Transcript The Transition to Neoclassical Economics

The Transition to Neoclassical
Economics – “Second Generation
Marginalists”
Chapter 9
Second Generation
Marginalists
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We use this term because they added to the
“first generation” by considering supply as
well as demand factors in value theory (price
determination)
Applied marginal analysis to the supply side –
marginal productivity analysis
Explains the forces determining the prices of
factors of production and the distribution of
income
Deficiencies of “First
Generation Marginalists”
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Assumed that supply was given and
that the economic problem was simply
one of allocating this fixed supply
No explanation of factor prices – wages,
interest, rent and profit
No explanation of distribution of income
No analysis of the firm (supply)
Marginal Productivity Theory
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Based on Diminishing Returns
Ricardo did use this concept with
respect to agriculture
Definition of Diminishing
Returns (Columbia Encyclopedia)
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Law stating that if one factor of production is increased while
the others remain constant, the overall returns will relatively
decrease after a certain point. Thus, for example, if more and
more laborers are added to harvest a wheat field, at some point
each additional laborer will add relatively less output than his
predecessor did, simply because he has less and less of the
fixed amount of land to work with. The principle, first thought to
apply only to agriculture, was later accepted as an economic law
underlying all productive enterprise. The point at which the law
begins to operate is difficult to ascertain, as it varies with
improved production technique and other factors. Anticipated by
Anne Robert Jacques Turgot and implied by Thomas Malthus in
his Essay on the Principle of Population (1798), the law first
came under examination during the discussions in England on
free trade and the corn laws. It is also called the law of
decreasing returns and the law of variable proportions.
Impact of Diminishing Returns
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Upward sloping supply curve
Why do producers have to have a
higher price in order to produce more?
Because of increasing marginal cost,
which is based on diminishing returns
(diminishing marginal productivity)
Impact of Diminishing Returns
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Downward sloping demand for inputs (factors of
production)
As the marginal product of a factor declines, it is
worth less to the firm, and so the firm is willing to
pay less for the input. This results in a downward
sloping demand curve for the input.
In a competitive market, factors of production will
receive a payment equal to their marginal revenue
product, that is, they will receive a payment equal to
what they are worth to the firm.
Product Exhaustion
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Product exhaustion refers to the idea that
payments to factors of production based on
the value of their marginal product will
exhaust (use up) all of the total product.
Ricardo’s theory of distribution concluded that
all total product will be used up, or paid out
to landlords or workers.
In the Marginalist theory, this is not always
the case. It depends upon the property of
the production function
Constant Returns to Scale
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What do we mean by CRS?
Production function is homogeneous to
the degree one
When ALL inputs are doubled, output
doubles; when inputs are tripled, output
triples, etc.
Therefore, average cost is constant and
equals marginal cost
Product Exhaustion and CRS
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If inputs are paid their MRP, then all
revenue is “used up” as factor
payments
Assume perfect competition
ATC = MC and MC = MR
This means that ATC = MC = MR, so
there are no (economic) profits
Decreasing Returns to Scale
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What do we mean by DRS?
Production function is homogeneous to
a degree less than one
When ALL inputs are doubled, output
less than doubles; when inputs are
tripled, output less than triples, etc.
Therefore, average cost is increasing
and MC > ATC
Product Exhaustion and DRS
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In this instance there are economic
profits – therefore no product
exhaustion
Increasing Returns to Scale
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I leave it to you to make this analysis
Product Exhaustion
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So, the Second Generation Marginalists
realized that product exhaustion would
not always occur in the short run
But, it would occur in the long run
under perfect competition
WHY?
Ethical implications of
marginal productivity theory
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Is the distribution of income that results
from marginal productivity theory (and
based on perfect competition) a “just”
or “fair” distribution?
John Bates Clark
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Said “yes” because perfect competition
rewards the factors of production according
to their economic contribution
Rent, interest and profit are not “unearned”
income – they are a return to the contribution
of scarce factors of production
But what about conditions of less than perfect
competition???
Marginal productivity as a
theory of employment
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At the micro level, a firm will hire workers
up to the point where. . .
Marginal Revenue Product (or value of
marginal product) = wage
The demand for labor depends upon the
marginal revenue product
Why is the demand for labor curve downward
sloping?
Diminishing marginal product
Marginal productivity as a
theory of employment
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What about the macro level?
Unemployment results from
disequilibrium in the labor market
Excess supply of labor
Can be corrected via falling wages
Criticism of Marginal
Productivity Theory
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Impossible to measure the marginal
product of a factor of production
What is the marginal product?
The additional to output as a single
factor changes – all other inputs remain
constant
How can we measure the contribution
of one factor independent of others?
Factor payments (review)
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Labor – wages
Land – rent
Capital – interest (remember this is real
capital, not financial capital)
Entrepreneurship - profit
Marginalists were concerned
with factor payments
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Factor payments determine income
distribution
Second generation
Marginalists and wages
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Demand for labor is downward sloping
– diminishing marginal productivity
See figure 9.2 on page 250
If wage rate is OD, then total wages are
equal to the wage rate of OD times the
quantity of labor hired of OC which is
equal to the area of OCBD.
Second generation
Marginalists and rent
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Demand for land is downward sloping –
diminishing marginal productivity
See figure 9.2 on page 250
If Oh units of land is used, then total
rent is equal to the area of OHGI
Wages then become the residual
Profits and Interest
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Classical writers failed to distinguish
between the two
In part this is because the typical firm
during this time did not separate
ownership from management
The capitalist (provider of funds) and
entrepreneur (risk taker) were the same
person
Profits and Interest
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Second generation Marginalists
recognized a difference
Interest is the return to capital and
profit is the return to entrepreneurs
Second generation
Marginalists and profit
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To the Marginalists, in competitive
markets all factors will be paid the value
of their marginal product which is equal
to opportunity cost
Normal profit is the amount needed to
keep the entrepreneur in business –
alternatively, it can be seen as the
opportunity cost of the entrepreneur
Second generation
Marginalists and profit
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What about economic profit (excess profit, pure
profit)?
An excess that occurs when competitive markets are
not in equilibrium OR
When markets are not competitive
Economic profit in competitive markets is not a return
(payment) to a factor of production but a windfall
associated with dynamic elements in an economy
For example, in a competitive market, demand may
increase in an industry resulting in higher output
prices – new firms enter and drive prices down and
eliminate economic profits
Second generation
Marginalists and interest
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Interest as a return to capital is still not
a settled issue
We can look at theories that examine
the reasons for the existence of interest
(Theories of Interest)
Or, we can examine theories of the rate
of interest
The “Problem” of Interest
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Interest is a return to real capital
But real capital is manmade machinery
that incorporates other factors of
production – it is not an “original” factor
of production like land and labor
But capital receives a return above its
initial price (or cost of production) –
there is a net return
The “Problem” of Interest
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Capital appears to be unique among the
factors of production in that it creates a
surplus value that flows to its owner in
perpetuity (Textbook, p. 264)
If product exhaustion occurs, then how
can there be interest paid to owners of
capital into the future?
Interest and time preference
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People prefer the present over the
future
A good available now has a different
value than the same good available at a
later date; value has a time as well as a
quantity dimension
Interest and time preference
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Because of this time preference, factors
of production will receive the
discounted value of their marginal
products
The difference between these
discounted values and the value of the
marginal product when the final goods
are produced is equal to interest
Looked at another way
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The supply curve of loanable funds is
upward sloping because people require
some payment for deferring
consumption into the future
The demand for loanable funds is
downward sloping because of
diminishing returns to capital