Ignazio Musu

History of Economic Thought

Lecture 6

Marginalism and the

neoclassical school
1
Towards the marginalist revolution.

• Economic thought fundamentally changed during the

1870s, with the so- alled marginalist e olutio that
rapidly became the dominant paradigm of the discipline.

• In comparison with the classical school, the marginalist

revolution was characterized by a focus on the behavior
of individual economic agents (consumers and firms).

• It focused on the utility as the source of economic value.

2
• The development of the individualistic approach of
marginalism was favored by the development of the
economic reality.

• The period from 1868 to the mid-1870 was characterized

by sharp social conflicts.

• The classical school of economics seemed to have evolved

in the Marxian direction as a foundation for a theory of
capitalist exploitation and more generally as a basis for
socialists proposals.

• Economics was considered by many to have become too

ideological and there was the urgency of re-constructing it
on a more analytical a-politi al foundation.

3
• In the neoclassical theoretical system economics is
separated from social and political aspects: the term
politi al e o o is gradually replaced by the term
e o o i s ie e .

• In the neoclassical theoretical system the economic laws

are completely independent of history.

• Economics is considered as a science likened to natural

sciences, mechanical physics in particular, that should deal
with objective rules of universal validity independently of
the historical and social situation.

4
• There have been also reasons internal to the classical school
itself that justified the need of a new approach to economic
thinking.

• In the classical orthodoxy there were serious problems with

the labor theory of value.

• Above all, classical economists did not pay enough attention

to the role of demand in the economy.

• Marginalism adopted a more subjective theory of value than

the objective one adopted by classical economists and based
mainly upon production costs.

5
• A characteristic of the neoclassical thought has been the
acceptance of the utilitarian approach, reformulating it
within a utility theory of value that reduces human
behavior to rational calculation aimed at maximization of
utility.

• The fundamental role of utility means that the individual

subject becomes dominant in determining economic
values: individuals, and not social classes, became the
center of economic neoclassical analysis.

6
• The neoclassical theoretical system did not pay the attention
to economic growth that was central in the classical
economists.

• The attention was shifted to the problem of allocation of

given resources among alternative uses.

• The neoclassical theory recovered the Smithian perspective

of the good job made by the free market considering it as a
mechanism to optimally allocate given resources.

• The neoclassical theoretical system turned out to be more

static and less dynamic than the classical one.

• The problems of growth were treated again by the

neoclassical school only very recently.
7
The marginalist revolution in England: William Stanley
Jevons.

• In 1871 the marginalist e olutio as introduced in

England by William Stanley Jevons.

• Jevons (1835- , afte the pu li atio of The Theory

of Politi al E o o in 1871, became professor of
political economy at University College, London.

• He died tragically in 1882 from a drowning accident while

swimming during a seaside holiday.

8
• I his Theo of Politi al E o o Je o s e plai s that he
wants to make economics a mathematical and quantitative
science:

• It is lea that, if e o o i s is to e a s ie e at all, it ust

e a athe ati al s ie e… To e it see s that ou s ie e
must be mathematical, simply because it deals with
quantities. Whenever the things treated are capable of
being greater or less, there the laws and relations must be
athe ati al i atu e .

• Jevons however showed many difficulties in translating his

economic insights into the formal mathematical language.

9
• A large part of the work of Jevons is devoted to develop the
utility theory.

• He believed that utility is a subjective feature, and not an

intrinsic quality of commodities.

• He claimed that the only real criterion to be used in

economics to define what is or is not useful is the judgment
and attitudes of the individual person.

• A e t al ole i Je o s’s thought is pla ed the idea of

marginal utility as a decreasing function of the quantity
consumed of a good.

10
• I The theo of Politi al E o o he ites: Let us
imagine the whole quantity of food which a person
consumes on a average during twenty-four hours to be
divided into ten equal parts. If his food is reduced by the
last part, he will suffer but little; if a second tenth part be
deficient, he will feel the want distinctively; the
subtraction of the third tenth part will be decidedly
injurious; with every subsequent subtraction of a tenth
part his sufferings will be more and more serious, until at
length he will be on the verge of starvation. Now, if we call
each of the tenth part an increment, the meaning of this
fact is that each increment of food is less necessary, or
possesses less utility, than the previous one .

11
• Although Je o s did ot use the te a gi al utilit ,
there is no doubt that he had in mind was what in the
su se ue t e o o i a al sis as ee alled de easi g
marginal utilit .

• Jevons used it to derive a demand function: each person

should demand a good until the decreasing marginal
utility is equal to the price of the good.

• This proposition had been anticipated by the German

economist Hermann Heinrich Gossen (1810-1859) in his
ook The De elop e t of the La s of Hu a
I te ou se a d the Co se ue t Rules of Hu a A tio .

• When published in 1854, this book was a total failure; but

30 years later a Berlin publisher reprinted the book with a
new date (1889) and it was an extraordinary success. 12
• Only afte the pu li atio of the fi st editio of The Theo
of Politi al E o o Je o s had the oppo tu it to k o
the work of Gossen.

• Thus, in the second edition of the book, that came out in

1879, he added a new introductory chapter fully
recognizing the work of Gossen.

• However, his recognition was mixed with some

disappointment for having discovered that he had not been
the first to arrive to the same results.

• Je o s a k o ledged that eg et a easil e s allo ed

up in satisfaction if I succeed eventually in making that
u de stood a d alued hi h has ee so sadl egle ted .
13
• Je o s de eloped Mill’s esult that p i es a e dete i ed
by demand and supply, explicitly expressing both demand
and supply as functions of the price.

• His ambition was to arrive at a general theory explaining

how the prices are determined by demand and supply in
all markets of the economy.

• But he did not succeed in this task.

14
Marginalism in Austria: Carl Menger.

• Carl Menger (1840-1921) can be considered as the founder

of the so-called Austrian school, an important pillar of the
marginalist neoclassical revolution.

• Me ge ’s dissertation fo ha ilitatio at the University of

Krakow as pu lished as the ook P i iples of
E o o i s i .

• From 1873 he held the chair of political economy at the

University of Vienna.

• The second edition of his Principles, which was published

posthumously by his son Karl in 1923.
15
• The ambition of Menger ith his P i iples of E o o i s
was to develop a general theory of value, that could be
used to explain all prices both of final consumer goods and
of factors of production.

• He strongly opposed any objective theory of value such as

the labor theory of value; he had in mind a subjective
theory of value, based on subjective need satisfaction.

• Menger ites that alue does ot e ist outside the

consciousness of men.... The value of goods is entirely
subjective in nature .

16
• Menger adopted the theory of marginal decreasing utility
as a source of the value of a good.

• But his step forward with respect to Jevons (and Gossen)

was his use of a subjective theory of value to analyze not
only consumption but also production.

• This he did in a very special way that gave to those

e o o ists usi g his ethodolog the a e of Aust ia
school .

• Menger had the problem to reduce the value of goods

that are means of production to the final stage of
satisfaction of needs.

17
• This meant determining the cost of production (and then
not only demand but also supply of goods) reducing this
process eventually to utility.

• To do this, Menger classified goods according to their

distance from the final consumption.

• The satisfa tio of eeds is di e t i the ase of

o su ptio goods that a e defi ed as goods of the fi st
o de .

• But it is i di e t i the ase of p odu tio goods that,

according to the stage of production in which they are
used, a e defi ed as goods of the se o d, thi d et .
order .
18
• In this vision the fa to s of p odu tio s a e highe -order
goods that eventually derive their value from the fi st-
o de goods o su ptio goods the o t i ute to
produce.

• Goods of higher orders, as the factors of production, have

no immediate connection with the satisfaction of human
wants, but they indirectly affect the satisfaction of final
needs.

• The value of a certain quantity of consumer goods is

imputed to the goods of the second (or higher) order
employed in its production in proportion to their
contribution.
19
• Menger writes: "Thus, as with goods of the first order, the
factor that is ultimately responsible for the value of goods
of higher order is merely the importance we attribute to
those satisfactions with respect to which we are aware of
being dependent on the availability of the goods of higher
order whose value is under consideration. But due to the
causal connection between goods, the value of goods of
higher order is not measured directly by the expected
importance of the final satisfaction, but rather by the
expected value of the corresponding goods of lower
order."

20
• The result of Me ge ’s conclusion is that the value of a
factor of production is determined by the additional
contribution to the final product.

• I the eo lassi al s hool this is k o as the alue of the

a gi al p odu ti it of the fa to to the fi al p odu t, a
theory widely used in the neoclassical school.

• Thus each factor of production will be demanded until the

value of its marginal productivity is equal to its price.

• Hence in the neoclassical thought results in production

theory are ultimately derived by the utility theory.

21
Menger and the controversy about mehod.

• Menger is also known for his position in the so-called

Methodenstreit o t o e s a out ethod i hi h he
opposed the Ge a histo i al s hool led Gusta
Schmoller.

• Schmoller was a socialist and a strong opponent of a

deductive approach to economics, because this approach did
not consider the role of historical facts.

• Schmoller supported the historical research as the basis for

an interdisciplinary approach to the analysis of society of
which economics was only one part, together with
sociological, psychological and philosophical dimensions.
22
• Schmoller was a supporter of social reforms and
distributive justice, but he believed that they could be
ensured only by an illuminated sovereign, such as the
Prussian king.

• These ideas ha e ee k o as so ialis of the hai ,

a ki d of so ialis f o a o e .

• They were used by the high bureaucracy of the Prussian

empire, in particular by the Chancellor Otto Bismarck, to
adopt social insurance policies which represented the first
e pe i e t of Welfa e “tate .

23
• Menger o je ted to the positio s of the histo i al
s hool stati g that e o o i s, if it ishes to e a
science, should keep it self free of value judgments.

• I a ook e pli itl itte agai st the histo i al s hool ,

Menger ites: The so- alled ethi al o ie tatio of
political economy is thus a vague postulate devoid of any
deeper meaning in respect both to the theoretical and to
the practical problems of the latter, a confusion in
thought .

• Menger claimed that economics as a science should only

deal with the behavior of individual agents without giving
space to concepts such as national interests or collective
wealth.
24
Neoclassical theory in Austria: Eugen von Bohm-Bawerk

• Another important representative of the neoclassical

Austrian school has been Eugen von Bohm-Bawerk (1851-
1914).

• Bohm-Bawerk was educated in law and political science

and became interested in economics under the influence of
Menger.

• He was professor of political economy at Innsbruck from

1880 to 1889.

• After having covered important posts in the Austro-

Hungarian administration, he was minister of finance three
times (1893, 1896-97, 1900-04).
25
• After having resigned because he did not agree with a
parliamentary decision to increase sharply military
expenditure, he became professor of political economy at
the University of Vienna.

• Bohm-Bawerk most important contribution is the two

volumes Capital and Interest ; the fi st olu e as
published in 1884 and the second one in 1889. They have
been later translated in English as a single volume.

• The first volume of Capital and I te est , titled Histo

and Critique of Interest Theo ies is an exhaustive survey of
the alternative treatments of the phenomenon of interest.

26
• The Positi e Theory of Capital , offered as the second
volume of Capital and I te est , contains Bohm Ba e k’s
most substantial theoretical contribution.

• Bohm-Bawerk sta ted f o the idea of a sti e e as the

willingness of reducing consumption now in the expectation
of obtaining more consumption in the future.

• Bohm Bawerk linked this idea to the fact that additional

future consumption can be obtained through the recourse
to more indirect but more fruitful methods of production.

27
• Bohm-Bawerk saw the rate of interest as the price to
compensate the abstinence from consumption now in view
of more consumption in the future.

• The building of the machines (and machines to produce

machines) required to allow for higher future consumption
means a longer interval of time between the moment in
which work is performed and the moment when the higher
final product is obtained.

• Bohm Bawerk defi es the a e age pe iod of p odu tio

as the average of all the intervals of time during which
labor is employed: first in producing means of production
to produce means of production; then to produce further
means of production with them; and finally to produce the
final consumption output.
28
• The series of employed quantities of labor at different
dates can be reduced to a unique weighted average of
these different intervals of time, using as weights the
amount of labor employed at each stage.

• For example, if to obtain 100 liters of wine 1 hour of

labor was used 10 years ago, 1 hour of labor was used 5
years ago and 1 hour of labor is used now, the average
period of production is five years
(10x1+5x1+1x0=15/3=5).

• For Bohm Bawerk this a e age pe iod of p odu tio is

the ua tit of apital ti e-capital) utilized with labor
(three hours) in the productive process.

29
• The higher is capital (the average period of production) the
higher must be the interest to compensate for the waiting of
further additional consumption.

• The increase in productivity allowed by a longer period of

production is what allows for a positive rate of interest.

• On the other hand, the lower the rate of interest (the price
of capital) is, the longer is the period of production chosen
by the producers.

• Thus Bohm-Ba e k’s theory implies a negative relation

between the rate of interest and the capital intensity of
production (represented by the average period of
production): a fundamental relation in the neoclassical
theory.
30