Chapter one.pptx, Neoclassical Economic Thought

This ppt gives some basic concepts related to Neo-classical economic ideology.

1. CHAPTER ONE NEO – CLASSICISM 1.1 NEOCLASSICAL ECONOMICS Neoclassical economics is an approach to economics focusing on the determination of goods, outputs, and income distributions in markets through supply and demand. This determination is often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production, in accordance with rational choice theory. 10/4/2024 1

2. Cont--- Neocl a ss i c al economics dominates mic r oeconomic s , and together with Keyne s ian economi c s f o r ms the neocl a ss ical s ynth e s is which dominates main s t r eam economi c s toda y . T oday it is u s u ally u s ed to r e f er to main s t r eam economic s , although i t h a s al s o been u s ed as an um b r ella te r m encompa s s ing a number of oth e r s chools of thought, notably excluding in s titutional economi c s , va r ious hi s to r ical s chools o f economi c s , and M a r xian economic s , in addition to v a r ious other het e r odox app r oach e s to economic s . 10/4/2024 2

3. Cont--- T he ce n t ral a ss u m p t ions o f t he Neocla s s ical T heor y : R a t ionali t y : This a s s umption made is that people a r e r ational and p r e f er mo r e valuable goods and s e r vices or lei s u r e to le ss . P e r f ect Knowledg e : B uye r s and s elle r s know all the p r ices o f all the goods in the ma r ket, know eve r yt h ing they need to know about the quality o f good s , the cha r acter o f the other economic agen t s , what the gove r nment is going to do next, and s o on. Di m ini s hing Re t urn s : T his a ss umption is m o r e p r op e r ly called a behavioral hypothe s i s , becau s e it can be te s ted. Since ha r dly anyone bothe r s to te s t it, it is o f ten called an a s s umption. 10/4/2024 3

4. Cont--- T he hypothe s i s is known as the L aw of Di m ini s hing R etu r n s . I t is e s s ential becau s e it means that on the buye r ’ s s ide, the m o r e and m o r e they bu y , the s maller and s maller t he inc r ement in s at i s f action become s . E quali t y of Sales and P u r c ha s e s : W e mu s t a ss ume that whatever is bought equa l s whatever is s old. I f goods a r e put into s to r e, we mu s t count them as either being pa r t of what is bought, or exclude them f r om the m a r ket calculation all togethe r . Othe r wi s e, equili b r ium will never be di s cove r ed. 10/4/2024 4

5. Cont-- Uni q ue E qu i libriu m : E quilib r i u m is r eached when all economic agents a r e content with their actio n s and f eel no r ea s on to change them. I n the ne o - cl a ss ical model, p r ice chang e s until s elle r s a r e happy to s ell what they s ell, and buye r s a r e happy to buy what t hey bu y . I t is this concept of equilib r ium which di s tingui s h e s the neo - cla s s ical ap p r oach. Many par t icipa n t s , F r eedom o f E n t ry and E xi t : T he s e a ss umptions e n s u r e that a ma r ket is f r eely competi t ive. I f a f ew buye r s o r s eller dominate, this means the outcome may be equili b r ium, but it may not be the be s t, o r optimal, outcome f o r the economy as a whole. I t is an ine f f icient equili b r ium . 10/4/2024 5

6. Cont- I ndependence of De m and and Suppl y : W e a ss ume that buye r s a r e quite d i s tinct fr o m s elle r s , s o that the act of buying does not a f f ect s elling, and s elling does not a f f ect buying, except th r ough the mechan i s m of the m a r ket. T he t ime when it does get r elaxed is in the analy s is of pe a s ant f a r ms which a r e pa r tially s el f- s u f f icient. I n this ca s e the f a r m is r e s po n s ible f o r s upplying t he hou s ehold and the ma r ket, s o the hou s ehold is both a buyer ( f r om its f a r m and m a r ket) and a s elle r . 10/4/2024 6

7. Alfred Marshal (1842-1924) M a r s hall appea r ed on the economic s c ene at a time when the cla ss i cal s chool und e r heavy c r itici s m f or its objective app r oach of analy s is as di s tinct f r om the s ubj e ctive app r oach o f the m ode r n economi s t s . T he economics di s cipline as s u ch was pa ss ing th r ough a c r i s is and was te r med as a ‘ di s mal s cien c e ’ . M a r s hall p r e s ented a s ynth e s is t h r ough his w r iting s , a p r oper blending of the cla s s ical doct r ines and the ma r ginal utility analy s i s of the s ubjectivi s t s . He was chie f ly i nte r e s ted in mathematics and lat e r developed int e r e s t in metaphy s i c s and ethics and al s o in p o litical econo m y . 10/4/2024 7

8. Cont--- Under the influence of C ou r not and B entham and his own mathematical backg r ound he t r an s lated many o f the theo r ems o f R ica r do and M ill in to dia g r ammatic language . M a r s hall is claimed to have e s tabl i s hed the C amb r idge s chool of thoug h t and al s o the neo - cla s s ical s chool. T his s chool has ce r tain di s tinct cha r acte r i s tics as compa r ed with the oth e r s choo l s o f thoug h t like Au s t r ian and L au s anne. T h e s e s choo l s we r e dealing with ce r tain pa r t ial mod i f icatio n s o r r eplacemen t s o f the cl a ss ical t r adition as e s tabli s h ed by R ica r do and r e s tated by M ill. W ith the s e modi f ications the s e s choo l s claimed to have launched an intellectual r evolution in economic thought.. 10/4/2024 8

9. Cont--- M a r s hall did not claim s uch r ev o lution and acco r ding to him it is an evolution that is taking place and t h r ough the r e - buil d ing of the cla s s ical mate r ial he is s aid to have e s tabli s hed the neo - cla ss i c al s chool. Al f r ed M a r s hall T heo r etical C ont r ibutions co n s ide r ed to be one of the mo s t in f luential economi s t s o f his time, la r gely s haping main s t r eam economic thought f o r the next 50 yea r s , and being one of t he f ound e r s neocl a ss ical economi c s . 10/4/2024 9

10. Cont--- Although his economics was adve r ti s ed as exte n s ions and r e f inements of the wo r k o f Adam S mith, David R i c a r do, T hom a s R obe r t M alth u s and J ohn Stua r t M ill , he extended economics away f r om its cla s s ical f ocus on the ma r ket economy and in s tead popula r i z ed i t a s a s tudy o f human behavior. He downplayed the cont r ibutions of ce r tain oth e r economi s t s t o his wo r k, s uch as L éon W a l r a s , V i l fr edo Pa r eto and J ul e s Dupuit, and only g r udgin g ly acknowled g ed the in f luence of Stanley J evo n s him s el f . 10/4/2024 10

11. His U t ili t y a nd De m and On Marginal U t i l i t y: Acco r ding to M a r s hall, demand is ba s ed on the LDMU. " T he ma r ginal utility of a thing to anyone dimini s hes with eve r y inc r ea s e in the amount of it he a l r eady ha s . ” Two impo r tant conditions f o r the law t o appl y . T he pe r iod is ju s t a moment in time, which is too s ho r t an inte r val to con s ider any chang e s in cha r acter and ta s t e s of a pa r ticular p e r s on. The con s umer goods mu s t be indivi s ible . 10/4/2024 11

12. On Mea s u r e m e n t o f U t ili t y M a r s hall was one of tho s e who u s ed util i ty analy s i s , but not as a theo r y of value. He u s ed it as a pa r t of the theo r y to explain demand cu r ves and the p r inciple o f s u b s titution . M a r s hall ' s s c i ss o r s analy s i s – which combined demand and s upp l y , that is u t ility and c o s t of p r oduction , as i f in the two blad e s of a pa i r of s c i ss o r s – e f f ectively r emoved the the o r y of value f r om the center o f analy s i s and r eplaced it with the theo r y of p r ic e. 10/4/2024 12

13. Cont--- T he utility ap p r oach o f the M a r s hallian s y s tem dealt with ple a s u r es and pain s , de s i r es and a s pi r ation s , and incentiv e s to action. How can we mea s u r e the utility of s uch intangible s ? M a r s hall boldly s aid, "with mone y . " T he ea r li e r ma r ginali s ts s aid that the s t r ength of a pe r s on ' s p r e f e r ences dete r mines the amount of money the pe r s on is willing t o s pend to acqui r e s ome p r oduct or the amount o f labor the pe r s on is willing to s a c r i f ice to achieve s ome goal. 10/4/2024 13

14. Cont--- M a r s hall, howeve r , t u r ned the r elation s hip a r ound s o as to mea s u r e p r e f e r ences acco r ding to the f inancial s c ale o f payment s. Example: Suppose that the a unit price of two goods, hate and shoes given by $20 and $40 respectively. T he ea r lier ma r ginali s t s would s ay that s ho e s a r e twice as u s e f ul to you as a ha t , you a r e willing to pay twice as much f o r s ho e s . M a r s hall would s ay that becau s e you a r e willing to pay twice as much f or s ho e s as f a r the hat, we can conclude that the s h o es yield twice as m uch u t ility to you . 10/4/2024 14

15. On L aw o f D e m and M a r s hall ' s law of demand f ollows d i r ectly f r om h is notions of dimini s hing ma r ginal utility and r ational con s umer choice . Suppo s e that a con s u m e r 's expenditu r es a r e in equili b r ium s uch that the la s t dollar s pent on each of s eve r al p r oducts yields identical ma r ginal utility'. T hat i s , s upp o s e that M Ux / P x = M Uy / P y = --------= MUn / Pn . How will this con s umer r eact i f the p r ice of p r oduct X f a lls while the p r ices o f the other goods r emain con s tant? 10/4/2024 15

16. Cont--- At s ome point the no w - lower m a r ginal uti l ity o f X , in r elation to the lower p r ice o f X , will yield a r atio equal to the M Uy / P y , and the M UZ / P Z . T h u s , equili b r ium w i ll be r e s to r ed. T he r e f o r e, in M a r s hall ' s w o r d s : "the amount demanded i nc r e a s es with a f all in p r ice, and dimi n i s hes with a r i s e in p r ice." T his is the now - f amiliar law of downwa r d s loping demand. M a r s hall i llu s t r ated the law of demand with b o th a table and a demand cu r ve. 10/4/2024 16

17. Cont--- He d r ew his demand cu r ve by a ss uming that: T he pe r iod of time is s u f f iciently s ho r t to ju s ti f y a cet e r is pa r ibus a ss umption. T a s t e s or p r e f e r enc e s of the consumer remain con s tant . Pe r s on ' s wealth, the p u r ch a s ing power o f mone y , and the p r ice of s u b s titute commoditie s remain unchanged. T oday s uch "other things equal" con s titute what we call the det e r minants o f demand . 10/4/2024 17

18. Cont--- However, i n the long r un the s e dete r minants can change, and t he enti r e demand cu r ve s hi f ts eith e r le f twa r d o r r ightwa r d. T h u s , M a r s hall had a clear conception o f di f f e r ences between chang e s QD and DD. On Con s u m er's Sur p lu s (CS) M a r s hall a s s e r ted that the total uti l ity of a good is the s um of the s ucc e ss ive MU of each added unit . T he r e f o r e, the p r ice a pe r s on pays f o r a good never excee d s , and s eldom equa l s , that which he or s he would be willing to pay r a ther than go without the de s i r ed object. Only at the ma r gin p r ice = pe r s on ' s willingne s s to pa y . R e c all that: CS=Total Utility-Total Expenditure 10/4/2024 18

19. Cont--- Although Dupuit w a s the one who f i r s t noted this concept M a r s hall is c r edited f or naming the concept "co n s ume r 's s u r plu s " and s y s tematically expl o r ing it. On E l a s t ic i t y o f De m a n d: M a r s hall was f a r s upe r i o r to his p r edece s s o r s in handling el a s ticity of demand, ana l yzing the s ub j ect v e r ball y , dia g r ammatical l y and mathematicall y . E la s ticity o f demand tells us whether the diminution o f de s i r e ( ma r ginal utility) is s low or r apid as the quantity inc r ea s e s . I t r elates the pe r centage d r op in p r ice to the pe r centage inc r ea s e in QD, which, of cou r s e, is ba s ed on DMU of the good. M a r s hall al s o di s cu s s ed what we now call the det e r minants o f the el a s ticity of demand . 10/4/2024 19

20. His T heory o n Supply Suppl y , s aid M a r s hall, is gove r ned by co s t o f p r oduction . Supply is a whole s e r i e s of quantities that would be f o r thcoming at a whole s e r i e s of p r ic e s . M a r s hall divided time into t h r ee pe r iod s : T he immediate p r e s ent The s ho r t r un The long r un. 10/4/2024 Set By Shibabaw Z. (MSc) History of Economic Thought II (2024), MAU. 20

21. His T heory o n E quilibrium P rice a nd Qua n t i t y What d e t er m ines m arket price? T he cl a ss ical econom i s ts , " C o s t o f p r oduction,“ (Supply side). The ea r ly ma r ginali s t s "Demand," s aid. M a r s hall, t he g r eat s ynt h e s ize r , s aid, " B o th s upply and demand." B ehind s upply l ie both f inancial (objective costs) and s ubjective co s t s where as b ehind demand lie uti l ity and d imini s hing ma r ginal utilit y. 10/4/2024 21

22. His T heory o n Di s t ribution o f I nco m e   T he di s t r ibution o f income in a competitive economy is dete r mined by t he p r icing of f acto r s o f p r oduction . B u s in e ss p eople, s aid M a r s hall, mu s t co n s tantly compa r e the r elative e f f iciency of eve r y agent o f p r oduction they emplo y. T hey al s o mu s t con s ider the po ss ibilities o f s u b s tituting one agent f o r anothe r . H o r s ep o wer r eplaced hand power , and s t e am power r eplaced ho r s epowe r . At the ma r gin o f indi f f e r ence between two s u b s titutable f acto r s of p r oduction, their p r ices mu s t be p r op o r tionate t o the m oney value they add to the total p r oduct. M a r s hall ba s ed this analy s i s on the dimini s hing r et u r ns that r e s ult f r om the " di s p r opo r tionate u s e o f any agent of p r oduction." 10/4/2024 22

23. His T heory o n I nc r e a s ing & Dec r ea s ing Co s t I ndu s t ries A key analytic device f or M a r s h all w a s his concept of t he " r ep r e s entative f i r m.,'" which f or him was the typical 1 9t h century sole p r op r iet o r s hip. This concept , at le a s t, th r ee maj o r p u r po s e s in his anal y s i s. F i r s tly, the n o r mal co s t of p r oducing a commodit y , he r e f e rr ed to the expe n s es o f a r e p r e s en t ative p ro ducer who is neither the mo s t e f f icient nor the lea s t e f f ic i ent in the indu s t r y . Secondly, an indu s t r y can be i n lon g - pe r iod equilib r ium even though s ome f i r ms a r e g r owing and othe r s declining; they s imply neut r alize each othe r . T hi r dly, even though the r ep r e s entative f i r m may not be inc r ea s ing its inte r nal e f f icienc y , it can expe r ience f a lling co s t s of p r oduction as the indu s t r y expan d s . 10/4/2024 23

24. On I n t ernal ver s u s E x t ernal E cono m ie s I nte r nal economie s , s aid M a r s hall, a r e the e f f icienci e s or co s t s avings int r oduced by the g r owth in s i z e of the individual f i r m . As the f i r m g r ows la r ge r , it can enjoy m o r e s pecialization and ma s s p r oduction, u s ing mo r e and better machines t o lower the co s t o f p r oduction. H owever, ext e r nal economi e s come f r om out s ide the f i r m; they depend on the gene r al development of the indu s t r y , A s the indu s t r y g r ow s , s upplie r s o f mate r ials b u ild plants nea r by to s e r ve the expanding i ndu s t r y; the s e s uppli e s become cheaper both beca u s e t r an s po r t co s ts a r e r educed and beca u s e they a r e " l a s s p r oduced in f i r ms that a r e g r owing. 10/4/2024 24

25. Cont--- M a r s hall t hought that an inc r ea s ed volume o f p r oduction in an indu s t r y will u s ually in c r e a s e the s i z e and th e r e f o r e the int e r nal economi e s po s s e s s ed by a p r e sentative f i r m ; it w i ll al w a y s inc r ea s e the exte r nal economies to which the f i r m has acce s s . T he r e f o r e, he s aid, die c o s t of p r oduction in te r ms of labor and s ac r i f ice will f all i f the volume of output expand s . On I nc r ea s ing a nd Dec r ea s ing R e t urns t o Scale M a r s hall thought that we gen e r ally have IRS in indu s t r y; a s lab o r and capital expand, organization and e f f icie n cy im p r ove. Only when we r e ly heavily on natu r e, as in a g r icultu r e, do we have DRS . Wh e r e t he actions of the laws of IRS and DRS a r e balanced, we have the law of CRS . 10/4/2024 25

26. W el f a r e E ff e c t s of T axes and S u b s idi e s M a r s hall ' s anal y s is of con s tant, inc r ea s ing, and dec r ea s ing co s t indu s t r ies led him to the f ollowing novel policy concl u s ion s : E ither a tax or a s u b s idy w i ll r educe net co n s umer utility in a con s t ant co s t i ndu s t r y. Tax may add to net con s umer. Irving Fischer : Fisher’s Theory of Interest: In his The Rate of Interest, published in 1906, and in his revised and expanded version of this theory The Theory of Interest in 1930 Fisher perceived two factors interacting to establish the interest rate: the i mpatience rate and the investment opportunity rate. 10/4/2024 26

27. Cont--- The impatience rate is the extent of the community’s willingness to obtain present consumption (income) by giving up future consumption (income). The less impatient, the more it is willing to save and invest, thereby gaining future consumption. The more impatient, the less it is willing to give up present consumption (to save) in order to obtain goods in the future. the investment opportunity rate is determined by real factors such as the quantity and quality of resources and the state of technology. as people cut back present consumption to increase investment and thereby to obtain greater future consumption, the rate of return on investment—the investment opportunity rate—falls. 10/4/2024 27

28. Cont--- The less we save and invest as a society, the lower is the relative value of present consumption (Fisher’s impatience rate) and the higher is the marginal rate of return on investment. The equilibrium interest rate will occur where the rate of return on investment and the rate at which society is willing to trade off present for future consumption are equal . Fisher distinguished real rate of interest from monetary or nominal interest rate. 10/4/2024 28

29. Cont--- Nominal interest rate is the sum of real interest rate and expected inflation rate. If the expected rate of inflation is 5% and the real interest rate is 5%, then the nominal rate of interest will be about 10%. Lenders demand 10% to ensure that borrowers return the full purchasing power of the principal on top of the real interest rate. This effect of inflation on nominal interest rate is known as fisher’s effect. Fisher’s the Quantity Theory of Money: Fisher restated and amplified the old quantity theory of money based on the equation of exchange. 10/4/2024 29

30. Cont--- Fisher saw five determinants of the purchasing power of money, or its inverse, the price level: (1) the volume of currency in circulation (M), (2) its velocity of circulation (V), (3) the volume of bank deposits subject to check (M’), (4) its velocity(velocity of bank deposits (V’)), and (5) the volume of trade (T). MV + M’V’ = PT Where; P is the average level of prices, which vary directly with the quantity of M & M’ and vary inversely with the volume of trade (T). Monetary Policy: He advocated that; this might be achieved using paper money redeemable on demand with a quantity of gold that would represent constant purchasing power. 10/4/2024 30

31. Cont-- According to Fisher the scheme for stabilizing is increased prices leads increase the gold content, and reduced prices leads reduce the gold content. Fisher believed price fluctuations cause business fluctuations, not otherwise. Therefore, stabilizing prices by controlling the quantity would eliminate business cycle. After 1929, Fisher saw the greatest cause of deflation and depression as the growth of debts. 10/4/2024 31

32. T he Neocla s s ical School – Depar t u r e f r o m pu r e C o m pe t i t ion ( P o s t – Mars h allian Develo p m en t s ) T he Po s t – M a r s h allian economic thought took a new d i r ection s ta r ting f r om the c r itici s m of the ma r ket analy s is o f M a r s hall by Philip.H . W ick s teed ( 1844 – 1927) to J . R .Hick s Wick steed was not a f ollower o f M a r s hall but his contempo r a r y and can be included in the catego r y of M athemati c al economi s t s . He is one o f the economi s ts who developed new d ime n s ions to: Ma r ginal p r oductivity t heo r y o f di s t r ibution. Extending the application of ma r ginal p r inciple to eve r y s o r t of r e s ou r ce allocation. F ields of con s umption, p r oduction dec i s ion s , u s e of input s , s aving , inve s tment and opp o r tunity co s t a r ea. C o - o r dinate the laws of di s t r ibution it refers to r ate of payment to each f actor and then came to individual s ha re s i n national i ncome on the ba s i s o f the owne r s hip of f acto r s o f p r oduction. 10/4/2024 32

33. Cont--- Maintained that the t r aditional cl a ss i f ication o f f acto r s was i r r elevant. T he demand f o r f act o r s of p r oduction w a s de r ived f r om the demand f or the commoditie s , which they p r oduced. L ike J evo n s , wick s t eed al s o believed that the ma r ginal p r inciple explain the f actor p r ic e s th r ough the medium o f the valu e s of goods and s e r vices and hence th r ough the con s u m e r ’ s utilit y . T he r e f o r e, t he ma r ginal p r oductivity of a f act o r is not in phy s ical te r ms but in the ma r ginal r evenue p r oductivit y . 10/4/2024 33

34. Cont---- P o s t- M a r s hallian developmen t s in the ma r ket analy s is al s o developed s ome new t r end s . M a r s hall viewed the economy as an o r ganic whole and in this economy though the indu s t r y may r etain its over a ll cha r acter indi v idual f i r ms may g r o w , become old and die. T he new f i r ms to begin with may f ace a number of d i s economie s . B eca u s e o f the s e r ea s o n s mo s t econom i s ts c r iticized his way o f equilib r i u m anal y s is and r e p r e s en t ative f i r m . I m per f ect and Monop o li s t ic C o m pe t i t ion s P ie r o S r a f f a who led the c r itici s m o f M a r s hall ’ s contention that in c r e a s ing r etu r ns and competition could go togethe r . 10/4/2024 34

35. Cont--- His c r itici s m o f M a r s hall ’ s r ep r e s entative f i r m came in the wo r k “ T he laws of R etu r ns under competi t ive condition s ” publi s hed in the E conomic J ou r nal ( 192 6 ) . H e a r gued that f o r logical co n s i s tency we s hould either give up competitive ma r ket or the in c r e a s ing r etu r ns to get a s table long – t e r m equilib r ium. T h i s new idea o f S r a f f a suggested a new t r end of analy s is among economi s t s in di f f e r ent p a r ts o f the wo r ld like Ha rr od, J oan R obi n s on and othe r s in E ngland, E dwa r d C h ambe r lain and Yntema in United States and M ehta in I ndia to abandon the pe rf ect competition. T he r e s ult w a s the development of two imp o r tant piec e s of wo r k namely; T he economics o f impe r f ect competi t ion by J oan R obin s on : T he t heo r y of M onopoli s tic competition by E dwa r d C hambe r lain and both we r e publi s hed in 1933. 10/4/2024 35

36. Oligopoly F ollowed by the development o f two new ma r ket f o r ms led to the development of new ideas and an oligopoly m a r ket developed by Paul Sweezy in USA and Hall and Hitch in E ngland. T hey came out with the theo r y o f kinky demand cu r ve. T he r e is a Kink in the demand cu r ve f or the individual oligopoli s t ’ s p r oduct. A kink i n the demand cu r ve at the cu r r ent p r ice and the s lope of t he demand c u r ve above and below the kink a r e di f f e r ent. T he kink i ndicat e s the cu rr ent m a r ket p r ice. Above the kink the p r ice has a h igh el a s ticity and below low el a s ticit y . 10/4/2024 36

37. Cont---- Geo r ge A. Stigl e r ca r r i e s t his anal y s is a s tep f u r ther by developing the theo r i e s o f Sweezy , hall and Hitch by b r inging in the que s tion of Price lead e r sh ip . His disagreement is that if the s elle r s a r e v e r y f ew or when they a r e man y , the p r ices a r e r elatively f lexible . B ut when the s elle r s a r e mode r ate in number ( f ive to ten) p r ice r igidity develop s . When the m a r ket has a p r ice leader ( when a g r oup o f f i r ms acting togethe r ) p r ic e s would be m o r e f lexible than i f th e r e is no p r ice leade r . When di f f e r ent f i r ms joins hand to wo r k together it become a monopol y , the kink in the demand c u r ve di s appea r s and the p r ic e s will be mo r e f lexible. 10/4/2024 37

38. Economic Dynamic po s t – M a r s hallian pe r iod, there was dynamic economy and the dynamic tools o f analy s i s. A dynamic economy is one in which unp r edictable change takes p lace and the end s ituation cannot be wo r ked out with the help of initial condition s . B ut i n the i mpo r tant wo r k o f Hicks ‘ V alue and C apita l ’ he s ho w s that a dynamic economy need not nece s s a r ily be analyzed with dynamic tool s . T he analytical tools s uited to a s tatic economy ( T he compa r ative mac r o s tatic s ) can be f r uit f ully u s ed he r e. T hough he developed the method of M a c r o dynamic, he s a y s that even i n a dynamic economy the economy ’ s cou r s e can be divided in to s t r ips of s mall du r ation l ike days or weeks and the r e may not be any vi o lent change s , hence the initial condition and the end of the int e r val can be wo r ked out. 10/4/2024 38

39. Cont--- R o y . F . Harrowed explains that the concept of a s tatic economy i t s elf is meaningle s s . When the changes in the economy became un p r edictable it becom e s dynamic. Example: s avin g s would imply a cumulative s upply o f capital and it makes the economy dynamic. The following factors that makes the economy Dynamic: G r owth in population C hange in age compo s ition Change in the s upply of nat u r al r e s ou r c e s All elements of unc e r tainty 10/4/2024 39

40. Piero Sraffa (1898-1983) T w o condi t ion s ca n b r ea k u p th e p u r it y o f m a r ke ts ( pu r e competitio n o r natu r a l monopoly ) : A s ingl e p r oduce r ca n a f f ec t ma r ke t p r ic e b y va r yin g th e quantit y o f good s i t o f f e r s f o r s al e. E ac h p r oduce r ma y engag e i n p r oductio n unde r ci r cum s tanc es o f individua l dec r e a s in g co s ts. 10/4/2024 40

41. Cont--- E dwa r d C hambe r li n ( 1899 - 1967 ) explains T heo r y o f monopoli s tic competition , P r oduc t di f f e r entiatio n, Pu r e competitio n r e s ult s i n a la r ge r output , m o r e e f f icien t p r oductio n an d lowe r s ellin g p r ices than occur under monopoli s tic competition. B ut this conclu s ion r equi r es two quali f ication s . C h ambe r li n ’ s conclu s ion s a r e buil t o n th e u n r eali s ti c a s s umptio n tha t co s t cu r ve s a r e th e s ame i n eac h s ituation . E conomie s o f s c al e a r e a s s ume d t o b e achieve d b y al l th e f i r m s. 10/4/2024 41

42. Cont--- M onopol i s ti c competitio n p r ovide s po s itiv e bene f it s a s s ociate d wit h p r oduc t va r iet y . J oa n R obi n s o n ( 1903 - 198 3 ) M ono p s ony: a s ituation in which th e r e is either a s ingle buyer in a ma r ket or a g r oup of buye r s actin g as on e P r oduct - ma r ke t monop s on y . P u r e competi t ion : buye r ’ s P= M U, M ono p s ony : buye r ’ s MC = M U R e s ou r ce - ma r ke t monop s on y. M onop s on i s t wi l l emplo y X wo r ke r s , whe r e M R P = M W C ( M a r gina l r evenu e p r oduc t = ma r gina l wag e co s t ). 10/4/2024 42

43. Cont--- John Gustaf Knut Wicksell (1851-1926) W ic k s ell had a good und e r s t anding of cla ss i c al and neo - cla s s ical thought. He made a th o r ough s tudy o f the economic theo r ies o f M ill, M enger and B a w e r k. He  al s o attempted to p r e s ent a s ynth e s is of the ma r ginal p r oductivity analy s i s o f the  Au s t r ian s chool and the equilib r ium the o r y of the L uanne s chool. 10/4/2024 43

44. Cont--- Capi t al & I n t e r e s t - W ic k s ell made an impo r tant cont r ibution by b o rr owing the time element fr om B om– B awe r k. Acco r ding to him capital is s to r ed up p r oductive pow e r o r s to r ed up labor and land. I t is s epa r ated f r om the cu rr ent labor and land t h r ough time element. He r e Wick s ell b r ings in the ‘ pe r iod concept ’ . T he cu rr ent yea r s land and labor c o - ope r ate with s to r ed up land and lab o r o f the p r evious year f or t he p u r po s e o f p r oduction. I f the s upply o f s to r ed up land and lab o r equa l s with cu r r ent land and labo r , int e re s t would vani s h and if t he r e is a di f f e r ence between the s e two b r ings in inte r e s t. 10/4/2024 44

45. Interest and Prices T he analy s i s of int e r e s t and p r ice b r ings Wick s ell ’ s f amous di s tinction between ‘nat u ral’ r ate o f inte r e s t and ‘ money’ r ate of inte r e s t. T he natu r al or n o r mal r ate of inte r e s t acco r ding to him is the r ate at which the demand f o r loanable capital and s upply o f s avin g s a r e equal. T he nat u r al r ate of int e re s t in Wick s ell ’ s analy s i s is equal to the ma r ginal e f f iciency of capital in Keynes analy s i s . I t is a mea s u r e o f expected yield f r om new inve s tment. 10/4/2024 45

46. Cont--- T his in tu r n co r re s ponds to equality between s aving and inve s tment . Saving means leakage f r om s pending s t r eam and inve s tment mea n s an injection to it. T he r e f o r e, an equality o f s aving and inve s tment mea n s s table p r ic e s and income s . B ut in p r actice, natu r al r ate may not b r ing equality between demands f o r loanable f unds and s upply o f s aving, but between s upply and demand of loanable f und s . E quality in te r ms of loanable f unds need not b r ing p r ice s tability f o r the f act that bank c r edit is a pa r t of the s upply o f the loanable f und s . Hence the r e may be an exce s s o f inve s tment over s aving s . 10/4/2024 46

47. Cont--- W ic k s ell u s e s h is natu r al and money r ates o f int e re s t f or explaining the movement in p r ice in the econom y . T he money or ma r ket r ate of inte r e s t acco r ding to him as the ave r age o f the r ates at which banks a r e advancing loans to the potential inve s to r s . I f t h e s e two r ates a r e n o t equal, di s equilib r ia s ta r ts and will r e f lect in the va r iation of s avings and inve s tment and ultimately to the p r ice level. Savings and I nv e st m en t W ic k s ell does not ag r ee with the Wal r a s ian gene r al equi l ib r ium anal y s is that w i th a f all in p r ice the p u r ch a s ing power and hence t he e f f ective demand inc r ea s e s . 10/4/2024 47

48. Cont--- He believ e s that s ince the expenditu r e o f one is the income of anothe r , the agg r egate pu r cha s ing power would always r emain t he s ame. Du r ing no r mal conditions agg r egate income is equal to agg r egate s p ending . I.e. , the income not s pent on con s umption is s pent on capital and the p r ice level r emains co n s tant. When conditions a r e not no r mal s avin g s would not be equal to inv e s tment . Since t he dec i s ion to inve s t is taken by di f f e r ent people, inve s tment does not only depend on volunta r y s avings and in s uch a s ituation amount of s avings exceed i nv e s tment and income would be r educed, con s umption would decline and p r ices would f all. 10/4/2024 48

49. Cont--- I f inve s tment is mo r e than s avin g s , p r ices would r i s e. T his type of s ituations would be cont r o l led by manipulating the bank r ate s o that the m a r ket r ate of inte r e s t s hould be above or below the natu r al r a te to keep the p r ic e s r i s e or f all depending on the s ituation, f inally leading to a r i s e o r f all in the m a r ket r ate. T his is known as the ‘ C umulative p r oce s s ’ o f W ick s ell . T he f act o r s like hoa r d ing, di s s aving and va r iations in bank c r edit ca u s es di f f e r ence between s aving and inve s tment we r e b r ought to light by Wick s ell. 10/4/2024 49

50. Cont--- He was a pioneer in expl o r ing the u s e of the s e in s t r uments f or inve s tigation in f inancial m a r ket s . M ode r n economi s ts r ecognized the impo r tance o f the elemen t s u s ed by W ick s ell though he mi ss ed s ome a r eas in moneta r y f ield like ‘ liquidity t r ap’ and its i n f luence up on p r actical monet a r y polic y . 10/4/2024 50

51. Sidge wick, Nicolson and the Cambridge School The Cambridge School: Sidgwick’s importance as an economic thinker has often been underestimated, in part because of his stormy relationship with Alfred Marshall, who is generally regarded as the founder of the Cambridge School (Groenewegen, 1995). Sidgwick was more involved than Marshall in the methodological debates of the time, seeking to balance both deductive and inductive approaches, and he was also wary of the evolutionary metaphors and talk of ‘economic biology’ to which Marshall was given. 10/4/2024 51

52. Cont--- John Shield Nicholson (1850-1927): Nicholson's attack on utility theory and Marshall's consumer surplus prompted a brief controversy with F.Y. Edgeworth in the 1894 edition of the Economic Journal. Nicholson did his best to explain all sides of current economic debates -- from the impact of mechanization to the fallacies of Marxism. Like his great hero, Adam Smith, Nicholson nurtured a cautious liberal position, but he was not a doctrinaire laissez-faire apologist. 10/4/2024 52

53. Wicksell and Stockholm School T he Stockholm o r the Swedi s h s chool w a s f ounded by wic k s ell , L indhal , B . Ohlin and Gunnar M y r dal. W ick sell influenced economists of the Scandinavian count r ies l ike F r i s ch i n No r wa y , Z euthen in Denma r k and in f luenced the thought o f Hayek, Keynes and Hicks in E ngland. Wicksell made several major contributions to economics. Such as; he was one of the earliest economists to suggest that the typical firm will first experience increasing returns, then constant returns, and finally decreasing returns as it expands its size. But Wicksell’s chief claim to fame lies in his contributions to monetary economics. 10/4/2024 53

54. Cont--- These advancements include (1) an analysis of the role of interest rates in achieving an equilibrium price level or in generating cumulative inflationary or deflationary movements; (2) recognition of the potential contribution of the government and the central bank in retarding or promoting price stability; and (3) an early statement of the saving-investment approach to macroeconomic equilibrium . This last contribution established Wicksell as the father of the so-called Stockholm school of economics. 10/4/2024 54

55. Cont--- In addition, his work became one of the sources of Keynesian economics; Keynes himself complimented Wicksell as an important precursor of his own ideas. Wicksell’s overall objective was to synthesize monetary theory, business-cycle theory, public finance, and price theory into one system. On the Price Level Changes : Why do prices collectively rise or fall? To answer this question, Wicksell try to analysis interest rates and distinguished the normal or natural rate of interest and the bank rate. The normal or natural rate of interest, he said, depends on supply and demand for real capital that is not yet invested. The supply of capital flows from those who postpone consuming part of their income and thereby accumulate wealth. 10/4/2024 55

56. Cont--- Wicksell on forced saving: Assuming full employment through a bank loan financing of a new enterprise, more land and labor would be employed in producing capital goods. This leaves fewer resources for consumer goods production. However, the demand for consumer goods increases rather than diminish as income from labor and land increases with the bidding up of prices by entrepreneurs. With the resulting rises in prices entrepreneurs would acquire fewer capital goods and consumers restrict their consumption. i.e. will be forced to save. 10/4/2024 56

57. Cont--- Wicksell on Imperfect Competition: Wicksell recognized the inadequacy of the purely competitive model in retail markets, thus anticipating by several decades the theory of monopolistic or imperfect competition proposed by Edward Chamberlin and Joan Robinson. 10/4/2024 57