Lecture Five

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Title: Lecture Five

1
Lecture Five

Neoclassicism
Critiques of Neoclassicism
The Rise of Keynes

2
Recap

Neoclassical theory as developed by Jevons,
Walras, Marshall effectively the same as taught
in Microeconomics
2 strands
Analysis of individual consumers producers,
integrated into analysis of individual markets
(Marshallian partial equilibrium)
Analysis of overall coordination of multiple
markets (Walrasian general equilibrium)
Many components common to bothe.g., analysis of
individual consumer, individual firm, aggregation
of individual demands into market demand,
individual firm supplies into market supply

3
The First Zenith of Neoclassicism Demand

Individual demand based on
utility maximisation
subject to budget constraint

4
Demand

Individual demand curve derived by varying price
ratio

Z
Compensated demand curves (discussed in Micro
II?) needed to guarantee downward sloping
individual demand curve
X
Biscuits
B
Y
q1
q2
W
q3
II
III
I
Bananas
Price
Market demand derived by adding up individual
demand curves (but see later!)
p1
p2
p3
q3
q1
q2
Bananas
5
The First Zenith of Neoclassicism Supply

Individual firm supply curve derived from
production function combining
(at least) one fixed input with (at least) one
variable input
result diminishing marginal productivity
productivity may rise as initial variable inputs
added
but eventually diminishing productivity sets in

Diminishing marginal productivity sole basis for
rising marginal cost (variable input cost assumed
constant)
Flip axes multiply by wage rate
6
Supply

Firm maximises profit by maximising distance
between total revenue (straight line function for
PC firm) and total cost

Total Cost
B
Maximum Profit
Total Cost Revenue
C
Marginal Cost
A
Fixed Costs
Total Revenue
Wheat Output
Q
Hence equating marginal revenue to marginal cost
maximises profits
7
Supply

Relationship between
total cost and marginal cost,
total revenue marginal revenue

Height of this line
Equals area of this box
Supply curve for individual firm equals marginal
cost curve
8
Supply

Marginal cost curve is not supply curve for
monopoly because of downward sloping marginal
revenue curve

PerfectCompetition
Monopoly
MarginalCost
MarginalCost
Price
Price
S1
S1
S2
S2
D2
D1
D2
Supply Curve
D1
MR2
MR1
Quantity
Quantity
Diminishing marginal productivity and horizontal
marginal revenue curve therefore crucial to model
of perfect competition
9
First Zenith of Neoclassicism Supply Demand

Diminishing marginal productivity generates
rising marginal cost
Horizontal marginal revenue ensures that marginal
cost curve is the individual firm supply curve
Sum of all firm marginal cost curves is market
supply curve
Price set by intersection of downward sloping
market demand curve and upward sloping market
supply curve

Analysis of single market integrated into
analysis of all markets General Equilibrium
10
General Equilibrium

Walras (1870s) showed that general equilibrium
feasible
Number of equations equals number of unknowns
Income and Expenditure equations consistent (see
last years notes, slides at end of this
lecture)
However he assumed process
I.e., given that general equilibrium can exist,
how do we get there?
Must be able to go from initial disequilibrium
prices to prices which result in equilibrium in
all markets
Walras model proposed hypothetical way this
could occur tatonnement

11
General Equilibrium

Tatonnement
Auctioneer declares prices
Buy Sell bids recorded
If BuygtSell quantity for any stock, price
adjusted up
If BuyltSell quantity, price adjusted down
No trades allowed until all markets in
equilibrium
Tatonnement--groping for equilibrium vector of
prices
Applied to model of exchange of given quantities
of commodities (distribution taken as given)
Extended to model of production from given
resources

12
Problems I Does tatonnement work?

Walras fiction of auctioneer and tatonnement
auctioneer suggests initial prices, adjusts
prices according to algorithm, forbids trades
until all markets in equilibrium
needed to outlaw out of equilibrium exchanges
if disequilibrium trades allowed, income effects
distort market outcome (those selling at above
equilibrium prices have windfall gain, others
windfall loss)
clearly a fiction disequilibrium trades occur in
real world.
But does the fiction itself work? can Walras
market grope its way to equilibrium price
vector from random initial prices?
Walras believed so

13
Groping towards general equilibrium?

Once the prices have been cried at random in
terms of one of them selected as numeraire, each
party to the exchange will offer at these prices
those goods or services of which he thinks he has
relatively too much, and he will demand those
articles of which he thinks he has relatively too
little for his consumption during a certain
period of time. The prices of those things for
which the demand exceeds the offer will rise, and
the prices of those things of which the offer
exceeds the demand will fall. New prices now
having been cried, each party to the exchange
will offer and demand new quantities. And again
prices will rise or fall until the demand and the
offer of each good and each service are equal.
Then the prices will be current equilibrium
prices and exchange will effectively take place.
(Walras 1874)

14
Groping towards general equilibrium?

Initial stab at prices wont clear all markets
Walras assumes process of adjustment will
eventually get there
but direct effect of reducing price of one
commodity where supply exceeds demand could
destabilise other markets (indirect effect)
Walras assumed that direct effects would outweigh
indirect effects
If demand for B lt supply of B, reduce price of B
change directly reduces oversupply of B
indirectly alters demand for all other
commodities
increases demand for some, decreases demand for
others
Walras assumed some cancellation, so direct
effect gt indirect effect, process gradually
converged

15
Groping towards general equilibrium?

This will appear probable if we remember that
the change from pb to pb, which reduced the
above inequality to an equality, exerted a direct
influence that was invariably in the direction of
equality at least so far as the demand for (B)
was concerned while the consequent changes
from pc to pc, pd to pd, ..., which moved
the foregoing inequality farther away from
equality, exerted indirect influences, some in
the direction of equality and some in the
opposite direction, at least so far as the demand
for (B) was concerned, so that up to a certain
point they cancelled each other out. Hence, the
new system of prices (pb, pc, pd, ...) is
closer to equilibrium than the old system of
prices (pb, pc, pd, ...) and it is only
necessary to continue this process along the same
lines for the system to move closer and closer to
equilibrium. (Walras 1874 1954 171-172)

16
Groping towards general equilibrium?
?
P
Reducing wheat price directly pushes wheat market
towards equilibrium
Wheat
Q
But what does it do to all other markets?
?
?
?
?
?
17
Groping towards general equilibrium?

Mathematics of proof of this beyond Walras
In 20th century, mathematical economists (see
references at end) established
Two stability conditions on input-output matrix
For stable growth, matrix must have key value
(eigenvalue) less than one
For stable prices, inverse of matrix must have
key value less than one
Both conditions cant be fulfilled (there is no
number bigger and smaller than one), so groping
wont work
In Walras terms, indirect effects outweigh
direct effects
Groping will never locate equilibrium vector
If no trade till equilibrium found, trade will
never occur

18
Groping away from general equilibrium!
Reducing wheat price directly pushes wheat market
towards equilibrium
But indirect effect on all other markets
outweighs direct effect on wheat
19
Groping towards disequilibrium?

Tatonnement thus ineffective device to avoid
out of equilibrium trades
Price model therefore cannot avoid disequilibrium
analysis
Intersection of supply and demand curves for all
markets at once cannot be found by market
processes
even if no trades occur until equilibrium,
because equilibrium wont be attained
If system diverges from equilibrium, it will
never return there
if trades occur out of equilibrium, wont
converge because trades will alter equilibrium
simple techniques for one market (ceteris
paribus) dont generalise to all markets
So why do economists still use equilibrium models
of prices?

20
Groping towards disequilibrium?

Most dont know literature (see references at end
of lecture)
Some who do know it believe result doesnt apply
to model with flexible production functions
They are wrong, it does
Those who do, and know it applies in general,
have given up on modelling process of reaching
equilibrium
process of reaching equilibrium ignored in favour
of simply showing existence of equilibrium
time (and therefore process of achieving
equilibrium) completely abstracted from
Gerard Debreus Nobel Prize-winning Theory of
Value (see OREF III)

21
Modern Arrow-Debreu General Equilibrium

For any economic agent a complete action plan
(made now for the whole future), or more briefly
an action, is a specification for each commodity
of the quantity that he will make available or
that will be made available to him, i.e., a
complete listing of the quantities of his inputs
and of his outputs
For a producer, say the jth one, a production
plan (made now for the whole future) is a
specification of the quantitities of all his
inputs and all his outputs... The certainty
assumption implies that he knows now what
input-output combinations will be possible in the
future (although he may not know the details of
technical processes which will make them
possible)
As in the case of a producer, the role of a
consumer is to choose a complete consumption
plan... His role is to choose (and carry out) a
consumption plan made now for the whole future,
i.e., a specification of the quantities of all
his inputs and all his outputs.

22
More problems with neoclassical economics

Partial equilibrium building blocks of general
equilibrium have also come in for criticism
Derivation of downward sloping market demand
curve invalid
Logical basis of upward sloping supply curve
unsound
Demand critique discovered by neoclassical
economists (Gorman, Sonnenshein, Mantel, Debreu)
Supply critique made by Piero Sraffa (and others)

23
Smooth individual jagged market demand

Remember Engels curves?
Show how consumption on different commodities
change as income rises
Four possibilities
Luxury consumption rises proportionately as
income rises
Necessities consumption falls proportionately as
income rises
Giffen consumption falls absolutely as income
rises
Neutral consumption proportion remains constant

24
Feasible Engels curves
a. Necessity
b. Inferior
All other goods
Bananas
Bananas
c. Luxury
d. Neutral
Bananas
Bananas

All goods likely to fit 1st 3 cases few if any
likely to fit 4th

25
Engels curves for different individuals

Engels curves will differ between individuals
because indifference curves differ between
individuals
Engels curves could only be identical if people
were all clones of each other

All other goods
Bananas
Sounds obvious?
26
The Sonnenshein-Mantel-Debreu conditions

Downward-sloping individual demand curve derived
from individual indifference curves which are by
definition smooth
Can market demand curves be similarly derived?
If and only if
All Engels curves are straight lines
Slope of indifference curves the same for all
individuals along Engels curves

27
The Sonnenshein-Mantel-Debreu conditions

Indifference curves represent lines of constant
subjective utility
like contour lines on map, different indifference
curves represent different levels of utility
Two different individuals will get vastly
different levels of utility from same combination
of goods
Effect is like adding two different smooth hills
together
composite hill has abrupt jumps where two sets
of contours intersect resulting social
indifference curve has kinks, intersections
Community indifference and utility possibility
loci are among the most useful concepts of
welfare economics. Their great disadvantage is
that they may intersect... Thus the analysis ...
frequently becomes inconclusive. (Gorman 1953)

28
The Sonnenshein-Mantel-Debreu conditions

Changing price at kink intersection points has
unpredictable effect on demand
Resulting market demand curve has flat bits,
kinks, inversions

Biscuits
Bananas
Unless changing prices doesnt change
distribution of income no swap in total demand
between banana lovers and banana
haters increasing income doesnt alter
consumption no change in demand as incomes rise
MarketDemandCurve
Price
p1
p2
p3
Bananas
q1
q2
q3
29
The Sonnenshein-Mantel-Debreu conditions

Smoothly downward sloping demand curves only
possible if
All commodities are the same
hence all Engels curves are straight lines
All consumers are identical
hence changing income distribution has no effect
on demand
Absurd conditions?
Not too absurd for some economists!
Suppose that all individual consumers indirect
utility functions take the Gorman form... where
... the marginal propensity to consume good j is
independent of the level of income of any
consumer and also constant across consumers...
This demand function can in fact be rationalized
by a representative consumer (Varian 1984)

30
The Sonnenshein-Mantel-Debreu conditions

The necessary and sufficient condition quoted
above is intuitively reasonable. It says, in
effect, that an extra unit of purchasing power
should be spent in the same way no matter to whom
it is given. (Gorman 1953)
Two criteria will be considered which lead to
the possibility of aggregation (1) identical
preferences (hence identical demand functions),
and (2) proportional incomes... These results
have a number of interesting applications in the
pure theory of international trade. (Chipman
1974)
There are several ways of rehabilitating the
Slutsky symmetry conditions... If consumers are
grouped ... However, both of the above grouping
conditions come very close to simply assuming
that the consumers in the aggregate have
identical tastes and income. (Diewert 1977)

31
General? Equilibrium

Sonnenshein-Mantel-Debreu conditions needed
even for Debreus general equilibrium model
Assumptions clearly unrealistic more
restrictive than those used in partial
equilibrium analysis (where Engels curves can
take any shape, differ between consumers)
Normally defended on methodological
groundsdiscussed in a few weeks time
Explanation for upward-sloping supply curve has
similar problems

32
Fixed factor in the short run

Essential foundation for upward sloping firm
supply curve is diminishing marginal productivity
Essential foundation for diminishing marginal
productivity is fixed factor in the short run
Sraffa (1926) challenged validity of this on 3
grounds
Broad definition and interdependence of supply
and demand
Narrow definition and availability of marginal
doses of fixed resource
Actual behaviour of businesses
2 ways to define a factor of production or
industry
Broade.g., Labour, Agriculture
Narrow e.g., Spanners, Barley

33
Sraffas Broad critique

If broadly define factor/industry, then can
regard factor as fixed since attracting
additional units difficult
But increasing output of industry will affect
incomes of all other industries/factors

If in the production of a particular commodity
a considerable part of a factor is employed, the
total amount of which is fixed or can be
increased only at a more than proportional cost,
a small increase in the production of the
commodity will necessitate a more intense
utilisation of that factor, and this will affect
in the same manner the cost of the commodity in
question and the cost of the other commodities
into the production of which that factor enters
and since commodities into the production of
which a common special factor enters are
frequently, to a certain extent, substitutes for
one another ... the modification in their price
will not be without appreciable effects upon
demand in the industry concerned. (Sraffa 1926)

34
Sraffas Broad critique
PF
(a)
(c)
Wheat
Fertiliser
PW
SW
MPF
(d)
(b)
P2
D2
P1
D1
Fertiliser
Wheat
35
Sraffas Broad critique

Sraffa 1926
No input can feasibly regarded as fixed
If define industry broadly (e.g., agriculture),
increased usage of fixed resource (land) will
increase price of land and change income
distribution
not all land used by agriculture (e.g., fallow,
housing)
increased demand for agriculture partly met by
switching resources from fallow/housing
prices of land, fertiliser will rise
Supply and demand curves therefore not
independent
If not independent, can have indeterminate
outcome
No unique equilibrium price because demand and
supply interdependent

36
Sraffas Broad critique
Income effects with Broad Definition of Industry
PL
Different demand curve for every point on
supply curve since change in supply changes
incomes
PF
PF, PL
(c)
37
Sraffas Narrow critique

Constant cost with narrow definition
If use sensible definition (e.g., wheat
industry),
Increased demand for wheat will mean conversion
of land from (e.g.) barley to wheat
Negligible change in cost of land
Fertiliser to land ratio remains constant
Marginal product thus marginal cost remains
constant
Conditions of supply thus determine cost
independent of demand
Conditions of demand determine quantity produced
rather than price
Contradicts neoclassical analysis

38
Sraffas Narrow critique

If we next take an industry which employs only a
small part of the constant factor (which
appears more appropriate for the study of the
particular equilibrium of a single industry), we
find that a (small) increase in its production is
generally met much more by drawing marginal
doses of the constant factor from other
industries than by intensifying its own
utilisation of it thus the increase in cost will
be practically negligible (Sraffa 1926)

39
Sraffas Narrow critique
Constant cost with narrow definition
Price of fertiliser unaffected by increased use
in wheat production
PF
(a)
(c)
Wheat
Fertiliser/land ratio held constant at ideal ratio
F
Horizontal wheat supply curve with constant MPF
Supply sets price, demand sets quantity position
of classical school
MPF
PW
(d)
(b)
D1
D2
Marginal productivity of fertiliser therefore
constant
P
SW
Wheat
F
40
Sraffas critique time

Many neoclassicals reject Sraffa critique because
it ignores neoclassical treatment of time
Short run when one factor fixed
Long run when all factors variable
Sraffa correct neoclassical treatment of time
inadequate. Consider short run profit
maximisation argument

Profit maximised when dP/dQ0, or MRMC. But what
about maximisation over time? In dynamic (real
world) setting, what matters is maximising profit
over time
41
Sraffas critique time

Profit a function both of quantity and time

Maximum change in profit thus depends on change
in quantity and change over time must consider
total differential w.r.t. quantity and time
rather than just differential w.r.t. quantity
Part due to change in quantity
Total change in profit
Part due to changein time
42
Sraffas critique time

This reduces down to (dropping (t) terms)

For maximum profit growth over time, this should
be as big as possible
Setting MRMC maximises static profit but
maximises dynamic profit (profit over time) only
if quantity produced does not change over time
(if first term is zero) A paradox static profit
maximisation advice wrong in dynamic
setting Whats going on?
43
Sraffas critique time

Static profit maximisation ignores time
If we ignore time, can only maximise profit by
varying quantity produced
But time exists
must consider both time and quantity when trying
to maximise profit
An analogy
consider trying to conserve fuel while driving
find most economical speed at which to drive
if ignore time, simple drive at zero kph
if consider time, want to minimise petrol use
while kphgt0

44
Sraffas critique time

Have to work out how to minimise

If do directly, get travel at zero kph
answer instead, break down into 2 stages
consider
Find minimum for this where both halves gt zero By
analogy, neoclassical profit maximisation ignores
this like advising that best way to conserve
fuel is to travel at zero kilometres per
hour Since
Dynamic profit maximisation requires MR gt MC
45
Sraffas critique time

Interpretation?
Maximising profit w.r.t quantity now leaves no
energy to devote to growth
hence get maximum possible returns today, but
have no resources left to invest, so no growth
Time cant be neatly compartmentalised into
short, medium, long run
Time is continuous
If theories ignore time, they are static, and
cannot make observations about change over time
Economic system is dynamic, necessarily changes
over time, so static analysis of little or no
relevance to economics
And there are more problems with theory of the
firm
check Debunking Economics Ch. 4 and website

46
Sraffas real world critique

Robbins definition sees economy as
resource-constrained
Robbins definition resources the key constraint
on output
Sraffa instead argues that economy is demand
constrained
Business men, who regard themselves as being
subject to competitive conditions, would consider
absurd the assertion that the limit to their
production is to be found in the internal
conditions of production of their firm, which do
not permit the production of a greater quantity
without an increase in cost (Sraffa 1926 543).
Instead limits to sales set by the absence of
indifference on the part of the buyers of goods
as between the different producers (Sraffa 1926
544).

47
Sraffas real world critique

Numerous reasons why resources do not in general
restrain output of capitalist firms
Excess productive capacity the norm
investment plans anticipate growth, so plants
built to cope
excess capacity enables firm to take advantage of
problems of competitors
Macroeconomic pressure to keep wages low
suppresses aggregate demand normality of
involuntary unemployment insufficient aggregate
demand (as per later Keynes) the norm.

48
Sraffas real world critique

Both a vice and a virtue
Demand constrained firm must innovate to remain
competitive high level of innovation
Resource constrained firm does not need to
innovate
Demand constrained economy (capitalist) will have
higher degree of innovation than resource
constrained (socialist) thus higher rate of
growth.
Thus according to Sraffa (and today Kornai),
Robbins definition thus fails to emphasise one of
key virtues as well as vices of the market
economy.

49
Sraffas real world critique

Empirical research supports Sraffa
Numerous studies (Meade, Tucker, Andrews,
Eiteman, Guthrie) find firms
Administer prices (set prior to marketing)
Endeavour to sell as much as possible at set
price
Perceive costs constant or falling with increased
output
E.g., Guthrie showed firms graphs of
cost/quantity relation
only 1 in 20 chose graphs showing rising marginal
cost

50
Sraffas real world critique

According to Eiteman (1947), engineers design
factories
so as to cause the variable factor to be used
most efficiently when the plant is operated close
to capacity. Under such conditions an average
variable cost curve declines steadily until the
point of capacity output is reached. A marginal
cost curve derived from such an average cost
curve lies below the average cost curve at all
scales of operation short of capacity, a fact
that makes it physically impossible for an
enterprise to determine a scale of operations by
equating marginal cost and marginal revenues.
(Eiteman 1947)

51
Sraffas real world critique

If MCMR doesnt determine price quantity, what
does?
Sraffa real-world researchers
price set by markup on average cost of production
quantity constrained by heterogeneous nature of
products and customers

Business men, who regard themselves as being
subject to competitive conditions, would consider
absurd the assertion that the limit to their
production is to be found in the internal
conditions of production in their firm, which do
not permit of the production of a greater
quantity without an increase in cost. The chief
obstacle against which they have to contend when
they want gradually to increase their production
does not lie in the cost of productionwhich,
indeed, generally favours them in that
directionbut in the difficulty of selling the
larger quantity of goods without reducing the
price, or without having to face increased
marketing expenses. (Sraffa 1926)

52
Sraffas real world critique

A picture of Sraffas vision of the firm

Average Cost (with very large fixed costs) falls
for all outout levels)
Average Cost Revenue
Marketing Costs
Price
TargetMarkup
Marginal Cost (constant or falling)
Output
TargetOutput
53
Supply and Demand after the critiques

Market Demand curve can take any shape at all
Unfortunately ... The aggregate demand function
will in general possess no interesting
properties... The neoclassical theory of the
consumer places no restrictions on aggregate
behaviour in general. (Varian 1992)

Supply curve notion meaningless (plays no role
in firms or markets behaviour), but if drawn
probably downward sloping
Not exactly a useful tool for analysis!
Price
Supply
Markup (based on competitive macro pressures)
the firms contribution to pricing
Demand
Quantity
54
Economic Reaction?

Conventional theory ignores critiques
partial equilibrium neoclassical economics
becomes ascendant under Marshall/Robbins
general equilibrium ascendant under Walras
Alternative markup pricing school of
microeconomics ignored
Neoclassical microeconomics goes on regardless
Meanwhile, on the national scale
Pre-Keynesian macro theory consistent with
neoclassical micro

55
Neoclassical Economics in Crisis

Predictions (full employment no general gluts)
and reality (30 unemployment all markets
depressed) completely out of whack
Policy advice reduce wages when already falling
lower price level will fix things when price
level already falling
Economic theory and policy ripe for a change
and along comes Keynes

56
References on instability of tatonnement

Blatt, J.M., 1983. Dynamic economic Systems, ME
Sharpe, Armonk.
Jorgenson, D.W., 1960. A dual stability
theorem, Econometrica 28 892-899.
1961. Stability of a dynamic input-output
system, Review of economic Studies, 28
105-116.
1963. Stability of a dynamic input-output
system A reply, Review of economic Studies, 30
148-149.
Mas-Colell, A., 1986. Notes on price and
quantity tatonnement dynamics, in Sonnenshein,
H.F., (ed.), Lecture Notes in economics and
Mathematical Systems, Springer-Verlag, Berlin.
McManus, M., 1963. Notes on Jorgensons Model,
Review of economic Studies, 30 141-147.
Sargan, J.D., 1958. The instability of the
Leontief dynamic model, Econometrica 26 381-392.

57
References on pricing

Bishop, R.L., 1948. Cost discontinuities,
declining costs and marginal analysis, American
Economic Review 38 607-617.
Clapham, J.H., 1922a. Of empty economic boxes,
Economic Journal, 32 303-314.
1922b. The economic Boxes - A rejoinder,
Economic Journal, 32 560-563.
Eiteman, W.J., 1947. Factors determining the
location of the least cost point, American
Economic Review 37 910-918.
1948. The least cost point, capacity and
marginal analysis a rejoinder, American
Economic Review 38 899-904.
Eiteman, W.J. And Guthrie, G.E., 1952. The shape
of the average cost curve, American Economic
Review 42 832-838.
Langlois, C., 1989. Markup pricing versus
marginalism a controversy revisited, Journal of
Post Keynesian Economics 12 127-151.
Lee, F., 1998. Post Keynesian Price Theory,
Cambridge University Press, Cambridge.

58
General Equilibrium

Walras initial model
Pure exchange (production not considered)
2 commodities, 2 parties, given quantities, given
tastes
Final model
Production based on factor endowments (land,
labour, capital) given distribution of factors,
given tastes
Inputs are factors, outputs are commodities (vs
classical inputs and outputs are both
commodities)
Land, labor, capital produce commodities, not
commodities produce commodities
Returns to factors based on marginal productivity

59
Walrass General Equilibrium Output