926)

The Stockholm school also known as the Swedish school founded by Knut Wicksell. E. Lindahl,

B.Ohlin and Gunnar Myrdal were the most illustrious members. The school had its influence in the

Scandinavian countries. Wicksell was the founder of the Swedish School of Economics. He studied

the economic theories of Mill, Karl Menger and Bohm-Bawerk for five years. After obtaining his

Ph.D. degree in 1895, he became the professor of Economics at University of Lund. Wicksell’s

main writings were: Interest and Prices (1898), Value, Capital and Rent (1893), studies in Finance

Theory (1896), Lectures on Political Economy Vol. I & Vol. 11(1906). “Value, capital and Interest”

contains Wicksell’s theories of value and distribution. “Studies in Finance Theory” shows his views

on public finance and “Interest and Prices” deals with his views regarding the relationship between

rate of interest and price level. “Lectures on Political Economy” is a systematic restatement of the

theories of value and distribution and price level.

His Economic ideas

MAIN IDEAS

A. Political economy

Wicksell used the term ‘Political Economy” in a wider sense. It was considered both as a theoretical

and practical science. As a theoretical science, it is a statement of economic laws, based on simple

assumptions. As a practical science, it examines the question of application of these laws to solve

practical problems of real life. It deals with economic policy and its effectiveness in solving real

social economic problems.

B. Competition

Wicksell considered perfect competition as good as far as it leads to an optimum allocation of

resources and reduces the prices of commodities to its marginal cost. Further more, under this form

of market, the rewards of the productive factors should be determined according to their marginal

productivity. At the same time, Wicksell felt that the welfare of the society depends on an equal

distribution of income and wealth if everything is left to the market. In this regard he welcomed

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state-intervention.

C. Economic Policy

Even though most of Wicksell’s writings contained theoretical analysis, he had a definite attitude

towards economic policy. He was a strong socialist. He was of the opinion that the welfare oriented

economic policy must aim for (a) an optimum allocation and full utilization of resources and (b)

equality of income, wealth and economic opportunities. For achieving these, he suggested a

‘revolutionary programme’ should be adopted. This programme includes (a) expansion of public

sector (b) development of trade union, movement and extension of free education facilities and (c)

introduction of progressive tax system and reduction of excise and tariff duties.

D. Production and Distribution

Wicksell in his theory of production analyzed only three factors of production-land, labor and

capital. He left the fourth factor of production namely, organization due to difficulties of

quantitative measurement. Like Bohm-Bawerk, Wicksell also regarded capital as a product of

cooperation of the two original factors-labor and land. Wicksell presented a general marginal

productivity theory of distribution. According to this theory, the reward of each factor of

production is determined according to the marginal productivity of that factor.All the factors of

production are subject to the law of diminishing returns. But Wicksell defined wrongly the law of

diminishing returns. It was considered to be a matter of diminishing average rather than marginal

returns.

E. Theory of Capital

To Wicksell capital was not a separate factor of production rather intermediate good used in

production. Capital is stored up labor and land, or stored up productive power. It is separated from

the current labor and land through time element. In a simple model, we may say that the stored up

land and labor of the previous years are used up with the current supply of labor and land. And out

of the current years resources a part must be saved up for the next year’s capital if continuity is to

be maintained. Now there is a difference between the marginal productivity of current year’s land

and labor and that of the previous years. This difference in productivity, according to Bohm-

Bawerk was due to the time element. But in Wicksell this time element operates through relative

marginal productivities which differ on account of the relative supplies of capital or productive

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power. In the current period, current supply of labor and land is abundant relative to that of stored

up labor and land. The marginal productivity of saved up labor and land is therefore more than the

marginal productivity of current labor and land. Interest in its pure form is this difference though it

may also be taken as the marginal productivity of waiting. Capital received remuneration for its services

in the form of interest. Thus interest was the difference between the value of annual product and profit plus

payment for land and labor. Wicksell distinguished between natural rate of interest and bank rate of interest.

The natural rate was that rate at which the demand for capital and supply of savings are equal. In other

words, at the natural rate of interest, savings and investment would be equal.

F. The Wicksell Effect

The Wicksell effect demonstrated Von Thunon’s marginal productivity principle, which is applicable to

labor and land. Only at the micro level and not at the macro level. At the macro level, when capital increases,

the marginal productivity of capital declines and real savings is absorbed in rising real wages and rent. Thus,

the social marginal productivity of capital is smaller than the rate of interest. However, at the micro level, the

marginal productivity of capital is equal to the rate of interest.

G. Cumulative Process

Wicksell criticized the traditional quantity theory of money and attempted to explain its method of

operation through the cumulative process. Cumulative process is a state of disequilibrium in which

a discrepancy arises between the natural rate of interest and market rate of interest. If the natural

rate of interest is more than the market rate, investment will be more than savings and there will be

a cumulative rise in prices. On the other hand, if natural rate is less than the market rate, investment

will be less than savings and there will be a cumulative fall in prices.

H. Trade Cycle

Wicksell regarded trade cycle as real phenomena, and not a monetary one. According to him the

main cause for trade cycle is the changes in investment and not in prices. In trade cycle theory, the

important contribution of Wicksell is the idea that, “technical progress does not increase in perfect

simultaneously with the increase in population”

Wicksell tried his best to respond for the question why prices collectively rise or fall? To answer this

question, he turned to an analysis of interest rates. He has distinguished between normal rate and the bank

rate. The money (market) rate is to be conceived as the average of rates at which banks are

advancing loans to the potential investors. The natural rate is the measure of expected yield on new

investment, which is therefore equivalent of the marginal efficiency of capital in Keynes and

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marginal productivity of capital in Bohm- Bawerk. Wicksell uses the difference between natural

and money rates of interest for explaining the movement in prices in the economy.

The normal or natural rate of interest depends on supply and demand for real capital that is not yet invested.

The supply of capital flows from those who postpone consuming part of their income and there by

accumulate wealth. The demand for capital depends on the profit that can be realized from its or marginal

productivity. The interaction between demand and supply determines the natural interest rate. The natural or

normal rate of interest applies only to credit between individuals.

Bank rate may be either greater than or less than normal rate.

If Bank rate less than natural rate, saving will be discouraged, and demand for consumption goods and

services will rise. Simultaneously, entrepreneurs will seek more capital investments because of greater net

profit to be realized as the cost of borrowing money falls. This lead to rise in income accrues to workers, land

owners, owners of raw materials, which leads to a rise in price level. If for example, market rate is less

than natural rate, it leads to a greater total expenditure or demand in the economy and prices move

up. The market rate may be kept low, through creation of bank credit or through dishoarding and the

inflationary price rise may be fed on them.

On the other hand, if bank rate of interest is above the natural rate, prices will fall. Because, saving will

increase, and investment spending will decline. The decline in investment will reduce national income, which

will in turn causes the price of consumer good to decline.If these two rates are not equal in the market, a

disequilibria results and a process of adjustment starts.

I. Savings and Investment

Wicksell considers the equality between savings and investment in ex-ante sense. Accordingly, if

savings exceed investment, income is reduced, consumption falls and so do the prices. Just the

opposite would happen if savings fall short of investment. Wicksell believed that this relative

position between savings and investment could be regulated by the use of bank rate. Assuming that

the bank rates sets the level of other market rates of interest, it follows that by keeping the market

rates sufficiently low, investment can be stimulated while savings would be discouraged. Similarly,

a high bank rate should lead to an access of savings over investment. And through trial and error an

equilibrating rate can also be chosen. Wicksell therefore, integrated interest, savings and investment

in his theory and imparted dynamism to it.

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J. Monetary Policy Monetary authorities can play an important role in price stability by changing the bank rate. In order to

equate the market rate and natural rate of interest, bank rate can be manipulated.

Assessment

Wicksell occupies an important position in the history of economics thought. He was not only

provided a representative synthesis of the existing economic thought but also established a ‘School’

on the strength of his economic reasoning and laying the foundations along new lines of

exploration. He was a contemporary of the economists who were making a revolution in economics

through marginalism. Though he covered a wide area in economics theory, he is better known for

his contribution in the fields of capital interest, monetary theory and economic fluctuations.

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Chapter 2: Heterodox Economic Thought

2.1 Early critics’ of neoclassical school of thought

Neoclassical economics is methodologically individualist and tries to rest explanations of

aggregate phenomena on micro foundations of individual behavior. Arguably, a

“macroeconomics is irrelevant. But coherence exists at a higher level of integration than at

individual level.

The treatment of Labor as a regular commodity and erasure(removal) of the labor/labor power

distinction Portrayal of the modern economy as a barter economy

The misuse of Ceteris Paribus (i.e. the holding constant of factors that logically vary when the

target variable is changed, such as the level of aggregate demand when wages fall)

The derivation of real world conclusions from idealized models without rigorous theoretical or

empirical argument.

Failure to acknowledge the difficulties involved with empirical demonstration of neoclassical

claims and misleading assurances that the texts’ conclusions rest on more or less indisputable

empirical results.

Failure to acknowledge well-known problems with neoclassical capital theory.

Use of questionable analogies to make theoretical claims and public policy recommendations.

Interesting things here is the oft repeated claim that because two people benefit from

exchange, so must two nations. The argument ignores distributional issues, the implications of

path dependency, problems of the second best, social externalities, and so on.

The assumptions of general equilibrium theory: Homo Economicus (rational, isolated, self-

interested man), Perfect Information, Perfect Competition, and Says Law (permanent full

employment) is not realistic.

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2.2 The development of Modern Heterodox school

Heterodox is usually defined in reference to orthodox, meaning to be “against orthodox” or non-

orthodox and defines itself in terms of what it is not, rather than what it is. An economist who sees

him or herself as heterodox does not subscribe to the current orthodox school of thought, as defined

by the historian’s classifications.

Heterodox include the following alternative economics:

• Keynesian economics / post-Keynesian economics

• Marxian economics / neo-Marxian economics

• Structuralist economics

• Institutionalist economics

• Ricardian economics

• Feminist economics

Key characteristics found in the writings of heterodox economists

1. Methodology (rather than just method) is important to understand economics.

2. Human actors are social and less than perfectly rational, driven by habits, routines, culture

and tradition.

3. Economic systems are complex, evolving and unpredictable – and consequently equilibrium

models should be viewed skeptically (doubt accepted opinions).

4. While theories of the individual are useful, so are theories of aggregate or collective

outcomes. Further, neither the individual nor the aggregate can be understood in isolation

from the other.

5. History and time are important.

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6. All economic theories are fallible (capable of making mistake) and there is contemporary

(originating at the same time) relevance (appropriate to the matter in hand) of the history of

thought to understanding economics.

7. Pluralism, i.e. multiple perspectives (particular evaluation of something), is advocated

8. Formal mathematical and statistical methods should be removed from their perceived

position as the supreme method – but not abandoned – and supplemented by other methods

and data types.

9. Facts and values are inseparable.

10. Power is an important determinant of economic outcomes.

Heterodox economists as distinct from Neoclassical economics:

• Do not propose that “capitalism” (i.e. “the free market system”) is an ultimately perfect

system of organizing society;

• Unlike neoclassical economists they criticize the shortcomings of the market system to

various degrees;

• Call for government intervention to overcome these shortcomings;

• Emphasize political, social, cultural, historical, structural and institutional factors that

interplay with economic factors.

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CHAPTER THREE: WELFARE ECONOMICS

3.1 INTRODUCTION

Welfare economics analyzes social welfare. Social welfare refers to the overall welfare of society.

Individuals are the basic units for social welfare as there is no "social welfare" apart from the

"welfare" associated with its individual units. With sufficiently strong assumptions, it can be

specified as the summation of the welfare of all the individuals in the society. It uses

microeconomic techniques to simultaneously determine allocative efficiency within an economy

and the income distribution associated with it. Welfare may be measured either cardinally in terms

of "utils" or dollars, or measured ordially in terms of ranking of preferences.

Welfare economics have been evolved over time starting from Adam Smith up to now. There are

many aspect of welfere. One aspect of welfare economics typically takes individual preferences as

given and stipulates a welfare improvement in Pareto efficiency terms from social state A to social

state B if at least one person prefers B and no one else opposes it. There is no requirement of a

unique quantitative measure of the welfare improvement implied by this. Another aspect of welfare

treats income/goods distribution, including equality, as a further dimension of welfare. In this chapter

we deal with welfare economics; more specifically, basic principles of welfare maximaization,

contributions Pigou, Pareto, and others.

3.2. Historical evolution of welfare economics

Concern for social welfare were there in the world starting from ancient period. For instance, the

question as to what exactly was a "good society"? Had figured prominently in the minds of

economists at least since Aristotle and it was not easy to resolve. Historical treatment of welfare

economics began with the classical economists like Smith, Bentham, and others. Classical writers

regarded political economy as a science which deals with valuable things or economic goods (with

wealth). While defining economics as a science of wealth, they proceeded to assert that wealth

promotes the economic welfare of man and that economics should be essentially concerned with

welfare or at least material wellbeing. This peculiar idea of welfare was challenged by later

economists in course. Several subsequent economists of neoclassical like Marshal dealt with the

welfare aspects. Concern about the relationship between the competitive market system and social

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welfare dates back centuries. Of particular concern was whether the outcome of a market economy

as a "good" outcome. The classical economists emphasized production, supply and costs, the

welfare economists lay stress on consumption, utility and demand. England is the home of the

welfare economics, which was a direct refutation of classical economics, especially the laissez-faire

doctrine.

With growth of capitalism the operation of economy in area of production, employment, prices,

economic growths etc were found to be at sub- optimal level. In area of production, employment,

prical, rate of capital accumulation economic growth, reginonal balance and distribution of wealth

and so on. These diverse dimensions are interrelated. Classical economics ignores the

interdependence of diverse dimension of economy and concentrate on one dimension at a time. To

solve these corrective actions were needed and proposed in diverse sphere of the economy were not

effective. With the marginalist the wealth concept and new dimensions of economic ideas that

focus on marginal utility and utility were forwarded. Broadening of the economics of wealth into

economics of welfare was actually effected by the marginal utility school which rejected the

classical wealth oriented definition of economics. Welfare economics has been described as a

tendency to modify the classical doctrines and to make economics to deal with social policies,

directed towards achieving the goal of social welfare. Many of the early Marginalists, like Hermann

Heinrich Gossen (1854), were so entranced by the concept of utility in their economics that they

naturally fell into the trap of arguing that the market yielded this social optimum. According to

Reder, welfare economics is ‘the branch of economic science that attempts to establish and apply

criteria of propriety to economic policies.’

The 20th

Century welfare economics is realistic and pragmatic. Alfred Marshall has been regarded

as the founder of welfare economics. He provided the concepts of consumer’s surplus and

producers’ surplus. He also maintained a policy to augments the two were desirable. It has been

developed further by a host of writers including Henry Clay, R.G Hawtrey, Edgeworth, Vilfredo

Pareto, J. A. Hobson and A.C Pigou.

However with the advancement of capitalism in Western Europe and America economist started

branching in to two distinct lines. On one hand the imperfections of the capitalist system of

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economy were recognized. Scholar started evaluating imperfection with reference to the generally

accepted morns. They seek to pin-point specific causes of maladies (including inequalities of

income and wealth) and to suggest remedial actions which don’t entail changing the basic structure

of the economy including its institutions and productions relations. They did not advocate state

intervention and / or modification of the basic production relationships.

On the other hand, economic analyses tend to become more and more abstract and pure in which the

emphasis was given on the positive dimension of economics. Positive economics tended to judge

the allocation of productive resource as optimum and the working condition of the economy as the

best possible. It conformed to the model of competitive markets and laissez- faire. No value

judgments were expected to be expressed and therefore no policy conclusion was to be drawn.

However, this positive economic found it difficult to keep the normative aspect out of picture.

Modern welfare economics also proceeds along similar lines. Jeremy Bentham and the

utilitarianians had set the dominant interpretation in the late 18th and early 19th centuries. He had

provided a subjective standard for estimating the aggregate satisfaction in the society. This

approach obviously assumed measurability of utility and interpersonal comparison of thereof. It was

also hedonistic in nature as it assume all utility was pleasure and all disutility was pain. For them,

the best criterion for any policy would be to provide the greatest happiness for the greatest number

of people. The social optimum was thus quickly defined as the allocation where the sum of

individual utilities is greatest. Equity became one of the big topics of discussion: by the principle of

diminishing marginal utility, a dollar is worth less to a rich man than it is to the poor, thus an

egalitarian redistribution of income was called for. Of course, this raised the question of what

"equity" meant anyway -- equitable in utility, equitable in income or equitable in means to

income? Furthermore, there was the question of a trade-off between social equity and the

efficiency of an economy. John Stuart Mill (1848) eloquently argued that income could be

redistributed without sacrificing efficiency.

Emphasis of welfare by welfare economists received fillip only after the World War I, mainly

because of the increasing inequalities and the existence of poverty amidst plenty. However, classical

economic thought had maintained that economic welfare would be optimized if the market

mechanism is allowed to function with out intervention - the basic classic position.

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Only in the 1920s a fully self-conscious welfare theory began to be written. This self-consciousness

about its distinct character and even the name welfare economics are due to Arthur Cecil Pigou.

His great book “The Economics of Welfare” was the beginnings of fully self-conscious welfare

analysis. History of economics thought considers views of Pareto as originator of welfare

economics “new welfare economics”, which is rooted in Walra’s general equilibrium.

The "unholy alliance" between neoclassical economics and Benthamite social philosophy persisted

well into the 20th Century. The main problem, of course, is that the utilitarian calculations require

that one must, one way or another, compare utility levels across people. Vilfredo Pareto had

vociferously opposed this notion, arguing that utility was merely an ordinal representation of

personal preferences between consumption bundles. Not only does the "number of utils" not matter

for utility representation for a single person, but they are certainly not available for adding or

comparing across people. This is why he refused to use the term "utility" and replaced it with

"ophelimity".

3.3. Approaches of welfare economics

There are two mainstream approaches to welfare economics: the old neoclassical approach and the

new welfare economics approach. The early neoclassical approach was developed by Edgeworth,

Sidgwick, Marshall, and Pigou. It assumes that:

Utility is cardinal, that is, scale-measurable by observation or judgment.

Preference is exogenously given and stable.

Additional consumption provides smaller and smaller increases in utility (diminishing

marginal utility).

All individuals have interpersonally comparable utility functions.

With these assumptions, it is possible to construct a social welfare function simply by summing all

the individual utility functions. Old welfare economics contained a significant utilitarian (the

doctrine that value is measured in terms of usefulness) heritage: Economists assumed individual

utilities could be summed to calculate total utility in society, and it was accepted to compare the

utility of one individual to that of another.

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3.3.1. Early Neo classical approaches

3.3.1.1. Sidgwick( 1838-1900)

He was among the first to mention the divergence between private and social products. He wrote “principle

of political economy”. In his work he challenged (put reservation) that an individual’s claim to wealth is not

always the exact equivalence of his net contribution to society (social product). He argues that there may be

externalities (positive or negative) associated with economic activities of individuals. Positive externalities

are activities that yield benefit to others for which the individual is not paid. On the other hand, negative

externalities are activities that impose costs on others for which the individual is not charged. He pointed out

the possibility & significance of the divergence. Therefore, he argued, government intervention is necessary

if such divergence prevails.

3.3.1.2. Alfred Marshall (1842-1924)

After Sidgwick, Marshall also raised the possibility & significance of divergence between private & social

product. This possibility, according to him, is associated with the cases of long run increasing & decreasing

cost industries. He argued that there may be a need for government intervention to correct these

divergences. His analysis was based on two assumptions:

1. Marginal utility of real money is constant, implying that demand is independent of income

(only substitution effect is recognized).

2. Utility is measurable (can be quantified) – cardinal utility.

He believed, at equilibrium, .....PYMUyPxMUx This implies the traditional equi-marginal

equilibrium theory. Nevertheless, his contribution was on partial welfare analysis.

3.3.1.3 ARTHUR CECIL PIGOU

Son of an army officer, A.C. Pigou was born in 1877 and educated at Harrow and King's College,

Cambridge. He compiled a brilliant record that included numerous prizes. Pigou was a prominent

member of the Cambridge school and faithful pupil of Marshall. He was Marshall’s student and teacher

of J.M. Keynes. After Marshall, he became the leading neo classical economist. He was the founder of

Welfare Economics. His leading ideas on welfare economics were found in his “Economics of Welfare”

(1920). Prof Pigou popularized the word of welfare and gave a concrete meaning to it. In his book, Pigou

dealt with three things: (1) a definition of economic welfare (2) spelling out the condition under which

welfare is maximized and (3) pronouncement of policy recommendations for increasing welfare.

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He may be credited with establishing a scientific welfare economics. He was the first to put the whole thing

about welfare in to a system. He shifted on to the consideration of national welfare with reference to social

marginal cost and social marginal benefit. He had also suggested that the problem of unemployment could be

solved through the manipulation of wages; but, later on, he appeared to be much nearer to Keynes when he

suggests the manipulation of investment for combating unemployment. For him, the chief aim of economic

science will be unrealistic.

A. Definition of economic welfare

Pigou carried on in Marshall’s tradition with the same attitude, but he was more abstract and

mathematical. Marshall and others had provided what may be called case-to-case studies and the

areas where there was a need for state intervention for improving the welfare of the society. Pigou

was the first to put the whole thing into systems. Like Marshall, Pigou felt that the study of

economics could be justified only as a means of improving human society. Building upon the base

of Marshallian economics, he set out modifying, expanding, and adapting the apparatus so that it

could be directly applied to the exploration of ways and means by which social intervention would

yield benefits in terms of economic welfare.

Pigou carefully analyzed the competitive economic system to find how it falls short of the ideal and

the means by which the ideal can be achieved. Social welfare is the summation of all individual welfare

in a society. He regards social welfare as a sum of individual welfares which depend upon a balance

between individual satisfactions and dissatisfactions. Individual welfare is capable of measurement

through choices expressed in money payments. Thus, he regards welfare as a psychic good rather

than the mere accumulation of material things. He defined individual welfare as the sum of satisfactions

obtained from the use of goods and services. Since general welfare is very wide and complicated, he limited

his study to economic welfare. He defined economic welfare as that part of social welfare “that can be

brought directly or indirectly into relation with the measuring rod of money.” Economic welfare depends

upon the size, the manner of distribution, and the variability of the national dividend.

B. Condition for maximization of social welfare

According to Marshall, the national income represents the general welfare, but Pigou believes that

welfare is not only dependent on the size of the nation’s income but also on the equality of its

distribution, i.e. the more the equality of the distribution of income the higher will be the level of

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welfare. According to him, economic welfare is generally proportional to the size of the national

income, provided the dividend accruing to the poor is not diminished.

Prof Pigou had a dual criterion for detecting the increase in social welfare. First, he measured the

economic welfare of the society in money value and thus, given the supply of resources, an increase

in national dividend meant an increase in social welfare. The other words, Pigou’s concept of

economic welfare is that part of social welfare that can be brought directly or indirectly into relation

with the measuring rod of money. Economic welfare is generally proportional to the size of the

national income, provided the dividend accruing to the poor is not diminished. While advocating, in

the interest of economic welfare, he argued that the state should protect the interests of the poor the

transfer of purchasing power from the rich to the poor. He favored an income equalization policy

and therefore, reorganization of the economy to increases the share of the poor without offsetting

adversely “productive effort enterprise and development of capital equipment was to be taken as a

gain in social welfare.”

Coming to the division of national dividend between members of the society, Pigou makes a

qualified statement that a shift towards equality should enhance economic welfare. In this

connection he first proceeds on the assumption that income enjoying capacity of all the members of

the society is the same. Hence, obviously a reduction in inequalities would increase economic

welfare. But he then refers to the typical objection that some races have low income enjoying

capacity even within a society, the poorer sections may not know what to do with increased income

and may spend the same wastefully and to their disadvantage. Pigou, however, believes that the

solution of this problem is to redistribute income in those manners which would not be quickly

perceived by the poorer sections through price reductions or the process may be completed rather

slowly which would allow the poorer sections to acquire more of income-enjoying capacity.

Similarly, the government may provide more of public goods and “merit goods” which would

naturally enhance their total enjoyment.

He lays down two conditions for the maximizations of welfare: (i) given the taste and income distribution, an

increase in national income represents an increase in welfare. (ii) For welfare maximization, the distribution

of national income is equally important. If national income remains constant, transfer of income from rich to

the poor would improve welfare. With income subject to diminishing marginal utility, transfers of income

from the rich to the poor will increase social welfare by satisfying the more intense wants of the poor. Thus it

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is economic equality that maximizes welfare

C. Difference between social and private benefit and cost

The central concept of his analysis was the distinction between private and social net product

private product being the product that accrues to the individual making a decision concerning

production. Social net product being the net product that accrues to society as a result of the

decision. In a competitive economy, decisions are made in such a way as to maximize private net

product but not necessarily social net product. Appropriate taxes and subsidies could, however,

make private and social net products equal, thus leading each individual to behave in a way that

maximizes social welfare.

The presence of external effects in production was seen by Pigou in the divergence between social

net product and private net product. He defined social net product “as the aggregate contribution

made to the national dividend” and the private net product as the contribution which is capable of

being sold and the proceeds added to the earnings of the person responsible for investment. The

divergence between the two products shows itself in the form of external effects of production

associated with marginal increments of output. In some cases social net product is more than the

private product while in others private product is greater than the social product.

As an illustration he cited the fact that the smoke rising from the chimneys of private factory spoils

the atmosphere of the locality and increases the laundry bills of the people of the neighborhood. But

people are not compensated in any way by the factory owner. He was of the opinion that the state

should equalize the private net product with social net product. If in industry where private net

product is more, it should be taxed and if another industry shows a lesser private net product ought

to be subsidized. Prof Pigou recognized the divergence between private net product and social net

products cannot always be quantified and measured in terms of money.

Pigou has made a distinction between private and social costs. The private marginal, cost of a commodity is

the cost of producing an additional unit. The social marginal cost is the expense or damage to society as a

consequence of producing that commodity. Private marginal benefit can be measured by the selling price of

the commodity. Social marginal benefit refers to the total benefit that society gets from the production of an

additional unit. By making a distinction between social and private valuations of economic activity, he paved

the way for the analysis of external effects or externalities in social welfare economics.

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Pigou lists three groups of divergence between social and private costs and benefits.

1. There is the fact that the tenancy and ownership of certain durable instruments of production

are in effect separated from each other. When the ownership of the instruments of

production is of someone else, the tenant would not use the instruments properly or maintain

them or improve them. This would therefore lead to a less than socially desirable

investment.

2. The source of divergence between social and private measures of marginal benefits may be

put in terms of what we now call the public goods to the principle of exclusion. It means that

in the case of roads, the beneficiaries cannot be fully, identified, and even if they cannot be

charged for the benefits. Similarly, in the case of certain cost or disadvantages, the sufferers

cannot recover damages from the producers. Actually in a number of goods, elements of

externalities exists which can assigned to individuals.

3. Pigou also talks of the elasticity of demand which these specific goods and the criterions as

to whether their consumption is to be encouraged or discouraged. For instance, in case of

increasing returns industries, investment will be less than socially desirable if the elasticity

of demand is high and if consumption is desirable. In such a situation, these industries shot

subsidized.

Prof. Pigou made the first attempt to lay down conditions of social optimum which he termed “the ideal

output” of the economic system as a whole. In his view, the social optimum prevails when marginal social

products are equal in all industries and thus production of real wealth is maximized. Assuming that all the

productive resources are being employed and that there is no cost of movement between different

occupations and places, it can be concluded that the national dividend is the largest when the values of the

marginal net products are equal in all industries. If this arrangement prevails, the society is having its” ideal

output”.

Pigou built his analysis based on the following assumptions like what Marshall did: These were; cardinal

measurement of utility, equal income enjoying capacity of individuals under the same circumstance,

possibility of inter-personal comparison of utility as also possible for commodity, that the society’s welfare

is the sum total of individual welfares. Pigou also believed that the marginal utility of income falls as

money income increases. As a result, the marginal utility of an additional to the income of a poor

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man is compared to the loss of utility from the loss of the same are of income to a rich man.

Their difference lies mainly on the fact that while Marshall’s welfare economics analysis runs in terms of

partial equilibrium in the form of consumers’ surplus and producers’ surplus. Pigou, considered total

welfare. For this, his rule is that the allocation of resources & their utilization in different employments

should be such as to lead to equality between social marginal benefit & social marginal cost. (SMB = SMC).

The crucial thing in Pigou’s analysis here is that, left to it self, the economy is likely to allocate its resources

in a manner different from the one where the marginal social benefit & marginal social cost would be

equated in each line of employment. These divergences ought to be remedied through fiscal & other policies.

He emphasized the fact that the economic system as viewed by the classical & neo classical economists was

not a friction-free phenomenon and these frictions were major sources of the need for state intervention. That

is, for the achievement of this goal of equality of social marginal cost and social marginal benefit, he has

suggested government intervention.

He has suggested that economic welfare could be increased by the transfer of income/purchasing power from

the rich to the poor. Because the transfer of income from a relatively rich man to relatively poor man of a

similar temperament enables more intense wants to be satisfied at the expense of less intense wants. This will

increase the aggregate sum of satisfactions. Therefore, any cause which increases the absolute share of the

real income in the hands of the poor, provided that it does not lead to a contraction in the size of the national

dividend from any point of view, will, in general increase economic welfare..

According to Pigou, ‘Welfare economics is that part of social welfare that can be brought directly or

indirectly in to relation with the measuring role of money.’ Economic welfare is generally proportional to the

size of national income, ‘provided the dividend accruing to the poor is not diminished, increase in the size of

the aggregate national dividend, if they occur in isolation without anything else whatever happening must

involve increases in economic welfare.’ While advocating, in the interest of economic welfare that the state

should protect the interests of the poor, he has suggested that economic welfare could be increased by the

transfer of purchasing power from the rich to the poor. He introduced the concepts of private net products

and social net products. According to him, private net product is ‘the contribution, that is capable of being

sold and the proceeds added to the earnings of the person responsible for the unit of investment,’ while the

social net product is ‘the aggregate contribution made to the national dividend.’ His treatment of short and

long-term effects of government intervention on the distribution of national dividend is quite interesting.

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Evaluation

Pigou provided the first systematic theoretical base of welfare economics and integrated the normative

problems with positive ones. He provided a rationale for state intervention where private and social

net product diverged. But his policy recommendations were all value based. Though Pigous

Economics of Welfare was the first clear analysis of welfare economics, yet the Pigovian conditions

of welfare have been criticized on the following grounds. Pigou lays emphasis on the maximization

of welfare, but he does not clarify the notion of maximization. Pigovian assumption of equal capacity

for satisfaction is scientifically untenable. This represents a broad value judgment favor of equal distribution

of wealth. The capacity for satisfaction of any individual is a subjective thing incapable of “objective

quantification”. Another trouble with Pigovian welfare economics, is the lack of rig our and

operational content in the distinction between private and social products. Pigou seems to have

assumed that the divergence between the two is not inherent in the working of the free enterprise

system. It is traceable to and can be corrected through governmental intervention. In the real world,

structural failures resulting from immobility, indivisibility and imperfect knowledge are so

numerous as to defy correction through social action. The classification of general welfare into

economic’ and ‘non-economic welfare has also hence criticized as too superficial to be made the

basis of all welfare analysis.

The most destructive criticism of the Pigovian welfare economics was the unrealistic nature of the

assumptions of cardinal additively of the individual utility functions to get the social welfare functions.

Economists do not agree with this view because quantitative measurement of utility is not possible. Pigous

welfare conditions are related to national income. But it is not easy to calculate national income.

Again, social welfare does not increase by mere increase in national income. It is possible that

national income may increase due to inflationary rise in prices and poor may become worse off than

before. Welfare economics is closely related to ethic does not clarify it. Welfare economics is

essentially study in which value judgments and inter personal comparisons are made. By not

relating these concepts with his welfare, Pigous economics of welfare is not considering objective

study of the causes of welfare.

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3.4.1.4 Wilfred Pareto Pereto was born in Paris to Italian parents. He studied at the University of Turin in Italy, and later accepted

the chair as professor of economics at the University of Laussanne, Switzerland. There he studied and

expanded the mathematical traditions established by his processor Walras.

A. Pareto Optimality

Pareto refined Walras’s general equilibrium and set forth the conditions for maximum welfare. Paretian

welfare economics assumes that everyone is the best judge of his own interests and that this welfare

depends upon economic variables only and there are no externalities involved in the process.

Maximum welfare, said Pareto, occurs when there are no longer any changes that will make someone better

off while making no one worse off. This implies that society cannot rearrange the allocation of resources or

the distribution of goods and services in such a way that it aids someone without harming someone else. The

Pareto optimum thus implies: optimal distribution of goods among consumers; optimal technical allocation

of resources, and optimal quantities of outputs. Paretian welfare economics rests on the assumed value

judgment that, if a particular change in the economy leaves at least one individual better off and no

individual worse off, social welfare may be said to have increased.

We can demonstrate these conditions by supposing the existence of simple economy containing two

consumers (smith and Green), two products (hamburger and potato), and two resources (labor and capital).

According to Pareto, the following are the conditions of this optimum:

1. Optimal distribution of goods: The marginal rate of substitution between any two commodities

must be the same for any pair of owners of the same two commodities. The optimal distribution of

goods occurs where smith and Green each have identical marginal rate substitution between the two

goods. We express this symbolically as, MRShpS=MRShpG where MRShpS and MRShpG are smith’s

and Green’s MRS of hamburger for potatoes.

2. Optimal technical allocation of resources: The marginal rate of transformation between any factor

and any product must be the same for any pair of producers using the factors and producing the

product. In our two goods, two resources example, and the optimum allocation of resources to

productive uses will occur where the marginal rate of technical substitution between labor and

capital in the production of hamburger and potatoes are equal. This second condition for Pareto

optimality can be shown symbolically as, MRTSLKH=MRTSLKP, where MRTSLKH and MRTSLKP

are the marginal rate of technical substitution labor for capital in the production of hamburger and

potatoes respectively.

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3. Optimal quantities of output: The marginal rate of substitution between any pair of factors

must be the same for any two producers using both, in producing a given product. If

production and distribution meet the conditions of Pareto optimality, then optimum level of

output will be achieved where the marginal rate of substitution of hamburger for potatoes

equals the marginal rate of transformation (MRT) of potatoes for hamburger. This is the rate

at which it is technically possible to transform potatoes in to hamburger. Symbolically,

MRShp=MRTph.

Efficiency

Many economists use Pareto efficiency as their efficiency goal. According to this measure of social

welfare, a situation is optimal only if no individuals can be made better off without making

someone else worse off. This ideal state of affairs can only come about if four criteria are met: The

marginal rates of substitution in consumption are identical for all consumers. This occurs when no

consumer can be made better off without making others worse off. The marginal rate of

transformation in production is identical for all products. This occurs when it is impossible to

increase the production of any good without reducing the production of other goods. The marginal

resource cost is equal to the marginal revenue product for all production processes. This takes place

when marginal physical product of a factor must be the same for all firms producing a good. The

marginal rates of substitution in consumption are equal to the marginal rates of transformation in

production. These are where production processes must match consumer wants.

There are a number of conditions that, most economists agree, may lead to inefficiency. They

include: imperfect market structures, such as a monopoly, monopsony, oligopoly, oligopsony, and

monopolistic competition, factor allocation inefficiencies in production theory basics, market

failures and externalities; there is also social cost, imperfect Price discrimination and price

skimming, asymmetric information, principal-agent problems, long run declining average costs in a

natural monopoly, certain types of taxes and tariffs.

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Assessment

Pareto did much to help economists better understand the conditions for, and the welfare significance of

economic efficiency. However, the central Pareto criterion, “does a change makes someone better off while

making no one worse off?” is not well suited for evaluating public policies. In addition the Pareto criterion

has the following limitations; it fails to address the issue of distributive justice; it is based on static

view of efficiency; it has conflict with social moral values; it is against public policies; his theory failed to

recognize that his definition of optimum distribution of income admitted of a multiple (instead of a

unique) solution. It also leaves out the case where the loss of losers (on account of redistribution of

income) is smaller than the gain to gainers.

3.3.1.5 J.A. Hobson (1858–1940)

Hobson was a prolific writer. He wrote voluminously on issues like inequalities, injustices and

maladjustment of economic society under capitalism. He was also a social reformer. Unlike the

classical economists, he held that competition was often imperfect, and that in the absence of

effective demand, market gluts often occurred. Hobson regarded economics as a qualitative science

of human values. He considered individual welfare as an organic whole which could hardly be

explained in terms of marginal increment of specific commodities. His important works include;

‘The Economics of Distribution,’ ‘The Industrial System,’ ‘Work and Wealth: A Human

Valuations,’ and ‘Economics of Unemployment.’

His economic ideas

A. Criticism of the Classical Economics

Hobson criticized the classical economics on the score of individualism and competition. According to him,

the assumption of free competition is no longer valid. He held that the quantitative approach of the classical

economists was improper and the market price was no index to welfare. By welfare he meant good life. In his

opinion, the entire analysis of the classical economists with its emphasis on production was defective, since it

undermined the importance of consumption. He said that production is meant for consumption, and, hence it

was subordinate to consumption. The result of this wrong approach regarding the relationship between

production and consumption is that an important economic field is left ill-explored. He thought that

economics must be studied from the welfare point of view. To him economic life was a network of business

and trades, but thoughts desires and relation were its spiritual texture. According to him, there are three

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defects in classical economics; an exaggerated stress upon production, reflected in the terminology and

method of the science, with a corresponding neglect of consumption; a standard of values which has no

consistent relation to human welfare; and mechanical conception of the economic system due to the

treatment of other human action as a means to the production of non-humanly valued wealth.

B. Reconstruction of Economic science

Hobson’s attempt to reconstruct economic science appears to be more important than his other contributions.

He wanted to make ‘welfare’ the center of economics, instead of the analysis of value and price, which

according to him was unreal. It is the goal towards which all his writings lead.

Hobson has divided all productive activity into seven classes: art, invention, professional service,

organization, management, labor and savings. He has tried to show that in each of these categories costs and

utility differ. Whereas in each of these activities, economic costs are incurred, there may be activities in

which the human costs may be nil. In short, he concludes that persons receiving the highest pay in society

incur the lowest cost. In laboring class occupations, workers get physically tired. They get involved into

accidents and other nervous disorders. Their energy is dissipated and their morale is very much lowered

down. Again, unemployment and intermittent employment further adds to human costs and force women and

children to take up employment. Further the modern industry, owing to its disruptive and discriminatory

tendencies also increase human costs of production. To him, it is necessary that while determining the values

emanating from the industrial system, human costs must be set against the utilities derived.

C. Social Reforms

For Hobson, despite industrial progress, material welfare has not increased. He, therefore, holds that for

better distribution, intervention by the state is essential. He desired that the costs of production should be

distributed according to the ability of individuals to bear them and commodities should be allotted according

to the capacity of the individual to derive utility from them. Thus, he proposes social reform through

equitable distribution of the surplus produced under scientific process of production on the basis: ‘from each

in accordance with his ability and to each in accordance with his needs.’ He, therefore, suggests the

establishment of social control. Under his scheme, artistic activity and experimental industries should be let

free. New industries would be subject only to laws relating to minimum wages and high taxation of profits.

Professions would be parts of the governmental service. Public utility industries and those tending to

monopolistic position would be socialized. Thus, he proposes a happy blending of freedom and control,

supported by wage and other social legislation.

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E. Evaluation

Hobson’s analysis has been a subject of severe criticism at the hands of professional economists. It

has been pointed out that Hobson failed to provide us with a criterion for the measurement of

human costs. His reform proposal based on the measurement of human welfare can not be adopted

in case the measurement is not possible. Similarly, his contention that the man who enjoys his work

should be paid less than a man who does not enjoy his work. Despite the weakness in Hobsonian

analysis, he was undoubtedly one of the important inspirations to Keynes.

Criticisms

Some, such as economists in the tradition of the Austrian School, doubt whether a cardinal utility

function, or cardinal social welfare function, is of any value. The reason given is that it is difficult to

aggregate the utilities of various people that have differing marginal utility of money, such as the

wealthy and the poor. Also, the economists of the Austrian School question the relevance of pareto

optimal allocation considering situations where the framework of means and ends is not perfectly

known, since neoclassical theory always assumes that the ends-means framework is perfectly

defined. Some even question the value of crdinal utility functions. They have proposed other means

of measuring well-being as an alternative to price indices, "willingness to pay" functions, and other

price oriented measures. These price based measures are seen as promoting consumerism and

productivism by many. It should be noted that it is possible to do welfare economics without the use

of prices, however this is not always done. Value assumptions explicit in the social welfare

function used and implicit in the efficiency criterion chosen make welfare economics a highly

normative and subjective field. This can make it controversial.

3.3.1 New Welfare Economics

A new type of welfare economics quite different from that developed by Pigou and his followers

Vilfredo Pareto and others. Paretian optimality came to the forefront in which optimum decision of

income is the one from which none can gain additional utility or satisfaction through a redistribution

with out some one losing some utility in the process. The Paretian tide of the 1930s rolled in on the

back of the Hicks-Allen ordinal utility function, where the "number of utils" is not clearly a number

at all, much less one that can be ascertained and manipulated by an external observer. This was

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taken up as a direct assault on the old English utilitarianian tradition that had been kept alive by

Arthur C. Pigou and the Cambridge Marshallians. This stand was further refined to bring in a

distinction between efficiency and equity dimensions of redistribution. It has further been extended

by Edgeworth, Hicks, Kaldor, Barone, Scitovsky, etc. The new welfare economics is normative in

character and is free from value judgments and utility measurement.

The one thing that distinguishes “new” from “old” welfare economics is the search for welfare

propositions that do not rest on interpersonal comparisons of utility, happiness or well-being.

NWE emerged in the 1930's as Robbins (1932) argued that interpersonal comparisons of utility are

essentially normative and unscientific. Robbins' critique had a great impact, and old welfare

economics with interpersonal comparisons was transformed into new welfare economics without

interpersonal comparisons. Robbins' main argument was that ''introspection does not enable A to

measure what is going on in B's mind, nor B to measure what is going on in A's.'' He dismissed

cardinal utility outright and argued that the Pigovian defense of "equal capacities for satisfaction"

was not based on any "scientific" fact. Robbins went on to argue that, consequently, social welfare

should not be a subject of economic study at all. As utility is not comparable across individuals,

then the choice of social optimum is necessarily a normative concern, a value judgment and thus it

is not within the scope of economic "science". Economics "is incapable of deciding as between the

desirability of different ends. It is fundamentally distinct from Ethics.". The Paretian welfare

theorems, which rest comfortably on ordinal utility, was deemed the only acceptable criterion.

The Robbins argument troubled some contemporaries. Roy Harrod posed the question as to

whether Robbins' argument would allow any policy recommendations at all. As long as somebody

suffers from a policy measure, Harrod argued, the Pareto-improvement criteria (everyone better off,

nobody made worse off) does not apply and thus, by Robbins's argument, economists are not in a

position to judge such a measure. There are very few, if any instances, where a policy proposal is

clearly Pareto-improving. Harrod proposed an interesting exercise to Robbins: how would one

defend policy measures long advocated by economists, such as the repeal of the Corn Laws or free

trade? "If the incomparability of utility to different individuals is strictly pressed, not only are the

prescriptions of the welfare school ruled out, but all prescriptions whatever. The economist as an

advisor is completely stultified" (Harrod, 1938).

48

His conclusion was that ''There is no way of comparing the satisfactions of two different people''.

However, many Paretians, as could be expected, were dissatisfied Robbins's conclusion and

launched the "New Welfare Economics" movement in 1930s. New Welfare Economics accepted

the argument that utility is not comparable across people, but nonetheless thought that welfare

judgements could nonetheless be made by appropriate modifications of the concept of Pareto-

optimality. Roughly speaking, the Robbinsian, the Harvard, the LSE and the Distributist positions

were the four sides involved in the debate over the New Welfare Economics that raged for over a

decade in the 1940s, a debate whose terms and tone changed considerably after Kenneth J. Arrow's

famous "Impossibility Theorem" (Arrow, 1951). We take up first the L.S.E. theory, and consider

the Harvard theory later. We treat Arrow's theory elsewhere

We can divine two strains of New Welfare Economics, which we shall call the "Harvard" and the

"L.S.E." positions, respectively. The "Harvard" position is associated mainly with Abram Bergson

(1938) and Paul Samuelson (1938, 1947, 1950). Roughly, the Harvard position accepts that

individual utilities are not comparable and also accepts Robbins's contention that the choice of

social optimum is a normative issue. However, unlike Robbins, it does not accept that it lies outside

the purview of economics.

The "L.S.E." position, expounded by Nicholas Kaldor (1939), John Hicks (1939) and Tibor

Scitovsky (1941), is a bit braver. Again, it accepts that individual utilities are not comparable, yet it

does not regard social choice as a normative issue, but rather a clearly positive one. All that is

necessary is to construct the proper criteria for comparison of social situations which does not

involve value judgments of any sort, that one can make the same welfare conclusions regardless of

whether "one is a liberal or a socialist, a nationalist or an internationalist, a christian or a pagan"

(Hicks, 1939).

As it turned out, welfare economics without interpersonal comparisons was still a potent school of

thought. There are three objectives of the new welfare economics:

a. To clarify and express in terms of quantity the vague concepts of riches;

49

b. To clarify what it is that the economists have to say on matters of public policy which are, from the

economic point of view, desirable or not; and

c. To develop those propositions which are scientifically free from ethical considerations and which can

serve as a basis for policy making.

Regarding the first objective economists says that economics is primarily concerned with the material and

immaterial commodities which are produced, distributed, exchanged and consumed, and not with man as a

producer, distributor, exchanger and consumer. In this sense the economic welfare in a country would

increase proportionally with an increase in the national income. The second objective is concerned, it relates

to the social optimum, which is the centre of gravity of welfare economics. By social optimum is meant the

maximum social utility which can be had by adding the utilities of all individuals. With regard the third

objective it includes the following: All taxes should be as far as possible non-marginal or in the form of lump

sum. There should be a perfect market, that is, a market in which price is the same for all individuals. In such

a situation all individuals would be in a position to maximize their profits or satisfaction; and conditions of

social optimum can be fulfilled only under a system of well-planned socialism and not under capitalism in

which the conditions of perfect competition do not exist.

The new welfare economics approach is based on the work of Hicks, and Kaldor. They explicitly

recognize the differences between the efficiency part of the discipline and the distribution part and

treat them differently. Questions of efficiency are assessed with criteria of as Pareto efficiency and

the Kaldor-Hicks compensation tests, while questions of income distribution are covered in social

welfare function specification.

Below is a brief description of the central concepts, tools and results in NWE: Ordinal preferences,

indifference curves, the Edgeworth box, Pareto efficiency and the two fundamental theorems of

welfare economics, the Kaldor-Hicks compensation criteria and the Bergson-Samuelson social

welfare function.

50

3.3.2.1 Basic assumptions and tools to new welfare economics.

I. Ordinal preferences and indifference curves

NWE rests on the assumption of rational preferences. The notion of rationality here essentially only

states that preferences are complete and transitive. Completeness means that for pair-wise

comparisons of all available alternatives, an individual can always state which alternative s/he

prefers the most or state that she is indifferent between the two. Transitivity means that if the

individual prefers alternative a to alternative b, and b to c, then she must also prefer a to c. Rational

preferences can be described by a utility function u, so that u(x) > u(y) if and only if x is preferred

to y. Thus, in NWE the utility function is not a measure of well-being, happiness or welfare: it only

describes the order in which an individual ranks different alternatives.

A graphical way of illustrating preferences is by using indifference curves. Mathematically, these

are the level curves of the utility function. The indifference curve separates preferred from less

preferred alternatives, and the name comes from the fact that the individual is indifferent between

all the alternatives that lie exactly on the curve. An important assumption often made is that

preferences are convex.

II. The Edgeworth box, Pareto efficiency and the two fundamental theorems of

Welfare economics

The Edgeworth box (also known as the exchange box) is a central tool in NWE and it is used in

almost every modern textbook in Economics. It illustrates all possible allocations of two goods

among two individuals whose preferences are illustrated with indifference curves drawn in the box.

Any point in the box represents an allocation of the two goods between the two individuals. Given

any initial allocation of the two goods, it may be possible for both individuals to engage in

voluntary exchange in order to improve their situation. For some allocations, it is not possible to

reach preferred allocations through voluntary exchange. These allocations are called Pareto efficient

or Pareto optimal. The contract curve connects all Pareto efficient allocations. There are drawbacks

of the Edgeworth box, as is the case with all simplified models. Notably, the analysis is static and

there are no transaction costs. On the other hand, the analysis can be generalized to an economy

51

with a large number of consumers and a large number of goods. It can also be extended to

incorporate a production technology that converts certain goods (inputs) to other goods (outputs).

In the two-dimensional version the Edgeworth-box is often used to illustrate the two fundamental

theorems of welfare economics: The first theorem states that any competitive equilibrium is Pareto

efficient.

The second theorem states that any Pareto efficient equilibrium can be reached through an

appropriate redistribution of the initial endowments. Note that both theorems require a number of

assumptions to hold, the second theorem being the more demanding, as it requires convex

preferences and that the production technology does not exhibit increasing returns to scale.

However, the two theorems do not require interpersonal comparisons of utility.

A policy is said to pass the Pareto criterion if it raises the utility of at least one individual without

rendering anyone worse off in terms of utility. Equipped with only the Pareto criterion and the two

theorems, economists are handicapped in two ways. First of all, there may be several allocations

that are all Pareto efficient but no criterion regarding how to chose between these allocations.

There are many combinations of consumer utility, production mixes, and factor input combinations

consistent with efficiency. In fact, there is infinity of consumer and production equilibria that yield

Pareto optimal results. There are as many optima as there are points on the aggregate production

possibilities frontier. Hence, Pareto efficiency is a necessary, but not a sufficient condition for social

welfare. Each Pareto optimum corresponds to a different income distribution in the economy. Some

may involve great inequalities of income. So how do we decide which Pareto optimum is most

desirable? This decision is made, either tacitly or overtly, when we specify the social welfare

function. This function embodies value judgements about interpersonal utility. The social welfare

function is a way of mathematically stating the relative importance of the individuals that comprise

society.

A utilitarian welfare function (also called a Benthamite welfare function) sums the utility of each

individual in order to obtain society's overall welfare. All people are treated the same, regardless of

52

their initial level of utility. One extra unit of utility for a starving person is not seen to be of any

greater value than an extra unit of utility for a millionaire. At the other extreme is the Max-Min, or

Rawlsian John Rawls utility function. According to the Max-Min criterion, welfare is maximized

when the utility of those society members that have the least is the greatest. No economic activity

will increase social welfare unless it improves the position of the society member that is the worst

off. Most economists specify social welfare functions that are intermediate between these two

extremes.

The social welfare function is typically translated into social indifference curves so that they can be

used in the same graphic space as the other functions that they interact with. A utilitarian social

indifference curve is linear and downward sloping to the right. The Max-Min social indifference

curve takes the shape of two straight lines joined so as they form a 90 degree angle. A social

indifference curve drawn from an intermediate social welfare function is a curve that slopes

downward to the right.

The intermediate form of social indifference curve can be interpreted as showing that as inequality

increases, a larger improvement in the utility of relatively rich individuals is needed to compensate

for the loss in utility of relatively poor individuals. A crude social welfare function can be

constructed by measuring the subjective dollar value of goods and services distributed to

participants in the economy.

Secondly, strict Paretian economics can not advocate policies where some individuals are worse off

as a result of the policy. Most actual situations that economist must analyze involve choosing

53

between policies that result in some people being worse off, and thus the Pareto criterion is violated.

For example, mainstream economists today advocate abandoning the common agricultural policy

(CAP) in the European Union. This advice does however not rest on the Pareto criteria. Even if

consumers worldwide and producers outside the EU would benefit from a free trade oriented policy,

it is a fact that there are producers inside the union that would be losers if such a policy were to be

carried out. These two problems illustrate the weakness of the Pareto criterion. This weakness

spawned two different schools of thought in NWE: The Kaldor-Hicks position and the Bergson-

Samuelson position, dealt with in the next section.

3.3.2.2. The Kaldor-Hicks compensation criterion and the Bergson-Samuelson

social welfare function

The Kaldor-Hicks approach to NWE (also called the LSE-position, from London School of

Economics) attempted to show that the choice of social optimum was a positive question rather than

a normative. To determine whether an activity is moving the economy towards Pareto efficiency,

two compensation tests have been developed. Any change usually makes some people better off

while making others worse off, so these tests ask what would happen if the winners were to

compensate the losers. The original Kaldor-criterion amounted to saying that a change that does not

pass the Pareto criteria should still be carried out if it is possible for the gainers from the change to

compensate the losers, and still be better off them selves. Pareto’s stand was modified to say that

income distribution becomes more efficient if, through redistribution, gainers gain more than is the loss of

the losers; in that case the gainers can compensate the losers and still be better off. This had been known as

the Kaldor principle. That is, Kaldor argued in favor of ignoring the equity dimension by pointing out that

the economist should leave the equity decision to the state/legislature. He said that if the gainers can

potentially compensate the losers and still gain after redistribution, the redistribution is welfare enhancing.

Later on, this compensation principle was modified and it was pointed out that the gainers need not actually

compensate the losers.

Hicks proposed a slightly different version, according to which a change should be carried out if it

is impossible for the losers to bribe the winners to abstain from the change. Using the Kaldor

criterion, an activity will contribute to Pareto optimality if the maximum amount the gainers are

prepared to pay is greater than the minimum amount that the losers are prepared to accept. Under

the Hicks criterion, an activity will contribute to Pareto optimality if the maximum amount the

54

losers are prepared to offer to the gainers in order to prevent the change is less than the minimum

amount the gainers are prepared to accept as a bribe to forgo the change. The Hicks compensation

test is from the losers' point of view, while the Kaldor compensation test is from the gainers' point

of view. If both conditions are satisfied, both gainers and losers will agree that the proposed activity

will move the economy toward Pareto optimality. This is referred to as Kaldor-Hicks efficiency or

the Scitovsky criterion.

Seemingly, the compensation criterion solved the problem of for example not being able to

advocate abandoning trade barriers: If the gain from free trade is large enough, the winners can

potentially compensate the losers. Whether compensation actually should take place or not is

strictly a matter of politics, not economics, according to this view. Little (1950) pointed out that if

the possibility of hypothetical compensation is enough to pass a certain policy, then the Kaldor-

Hicks criterion collapses into favoring policies that increase total real income regardless of

distributive considerations. Thus, the compensation criteria expanded the set of acceptable policies

without making the Pareto-criterion any more specific, resulting in increased rather than decreased

indeterminacy.

3.3.2.3. Bergson-Samuelson approach to new welfare economics

The Bergson-Samuelson branch of NWE (sometimes referred to as the Harvard-position) was more

successful in establishing criteria for a social optimum, but also used a more controversial method:

the social welfare function (SWF), introduced by Abram Bergson (1938). It is written

W = f( u, u2, u3…….un )

Social welfare W depends only on the utilities of the n individuals in society (u1... un). The SWF

assigns a value to each possible distribution of individual utilities in society. Depending on the

functional form, the social welfare function will exhibit different normative characteristics. A

particularly convenient form based on the Atkinson (1970) inequality index is

1

11

1

n

i

i

W u

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Where ρ can vary from 0 to ∞. This specification allows for varying degrees of inequality aversion.

For ρ=0 we get the pure utilitarian case, where society's utility is the sum of all individuals' utility.

As ρ approaches infinity, we get W = min(u1,...,un). It should be noted that neither Bergson nor

Samuelson was clear about the extent to which the SWF requires interpersonal comparisons of

utility. This changed during the debate that followed Arrow's famous theorem, first presented in

Arrow (1951) and then again in Arrow (1963). Arrows result proved the impossibility of

aggregating individual preferences into collective preferences under surprisingly weak conditions.

The reaction from the Bergson-Samuelson school was that this result had no implications for

welfare economics. However, the debate that followed the theorem made it (more or less) clear that

the Bergson-Samuelson SWF must either make interpersonal comparisons or be dictatorial.

However, the utilitarianian did not just evaporate and die but were given a new coat a point and

relabeled as the "Distributists". Ian M.D. Little led the charge against New Welfare Economics.

Specifically, Little argued that individual utilities are comparable in a scientific manner, and thus

the choice of social optimum is a positive issue which economists should, indeed must, analyze.

Little's basic argument, reiterated by Dennis H. Robertson (1950, 1951), is almost "behaviorist" in

tone. We need not worry so much about "utility and all that" but concentrate instead on things we

can empirically see, such as people's reactions to income. We can safely say that a dollar to a poor

man means more than a dollar to rich man. This does not rely on "interpersonal comparisons of

utility" in a formal sense, but it is plain common sense, i.e. an empirically-validated hypothesis.

We should also mention that the old utilitarian "stochastic argument" for equity, that had been

forwarded earlier by Edgeworth was reiterated by Abba P. Lerner (1944: p.24-32). Admittedly,

Lerner argued, we do not know what people's "capacities for satisfaction" are, and thus we have no

way of compare the utility gains of one person with the utility losses of another from a proposed

policy. However, the statistical expression for the term "we do not know" translates itself into

saying that every alternative is equally likely. This is Laplace's principle of indifference.

Consequently, as we do not have any reason to assume Mr. A has a greater capacity for satisfaction

than Mrs. B, then we can do no better than to assume they have equal capacities for satisfaction. It

is in this manner, then, that Lerner drives us right back into the arms of Pigouvian welfare theory

and his famous result that "if it is desired to maximize the total satisfaction in a society, the rational

56

procedure is to divide income on an egalitarian basis" (Lerner, 1944: p.32). [for a critique of Lerner,

see Milton Friedman (1947)].

Finally, we should mention that the Oskar Lange (1936, 1938) and Abba Lerner (1934) also

resurrected the old Pareto-Barone position on the efficiency of a socialist society thus reigniting the

"Socialist Calculation debate" with the Austrian economists.

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CHPTER 4: THE KEYNESIAN AND POST KEYNESIAN SCHOOL OF THOUGHT

4.1 Keynesian School of thought

Introduction

The Keynesian system of ideas is one of the most significant schools of economic thought in 20th

century. The school begun with the publication of “General theory of Employment, Interest and

Money” of Marald Keynes in 1936, and remains a major thought in orthodox economics today. It

arouses out of the condition of the time such as great depression and failure of the neo classical

school theories. Keynes idea succeeded in short time, in revolutionarizing the entire thinking

process in economics. For this reason it is termed as “Keynesian Revolution”. It is also called as

“New economics” because he integrated the economy as incorporating both physical and monetary

aspects. Further more; he introduced the techniques of presenting economy in terms of international

income and employment and the determinant of demand and supply functions rather than individual

price determination.

The school was criticizing many of principles and theories of neo-classical thought. Keynesian

economics advocates a mixed economy; predominantly private sector, but with a large role of

government and public sector. The school argues that private sector decisions sometimes lead to

inefficient macroeconomic outcomes and hence advocates active policy responses by state. The

policy response includes monetary policy actions by the central bank and fiscal policy actions by

the government with the major emphasis on the latter.

The school of thought served as economic model during the latter part of the Great Depression,

World War II, and the Post-War Golden Age of Capitalism, 1945–1970, though it lost some

influence following the stagflation of the 1970s. As a middle way between laissez-faire capitalism

and socialism, it has been and attacked from both the right and the left. In this chapter, we will see

the works of Keynes and basic historical background of the Keynesian thought.

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The historical background of the school

Keynesian economic thought was the product of empirical changes experienced from the time of

Adm Smith to early 20th

century mainly the great depression and intellectual works ,which includes

among other, works of Smith, Ricardo, socialist writers, Mitchell, Marginalist writers and

neoclassical writers. The American as well as the world economy was ragged downturn as a result

of many factors before and after 1929. More specifically, the situation of World War I, growth of

large scale industrial production in Western, declining trend in productivity of capital, intense

competition, government intervention schemes and economic conditions during depression, and so

on.

Over a century firms grew to large scale industries and industrial production, and trade. With

growth of industries, competition became intense. The competitions reduced return on the rate of

replacements of old machine with new and better once. As a result of these additional investments

were low and there were growing accumulated deprecations fund from the past investments over

time as they were not spent quickly enough. Further more, the mature private enterprise economies

of the Western World were not growing at a faster rate (rate expected) owing to declining rate of

growth of population, absence of rooms for further geographical expansion as most of the areas

were already colonized. As a result production appeared to outrun consumption as income and

saving rose. It made the economy more susceptible to statistical measurement and control, making

the inductive aggregate approach more feasible than in the past.

On the other hand, in the economies of the Western there were declining trend in huge productive

investments especially in area of infrastructures. There were no new inventions and innovations as

there were loss of incentives. Further more, there were decline in productive investment in

productive sectors like steam engine, the rail road, electricity, automobile that stimulate new and

vast capital investments and induce growth in other sectors of the economy. Besides, WWI

destructed many countries of the Western world. Those war destructed countries of the world

adopted mechanism to rehabilitate their economy through government interventions. The

government interventions enacted recovered economies of those countries necessitated looking at an

overall view of the economy.

59

The Great Depression of the 1930s was the longest, most widespread, and deepest depression of the

20th century that had been experienced by western world and then propagated to the rest of the

world. The Great Depression had devastating effects in virtually every country, rich and poor. But

it drastically affected the economies of USA, Chile, France, Germany, Japan, Latin America,

Netherlands, South Africa, Soviet Union, Canada, Australia, etc. The timing of the Great

Depression varied across nations, but in most countries it started around 1929 and lasted until the

late 1930s or early 1940s.

There were disagreement as to the cause and effects of Great Depressions by scholars: economists,

historians, and scholars. According to historians, the decline in the US economy was the factor that

pulled down most other countries at first, and then internal weaknesses or strengths in each country

made conditions worse or better. Historians most often attribute the start of the Great Depression to

the sudden and total collapse of US stock market prices on October 29th, 1929, known as Black

Tuesday and it was quickly spread to almost every country in the world. There were multiple causes

for the first downturn in 1929, including the structural weaknesses and specific events that turned it

into a major depression and the way in which the downturn spread from country to country.

However, some dispute this conclusion, and believe the stock crash as a symptom, rather than a

cause of the Great Depression. Beginning in the summer of 1930, a severe drought ravaged the

agricultural heartland of the USA.

As a result of series problems, by mid-1930, consumer spending, many of whom had suffered

severe losses in the stock market in the previous year, cut back their expenditures by ten percent;

automobile sales had declined to levels below the 1928. Investments were depressed as interest

rates had dropped to low levels as there was reluctance on the side people to add new debt by

borrowing. Prices in general began to decline, but wages held steady. Farming and rural areas

suffered crop prices fall by approximately 60 percent. Further more, unemployment in the United

States rose to 25% and in some countries rose as high as 33%. Cities all around the world were hit

hard; especially those depend on heavy industry. Construction was virtually halted in many

countries. Conditions were worse in farming areas, where commodity prices plunged and in mining

and logging areas, where unemployment was high and where there were few other jobs. Facing

60

plummeting demand with few alternate sources of jobs areas dependent on primary sector industries

such as cash cropping, mining and logging suffered the most.

Similar situations and economic activities were experienced by other countries mainly in Western

World. For instance, France, Germany. In general in almost all countries as a result of depression

personal expenditure declined, unemployment increased, Poss of incentive on part of business on

productive investment, tax revenue declined, profits and prices dropped, and international trade

plunged by half to two-thirds. Frantic attempts to shore up the economies of individual nations

through protectionist policies, such as the 1930 U.S. Smoot-Hawley Tariff Act and retaliatory tariffs

in other countries exacerbated the collapse in global trade.

People question the neoclassical economic thought on actual observations and historical studies.

Many scholars proposed government interventions through public work programs, deficit budgets

for the federal government, easing of credit by the Federal Reserve System. British economist, John

Maynard Keynes, provided the scientific analytical framework. He wrote a book entitled “The

general Theory of Employment, Interest and Money” in 1936. Rejecting classical approach

Keynes held the view that mal-adjustment in economic system of a country was a normal feature

which lead the national economy to the ravages of trade cycle. He argued that lower aggregate

expenditures in the economy contributed to a massive decline in income and employment that was

well below the average. In such a situation, the economy reached equilibrium at low levels of

economic activity and high unemployment. For the smooth and uninterrupted functioning of the

national economy, he suggested state intervention. More specifically, during times of economic

crisis to pick up the slack by increasing government spending and/or cutting taxes.

Different countries of the world adopted and implemented the policies recommendations of Keynes

and hence recovered their economy. Countries started to recover by the mid-1930s, but in many

countries the negative effects of the Great Depression lasted until the start of World War II. The

common view among economic historians was that the Great Depression ended with the advent of

World War II when nations increased their expenditure on production of war materials. Many

economists believed that government spending on the war caused or at least accelerated recovery

from the Great Depression. The massive armament policies leading up to war helped countries

61

stimulate their economies from 1937-39. In Europe for instance, by 1937 unemployment in Britain

had fallen to 1.5 million. The mobilization of manpower following the outbreak of war in 1939

finally ended unemployment. In the United States, massive war spending doubled economic growth

rates, either masking the effects of the depression or finally eliminated the last effects of the great

depression and brought the unemployment rate down below 10%.

Many factors legitimize the Keynesian economics during this period. One was the advancement in

technology that transformed the nature of economics from theoretical to quantitative helped

Keynesian policies recommendation and complementation. The other was development of national

income accounting (NIA) methods that made economists to get access to macroeconomic data on

output, employment and prices, in addition to the traditional data on interest rate and money supply.

Moreover, the methods devised to compute NIA were based on aggregate quantities of

consumption, investments, and government spending suggested by Keynes. Besides, expansion in

computer sciences and power enabled economists to formally test some of the hypothesis suggested

by Keynes in a more rigorous ways.

Keynes biography

He was born in 1883 in Cambridge, England, to Florence Ada Keynes and John Neville Keynes.

His father was a distinguished writer on political economy and logic, and for many years the

registrar of the Cambridge University. Keynes graduated from Cambridge University in 1905 in the

Mathematical Tripos and then he entered the Indian civil service. In 1909, he became a fellow at

King’s College where he started teaching economics in Marshallian tradition. In 1912, he was

chosen editor of the economic journal and shouldered his responsibility till his death. He was the

leader of the British delegation to the Bretton Woods Conference in 1944 and served as a Governor

of the J.B.R.D. and I.M.F. He served his country in various capacities. In appreciation of his

services to the nation; his government made him the first Baron of Tilton in 1942.

Keynes contributes a lot to the development of economic thought especially after the occurrence of

Great Depression. His publications include: Indian Currency and Finance (1913), The Economic

consequences of the peace (1919), A Treatise on probability (1921), A Revision of the Treaty

(1922), A Tract on Monetary Reform (1923), A Short view of Russia (1925), The Economic

consequence of Mr. Churchill (1925), The End of Laissez Faire (1926), A Treatise on Money

62

(1930), Essays in Persuasion (1931), Essay in Biography (1933), The Means to Prosperity (1933),

The General Theory of Employment, Interest and Money (1936), and How to Pay for the War

(1940). Besides he wrote about 300 articles and about 50 reviews on official and non-official

reports.

He revolutionized economics with his classic book. With the pretentious title of “The General

Theory of Employment, Interest and Money”. Heavily anticipated, cheaply priced and

propitiously timed for a world caught in the grips of the Great Depression. The General Theory

made a splash in both academic and political circles. This is generally regarded as probably the

most influential social science treatise of the 20th

Century. The General Theory is a monumental

work and can easily be grouped with Smith’s “Wealth of Nations”. It has been truly remembered

that “no book in economics has ever made such a stir within the first ten years of its publication as

has the General Theory”.

The general theory of Employment

The most important theory of Keynes was the theory of employment. Keynes criticized and rejected

the classical theory of employment which denied the existence of unemployment or over production

in the economy. The starting point of Keynesian theory of employment is the concept of effective

demand. According to Keynes employment depends on effective demand and hence unemployment

is due to lack of effective demand.

Interest and money

According to Keynes, interest is the reward for parting with liquidity. Liquidity preference is the

preference of the people to keep their assets in the form of money. He argued that saving and

investment are not the main determinants of interest rates, especially in the short run. According to

him, the rate of interest is determined by the supply of money (Central Bank of a Country) and the

demand for money (liquidity preference due to transaction, precautionary and speculative motives).

63

Keynes developed the liquidity preference theory of interest according to which liquidity preference

and supply of money determines the rate of interest.

THEORY OF MONEY AND PRICES

The classical economists had rigidly separated the monetary theory from the general economic

theory. For them, the monetary theory was only the theory of prices. According to them, monetary

expansion led straight to an increase in the price level, without affecting out put, and employment in

existence. It is on this account that they established a direct link between monetary expansion and

the price level. The same thought were there with Keynes before 1930s. Keynesian analysis of price

is quite close to classical analysis. They agree with the orthodox views that increase in the quantity

of money in circulation leads to an increase in the price.

It was in 1930 that his old conception of the monetary theory underwent a change. From a monetary

theory of prices, he shifted to a monetary theory of output. He reformulated quantity theory and

spotlighted the process of causation and the factors determining the value. Keynes has differed from

traditional economists in the process through which this effort is caused. Keynes tried to fill the gap.

He pointed out that there existed only an indirect relationship between price and the quantity of

money. The changes in the quantity of money are influenced by the rate of interest, which in turn,

affected investment, income, output and prices. Monetary expansion led first to an increase in the

output. As the output continues to expand, certain new factors come into existence which leads to a

rise in costs. The rise in costs due to the inelastic supply of certain factors of production. The net

result is that a successful integration of the quantity theory of money with the theory of output and

the theory of value.

According to him, the finding out of the exact process through which the quantity of money affects

the price level, would involve the following measures;

a) Finding the relation between money and aggregate demand

b) Assessing the effect of changes in aggregate demand on output and

c) Taking into account, the change in the wage rates.

Increase in the supply of money is likely to increase the availability of funds to a certain extent, for

64

speculative purposes. An increase in money supply tends to lower the rate of interest and increase

the demand for investment, which ultimately leads to an increase in income, employment and

output. This increased output can only be possible at an increasing cost beyond a contain point.

Wages form the most important constituent of the cost of production. During the period of

expanding output, labor will become increasingly scarce and the wage rates will be depending on

the bargaining capacity of the laborers.

It may be possible that a change in money wage rates may cause a change in the investment. Neo-

classical theory supports that the two main costs that shift demand and supply are wage and money.

Through the distribution of the monetary policy, demand and supply can be adjusted. If there were

more labor than demand for it, wages would fall until hiring began again. If wage rate decline, the

rate of real investment can be affected in three Ways: in the first instance, affect the business

confidence. The individual businessmen may think that a cut in the money wage rate reduces their

costs. On the other hand, a cut in wage rates and prices increase the real burden of the debt of the

entrepreneurs. A cut will stimulate demand for exports and lead to increased consumption of home

goods as compared to foreign goods. This would result in an increase in the real investment and

finally in the real income and total employment in the currently. Similarly, the marginal efficiency

of capital is not changed by a change in money wage rate.

A rise in money wage rates would lead to an opposite situation. It may be possible that these effects

may be neutralized by corresponding change in the wage rates of exchange rates in other countries.

A change in the money wage rates, prices and money incomes brings out a change in the demand

for cash balances for transportation purpose, in the same direction. If the quantity of money in

circulation remains the same, a reduction in the money wage rates would leave a larger supply of

money to satisfy the demand for cash balances. The rate of interest would fall and thus, the rate of

real investment would increase. Like wise, an increase in money rate would increase the interest

rate and diminish the rate of real investment. This is how Keynes could justify the relationship

between money wage rates in a closed economy.

The problem of greater depression was differently interpreted by classical and Keynesian .To

classical theory, economic collapse as simply a lost incentive to produce. To Keynes, the

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determination of wages is more complicated. First, he argued that it is not real but nominal wages

that are set in negotiations between employers and workers, as opposed to a barter relationship.

Second, nominal wage cuts would be difficult to put into effect because of laws and wage contracts.

Even classical economists admitted that these exist. However, to Keynes, people will resist nominal

wage reductions, even without unions, until they see other wages falling and a general fall of prices.

Keynes also argued that to boost employment, real wages had to go down: nominal wages would

have to fall more than prices. However, doing so would reduce consumer demand, so that the

aggregate demand for goods would drop. This would in turn reduce business sales revenues and

expected profits. Investment in new plants and equipment already discouraged by previous excesses

and would then become more risky, less likely. Instead of raising business expectations, wage cuts

could make matters much worse. Further, if wages and prices were falling, people would start to

expect them to fall. This could make the economy spiral downward as those who had money would

simply wait as falling prices made it more valuable rather than spending.

MULTIPLIER

The concept of multiplier was first developed by R.F. Kahn. Keynes borrowed this concept from

him and developed income and investment multiplier. To him, investment multiplier expresses the

relationship between an initial increase in investment and the final increase in national income.

Multiplier is the ratio of a change in investment to change in income. That is K= I/Y and, where

Y= income, K= multiplier I= investment. The value of multiplier depends on marginal propensity to

consume. The ratio between an increment of investment and the resultant increment of the total

income, the creation of one gives rise to a number of waves. Similarly, in economy each injection of

money gives rise to a series of new money. The multiplier is, thus, a number by which the increase

in investment must be multiplied in order to give the resulting increase in income. If investment of

Birr 1 causes an increase in the total income by Birr.3, then the multiplier is 3. In case the increased

income amount to Br 2 is the multiplier is 2. Thus multiplier, in short, is a numerical co-efficient,

indicating how great an increase in income result from each increase investment.

How and why the increase in the total income is more than proportionate to the increase in the

investment? Because, with each investment, the expansion in production and national income is

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much more than the primary investment. A pan of increased income will be spent by the wage

earners and by the recipients of profits and interest. Increase in receipt also increased income to

others in the economy. If the total of these secondary incomes was immediately spent, the increase

in second income would be so rapid at each turn-over that it would result in maximization of

income and full employment. Thus increased income will again be spent and the process will go

on repeating. If the process continues. At each step, the increase in spending is smaller than in the

previous step, so that the multiplier process tapers off and allows the attainment of equilibrium. This

story is modified and moderated if we move beyond a "closed economy" and bring in the role of

taxation. To him tax payments at each step reduces the amount of induced consumer spending and

the size of the multiplier effect.

Keynes explained that neither savings nor investments are functions of interest rate. Savings

depend on the capacity of interest of the people to save and this capacity is determined by income.

So S= f(y) and not interest rate. Just if the rate of interest is high, people will not starve and save

money when their are low. Investment is also not a function of interest rate, the rate of return or

profit which determines the investment. Investment is a function of MEC and not so mere interest

rate flexibility cannot bring about an between savings and investment.

The concept of multiplier establishes a precise relationship between aggregate income and the rate

of investment (which is function of marginal propensity to save), assuming the marginal propensity

to consume remain the same. The multiplier explains the level of employment expected from a

given fluctuation in investment. This concept gives an insight into the working of the economy and

the part played by the psychological desire among men to save or consume. To him, savings during

depression are likely to make depression worst and reduce the level of income. High consumptions

and high investment should, however, go hand in hand and should not compete with each other.

This is why Keynes thought that government spending on productive purposes may produce or

multiplied increase in employment.

To Keynes knowledge of multiplier is of supreme importance not only in analyzing the course of

business cycles but also in devising an ant cyclical policy to smoothen the business fluctuation in

the working of the economy. The concept of multiplier has brought about a revolution not only in

economic theory but also in policy making at the state level.

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The concept of multiplier plays an important role in understanding the nature of cyclical

fluctuations in income and other macro variability, the process of income propagation and policy

making.

KEYNES AND THE UNDERDEVELOPED COUNTRIES

Keynesian economics was primarily concerned with the problem of economically advanced

countries, and therefore said little about the underdeveloped countries. The General Theory is not

general in the sense that it is inapplicable in all places and at all times. It was written in environment

of developed countries, was meant to solve problems of these countries. It can not directly applied

to problems of underdeveloped countries. Because, the root of the problem, the nature of

unemployment are quite different from that prevailing in the advanced countries and with which

Keynes was concerned. Unemployment, in the advanced countries, is due to the deficiency of

effective demand. In a rich country as income and output increases, consumption expenditure does

not increase at the same rate because of high marginal propensity to save.

Effective Demand: Unemployment is caused by the deficiency of effective demands and to get

over it. The concept of effective demand is applicable to those economies where unemployment is

due to excess saving. But in an underdeveloped economy, income levels are extremely low, the

propensity to consume is very high and savings are almost nill. Here, the problem is not one of

raising the effective demand but one of raising the levels of employment, and per capita income in

the context of economic development.

Propensity to consume: One of the important tools of Keynesian economics is the propensity to

consume which highlights the relationship between consumption and income. When income

increases, consumption also increases but by less than the increment in income. This behavior of

consumption further explains the rise in saving as income increases. In underdeveloped countries

these relationships between income, consumption and saving do not hold. Peoples are very poor and

their marginal propensity to consume is very high. The Keynesian economics tells us that when the

MPC (marginal propensity to consume) is high, consumers demand, out put and employment

increases at a faster rate with the increase in income. But in an underdeveloped countries it is not

possible to increase the production of consumer goods due to the scarcity of cooperate factors when

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consumption increases with the rise in income. As a result prices rise instead of rise in the level of

employment.

On the saving side: Keynes regarded saving as a social vice. It is excess of saving that leads to a

decline in aggregate demand. Again, this idea is not applicable to underdeveloped countries because

saving is the panacea for their economic backwardness. Underdeveloped countries can progress by

curtailing consumption and increasing saving, as opposed to the Keynesian view of raising

consumption and reducing saving. To underdeveloped economy saving is a virtue and nor a vice.

Marginal efficiency of capital: According to Keynes one of the important determinants of

investment is the marginal efficiency of Capital. There is an inverse relationship between

investment and MEC. When investment increases MEC falls and vice versa. This relationship is

however not applicable to underdeveloped countries. In such economies, investment is at low level

and MEC is also low.

Rate of interest: of the motives for liquidity preference transaction and precautionary motives are

income elastic and they do not influence the rate of interest in advanced countries. It is only the

demand for money for speculative motive that affects the rate of interest. In underdeveloped

countries, the liquidity preference for transaction and precautionary motives is high and for

speculative purpose is low. Therefore, liquidity preference fails to influence the rate of interest.

The assumption of on which the Keynesian theory was based, are not relevant to the condition

prevailing in under developed countries. The following are the principal tools of the Keynesian

theory to test validity to underdeveloped countries.

These assumptions are:

Involuntary Unemployment: For the efficient working of the multiplier, involuntary

unemployment must exist. Involuntary unemployment means an elastic supply of labor at the going

wage rate. But, in the underdeveloped countries, the unemployment is to a large extent disguised.

An Industrialized Economy. The multiplier prior operates in an industrialized economy

where the supply of output is elastic. The underdeveloped countries are has agricultural

economies where the supply curve of output is more inelastic than that of an industrialized

economy. When investment is increased in a poor country, it raises n income and prices and

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not output.

Excess capacity in the consumer goods industries: The theory of multiplier also assumes

the existence of e capacity in the consumer goods industries so that when in and

consumption expenditure increase as a result of an increase in investment, output of

consumer goods also rises tome increased demand. In the underdeveloped countries,

production is mainly for self-consumption and not for the market. When there is an increase

in income, the high MPC tends to increase the demand for self-consumption and not the

demand in the market.

Elastic Supply of Working Capital: The multiplier effect is only possible when there is

enough supply of the working capital necessary for increased output. The underdeveloped

countries on the other hand are marked by a compares inelastic supply of the working

capital. In the field of economic policy, too, Keynes’ economic policy were not of much

help to the underdeveloped countries.

In the end, the obvious conclusion is that Keynes General Theory has no relevance to the

conditions and problems of the underdeveloped countries. On the contrary, it is the classical

theory with its emphasis on saving and capacity creation, that provides remedy for the

problem of economic development in these countries.

KEYNES VERSUS CLASSICALS

Keynes differs from the classical school in almost all aspects. Keynes school criticized each and

every concept of classical.

The classical said that there exists in the economy a state of perfect competition which

allocates resources ideally and ensures maximization of output and welfare. But Keynes

argued that perfect competition is a myth. Today’s market structure is characterized by

imperfect market which restricts output and leads to wastage of resources, and exploitation

of consumers.

The classical contributions constitute the core of micro economics’. The classical assumed a

fixed quantity of resources and concentrated on ideal allocation among firms, industries and

individual units in the economy. They studied ‘micro elements’ and implicitly believed that

what principles and rules govern, the micro problems are completely valid for macro

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problems also. Therefore no separate theory is required for macro problems. Keynesian

however argued tha, micro problems require one set of policies and for macro problems,

another set of policies is required. The same policy tools or instruments cannot be applied

for both. Macro is not a mere addition of micro elements. The nature, magnitude and

intensity of macro problems vary from that of micro problems.

According to the classical economists there is automatic self adjusting character of the

economy.The classical believed in invisible hand or flexible price mechanism which ensures

maximization in all market and also in allocation of resources and distribution of resource.

There is no such automatic or self adjusting system in Keynesian economics. If such a force

is there, depressions and booms can be easily avoided and fluctuations averted. He said that

private motives do not coincide with public welfare. So there are no invisible hands, or

automatic price mechanism which ensures the welfare of one and all in society. Artificial

hindrances in the price mechanism have led to exploitation, misallocation and improper

distribution of income.

The classical assumed full employment and there is no deviation from full employment.

Even if there are temporary deviations, the economy has the tendency to reach full

employment. Whereas Keynes stated that under employment equilibrium is the reality and

full employment is a distant goal. Achievement of full employment is very difficult and

maintenance of it on a permanent basis is still more difficult.

Wage-price flexibility is advocated by classical for solving unemployment problem. If at

anytime the economy slips down from the level of full employment it can be restored by

cutting down real wages. Since wages are determined by marginal physical product of labor

and MPL is subject to the operation of the Law of diminishing returns, more labor can: be

employed only if wages are reduced. As long as wages are flexible downwards, full

employment can be easily achieved. The classical school assumed that workers will accept a

lower wage. Thus wages are flexible both ways for them. According to Keynes, wage

flexibility is not found in the modern economy, especially downward flexibility of wages.

Modern trade unions never accept wage cut for solving disequilibrium. Keynes has

explained the following consequences if real wages are reduced: In Modern economy where

there are strong trade unions workers will not accept a reduction in real wage. The Union

may restore to strike in which case production will be completed affected.When wages are

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reduced, it may affect the consumption level of workers. A distribution of income takes

place from wage earners, whose MPC is high, to propertied class (low MPC) which means

overall reduction in consumption. Since consumption is an important element of aggregate

demand effective demand will fall short of aggregate supply and employment, instead of

increasing, will decline further.

The classical economists did not integrate the theory of value with the theory of prices or

money. While real interest rate or commodity market affects the money market, back cannot

have any influence on real market. Money is not problem creator, but just facilitates

transactions and apart that has no special significance. By inventing the speculative demand

for money, Keynes successfully interest the theory of value with the theory of prices. Both

money market and real markets are interdependent and not independently causes much

confusion in the economy. Liquidity prefers has a major impact on the level of investment

and other variables in the system. So money plays a very active role and not a role.

Critical estimates of the works of Keynes

Keynesian economics have profound influence on the world. His contribution has the following

point of strength of analysis and theory.

Keynes showed that the inherent weakness of classical economics which assumed self-

adjusting mechanism of the economy for attain full employment.

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4.2 POST- KEYNESIAN DEVELOPMENT

Emergence of the of the school

The modern macro economics field developed in response to the severe depressions, which

occurred throughout the world in 1920s and 1930s.

The “General theory of employment, interest and money” in 1936 had a huge immediate impact

Some of the major changes which necessitated involvement of government were great depression of

1930s, emergence of natural monopoly, imperfect competition, and policies to change the

economies of developing economies.

Furthermore, with Great Depression of 1930’s, scholar basic premise that the government should

intervene in the economy through fiscal policy, monetary policy, income policy to stabilize the

economy. More over, there were theories of economic development implied that government was

the only available instrument for breaking the vicious circle of poverty in developing economies.

Neo Keynesian economics

Back ground of Neo Keynesian economics

The first generation of Keynesian thought that was developed in the post-war period from the

writings of John Maynard Keynes was known by name Neo-Keynesian economics (or neo-classical

Keynesian economics). "Neoclassical-Keynesian Synthesis" was to pervade in America (and

elsewhere) as the dominant form of macroeconomics in the post-war era, particularly in the 1950s

and 1960s. Neo-Keynesian was the immediate followers that contributed to economic theory and

analysis following the publications of the general theory.

A group of economists notably John Hicks, Franco Modigliani, Paul Samuelson and others,

attempted to interpret and formalize idea of Keynes and to synthesize the neo-Keynesian models

of economics. They focused on unifying the ideas into workable paradigms by combining them with

ideas from classical economics and the writings of Alfred Marshall. For instance, these neo-

Keynesians generally looked regitiles at labor contracts as a source of price and wage stickiness to

generate equilibrium models of unemployment. Many believed that if government policy were used

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to ensure it, the economy would behave as classical or neoclassical theory predicted. Their work

has become known as the neo-classical synthesis, and created the models that formed the core ideas

of Neo-Keynesian economics.

Contributions of neo-Keynesian economics

I. IS-LM

It was with John Hicks that Keynesian economics produced a clear IS-LM model which policy-

makers could use to understand and control economic activity. It relates aggregate demand and

employment to three exogenous quantities, i.e., the amount of money in circulation, the government

budget, and the state of business expectations.

The IS-LM model has derived from Keynes’s liquidity preference (transaction motive). The IS-

curve represent all the combination of interest rate and levels of income at which planned

investment equals planned saving. The LM symbolizes equality between the demand for money (L)

and the supply of money (M). The LM-curve is a curve that shows potential points of equilibrium

in the money market. It indicates all combinations of interest rates and the levels of income at which

money supplied equals money demanded.

II. Phillips curve

This curve indicated that increased employment implied increased inflation. Keynes had only

predicted that falling unemployment would cause a higher price, not a higher inflation rate. The use

of Phillips curve to predict unemployment and inflation was forwarded by Phillips of the London

school of economics in 1958. His graphical presentation came to be known as the Phillips curves.

Paul Samuelson and Robert Solow ploted a Phillips scatter diagram for United State from which

they made a eough estimate of Phillips curve facing the economy in 1960.

III. Consumption function

The aggregate consumption expenditures were the relationship between income and consumption

expenditures for durable and nondurable goods. Scholars argued that consumption expenditure was

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not only related to current income but also to income earned in the past. This work was carried on

by James S. Duisenberg and Franco Modigliani who developed their ideas independently during the

late 1940s. In a theory of the consumption function (1957), Friedman distinguished between income

considered as transitory and income considered as permanent by the house holders. He attempted to

demonstrate that consumer spending mainly reflects permanent income, where as transitory income

is saved.

IV. International trade

Following the Second World War that Keynes’ followers entered into active discussion about the

relationship of the new theory of employment to international equilibrium through the Keynesian

multiplier theory. Macroeconomics has been effectively applied in the formulation of policy in the

field of foreign trade and international payments. It is also worth noting that the General Theory did

not influence the theory of international economic relations.

International economic relations were formally included immediately following the Second World

War with active discussion of about the relationship of the new theory of employment to

international equilibrium through the Keynesian multiplier theory. They related the closed economy

model of Keynesian and use open economy with external relations.

V. Multiplier

In area of multiplier, there was great advancement, particularly the means by which changes in one

of the major aggregates are transmitted to the others and to the level of economic activity at a

whole.

VI. Public policy

Public policy was generally connected with three problems. First, the study of short term changes in

the level of economic activity. Second, the ways to get out of a depression and finally, long term

trend of the economic system to wards stagnation. The entire analysis was primarily concerned with

the prevention of short term lapses from full employment caused by changes talking place in other

countries. The major concern of policy makers and economic theorist was with the maintenance of

full employment in a closed national economic system.

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VII. New economics

Another significant development of the period was the emergence of a new branch of economics,

macro economics. Prior to the beginning of the “New economics”, economic thinkers had

concentrated their efforts on the study of microeconomics problems via behavior of the firm’s

individuals. They failed to explain the behavior of the economy as whole.

Post-Keynesian economics

Back ground of post Keynesian economics

Samuelson and others, main stream economics modified Keynesian principles of macro economics

grafted upon new classical principle of microeconomics. Some denied both IS-LM interpretation of

Keynes and standard micro economics. Post-Keynesian economics is a school of economic thought

with its origins in The General Theory but criticize the work of Neo-Keynesian. The post keynsian

critics were from a group of economists at Cambridge, England including; Joan Robinson, Nicholas

Kaldor and Paul Davidson ,Piero Sraffa, Johen K.Galbraith etc that criticize Neo Keynsian theories.

The post-Keynesian school has remained closest to the spirit of Keyne's General Theory.

Post-Keynesian economics argued that Keynes's theory was seriously misrepresented by neo-

Keynesian economics. They dislike nature of Hick’s IS-LM interpretations as it ignores issues of

unstable expectation and uncertainty. They suggested reason for government intervention. The

existence of uncertainty also leads to the demand for liquidity. This implies that focus on

neoclassical static equilibrium situation as in Hick’s interpretation is misleading and irrelevant.

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Major Tenets of post Keynesian

1. Neo-Ricardian views of production, value and distribution

In 1960 Piero Sraffa published book entitled production of commodities by means of commodities.

He reconstructed Ricardo’s production and value theory in modern form. For Sraffa, the pattern of

demand for various products does not affect the pattern of prices, instead affecting only the scale of

output in each industry. The real value (prices) of goods depend on the shares of other commodities

necessary to produce them. Relative values (prices) and profits (if wages are given) are determined

by the production techniques used to produce a composite standard commodity which consists of

the basic commodity in the economy. These basic commodities are goods that enter in to the

production of all other commodities. They are in essence “capital” goods that appear both as inputs

and out puts. Any distributions of wages and profits is consistent with a particular level of output.

According to Sraffa, the composite standard commodity is Ricardo‘s elusive invariable measure of

value or of relative prices.

2. Endogenous money

For Post Keynesians, the stock of money was assumed to be essentially endogenous to the

economy. It changes in response to changes in the level of wages. Wage increases,cause production

costs to rise, creating a greater demand on the part of firms for working capital to finance their more

expensive goods in progress and inventories. Hence, business borrowing rises and money stock

increases. Inflation arises from the fight over the shares of the distribution of income.

3. Markup pricing

For Post Keynesian prices are set by oligopolistic corporations through corporation pricing policies

in product market, trade union, wage bargaining behavior in labor markets, and so on. They

finance investment from retained profits. To achieve the level of profit and investment plans, they

set prices above current costs. Thus, prices do not reflect the current demand condition, but the

funds requirements for planned investment.

4. Pronounced cyclical instability

For post Keynsian, the economy is inherently unstable. Investment must grow sufficiently to keep

national income and output growing at a steady rate do not hold true as periods of altering

environment of business optimism and pessimism. When investment is less than required to

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maintain the steady rate of growth, the economy recedes and unemployment rises.

5. Need for an incomes policy:

Post-Keynesian believes that convectional fiscal and monetary policies could not solve the problem

of inflation. The reason is that inflation is resulting from a more fundamental conflict over, and the

distribution of available income and output is not because of excess demand. The convectional

policy instrument of curtailing the level of economic activity, reducing the amount of output

available for distribution, there by heightening the social conflict underlying the inflationary process

could not solve the problem. Hence the best policy for post-Keynesian is income policy.

In the field of monetary theory, Post-Keynesian economists were among the first to emphasize that

the money supply responds to the demand for bank credit, so that the central bank can choose either

the quantity of money or the interest rate but not both at the same time.

New-Keynesian economics

Back ground of new-Keynesian economics

The advent of stagflation, and the work of monetarists mainly by Milton Friedman, cast doubt on

neo-Keynesian theories and post-Kenysian thought. In the 1970s new classical economists such as

Robert Luces, Thomas J. Sargent, and Robert Barro called into question many of the precepts of the

Keynesian revolution.

The other was Robert Lucas call for micro foundations were as a critique of traditional macro

econometric forecasting models. On the other hand, from within peoples criticize continuous market

clearing in short run by classical. They emphasize the role of quantity constraint and non-clearing markets

due to uncertainty, imperfect information, and imperfect competition. The result would be a series of new

ideas to bring tools to Keynesian analysis that would be capable of explaining the economic events

of the 1970s. The next great wave of Keynesian thinking began with the attempt to give Keynesian

macroeconomic reasoning of a microeconomic basis. This is known as the new Keynesian

synthesis, and currently forms the mainstream of macroeconomic theory.

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Through the 1970s Keynesian macro-economics fell out of fashion as a policy tool, and as a field of

study.

New Keynesian economics is the school of thought in modern macroeconomics that evolved from the ideas

of John Maynard Keynes together with various strands of neoclassical economics. It has been dominant

in mainstream macroeconomics since the 1980s. The label “new Keynesian” describes those economists

who, in the 1980s, responded to this new classical critique with adjustments to the original Keynesian tenets.

The heart of the new Keynesian view rests on microeconomic models that indicate that nominal

wages and prices are "sticky," (i.e., do not change easily or quickly with changes in supply and

demand,) so that quantity adjustment prevails in short run.

In economics, the term micro foundations refer to the microeconomic analysis of the behavior of

individual agents such as households or firms that underpins a macroeconomic theory. Most early

macroeconomic models, including early Keynesian models, were based on hypotheses about

relationships between aggregate quantities, such as aggregate output, employment, consumption,

and investment. Critics and proponents of these models disagreed as to whether these aggregate

relationships were consistent with the principles of microeconomics. Therefore, in recent decades

macroeconomists have attempted to combine microeconomic models of household and firm

behavior to derive the relationships between macroeconomic variables. Many macroeconomic

models, representing different theoretical points of view are derived by aggregating microeconomic

models, allowing economists to test them both with macroeconomic and microeconomic data.

New classical economics relied on the theory of rational expectations Robert Lucas argues that

rational expectations will defeat any monetary or fiscal policy of Keynesian school. But new

Keynesians argue that this critique only works if the economy has a unique equilibrium at full

employment. Due to price stickiness there are a variety of possible equilibrium in the short run, so

that rational expectations models do not produce any simple result.

New Keynesian economist has returned to the IS-LM model and the Phillips Curve as a first

approximation of how an economy works. New versions of the Phillips Curve, such as the "Triangle

Model", allow for stagflation, since the curve can shift due to supply shocks or changes in built-in

inflation. In the 1990s, the original ideas of "full employment" had been replaced by the NAIRU

theory, sometimes called the "natural rate of unemployment." This theory pointed to the dangers of

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getting unemployment too low, because accelerating inflation can result. However, it is unclear

exactly what the value of the NAIRU is or whether it really exists or not.

Basic Tenets of New Keynesian Economics

A. Reject Neo-Ricardian value theory

Modern Keynesians reject the neo-Ricardian value theory and income policies of post-Keynesians.

They focused on the traditional Keynesian question of why recessions occur. According to them,

recession occurs due to a decline in aggregate demand. Decline in aggregate demand leads to a

decline in real output and corresponding increases in unemployment because the price and nominal

wages are inflexible downward.

B. Menu Costs and Aggregate-Demand Externalities

Economists disagree about whether menu costs can help explain short-run economic fluctuations.

Skeptics point out that menu costs usually are very small and are unlikely to explain recessions,

which are very costly for society. Proponents reply that “small” does not mean “inconsequential”.

Even though menu costs are small for the individual firm, they could have large effects on the

economy as a whole. One reason for prices not adjusts it self immediately to clear markets is that

adjusting prices is costly. These costs of price adjustment, called “menu costs,” cause firms to

adjust prices intermittently rather than continuously. Furthermore, some firms must incur costs

when they lower prices in printing a new menu, printing new price lists, communicating with

customers with advertising and so on. When such menu costs are high, firm may be reluctant to

lower their prices even when faced with slack demand.

To understand why prices adjust slowly, one must acknowledge that changes in prices have

externalities. That is, change in prices has effects that go beyond the firm and its customers. For

instance, a price reduction by one firm benefits other firms in the economy. When a firm lowers the

price it charges, it lowers the average price level slightly and thereby raises real income. The

stimulus from higher income, in turn, raises the demand for the products of all firms. This

macroeconomic impact of one firm’s price adjustment on the demand for all other firms’ products is

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called an “aggregate-demand externality.”In the presence of this aggregate-demand externality,

small menu costs can make prices sticky, and this stickiness can have a large cost to society.

C. The Staggering of Prices

For New Keynesian explanations of sticky prices can be explained how the firms adjust their prices.

If all firms are synchronized, all firms can raise prices together, leaving relative prices unaffected.

They argue that not everyone in the economy sets prices at the same time. And, the adjustment of

prices throughout the economy is staggered. Staggering complicates the setting of prices because

firms care about their prices relative to those charged by other firms. Staggering can make the

overall level of prices adjust slowly, even when individual prices change frequently.

D. Coordination Failure

Some new Keynesian economists suggest that recessions result from a failure of coordination. Coordination

problems can arise in setting wages and prices because those who set them must anticipate the actions of

other wage and price setters. Union leaders negotiating wages are concerned about the concessions other

unions will win. Firms setting prices are mindful of the prices that other firms will charge. To see how a

recession could arise as a failure of coordination, consider the following parable. “The economy is made up

of two firms. After a fall in the money supply, each firm must decide whether to cut its price. Each firm

wants to maximize its profit, but its profit depends not only on its pricing decision but also on the decision

made by the other firm. If neither firm cuts their price, the amount of real money (the amount of money

divided by the price level) is low, a recession ensues, and each firm makes a profit of only fifteen dollars.

If both firms cut their price, real money balances are high, a recession is avoided, and each firm makes a

profit of thirty dollars. Although both firms prefer to avoid a recession, neither can do so by its own actions.

If one firm cuts its price while the other does not, a recession follows. The firm making the price cut makes

only five dollars, while the other firm makes fifteen dollars.” The essence of this parable is that each firm’s

decision influences the set of outcomes available to the other firm. When one firm cuts its price, it improves

the opportunities available to the other firm, because the other firm can then avoid the recession by cutting its

price. This positive impact of one firm’s price cut on the other firm’s profit opportunities might arise because

of an aggregate-demand externality.

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E. Efficiency Wages

Normally, economists presume that an excess supply of labor would exert a downward pressure on

wages. A reduction in wages would in turn reduce unemployment by raising the quantity of labor

demanded. Hence, according to standard economic theory, unemployment is a self-correcting

problem.

New Keynesian economists often turn to theories of what they call efficiency wages to explain why

this market-clearing mechanism may fail. These theories hold that high wages make workers more

productive. The influence of wages on worker efficiency may explain the failure of firms to cut

wages despite an excess supply of labor. Even though a wage reduction would lower a firm’s wage

bill, cause worker productivity and the firm’s profits to decline.

There are various theories about how wages affect worker productivity. First efficiency-wage theory

holds that high wages reduce labor turnover. A second, efficiency-wage theory holds that the

average quality of a firm’s workforce depends on the wage it pays its employees. A third,

efficiency-wage theory holds that a high wage improves worker effort. This theory posits that firms

cannot perfectly monitor the work effort of their employees and that employees must themselves

decide how hard to work. The firm can raise worker effort by paying a high wage.

F. Minimum wage legislation

This imposed by the government economic policy with the aim to meet the inevitable well being of

the low income groups or workers. The intension is to avoid unnecessary exploitation of workers by

their employers. But it create market dis equilibrium so that market do not adjust quickly.

G. Imperfect information

Since every change in consumer tests and change in producers plan are not easily observable in the

market and even if it is observable there is information gap. As a result, markets do not adjust

instantly to the equilibrium market clearing wages and prices.

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H. Formal and implicit contracts

They point out that unions often sign long term contracts containing built in nominal wage increase.

When demand declines union leaders often prefer lay aggregate offs the few or reduce labors, rather

than wage costs.

Policy Implications

In new Keynesian theories recessions are caused by some economy-wide market failure. Thus, new

Keynesian economics provides a rationale for government intervention in the economy, such as

countercyclical monetary or fiscal policy. This part of new Keynesian economics has been

incorporated into the new synthesis that has emerged among macroeconomists.

5.5 New Keynesian and New classical

The primary disagreement between new classical and new Keynesian economists is over how

quickly wages and prices adjust. New classical economists build their macroeconomic theories on

the assumption that wages and prices are flexible. They believe that prices “clear” markets and there

will a balance between supply and demand. New Keynesian economists, however, believe that

market-clearing models cannot explain short-run economic fluctuations, and so they advocate

models with “sticky” wages and prices. New Keynesian theories rely on this stickiness of wages

and prices to explain why involuntary unemployment exists and why monetary policy has such a

strong influence on economic activity.

New classical economists criticized this tradition as it lacks a coherent theoretical explanation for

the sluggish behavior of prices. New Keynesian research attempts to remedy this omission.

5.6 New Synthesis

During the 1990s, the debate between new classical and new Keynesian economists led to the

emergence of a new synthesis among macroeconomists about the best way to explain short-run

economic fluctuations and the role of monetary and fiscal policies. The new synthesis attempts to

merge the strengths of the competing approaches that preceded it. From the new classical models it

takes a variety of modeling tools that shed light on how households and firms make decisions over

time. From the new Keynesian models it takes price rigidities and uses them to explain why

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monetary policy affects employment and production in the short run. The most common approach is

to assume monopolistically competitive firms (firms that have market power but compete with other

firms) that change prices only intermittently. The heart of the new synthesis is the view that the

economy is a dynamic general equilibrium system that deviates from an efficient allocation of

resources in the short run because of sticky prices and perhaps a variety of other market

imperfections. In many ways, this new synthesis forms the intellectual foundation for the analysis of

monetary policy at the Federal Reserve and other central banks around the world.

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Chapter 5

The Development of Modern Microeconomic Theory

Neoclassical economics was not a single entity: it was a multidimensional school of thought that

evolved over time. It focused on marginalism, assumptions of rationality, and a strong policy

presumption that markets worked, although that was subject to a number of provisos. The

neoclassical school was quite fluid: as soon as neoclassical economists became the orthodoxy, and

possibly even before, it started to change. Bit by bit economics moved away from its neoclassical

footing. Marginalist calculus was replaced by set theory; rationality assumptions were modified by

insights from psychology; the set of issues to which economic analysis was applied expanded;

evolutionary game theory raised the possibility that individuals exhibit class-consciousness; and

sociological explanations were used to supplement analyses of the labor market. As these and

similar changes occurred, what had been seen as necessary components of neoclassical thought

ceased to be components of modern thought. Our belief is that sufficient components have changed

to warrant a new term to describe modern economics.

Many elements of neoclassical economics still exist within modern microeconomics, but what

distinguishes modern microeconomics is not these elements; it is a modeling approach to problems.

The assumptions and conclusions of the model are less important than whether the model

empirically fits reality.

In this chapter we discuss the evolution of microeconomics from neoclassical to modern. We

trace that path from the 1930s through a highly formalistic stage in which there was an attempt to

tie microeconomics together within a single theory—with little regard for that theory’s empirical

relevance—to its modern state, in which microeconomics consists of a set of models focused almost

entirely on empirical relevance.

We start our story in the 1930s with the fall of Marshallian economics.

THE MOVEMENT AWAY FROM MARSHALLIAN ECONOMICS

Marshall’s engine of analysis, combining supply and demand curves with common sense, could

answer certain questions, but others exceeded its scope. Supply-and-demand analysis was partial

equilibrium analysis applied to problems of relative prices. But many of the questions economists

were trying to answer, such as what determines the distribution of income or what effect certain

laws and taxes would have either introduced problems beyond the applicability of partial

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equilibrium analysis or violated its assumptions. Nonetheless, economists continued to apply partial

equilibrium arguments to such issues, assuming that the aggregate market must constitute some as

yet unknown combination of all the partial equilibrium markets.

Most economists were content with this state of affairs for quite a while. After all, Marshallian

economics did provide a workable, if not formally tight, theory that was able to answer many real-

world questions. It was the middle ground. Marshallian economists were engineers rather than

scientists, and engineers are interested not in pondering underlying forces but in building something

that works. Marshallian economists were interested in the art of economics, not in positive or

normative economics. As Joan Robinson put it, Marshall had the ability to recognize hard problems

and hide them in plain sight.

Marshallian economics attempted to walk a fine line between a formalist approach and a historically

institutional approach. It is not surprising that in doing so it created critics on both sides. In the

United States, a group called the institutionalists wanted simply to eliminate the theory, arguing that

history and institutions should be emphasized and the inadequate theory dropped. Other critics,

whom we will call formalists, went in the opposite direction: they believed that economics should

be a science, not an engineering field, and that if economics were to conclude that the market

worked well, we needed a theory to show how and why it did so. These formalists agreed with the

institutionalists that Marshallian economic theory was inadequate, but their answer was not to

eliminate the theory: they wanted to provide a better, more rigorous general equilibrium foundation

that could adequately answer more complicated questions.

THE FORMALIST REVOLUTION IN MICROECONOMICS

In the late 1930s the formalist research program won and the Marshallian approach started to wane.

By the 1950s the formalists had reformulated microeconomics into a mathematical structure

dependent on Walras, not Marshall. Applications became less important than logical consistency.

The formalist revolution reached its apex in 1959 with the publication of the Arrow- Debreu model.

With the completion of that general equilibrium work, economists turned once again to applied

work. But they did not return to Marshall’s engine of analysis approach, which downplayed the use

of mathematics and stressed judgment. Instead, they integrated policy prescriptions into the

mathematical models. As that happened, the neoclassical era evolved into the modern modeling era.

In the modeling approach, mathematics is used to develop simple models that ideally capture the

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essence of the problem. Then econometric techniques are used to test those models. This

development and empirical testing of models has become the modern economic method.

The Battle over Formalist Approaches

The mathematical approach is rooted in the thought of several nineteenth- and early twentieth-

century figures discussed in our earlier chapters on neoclassical economics. The first of these great

pioneers in stating hypotheses in mathematical form was A. Cournot, who published his Researches

into the Mathematical Principles of the Theory of Wealth in 1838. Cournot expected that his

attempts to bring mathematics into economics would be rejected by most economists, but he

adhered to his method nonetheless because he found the literary expression of theory that could be

expressed with greater precision by mathematics to be wasteful and irritating.

Leon Walras and Vilfredo Pareto, who succeeded Walras as professor of economics at

Lausanne, were other early devotees of mathematical economics. Whereas Marshall had focused on

partial equilibrium, Walras, using algebraic techniques, focused on general equilibrium. His general

equilibrium theory has substantially displaced Marshallian partial equilibrium theory as the basic

framework for economic research. Jevons, in his influential Theory of Political Economy (1871),

also advocated a more extensive use of mathematics in economics.

Jevons was followed by another pioneer in mathematical economics, F. Y. Edgeworth (1845-

1926), who pointed out in 1881 that the basic structure of microeconomic theory was simply the

repeated application of the principle of maximization. This finding raised the question, Why re-

examine the same principles over and over again? By abstracting from the specific institutional

context and reducing a problem to its mathematical core, one could quickly capture the essence of

the problem and apply that essence to all such micro- economic questions. Following this reasoning,

Edgeworth declared that both an understanding of the economy and a basis for the formulation of

proper policies were to be found in the consistent use of mathematics. He accused the Marshallian

economists of being seduced by the “zigzag windings of the flowery path of literature.”1

As this extension was occurring, there was a simultaneous attempted extension of mathematics

not only into positive economics but also into questions of economic policy. Vilfredo Pareto, whose

name is familiar to many students of economics from its use in the phrase Pareto optimal criteria,

extended Walras’s general equilibrium analysis in the early 1900s to questions of economic policy.

Thus, in the push for formalization little distinction was made between positive economics and the

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art of economics, John Neville Keynes’s distinction between the two was lost, and the same formal

methodology was used for both.

Irving Fisher (1867-1947), writing in the last decade of the nineteenth century, was an early

American pioneer of formalism who supported and extended Simon Newcomb’s (1835-1909)

advocacy of increased use of mathematics in economics. The mathematical approach was not well

received in the United States, however, until nearly the middle of the twentieth century. All these

pioneers were, therefore, unheeded prophets of the future. a judicious blend of theory, history, and

institutional knowledge. Unable to compete with the Marshallian approach, early mathematical

work in economics was practically ignored by mainstream economists until the 1930s. Inattention to

their efforts can be attributed partly to the strength of Marshall’s analysis,

In the early 1930s, this situation began to change. Expositions of the many geometric tools that

now provide the basis for undergraduate microeconomics began to fill the journals. The marginal

revenue curve, the short-run marginal cost curve, and models of imperfect competition and income-

substitution effects were “discovered” and explored during this period. Though rooted in Marshall,

these new tools formalized his analysis, and as they did so they moved farther and farther from the

actual institutions they represented. The Marshallian approach to interrelating theory and

institutions had been like a teeter-totter: it had worked as long as the two sides balanced. But once

the theory side gained a bit, the balance was broken and economics fell hard to the theoretical side,

leaving history and institutions suspended in air.

History and institutions were abandoned because the new mathematical tools required stating

precisely what was being assumed and what was changing, and stating it in such a way that the

techniques could handle the entire analysis. History and particular institutions no longer fit in. One

could no longer argue, as in the earlier Marshallian economics, that “a reasonable businessman”

would act in a certain way, appealing to the reader’s sensibility to know what “reasonable” meant.

Instead, “reasonableness” was transformed into a precise concept— “rational”—that was defined as

making choices in conformance with certain established axioms. Similarly, the competitive

economy was defined as one in which all individuals are “price takers.” Developing one’s models

mathematically required noncontextual argumentation, abstracted from any actual setting, in which

assumptions are spelled out.

Though the use of geometry as a tool in Marshallian analysis was a relatively small step, it was

the beginning of the end for Marshallian economics. When geometry disclosed numerous logical

problems with Marshallian economics, the new Marshallians responded with further formalization.

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Thus, by 1935 economics was ripe for change. Paul Samuelson summed up the situation: “To a

person of analytic ability, perceptive enough to realize that mathematical equipment was a powerful

sword in economics, the world of economics was his or her oyster in 1935. The terrain was strewn

with beautiful theorems waiting to be picked up and arranged in unified order.”2

Because many economists had by this time acquired the requisite analytic equipment, the late 1930s

and early 1940s witnessed a revolution in micro- economic theory, which formalism won. Cournot,

Walras, Pareto, and Edge- worth gained more respect, and Marshallian economics was relegated

primarily to a role in undergraduate education.

The first step in the mathematization of microeconomic theory was to extend the marginal

analysis of the household, firm, and markets and to make it more internally consistent. As

economists shifted to higher-level mathematical techniques, they were able to go beyond partial

equilibrium to general equilibrium, because the mathematics provided a method by which to keep

track more precisely of items they had formerly kept somewhat loosely in the back of their heads.

The second step was to reformulate the questions in a manner consistent with the tools and

techniques available for dealing with them. The third step was to add new techniques to clarify

unanswered questions. This process is continuing today.

These steps did not follow a single path. One path had strong European roots; it included

generalizing and formalizing general equilibrium theory. An early pioneer on this path was Gustav

Cassel (1866-1945), who simplified the presentation of Walras’s general equilibrium theory in his

Theory of Social Economy (1918; English versions 1924, 1932), making it more accessible.

In the 1930s, two mathematicians, Abraham Wald (1902-1950) and John von Neumann (1903-

1957), turned their attention to the study of equilibrium conditions in both static and dynamic

models. They quickly raised the technical sophistication of economic analysis, exposing the

inadequacy of much of previous economists’ policy and theoretical analysis. Their work was noted

by economists such as Kenneth Arrow (1921- ) and Gerard Debreu (1921- ), who extended it and

applied it to Walras’s theory to produce a more precise formulation of his general equilibrium

theory. Following Wald’s lead, Arrow and Debreu then rediscovered the earlier writings of

Edgeworth. So impressed were they by these writers that they declared Edgeworth, not Marshall, to

be the rightful forefather of modern microeconomics. The work of these theorists, in turn, has

continued a highly formalistic tradition of general equilibrium theorists.

Some of the questions that general equilibrium analysis has addressed are Adam Smith’s

questions: Will the unfettered use of markets lead to the common good, and if so, in what sense?

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Will the invisible hand of the market promote the social good? What types of markets are necessary

for that to be the case? Because they involve the entire system, these are essentially general

equilibrium questions, not questions of partial equilibrium. They could not, therefore, be answered

within the Marshallian framework, although they could be discussed in relatively loose terms, as

indeed they were before formal general equilibrium analysis developed.

General equilibrium theorists have found the answer to the question “Does the invisible hand

work?” to be yes, as long as certain conditions hold true. Their proof, for which Arrow and Debreu

received Nobel prizes, was a milestone in economics because it answered the conjecture Adam

Smith had made to begin the classical tradition in economics. Much subsequent work has been done

in general equilibrium theory to articulate the invisible-hand theorem more elegantly and to modify

its assumptions, but by first proving it, Arrow and Debreu earned a place in the history of economic

thought.

MILTON FRIEDMAN AND THE CHICAGO

APPROACH TO MICROECONOMICS

The modern modeling approach that has come to dominate the profession has some grounding, too,

in the Chicago approach to economics, which ran counter to the formalist approach from the 1950s

through the 1970s. The Chicago approach was characterized, first, by a belief that markets work

better than the alternatives as a means of organizing society and, second, by its connection to the

Marshallian informal approach to modeling.

Milton Friedman (1912- ) was a counterweight to Paul Samuelson throughout the modern period

of economics. Friedman summarized his Chicago approach as follows: In discussions of economic

policy, “Chicago” stands for belief in the efficiency of the free market as a means of organizing

resources, for skepticism about government affairs, and for emphasis on the quantity of money as a

key factor in producing inflation.

In discussions of economic science, “Chicago” stands for an approach that takes seriously the use of

economic theory as a tool for analyzing a startlingly wide range of concrete problems, rather than as

an abstract mathematical structure of great beauty but little power; for an approach that insists on

the empirical testing of theoretical generalizations and that rejects alike facts without theory and

theory without facts

Friedman’s approach to economics was Marshallian rather than Walrasian. He saw economics

as an engine of analysis for addressing real problems and as something that should not be allowed to

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become an abstract mathematical consideration devoid of institutional context and direct relation to

real world problems.

In his consideration of policy issues, he combined strong beliefs in individual rights and liberty

and in the effectiveness of the market in protecting those rights (see Capitalism and Freedom,

1962). His political orientation was basically pro-market and anti-government. He advocated many

policy proposals that at first were seen as radical but later became more acceptable: financing

education with vouchers, eliminating licensing in professions, and legalizing drugs.

Around 1950, Friedman produced a number of provocative papers on methodology and also a

paper on the Marshallian demand curve and the marginal utility of money. In the late 1950s, he

made contributions to macroeconomics in his Studies in the Quantity Theory of Money (1956). His

column in Newsweek was read by many, and a TV series titled “Free to Choose” gave him greater

notoriety than most theorists. He won the Nobel Prize in economics in 1976.

Even as Friedman was becoming well known, his Marshallian approach was dying. In part, this

was because it was seen by many as ideologically or normatively tainted, causing researchers to

revert to formalism to avoid ideological bias. An example of what some economists considered to

be the normative bias in the Chicago approach to economics can be seen in the Coase theorem,

named for Ronald Coase (1910- ), another influential Chicago economist whose work led to the

recent field of law and economics. The Coase theorem was a response to the Pigouvian approach,

which saw the existence of externalities as a reason for government intervention. In “The Problem

of Social Cost,” Coase argued that in theory, externalities were not a reason for government

intervention, because any party helped or hurt by an action was free to negotiate with others to

eliminate the externality. Thus, if there were too much smoke from a factory, the neighbors hurt by

the smoke could pay the factory to reduce it.

The Coase theorem has been much discussed in the literature. The general conclusion is that in and

of itself the theorem is no more ideological than is the theory of externalities that predisposes one

toward government intervention. Issues involving government intervention are complicated, and

there is no answer that follows from theory; in modern economics, a theory of government failure

exists side by side with a theory of market failure. Which is more appropriate depends upon the

relative costs and benefits, issues upon which individuals may disagree.

Nonetheless, the Chicago approach has stimulated many new ideas, and it, rather than the more

formalist approach, may sow the seeds for major developments in microeconomics in the future.

Among those new ideas that have been stimulated has been Armen Alchian’s (1914- ) and Harold

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Demsetz’s (1930- ) work on property rights as underlying markets. Since the Chicago view is that it

is best to assume that markets work efficiently, much of the discussion of inefficiency in markets

(such as might be produced by monopolistic competition) is misplaced. But markets depend upon

property rights; thus, the study of property rights is of paramount importance to economics. What

are the underlying property rights? How do they develop? How do they change?

The most important follower of Friedman was Gary Becker (1930- ), who won the Nobel Prize

in economics in 1992. He has used microeconomic models to study decisions about crime,

courtship, marriage, and childbearing. Becker has shown that the simple-maximization

microeconomic model based on the assumption of rational individuals has potentially infinite

applications, and recent years have seen it used in widely diverse areas. These incursions of

economic theory into other disciplines have sometimes been treated facetiously by those who claim

that the economic approach is too simple. In one sense, they are right. The ideas and policy

conclusions of the “economics of everything” are often simple. But mere simplicity does not make

them wrong. Market incentives make a difference in people’s behavior, and noneconomic

specialists have often not included a sufficient consideration of these incentives in their analyses.

But analyses can go astray when only economic incentives are considered and insufficient attention

is paid to institutional and social incentives. Unfortunately, given modern economists’ training in

noncontextual modeling, this is often what occurs.

With the retirement of Milton Friedman and his colleague George Stigler and with Gary Becker’s

impending retirement, Chicago economics changed, becoming more mathematical and less

intuitive. Not stopping at simple models, it generalized models along the lines suggested by Varian.

Clearly, Chicago has entered the modern school of economics, and the modern school of economics

has become quite homogeneous. What one learns in graduate programs at Harvard, Chicago, MIT,

Stanford, or any top graduate school, is essentially the same thing.

summary

Modern microeconomics has evolved significantly from its neoclassical roots and is much better

defined by its eclectic formalistic modeling approach than by its beliefs. Its roots are to be found in

Cournot and Edgeworth rather than in Marshall. The movement away from Marshallian economics

started in the late 1930s with the publication of John Hicks’s Value and Capital and Paul

Samuelson’s Foundations of Economic Analysis. Their work was a culmination of many years of

frustration on the part of some economists with Marshall’s avoidance of formalizing economic

theory. Samuelson’s and Hicks’s work was followed by even greater formalization of neoclassical

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thinking in the work of Arrow and Debreu. After that work was complete, modern microeconomics

turned to eclectic applied policy work, in which assumptions could differ from core general

equilibrium assumptions.

The Marshallian approach could still be found in the Chicago school through the 1970s,

although the Chicago brand of Marshallian economics had a strong pro-market bias. With the

retirement of Milton Friedman and the impending retirement of Gary Becker, and the death of

George Stigler, Chicago economics melded into modern economics, becoming more mathematical

and less intuitive.

Modern economics has problems, but they are not the problems of neoclassical economics. Some

present-day economists level their criticisms of economics at neoclassical economics and in so

doing fail to examine the prevailing paradigm that characterizes modern economics.

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Chapter 6

The Development of Modern Macroeconomic Thought

Interest in macroeconomic issues has fluctuated throughout the years, reaching its nadir around the

turn of the nineteenth century. The attitude of the economics profession toward macroeconomic

thought at that time could be characterized as one of benign neglect. The macroeconomic thinking

that did exist, moreover, was somewhat confused. Alfred Marshall, who had codified and organized

microeconomics in his Principles of Economics, always intended to do the same for

macroeconomics, but he never did. He limited his discussion of macroeconomics to a determination

of the general level of prices, as did F. W. Taussig in his introductory textbook.

Growth, which had been the focus of Adam Smith’s work, received only slight emphasis in the

later classical and neoclassical periods. Instead, the profession focused on developing formal

models of allocation and distribution using the static reasoning that Ricardo championed; Smith’s

ambiguities lost out to Ricardo’s more formal models. Business cycles also received only fleeting

reference; the standard assumption of full employment of all resources precluded greater

consideration of them. That full employment assumption was often justified by reference to Say’s

Law, supply creates its own demand.

Analysis that used the full employment assumption and focused on explaining the forces

determining the general level of prices continued until the 1930s, when the Great Depression led to

new work on understanding business cycles. During the period from the 1930s to the late 1970s,

macroeconomics continued to focus on business cycles, an approach that came to be known as

“Keynesian economics.” The classification is not totally correct, since Keynesian ideas quickly

merged with neoclassical ideas; the actual macroeconomics that developed in the texts might more

appropriately be called neo-Keynesian economics. This chapter describes this evolution and its

historical foundation.

The 1970s saw a reaction against neo-Keynesian economics in the form of the new classical

revolution, which moved the focus of macroeconomics away from business cycles and toward

growth. Since the 1990s, the primary focus of cutting-edge macroeconomics has been on growth.

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HISTORICAL FORERUNNERS

OF MODERN MACROECONOMICS

Modern macroeconomics consists primarily of monetary theory, growth theory, and business-cycle

theory. Emphasis on these has fluctuated over the years, in part as the experience of the economy

has changed and in part as techniques have allowed economists to deal with issues that they

previously found unmanageable. We will begin with a discussion of growth theory.

Early Work on Growth Theory

Analysis of economic growth was the primary concern of Adam Smith, who emphasized the

relationships between free markets, private investment spending, laissez faire, and economic

growth. Ricardo refocused economics, turning it away from economic growth and toward the issue

of the forces determining the distribution of income. This change in viewpoint between Smith and

Ricardo concerning the essential subject matter of economics was fundamentally a reorientation of

economics away from the growth macroeconomics of Smith and toward Ricardo’s microeconomic

concerns—what determines wages, rents, profits, and other prices, and thus the distribution of

income. This emphasis on microeconomics, the allocation problem, continued to dominate

mainstream economic thought from Ricardo in the first quarter of the nineteenth century until the

major depression that engulfed the industrialized world in the 1930s.

Joseph Schumpeter, in the discussion of growth in his famous book on the history of economic

thought, distinguishes two types of economists by their thinking about growth: the optimists and the

pessimists. He argues that most mainstream economists fall within the pessimist group, the

strongest pessimists being Malthus, Ricardo, and James Mill. These mainstream economists

strongly emphasized decreasing returns, ever-increasing rent, and the stationary state toward which

the economy was progressing. They did this even as the economy around them was growing at rates

far exceeding those of earlier times. As Schumpeter notes, “They were convinced that technological

improvement and increases in capital would in the end fail to counteract the fateful law of

decreasing returns.”

Somewhat of an exception to this among the major mainstream economists was John Stuart

Mill, who discussed growth and technology more than Malthus or Ricardo did, and who, moreover,

was much more optimistic about the possibility of continued growth. But a close reading of Mill

shows that he did not base his belief so much on the continued growth of technology and capital as

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on his belief that societies would ultimately voluntarily restrict the birth rate and thus slow the

inevitable diminishing marginal returns.

Toward the end of his life, Mill became more of a pessimist. He seemed convinced that the

stationary state was near. However, he did not see this result as necessarily bad. Rather, he saw the

stationary state as a comfortable state in which there was moderate prosperity and reasonable

equality. This followed because he saw the distribution of income as being determined by social as

well as economic forces.

It was left to heterodox economists such as Henry Carey (1793-1879) and Friedrich List to

support the optimist vision. List, discussed in Chapter 12, was part of the German historical school,

which emphasized empirical observation and history over theory. Since he could see that the

economy was growing at a faster rate than it had earlier, it was only natural for him to believe that

growth could continue, possibly indefinitely. Carey was an American economist who deemphasized

theory and emphasized history and empirical observation. This led him to the same conclusion as

List: there seemed no end in sight to the growth of the economy. Given the American experience at

the time, with an expanding frontier and ever-increasing agricultural land, it was natural that

diminishing returns would be less emphasized in the American context.

It is interesting that the optimists, List and 6arey, supported tariffs, whereas the pessimists, such

as Ricardo, generally supported free trade. This difference probably flowed from their view of

theory and use of assumptions. Ricardo’s theoretical comparative advantage model directed

thinking toward the advantages of a policy of free trade. But the static nature of the model also led

to the view that once the gains of trade had been achieved, growth would stop. List and Carey

focused less on theory and more on observation and history. Direct observation of the economy

suggested the importance of technology and the possibility of continued growth. It also suggested

that protecting that technology by tariffs was important. Smith’s argument that trade expands

technology through expanding the division of labor and learning by doing, and therefore can be

beneficial for all, is a much more complicated argument to make; it follows from a dynamic view of

the economy that is difficult to capture in formal models.

Mainstream economists of the time vigorously attacked both List’s and Carey’s views and delighted

in pointing out their theoretical mistakes. But in doing so the mainstream economists failed to grasp

the broader lesson of List’s and Carey’s work that diminishing marginal returns could be overcome,

possibly forever, by technological development. Modern economists were likewise blind to Marx’s

insights concerning growth.

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As neoclassical economics developed, the movement away from a focus on growth accelerated.

The neoclassical, with the possible exception of Alfred Marshall, whose views on growth resembled

Mill’s, focused more on static equilibrium. Both Mill and Marshall held that technological progress

could temporarily create the conditions of growth but that the law of diminishing returns in

agricultural and raw materials would ultimately win out.

For the most part, economists in the first half of the twentieth century did not deal with growth. An

important exception was Joseph Schumpeter, who does not fit neatly into any school.

Quantity Theory of Money

Classical and neoclassical theorists maintained an interest in at least one macro- economic question:

what determines the general level of prices? They addressed this economic question by utilizing the

supply-and-demand approach developed in microeconomic theory. The supply of money was

assumed to be determined by the monetary authorities, so some orthodox economists contended that

the basic issues to be analyzed were on the side of demand. The household and firm are assumed to

be rational and to have a demand for money to be used for various purposes. Walras, Menger, and

others developed a supply-and-demand analysis to explain the value of money, but the most famous

of these theories is probably the one developed by Marshall, which has become known as the

Cambridge cash-balance version of the quantity theory of money.

The first clear statement of the quantity theory of money was made by David Hume in 1752.

This theory, as it came down through the literature, held that the general level of prices depended

upon the quantity of money in circulation. Marshall’s version of the quantity theory was an attempt

to give microeconomic underpinnings to the macroeconomic theory that prices and the quantity of

money varied directly. He did this by elaborating a theory of household and firm behavior to

explain the demand for money. Marshall reasoned that households and firms would desire to hold in

cash balances a fraction of their money income. If M is money (currency plus demand deposits), PY

is money income, and k is the proportion of their income that households and firms desire to hold in

the form of money, then the fundamental cash-balance equation is

M = kPY

Because Marshall accepted Say’s Law, full employment is assumed. An increase in the quantity of

money, assuming k remains constant, will lead to an increase in money income, PY. Because full

employment is assumed, an increase in the quantity of money will result in higher prices and a

consequent increase in money income; real income, however, will not change. Decreases in the

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quantity of money will result in a fall in money income as prices fall; real income again will remain

constant. We shall not examine the many different aspects of Marshall’s formulation; the important

point is that Marshall’s version of the quantity theory made an attempt to integrate the

microeconomic behavior of maximizing firms and households with the macroeconomic question of

the general level of prices.

A group of economists, the most prominent being the American Irving Fisher (1869- 1947),

developed another form of the quantity theory known as the transactions version. However, they

showed little interest in finding a microeconomic foundation for the macroeconomic analysis of the

general level of prices. In this version,

MV = PT

where M is the quantity of money, V is the velocity of money, P is a measure of the price level, and

T is the volume of transactions.

Although these two approaches have important differences, they have one element in common:

they were both designed to explain the forces that determine the general price level. They were not

used to explain the level of real income, which was assumed to be at full employment and fixed by

nonmonetary forces in the economy.

Not all economists were satisfied with this analysis. For example, Knut Wicksell (1851- 1926)

argued that the quantity theory of money failed to explain “why the monetary or pecuniary demand

for goods exceeds or falls short of the supply of goods in given conditions.”7 Wicksell tried to

develop a so-called income approach to explain the general level of prices; that is, to develop a

theory of money that explains fluctuations in income as well as fluctuations in price levels.

Business Cycle Theory

Although fluctuations in business activity and in the level of income and employment had been

occurring since the beginning of merchant capitalism and were acknowledged by orthodox theorists,

economists made no systematic attempts to analyze either depression or the business cycle until the

1890s. Heterodox theorists, the most important of whom was Marx, had pursued these issues with

greater vigor. But Marx’s works were largely ignored by orthodox theory. Thus, until the last

decade of the nineteenth century, orthodox economic the allocation and distribution of scarce

resources, a macroeconomic theory explaining the forces determining the general level of prices,

and a loose set of notions concerning economic growth. Prior to 1890, orthodox “work on

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depressions and cycles had been peripheral and tangential.”theory consisted of a fairly well

developed theoretical microeconomic structure explaining 8

One major exception to this generalization is the work of Clement Juglar (1819-1905), who in

1862, published Des crises commerciales et de leur rétour périodique en France, en Angleterre et

aux Etats-Unis. The second edition of this work, published in 1889, was considerably enlarged with

historical and statistical material. Juglar is a spiritual predecessor of W C. Mitchell in that he did not

build a deductive theory of the business cycle, but rather collected historical and statistical material

that he approached inductively. His main contribution was his statement that the cycle was a result

not of forces outside the economic system but of forces within it. He saw the cycle as containing

three phases that repeated themselves in continuous order:

The periods of prosperity, crisis, liquidation, although affected by the fortunate or unfortunate

accidents in the life of peoples, are not the result of chance events, but arise out of the behavior, the

activities, and above all out of the saving habits of the population, and the way they employ the

capital and credit available.9

Although Juglar’s work initiated the study of the business cycle, the modern orthodox

macroeconomic analysis of fluctuations is grounded in the writings of a Russian, Mikhail Tugan-

Baranowsky (1865-1919). His book Industrial Crises in England was first published in Russian in

1894; German and French editions followed. After reviewing past attempts to explain the business

cycle, he pronounced them all unsatisfactory. The chief intellectual influences on Tugan-

Baranowsky were Juglar and Marx, particularly Marx. Tugan-Baranowsky’s main contribution to

our understanding of the business cycle was his statement of two principles: (1) that the economic

fluctuations are inherent in the capitalist system because they are a result of forces within the

system, and (2) that the major causes of the business cycle are to be found in the forces determining

investment spending. The sources of the Keynesian analysis of income determination, with its

emphasis on the inherent instability of capitalism and the role of investment, run from Marx through

Tugan- Baranowsky, Juglar, Spiethoff, Schumpeter, Cassel, Robertson, Wicksell, and Fisher on the

orthodox side; and from Marx, Veblen, Hobson, Mitchell, and others on the heterodox side.

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Some of the mercantilists, the physiocrats, and a host of heterodox economists who

KEYNESIAN MACROECONOMICS

Keynesian economics is named after John Maynard Keynes, whose father, J. N. Keynes, was an

important economist in his own right. The son’s accomplishments quickly eclipsed his father’s,

however. In this and in several other ways J. M. Keynes’s life is like that of J. S. Mill. Both had

fathers who were contemporaries and friends of brilliant economists: James Mill was a friend of

David Ricardo, and J. N. Keynes was a friend of Alfred Marshall. Both the younger Keynes and the

younger Mill received the high-quality education typically provided to children of intellectuals, an

education that equipped their innately brilliant minds to break new ground and to persuade others

through the force of their writing. Both Mill and Keynes rejected the policy implications of their

fathers’ economics and proceeded in new directions. But here the similarities end, for J. S. Mill was

unable to break completely with the theoretical structure of his father and Ricardo; ultimately, he

constructed a halfway house between classical and neoclassical theory. Keynes’s break with the

past—that is, with the laissez-faire tradition running from Smith through Ricardo, J. S. Mill, and

Marshall— was more complete. Although he was familiar with the basic Marshallian partial

equilibrium analysis, he constructed a new theoretical structure to address the aggregate economy

that had significant effects on both economic theory and policy.

Keynes does not fit the stereotype of the intellectually narrow twentieth- century economist. He

was criticized, in fact, for devoting too little of his time to economic theory and spreading his

interests too broadly. Even as a student at Eton and Cambridge he displayed this proclivity to pursue

a wide range of interests; hence he came to be known as a dilettante. His education completed, he

entered the British government’s India Office as a civil servant, where he remained for two years

before returning to Cambridge. He was never exclusively an academic. His continuing interest in

economic policy led him to take a number of government posts throughout his life. He was active in

business affairs both for himself and as bursar of King’s College, and his ability in business is

manifested by the fact that his net worth rose from near bankruptcy in 1920 to more than $2 million

by the time of his death in 1946. Keynes was interested in theater, literature, and the ballet; he

married a ballerina and associated with a group of London intellectuals known as the Bloomsbury

group, which included such notables as Clive Bell, E. M. Forster, Lytton Strachey, and Virginia

Woolf. His unique mixture of talents enabled him to be an accomplished mathematician as an

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undergraduate, to write a book on probability theory, and to be a powerful and effective prose

stylist, which is evident in the sheer literary mastery of both his Economic Consequences of the

Peace and his essays, collected into two books as Essays in Persuasion and Essays in Biography.

The single most important aspect of Keynes the economist is his orientation toward policy. He

attended the Versailles peace conference as a representative of the British Treasury Department but

resigned abruptly in 1919. He was disgusted by the terms of the Versailles treaty, which imposed on

Germany large reparations that he thought could never be paid. He received international acclaim

for his criticism of the terms of the treaty, published in 1919 in his Economic Consequences of the

Peace. In 1940, he wrote How to Pay for the War, and in 1943, he advanced a proposal called the

Keynes Plan for an international monetary authority to be put into effect after World War II. As

head of the British delegation to Bretton Woods, he was instrumental in the formation of the

International Monetary Fund and the International Bank. But his most important contributions to

policy and theory are contained in his book The General Theory (1936), which created modern

macroeconomics and still forms the basis of much of what is taught in undergraduate

macroeconomics. Paul Samuelson captured its importance when, reflecting on the Keynesian era, he

wrote, “The General Theory caught most economists under the age of thirty-five with the

unexpected virulence of a disease first attacking and decimating an isolated tribe of South Sea

Islanders.”

The Contextual Nature of The General Theory

Possibly no book in economic theory has a more presumptuous first chapter than Keynes’s General

Theory. To be sure, other economists had proclaimed their own originality and brilliance, but

Keynes did it with such force that it seemed convincing. This lack of modesty apparently went back

to Keynes’s youth. When he took the civil service exam upon graduation from college and did not

receive the top score in economics, his response was, “I evidently knew more about economics than

my examiners.”11 While Keynes was working The General Theory, he wrote to George Bernard

Shaw that he was writing a new book that would revolutionize the way in which the world thinks

about economic problems. The first chapter of The General Theory is one paragraph long. Here

Keynes simply states that his new theory is a general theory in the sense that previous theory is a

special case to be placed within his more general framework. By “previous theory,” Keynes meant

both classical and neoclassical economics, which he defined as the economics of Ricardo as it

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pertains to Say’s Law, and of those who followed in this belief: J. S. Mill, Marshall, Edgeworth, and

Pigou. on

Although the single most important aspect of Keynes the economist was his policy orientation,

his most important work, The General Theory, in spite of its policy overtones, is essentially a

theoretical book whose major audience was to be found among professional economists. Keynes

wrote, “This book is chiefly addressed to my fellow economists. I hope it will be intelligible to

others. But its main purpose is to deal with difficult questions of theory, and only in the second

place with the application of this theory to practice.”12

We can reconcile this seeming contradiction by understanding the way in which Keynes used

theory. Many economic theories are what might be called noncontextual; that is, they are developed

in an institutional void. Such theories are best understood by deductive logic; they begin with first

principles from which conclusions are deduced on the basis of carefully stated assumptions. In

making these assumptions, one does not take reality into account but tries instead to understand the

inherent logic of the interactions among the assumptions. Such theories might be called analytic

theories. General equilibrium analysis, done correctly, is an analytic theory. Because the

assumptions are inevitably far removed from reality, drawing policy conclusions from broad-

ranging analytic theories is extremely complicated.

Keynes used a different kind of theory, one that might be called “realytic,” because it is a

compromise between a realistic and an analytic approach. A realytic theory is contextual; it blends

inductive information about the economy with deductive logic. Reality guides the choice of

assumptions. Realytic theories are less inherently satisfying, but because they correspond closely to

reality, it is easier to draw policy conclusions from them. Keynes did not start from first principles

in The General Theory but instead used reality to guide his choice of assumptions. Thus, although

he concentrated on theory, he never lost sight of its policy implications.

An example might make the distinction between realytic and analytic theories clearer. Keynes

assumed prices and wages to be relatively constant without attempting to justify those assumptions.

Although he briefly discussed the implications of flexible prices in The General Theory, arguing

that they do not solve the unemployment problem, a thorough consideration of their implications

was of little concern to him; for the problem at hand— what to do about unemployment—it was

reasonable to assume fixed wages and prices.

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have permitted such assumptions. Keynes left it to others to provide an analytic basis for his theory.

Much of the subsequent development of macroeconomic thinking has been an attempt to provide an

analytic base for macroeconomics. He could do this by using his realytic approach, whereas a truly

analytic model would not

Keynes began working on The General Theory immediately after completing his two-volume

Treatise on Money, which made use of the quantity theory of money to discuss cyclical fluctuations.

In The General Theory, Keynes abandoned this approach, much to the chagrin of his colleague

Dennis Robertson, with whom he had previously worked closely. He adopted instead a simple, new

approach that focused on the relationship between saving and investment. To provide himself with a

heftier target, Keynes lumped together the neoclassical disequilibrium monetary approach and the

earlier classical approach, exaggerated their beliefs, and called them collectively “classical theory.”

In doing so, he created a caricature of classical thought that emphasized its differences from his new

approach but concealed many of its subtleties.

Keynesian economics became embodied in the texts in a variety of models called the multiplier

model (sometimes called the AE/AP model), the IS/LM model, and the AS/AD model. These

models were the core of what was taught as macroeconomics through the 1980s and still appear in

many recently published undergraduate texts. But cutting-edge macroeconomics, for the most part,

went in different directions, as Keynesian economics lost favor.

The Rise of the Keynesian Multiplier Model: 1940-1960

In the 1940s and 1950s, economists explored the multiplier model, developing it in excruciating

detail. It was expanded to include international effects, various types of government expenditure,

and different types of individual spending. Terms such as the balanced budget multiplier became

standard parts of economic terminology, and every economics student had to learn Keynes’s model.

It is interesting to note that the model and the monetary and fiscal policies that were, and are,

generally called Keynesian are not to be found in Keynes’s book. There is not a single diagram in

The General Theory, nor any discussion of the use of monetary and fiscal policy. How, then, did the

multiplier model (done algebraically and geometrically) become the focal point of the

macroeconomic debates of the 1950s? Part of the reason is that it seemed to provide a better

description of current reality than did the alternatives. But other factors were also at work. The

initial policy debates about the validity of Keynesian economics focused on fiscal policy

(government deficits during the war had apparently pulled the Western world out of the

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Depression). Because the multiplier model nicely captured the effects of fiscal policy, it tended to

become the Keynesian model. We suspect that sociological reasons also played a role in both the

initial adoption and long-term acceptance of this model. The need for truth is often tempered by

other needs of the profession—specifically, teaching requirements and the necessity of publishing

journal articles. The multiplier model fit those needs beautifully.

It was in the United States that the multiplier analysis caught on. Paul Samuelson and Alvin

Hansen (1887-1975) developed it into the primary Keynesian model. Samuelson’s textbook

introduced it into pedagogy, other books copied Samuelson’s, and soon the multiplier model was

Keynesian economics. The multiplier analysis had many pedagogical advantages, being easy to

teach and learn. It allowed macroeconomics to develop as a separate field by providing a core

analytical structure for the course, just as supply-and-demand analysis had for microeconomics.

The Depression of the 1930s had changed the context within which society and economists

viewed the market. Prior to that time, the neoclassical arguments in favor of laissez faire had been

based not only on economic theory but also on a set of philosophical and political judgments about

government. The general political orientation of almost all individuals except radicals in the early

1900s was against major government involvement in the economy. Within that context, the

concepts of many government programs that we now take for granted, such as Social Security and

unemployment insurance, would have seemed extreme.

With the onset of the Depression, attitudes began to change. Many people felt that if the free

market could lead to such economic distress as existed during the Depression, it was time to start

considering alternatives. As economists began to analyze the aggregate economy in greater detail,

many became less confident of their policy prescriptions and much more aware of the shortcomings

of neoclassical theory. Consequently, economists began to advocate a variety of policy proposals to

address unemployment that were inconsistent with their mainstream neoclassical views. In the early

1930s, for example, A. C. Pigou in England and several University of Chicago economists in the

United States advocated public works programs and deficits as a means of fighting unemployment.

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Keynesian Policy

Keynesian economics subsumed policy argumentation and developed a model that had built into it

the need for activist government policies. In this model, aggregate demand controlled the level of

income in the economy, and the government had to control aggregate demand through monetary

and fiscal policies.

During the 1950s and 1960s, Keynesian policy came to mean fine-tuning through monetary and

fiscal policy. Abba Lerner (1903-1982) was an influential force in directing Keynesian analysis

toward such fine-tuning. In his Economics of Control (1944), Lerner advocated that government not

follow a policy of sound, finance (always balance the budget); it should instead follow a policy of

functional finance, which considered only the results of policies, not the policies themselves.

Functional finance allowed the government to “drive” the economy; in an oft-repeated

metaphor, monetary and fiscal policy were portrayed as government’s steering wheel. Lerner

contended that fiscal and monetary policy were the tools government should use to achieve its

macroeconomic goals: high employment, price stability, and high growth. The size of the deficit

was totally irrelevant: if there was unemployment, the government should increase the deficit and

the money supply; if there was inflation, the government should do the opposite.

Lerner’s blunt statement of the “Keynesian” argument offended the sensibilities of many

Keynesians and provoked considerable discussion, even causing Keynes to disavow

Keynesianism.13 Evsey Domar, a well-known Keynesian at the time, said, “Even Keynesians, upon

hearing Lerner’s argument that the size of the deficit did not matter, recoiled and said, no he had it

wrong, in no uncertain terms.”14 But Keynes soon changed his mind and agreed with Lerner, as did

much of the economics profession, and it was not long before Keynesian economic policy became

synonymous with functional finance.

Monetary and fiscal policies were, moreover, politically palatable. Many economists and others

believed the Depression proved that the government had to assume a much larger role in directing

the economy. The use of monetary and fiscal policy kept that role to a minimum. Markets could be

left free to operate as before. The government would not directly determine the level of investment;

it could simply affect total income indirectly by running a budget deficit or surplus. For many, the

legitimization of deficits had a second desirable characteristic: it allowed government to spend

without taxing.

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MODERN MACROECONOMICS

Monetarism

Throughout the 1950s and 1960s, the primary foil to the Keynesians was the monetarists. Under the

leadership of Milton Friedman, they provided an effective opposition to Keynesian policy and

theory. The consumption function model used by Keynesians in the 1950s had no role for money,

nor did it consider prices or the price level. This initial lack of concern about money supply and

prices manifested itself in policy based on Keynesian analysis. In an agreement with the Treasury

that developed during World War II, the Federal Reserve Bank agreed to buy whatever bonds were

necessary to maintain the interest rate at a fixed level. In so doing, the Fed relinquished all control

of the money supply. Monetarists argued that the money supply played an important role in the

economy and should not be limited to a role of holding the interest rate constant. Thus, the rallying

cry for early monetarists was that money mattered.

Keynesians were soon willing to concur with the monetarists that money mattered, but they felt

that the monetarists differed from them in believing that only money mattered. The debate was

resolved by means of the IS-LM Keynesian-neoclassical synthesis, in which the monetarists

assumed a highly inelastic LM curve and Keynesians assumed a highly elastic LM curve. Thus, at

least in terms of the textbook presentation, monetarist and Keynesian analyses came together in the

general neo-Keynesian IS-LM model, about which they differed slightly on some parameters.

Modern macroeconomics was a result of economists working through the neo-Keynesian model and

discovering many problems, some purely theoretical, and some becoming apparent as neo-

Keynesian policy failed.

Problems with IS-LM Analysis

IS-LM analysis remains part of most macroeconomists’ toolbox; it provides the framework most

economists initially use in tackling macroeconomic analysis. By the 1960s, however, it had been

well explored in the literature and found wanting in several ways. First, it forced the analysis into a

comparative static equilibrium framework. In the view of many economists, Keynes’s analysis

concerned—or should have concerned—speeds of adjustment. They believed that Keynes was

arguing that the income adjustment mechanism (the multiplier) occurred faster than the price or

interest rate adjustment mechanisms. Comparative static analysis lost that aspect of Keynes.

Second, in IS-LM analysis the interrelationship between the real and nominal sectors had to

occur through the interest rate and could not occur through other channels. Monetarists were

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unhappy with this because they thought money could affect the economy through several channels.

Many Keynesians were unhappy with the framework because it shed little light on the problem of

inflation, which in the 1960s was beginning to be seen as a serious economic problem. Third, the

demand for money analysis used to derive the LM curve was not based on a general equilibrium

model; instead, it was assumed in a rather ad hoc fashion. It had not truly integrated the nominal

and real sectors. Because it did not capture the true role of money and the financial sector, it

trivialized their function. It made it seem as if a fall in the price level could bring about an

equilibrium, when in fact most economists believed that a falling price level would make matters

worse, not better. Nonetheless, the IS-LM model was adopted. It was neat, it served its pedagogical

function well, it was a rough and ready tool, it provided generally correct insight into the economy,

and it was the best model available.

Dissatisfaction with existing analysis, however, led many macroeconomists to turn to other

models in their research. This led to a dichotomy. While IS-LM analysis remained the key

undergraduate model in the 1970s and 1980s, graduate research started to focus on quite different

issues. By the early 1990s the change in focus was filtering down to undergraduate courses. Modern

theoretical debates in macroeconomics have little to do with the shapes of the IS-LM curves.

Instead, they approach macroeconomic issues from a microeconomic perspective, and they deal

with issues such as the speeds of quantity and price adjustment. In a sense, many macroeconomic

researchers in the 1970s and 1980s argued that we should skip the Keynesian IS-LM interval and

return to the macroeconomic debate, as it existed in the 1930s, when issues were framed in

microeconomic terms. Thus, starting in the 1970s, we saw a reaction against Keynesian economics.

The Rise of Modern Macroeconomics

Monetarism’s focus on inflation brought it to the fore in the 1970s as inflation increased

substantially. At this happened, Keynesian policies and theory lost favor. Fiscal policy proved

politically too hard to implement; decisions on spending and taxation were made for reasons other

than their macroeconomic consequences. Monetary policy became the only game in town, but the

Keynesian models did not include the potential inflationary effects of monetary policy and so were

not well suited to dealing with discussions of monetary policy. So there was a movement away from

Keynesian economic models for formulating policy.

Simultaneously, there was a movement away from the Keynesian models on theoretical

grounds. As economists tried to develop the microfoundations for those models, they found that

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they could not do so within the context of the standard general equilibrium microeconomic

approach. This desire for micro- foundations deserves some comment, since it is important in

understanding the movement away from neoclassical economics and into modern formalistic

eclectic model-building economics.

Keynesian macroeconomics does not fit the neoclassical mold, and thus it can be seen as a step

in the direction away from neoclassical and into the eclecticism that characterizes modern

economics. It starts with analysis of interrelationships of aggregates rather than developing these

relationships from first principles. Thus, it has always had a tenuous theoretical existence, its

primary role being as a rough-and-ready guide to policy. Loose micro foundations were added to

macroeconomics throughout the 1950s and 1960s where they seemed to fit, but no attempt was

made to develop macroeconomics models from first principles. Macroeconomics was simply out

there—a separate analysis with little direct connection to the Walrasian theory that was at the core

of theoretical microeconomics.

The Micro foundations of Macroeconomics

In the 1970s, economists, in trying to fix this problem, began to lay the micro foundations of

macroeconomics by attempting to fit the Keynesian models into the neoclassical general

equilibrium model. They did this for two reasons: first, for theoretical completeness and, second, to

be able to expand the model to include inflation in the analysis. As they did so, they discovered that

Keynesian models broke down when normal neoclassical principles were applied to them.

Keynesian macroeconomics, the traditional macroeconomics of the textbooks, was inconsistent with

the microeconomics being taught.

The microeconomic foundations literature established new ways of looking at unemployment.

Whereas Keynesian analysis pictured unemployment as an equilibrium phenomenon in which

individuals could not find jobs, the micro- foundations literature pictured unemployment as a

temporary phenomenon— the result of the interaction of a flow of workers leaving work and new

workers entering. It argued that intersectoral flows were an important cause of unemployment and

that these flows were the natural result of dynamic economic processes. For the new

microfoundations approach to macroeconomics, unemployment was a microeconomic, not a

macroeconomic, issue.

Micro foundations economists argued that to understand unemployment and inflation

economists must look at individuals and firms’ microeconomic decisions and relate those decisions

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to macroeconomic phenomena. Search theory, the study of an individual’s optimal choice under

uncertainty, became a central topic of macroeconomics, as did a variety of new dynamic adjustment

models. As researchers began focusing more and more on these models, they focused less and less

on IS-LM models. The initial micro foundations models had been partial equilibrium models, but

once the micro foundations box was opened, economists needed to derive some method of

combining the various markets. The obvious choice was to use general equilibrium models. Thus,

general equilibrium analysis, which we saw in Chapter 14, had become the central model of

microeconomics, was ushered into macroeconomics along with micro foundations literature.

Micro foundations literature was cemented into the profession’s consciousness in the early

1970s by its accurate prediction about inflation. Advocates of the micro foundations approach

argued on theoretical grounds that the Phillips curve—a curve showing a tradeoff between inflation

and unemployment—was only a short-term phenomenon and that, once the inflation became built

into expectations, the unemployment-inflation tradeoff would disappear. The long- run Phillips

curve would be close to vertical and the economy would gravitate toward a natural rate of

unemployment.

The policy implications of the new micro foundations approach were relatively strong. Its

analyses removed the potential for government to affect the natural rate of long-run unemployment

through expansionary monetary and fiscal policy. Attempts to do so would work in the short run by

temporarily fooling workers, but expansionary policy would simply cause inflation in the long run.

According to the new microeconomics, government’s attempt to reduce unemployment below its

natural rate was the cause of inflation in the late 1970s.

Keynesian monetary and fiscal policies were not, however, completely ruled out. In theory, at least,

they could still be used temporarily to smooth out cycles. Thus, in the early 1970s, a compromise

arose between Keynesians and the advocates of a micro foundations approach to macroeconomics

economics: in the long run the classical model is correct; the economy will gravitate to its natural

rate. In the short run, however, because individuals are assumed to adjust their expectations slowly,

Keynesian policies can have some effect.

The Rise of New Classical Economics

In the mid-1970s the term rational expectations first appeared on the macroeconomic horizon. The

rational expectations hypothesis was a byproduct of the microeconomic analysis of Charles C. Holt

(1921- ), Franco Modigliani (1918- ), John Muth (1930- ), and Herbert Simon (1916- ), who were

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trying to explain why many people did not seem to optimize in the way that neoclassical economics

assumed they would. Their work was meant to explain by means of dynamic models what Simon

called “satisficing” behavior; that is, why firms’ behavior did not correspond to microeconomic

models. John Muth turned that work on its head, writing as follows:

It is sometimes argued that the assumption of rationality in economics leads to theories inconsistent

with or inadequate to explain, observed phenomena, especially changes over time. Their hypothesis

is based on exactly the opposite point of view: that dynamic economic models do not assume

enough rationality.19

Muth maintained that in modeling it is reasonable to assume that because expectations are

informed predictors of future events, they would be essentially consistent with the relevant

economic theory. As Simon wrote, “[Muth] would cut the Gordian knot. Instead of dealing with

uncertainty by elaborating the model of the decision process, he would once and for all—if his

hypothesis were correct—make process irrelevant.”20

With his assumption of a “dynamic rationality,” Muth turned disequilibrium into equilibrium.

Just as neoclassical writers used rationality to ensure static individual optimality or to ensure that

the individual moves to a tangency of his or her budget line and indifference curve, Muth used it to

express “dynamic” individual optimality—to set the individual on his or her inter-temporal

indifference curve. As long as the private actors in the economy are optimally adjusting to the

available information (and there is no good reason to assume the contrary), they will always be on

the optimal adjustment path.

Although Muth wrote his article in 1961, the rational expectations assumption did not play an

important role in economics until it was adopted by Robert Lucas into macroeconomics and

combined with the work being done in micro- foundations of macroeconomics. The rational

expectations hypothesis struck at the heart of the compromise between microfoundations

economists and Keynesians, because it held that people did not adjust their expectations toward

equilibrium in stages. They can discover the underlying economic model and adjust immediately,

and it would be beneficial for them to do so. Assuming that people have rational expectations,

anything that will happen in the long run will happen in the short run. Because in the

microfoundations-Keynesian compromise the effectiveness of monetary and fiscal policy depended

upon incorrect expectations, the rational expectations hypothesis was devastating. In the new view,

if Keynesian policy is ineffective in the long run, it is ineffective in the short run.

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In the mid-1970s, rational expectations caught on in macroeconomics, and there were significant

discussions of policy ineffectiveness and the unworkability of Keynesian-type monetary and fiscal

policy. This developing work in rational expectations soon came to be known as new classical

economics, because its policy conclusions were similar to earlier classical views. By the late 1970s

it seemed to many that the future of macroeconomics lay in new classical thinking and that

Keynesian economics was dead.

One of the lasting influences of the new classicals on macroeconomics was their contribution to

the theory of macroeconomic modeling. As will be discussed in Chapter 16, Keynesians had

developed macroeconomic models to a high level of sophistication in the work of economists such

as Jan Tinbergen (1903-1994) and Lawrence Klein (1920- ). In the 1960s and 1970s, many of these

econometric models were not good predictors of future movements in the economy, and many

economists were beginning to lose faith in them. Robert Lucas, a leader of the new classicals,

specified one reason why these models were poor predictors in an argument that became known as

the Lucas critique of econometric models. He argued that individuals’ actions depend upon

expected policies; therefore, the structure of the model will change as a policy is used. But if the

underlying structure of the model changes, the appropriate policy will change, and the model will

no longer be appropriate. Thus, it is inappropriate to use econometric models to predict effects of

future policy.

The majority response was to change their view of models: models were practical tools that

provided insights into particular policy questions; there could be a number of different models that

could be used whenever they seemed to apply; there was no need to have a broad consistency of all

the models. Thus, modern textbooks present the IS/LM model as a working tool, not as something

derived from strict microfoundations. This approach to modeling differed significantly from the

neoclassical approach, which saw all models as, in principle, developing from the core assumptions

of microeconomics.

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SUMMARY

The history of macroeconomics has been marked by changing interest in growth, business cycles,

and inflation and the determination of the price level. While Adam Smith was primarily interested

in the question of economic growth, later classical economists focused their analysis on the

distribution of income and saw the economy as ultimately being driven to a stationary state by the

law of diminishing marginal returns. They saw prices as being primarily determined by the quantity

theory of money, and they saw that determination as needing to be separated from the analysis of

the real economy. They saw the economy as essentially self-correcting, with little need for

government intervention.

Keynes’s General Theory marked a significant change in the focus of economics from

microeconomic questions of resource allocation to macroeconomic questions of business

fluctuations. It emphasized the short run over the long run. Keynes offered a new analytical

framework to explain the forces determining the level of economic activity. He not only found

capitalism inherently unstable but concluded that the usual outcome of the automatic working of the

market was to produce equilibrium at less than full employment. Following the leads of Marx,

Tugan-Baranowsky, Wicksell, and others, he focused on the role of investment spending in

determining the level of economic activity.

A great deal of literature followed that not only extended and improved the original Keynesian

formulation but also threw into sharper perspective the contrasts and similarities between the

Keynesian and pre-Keynesian models. The Keynesian concepts were in a form that invited

mathematical model building and empirical testing. The theoretical revolution was followed shortly

by a policy revolution as the major industrialized economies began programs and constructed

agencies designed to foster full employment.

The Keynesianization of macroeconomics developed in a rather curious manner: it took the

form of multiplier models advanced by leading Keynesians such as Alvin Hansen and Paul

Samuelson. The close association of the development of Keynesian macroeconomic theory with the

use of fiscal policy as a compensatory action available by government to promote full employment

probably accounts for this focus on the multiplier model. In response to internal inconsistencies in

the pure Keynesian formulation and to issues raised by monetarists concerning the role of money,

the IS-LM model became the dominant macroeconomic model by 1960.

With the formalization of the debate around 1975, however, this model was found to be

unsatisfactory for economic research. Inflation, as well as unemployment, seemed an important

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economic topic. A new literature appeared that tried to uncover the microfoundations of

macroeconomics and in so doing blurred the one aspect of Keynesianism that had divided

economics into microeconomic and macroeconomic spheres. With the rise of the microfoundations

literature, the debates and theoretical developments returned to something closer to the framework

of the early 1930s. The only exception was that general equilibrium analysis was increasingly

replacing partial equilibrium analysis. Initially, macroeconomics was closely associated with

econometrics and the development of large-scale models of the economy. Although numerous such

models exist, their early promise has not been realized. Thus, in the 1980s there was a movement

away from such models and from the focus on purely theoretical issues. Modern macroeconomics is

highly eclectic, and no single approach is accepted by all economists.

It is, moreover, in a period of transition; scholars are carrying on a wide range of research programs

addressing many different questions. The main focus of macroeconomics today is on a new growth

theory that deviates significantly from the earlier classical growth theory, especially in emphasizing

endogenous technology and in not considering the stationary state as inevitable.

The development of econometrics and empirical methods in Economics

There has been a continuous debate in the profession about the proper relationship between

theory and empirical methods

Empirical Approaches

1. Common Sense Empiricism

Relates theory to reality through direct observation with a minimum of statistical aids

Still commonplace in some subjects

History anthropology

Contemporary supporters point to the valuable insights found in

careful observation

extensive field work

case studies

direct contact with institutions

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personal experience “within” an event

2. Statistical analysis

Emphasizes those aspects of an economic event that can be quantified and is therefore

subject to measurement and analysis

Supporters claim that this approach permits a researcher to draw from a large number of

theories and select the most relevant one.

Also claim that it discouraged pre-considered theoretical notions from biasing one’s

interpretation of data

3. Classical Econometrics

- Rigorous defines the relationship between theory and empirical data

- developed in the 1930’s

4. Baynesian Approach

-Directly relates theory and data as above but assumes that no test can provide definite

answers

Does not seek objective laws but subjective degrees of belief

Statistical analysis cannot determine objective truths, but it does add in making

subjective judgments

Recent Developments

1. Computer Technology

2. Agent Based Modelling

3. Calibration: See if data is consistent with a theory

4. Experimental Economics

Neoclassical Era (1870-1950’s) and Empirical Analysis

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There was no accepted test to validate or reject the merits of various theories

This gradually changes as neoclassical theories became more formal and some sought to

make economics an exact science

This resulted in formalizing the approach that economists use in their empirical analysis