Economics, History of

V

The Marginal Revolution

The 1870s saw one of the great watersheds in the history of economics, the so-called “marginal revolution”. This revolution was essentially the work of three men: William Stanley Jevons, an Englishman; Anton Menger, an Austrian; and Léon Walras, a Frenchman. Their contribution was the replacement of the labour theory of value by the marginal utility theory of value. The idea of emphasizing the marginal or last unit proved in the long run to be more significant than the introduction of utility. It was the consistent application of marginalism that marked the true dividing line between classical theory and modern economics. The classical political economists saw the economic problem as that of predicting the effects of changes in the quantity of capital and labour on the growth rate of the national output. The marginal approach, however, focused on the conditions under which these factors tend to be allocated with optimal results among competing uses—optimal in the sense of maximizing the consumer’s satisfactions.

Throughout the last three decades of the 19th century, the English, Austrian, and French contributors to the marginal revolution largely went their own way. The Austrian school dwelt on the importance of utility as the determinant of value and vehemently attacked the classical economists as completely outmoded. A brilliant second-generation Austrian economist, Eugen von Böhm-Bawerk, applied the new ideas to the determination of the rate of interest, putting his stamp for all time on capital theory. The English school, led by Alfred Marshall, sought a reconciliation with the doctrines of the classical writers. The classical authors, Marshall argued, concentrated their efforts on the supply side in the market; marginal utility theory was concerned with the demand side, but prices are determined by both supply and demand sides, just as a pair of scissors cuts with both blades. Marshall, seeking to be practical, applied his “partial equilibrium analysis” to particular terms and industries. Walras, the leading French marginalist, carried the approach furthest by describing the economic system in general mathematical terms. For each product there is a “demand function” that expresses the quantities of the product that consumers demand as depending on its price, the prices of other related goods, the consumers’ incomes, and their tastes. For each product there is also a “supply function” that expresses the quantities producers will supply as depending on their costs of production, the prices of productive services, and the level of technical knowledge. In the market, for each product there is a point of “equilibrium”—analogous to the equilibrium of forces in classical mechanics—at which a single price will satisfy both consumers and producers. It is not difficult to analyse the conditions under which equilibrium is possible for a single product. But equilibrium in one market depends on what happens in other markets, and this is true of every market. There are literally millions of markets in a modern economy, and therefore “general equilibrium” involves the simultaneous determination of partial equilibria in all markets. Walras’s efforts to describe the economy in this way led one historian of economic thought, Joseph Schumpeter, to call his work “the Magna Carta of economics”. Walrasian economics is undeniably abstract, but it provides an analytical framework for incorporating all of the elements of a complete theory of the economic system.

VI

Neo-Classical Economics

The years between the publication of Marshall’s Principles of Economics (1890) and the Wall Street Crash in 1929 may be described as years of reconciliation, consolidation, and refinement. The three national schools gradually coalesced into a single mainstream. The theory of utility was reduced to an axiomatic system that could be applied to the analysis of consumer behaviour under various circumstances, such as changes in income or price. The concept of marginality in consumption led eventually to the idea of marginal productivity in production, and with it came a new theory of distribution in which wages, profits, interest, and rent were all shown to depend on the “marginal value product” of a factor of production. Marshall’s concept of “external economies and diseconomies” was developed by his leading pupil, Alfred Pigou, into a far-reaching distinction between private costs and social costs, thus laying the basis of welfare theory as a separate branch of economic inquiry. There was a gradual development of monetary theory, which explains how the level of all prices is determined as distinct from the determination of individual prices, notably by the work of the Swedish economist Knut Wicksell and the American economist Irving Fisher. In the 1930s the growing harmony and unity of economics was rudely shattered, first by the simultaneous publication of Edward Chamberlin’s Theory of Monopolistic Competition and Joan Robinson’s Economics of Imperfect Competition in 1933, and then by the appearance in 1936 of The General Theory of Employment, Interest, and Money by John Maynard Keynes.

VII

The Institutionalists

Long before this, however, the German Historical school and the American Institutionalist school had levelled a steady barrage of critical attacks on the orthodox mainstream. The German historical economists basically rejected the idea of an abstract economics with its supposedly universal laws; they urged the necessity of studying concrete facts in national contexts. While they gave impetus to the study of economic history, they failed to persuade their colleagues that their method was invariably superior. The American Institutionalists are more difficult to categorize. “Institutional economics”, as the term is narrowly understood, refers to a movement in American economic thought associated with such names as Thorstein Veblen, Wesley Clair Mitchell, and John R. Commons. These writers had little in common aside from their dissatisfaction with the abstract theorizing of orthodox economics, its tendency to cut itself off from the other social sciences, and its preoccupation with the automatic market mechanism. They failed to develop a coherent theoretical scheme to replace or supplement the orthodox theory. This may explain why the phrase “institutional economics” has become little more than a synonym for “descriptive economics”. The hope that institutional economics would furnish a new interdisciplinary social science proved stillborn, but the spirit of institutionalism is still alive in works such as The Affluent Society (1959) and The New Industrial State (1967) by John Kenneth Galbraith.

VIII

Monopolistic or Imperfect Competition

Returning to the innovations of the 1930s, the theory of monopolistic or imperfect competition remains somewhat controversial to this day. The older economists had devoted all their attention to two extreme types of market structure, that of pure monopoly, in which a single seller controlled the entire market for one product, and that of pure competition, characterized by many sellers, highly informed buyers, and a single standard product. The theory of monopolistic competition gave recognition to the range of market structures that lies between these extremes, including 1) markets having many sellers with “differentiated products”, employing brand names, guarantees, and special packaging that cause consumers to regard the product of each seller as unique; 2) oligopoly, markets devoted by a few large firms; 3) monopsony, markets with a single monopolistic buyer and many sellers. The theory produced the powerful conclusion that competition industries in which each seller has a partial monopoly because of product differentiation will tend to have an excessive number of firms, all charging a higher price than they would if the industry were perfectly competitive. Since product differentiation and the associated phenomenon of advertising seems to be characteristic of most industries in developed capitalist economies, the new theory was immediately hailed as injecting a healthy dose of realism into orthodox price theory. Unfortunately, it failed to provide a satisfactory theory of price determination under conditions of oligopoly. In advanced economies many manufacturing industries are oligopolistic. The result has been to leave a somewhat undigested lump at the centre of modern price theory, a constant reminder that economists still lack an adequate explanation of the conditions under which the giant firms of rich countries conduct their affairs.

IX

The Keynesian Revolution

The second major breakthrough of the 1930s was primarily the work of one man—John Maynard Keynes. Keynes asked questions that in some sense had never been asked before: what determines an economy’s level of national income and volume of employment. This was still a problem of supply and demand, but “demand” here means the total level of effective demand in the economy, and “supply” means the nation’s entire capacity to produce. When effective demand falls short of productive capacity, the result is unemployment and depression; when it exceeds the capacity to produce, the result is inflation. The heart of Keynesianism consists of an analysis of the determinants of effective demand. If one ignores foreign trade, effective demand consists essentially of three spending streams: consumption expenditures, investment expenditures, and government expenditures, each of which is independently determined. Keynes attempted to show that the level of effective demand so determined may well exceed or fall short of the physical capacity to produce goods and services, and that there is no automatic tendency bringing the two into line with one another. This fundamental implication of the theory came as something of a shock to exponents of the traditional economics who had been inclined to take refuge in the assumption that economic systems tend automatically to full employment. By keeping his attention focused on macroeconomic aggregates, like total consumption and total investment, and by a deliberate simplification of the relations between these economic variables, Keynes achieved a powerful model that could be applied to a wide range of practical problems. His system subsequently underwent considerable refinement and became thoroughly assimilated into the body of received doctrine. Still, it is not too much to say that Keynes is perhaps the only economist to have added something really new to economics since Walras and perhaps since Ricardo.

Keynesian economics as conceived by Keynes was entirely “static”; that is, it did not involve time as an important variable. But a disciple of Keynes, Roy Harrod, soon developed a simple macroeconomic model of a growing economy; in 1948 he published Towards a Dynamic Economics, launching an entirely new speciality, “growth theory”, which absorbed the attention of an increasing number of economists.