Mr Econ338Part5

7/30/2019 Mr Econ338Part5

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Alfred Marshall

1842-1924 Biographical Details

Trained in Mathematics atCambridge

Discovered economics by readingJ. S. Mill

1877 Married Mary Paley andboth lectured in economics atBristol

1884 Returned to Cambridge andworked to establish the economicsprogram

1890 Principles of Economics

1919Industry and Trade


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Marshalls Approach

Wanted his writing to be

accessible to the intelligent

layman

Mathematics confined to

appendices

Wanted to reconcile Classical,marginalist and historicist ideas

Neoclassical synthesis in theory

Theory and application toindustry studies


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Marshalls Approach Partial equilibriumlooking at

one market only with

everything else held constant

Contrast with Walras general

equilibrium approach

Short run/long run distinctionwhat is held constant varies

with the time frame

Static analysis vs biologicalanalogy


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Theory of Demand

Law of diminishing marginalutility

Diminishing marginal utilitytranslated directly into terms ofprice

Diminishing willingness to pay

Demand curve is not formallyderived through the conditionsfor a consumer maximum

In the Marshallian discussion

price is usually the dependantvariable


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Demand Theory

The demand curve is interpretedas a schedule of DemandPrices

What is held constant along thisdemand curve?

Marshall assumes both constant

money income and constant realincome (constant MU ofincome)

This rules out any significant

income effects Marshalls Law of Demand


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Marshallian Demand

Curves

Q

P

D

P1

P2

Q1 Q2

As Q increases the consumers

willingness to pay for additionalunits declines

Changes in Q cause changes in demand price,

so P is on the vertical axis


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Marshall and the Giffen

Good Case Marshall is aware that the MU of

income may be affected by price

changes If a good is inferior and important in

the budget a large income effect may

create an upward sloping demand

curve

Marshall attributes this idea to

Robert Giffen and to the demand for

bread by English labourers

No evidence that Giffen said this and

no evidence that bread was a Giffen

good


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Elasticity of Demand Marshall invented the elasticity

measure of the responsiveness

of demand to changes in price

Percentage or proportionate

change in Q demanded divided

by the percentage orproportionate change in P

Unit free measure of

responsiveness

Elasticity and relationship to

total expenditure on the good


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Consumers Surplus

Marshall interpreted a demand

curve as a willingness to pay at

the margin curve Consumer is willing to pay

more for the first few units of a

good than for subsequent units

If the consumer pays a single

price for all units bought then

the total willingness to pay for

those units will exceed theamount actually paid

This is consumers surplus


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Consumers Surplus

P

Q

D

a

0

P1

Q1

b

Total willingness to pay for Q1 = 0abQ1

Amount actually paid = 0P1bQ1

Consumers surplus = P1ab

Consumers Surplus


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Consumers Surplus

Marshall thought Consumers

surplus would be a vital tool for

practical policy appraisal

Problem of aggregation over

individuals and of interpersonal

comparisons

Can only aggregate and compare if

the MU of income is the same for

everyone

Marshall argued that provided that

on average the MU of income is thesame than can aggregate and

compare across groups


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Marshall on Production

Factors of production: land, labour,capital, and organization

Diminishing returns in agriculture

Diminishing returns can also occurwith fixed factors other than land

Increasing returns in industry withconcentration of industry in

particular localities Increased productivity in industry

due to larger scale of particularfirms--increased specialization of

labour and machinery Economies of buying and selling on

a large scale


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Forms of business organization and

the problems of maintaining energy

and efficiency

Joint stock companies and problemsof agency

Distinction between external and

internal economies

External economies are economiesderived from the general development

of an industry (external to individual

firms)

Internal economies derived from thesize of individual firms (internal to the

firm)


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Tendency to decreasing returns inagriculture and natural resourceindustries

Tendency to increasing returns inother industries

An increase of labour and capital leadsgenerally to improved organizationwhich increases the efficiency of labour

and capital

But limits to the size of particularfirms

Biological analogy and the life cycle

of firms Concept of the representative firm--

firm with average access to internaland external economies


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Cost and Supply

Expenses of productionprices

that have to be paid to call forth

the required supply ofproductive factors

Supply price of a good

Firms seek to minimize factorcostsprinciple of substitution

Importance of time frame

short run and long run

Prime costs and supplementary

costs (variable and fixed cost)


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Short Run Supply

In the short run the quantity of

capital available to the firm is

fixed

The price the firm receives has

to cover prime costs only

With fixed capital will have

diminishing returns so that in

short periods increased

production will raise the supply

price In the short term any return over

prime cost is a quasi rent


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Short Run Market

Supply Curve SR market supply curve slopes

upward

Firms have different levels of cost soat a given price some may be making

quasi rents, others just covering

prime costs and some may be

producing nothing (cant cover evenprime cost)

As price rises firms already in

production produce more and

previously shut down firms will

open up


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Short Run Market

Equilibrium

Q

P

D

S

P*

Q* QQ

At Q demand price is below supply price

And output will be reduced. At Q demand

price exceeds supply price and output will

Rise. At Q* demand price = supply price

Assuming competitive conditions


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Marshallian vs

Walrasian Adjustment toEquilibrium

P

Q

D

SP

Walras: At P there is excess supply and

price falls until D=S (red arrow)

Marshall: At Q supply price exceeds

demand price and quantity supplied will

fall until demand and supply prices are

equal (blue arrow)

Does it matter? Issue of stability

P*

Q* QQ

P


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Long Run Equilibrium

In the long run firms can changescale and the size of the industry canchange

Marshall thinks in terms of the costsof the representative firm

In long run equilibrium therepresentative firm must be at least

covering total costs (prime plussupplementary)

If this is true then size of theindustry will not change although

individual firms still going throughtheir life cycles

Long run equilibrium population offirms


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Long Run Supply

If the representative firm is notcovering total cost the industry

will shrink in size

If the representative firmindustry is more than normally

profitable the industry will grow

in size

What happens to the costs of a

representative firm as the

industry changes in size?

Importance ofexternal

economies and diseconomies


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Long Run Supply

In industries where externaleconomies dominate, growth inindustry size will lower thecosts of all firms

Long run industry supply curvewill be downward sloping

(decreasing cost industry) If external diseconomies

dominate industry growth raisescosts for all firms

Long run industry supply curvewill be upward sloping(increasing cost industry)


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Long Run Supply

If external economies anddiseconomies just cancel each otherout then the costs of firms will not

be affected by industry growth Long run supply curve will be

horizontal (constant cost industry)

Marshall though most industries

other than natural resource industrieshad declining long run costs

What might these externaleconomies consist of?

Reduction in factor cost due toindustry growth creating a pool oftrained labour in that locality


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Long Run Supply

CurvesP

Q

P

Q

DD

LS

S S

LS

S

S

DD

Increasing cost

Decreasing cost


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Importance of

Decreasing Cost Case Decreasing costs due to external not

internal economies

Therefore decreasing costs areconsistent with continued

competition

If decreasing costs were due to

internal economies this would resultin monopoly

Allows Marshall to concentrate on

the competitive casemonopoly an

exception

Link to modern literature on

endogenous growth


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Externalities, Taxes and

Subsidies Marshall argued that only in the case

of constant costs did competitionresult in an optimal allocation of

resources External diseconomies meant that

industries grew too large as newentrants did not take account of the

increased cost they imposed onothers

External economies meant thatindustries did not grow large enoughas potential entrants did not considerthe beneficial effects they wouldhave on other firms

Marshalls argument based onconsumers surplus measures of

welfare


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Constant Cost Case

LS

LS

P

Q

D

a

f

Q Q

b c

e d

Subsidy: LS to LS

Cost: acdf Benefit: abdf Cost > Benefit

Tax: LS to LS

Cost: abdf Benefit: abef Cost > Benefit

No case for subsidization or taxation


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Increasing Cost Case

LS

LS

D

P

Q

a b

c

de

f

g

h

i

j

Subsidy: LS to LS

Cost: abci Benefit: jgci Cost > Benefit

Tax: LS to LS

Cost: jgci Benefit: jgfh Benefit > Cost

Case for tax where there are external

diseconomies


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Decreasing Cost Case

LS

LSD

ab

c

d

ef

g

h

i

j

Subsidy: LS to LS

Cost: jcdh Benefit: abdh Benefit> Cost

Tax: LS to LS

Cost abdh Benefit: abgi Cost > Benefit

Case for subsidizing where there are

external economies


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Monopoly

Marshalls analysis of monopolyuses average total cost and averagerevenue curves

Average cost as the monopolysupply price

Monopoly will maximize thedifference between demand priceand supply price

ATC

D

P* profit

Q*

P

Q


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Factor Prices

Critiques both the wage fund theoryand the Marxian view that surplusis produced by labour

Marginal productivity theory offactor demand

Demand for factors a deriveddemand

Firms demand curve for a factorbased on the value of marginalproduct

On factor supply

Labour supply a function of wages

Supply of capital a function of theinterest rate

Producers surplus and rent


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Factor Markets

Demand and supply explanationof factor prices

Generally assuming competitivefactor markets

Concern with the extent of theinequality of the distribution of

income Emphasis on improvement in

the quality of labourtrainingand education to increase

productivity Saw long run possibilities for

improvementcautious reform

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