Marginalist and Neoclassical Schools

It is frequently argued that there was a marginalist revolution in the late nineteenth century, which replaced classical economics with marginalist economics. Alas, things are invariably more complicated. Crucial concepts of the marginalist school were forged much earlier. The Swiss mathematician Daniel Bernoulli assumed a declining marginal utility of income as early as 1738 in discussing a game in which a coin is tossed. In 1837 the German economist Karl Heinrich Rau spelled out the concept of marginal utility (Grennutzen) although the expression Grenznutzen was only coined in 1884 by the Austrian economist Friedrich von Wieser. Marginal utility is the additional satisfaction a consumer gets from consuming one more unit of a good, keeping the amounts of all other goods consumed constant. Johann Heinrich von Thünen elaborated the parallel concept of marginal productivity in 1850: marginal productivity is the additional output a producer gets by adding one more unit of an input, keeping the amounts of all other inputs employed in production constant. Both marginal utility and marginal productivity are typically assumed to decline as the amount of goods consumed or of inputs employed increases ceteris paribus (all things being equal). In 1838 the French mathematician Antoine-Augustin Cournot and von Thünen formulated the problems of utility and profit maximization as problems of constrained optimization and used calculus to solve them.

The conception of the economy as a system of relationships between agents performing different roles in the system (workers, landlords, capital owners, merchants etc.) that are in equilibrium as regards production, trade, consumption and the circulation of money was anticipated in the mid eighteenth century by the Irish economist Richard Cantillon and the French economist Anne-Robert-Jacques Turgot.

Hence, while crucial concepts of marginalism had been available for some time, what was lacking was their integration into a new theoretical edifice that attempted to explain all prices of goods, services, and incomes (wages, profits, interest and rents) indiscriminately in terms of a single, universal principle: the principle of relative scarcity. The gradual elaboration of a theory of demand and supply centred around that principle was confronted with a number of analytical problems and differing versions spread from Great Britain, Europe and America, championed by William Stanley Jevons, Carl Menger, Léon Walras and John Bates Clark (who advocated a macro version), respectively. The English economist Alfred Marshall attempted a reconciliation of the new view with the old theories of the classical economists: instead of political economy he talked of economics and was most successful in propagating marginalism in his Principles of Economics (1890). Both in production and in consumption, he insisted, the possibility of substitution was of great importance: a given level of production or utility could be achieved with different combinations of inputs or consumption goods.

The American Thorstein Veblen introduced the term neoclassical school in 1900. The British economist Lionel Robbins redefined economics in a way that was compatible with the new perspectives and methods: economics is said to study “human behaviour as a relationship between ends and scarce means which have alternative uses” (Lionel Robbins, An Essay on the nature and significance of Economic Science, 1932). It sees humans as optimizing entities: minimizing costs and maximizing profits (firms) or maximizing utility (consumers). Homo oeconomicus (economic man) had conquered the arena on which this new theoretical orientation was staged. Man was no longer regarded as “but a heap of contradictions” and reason as “the slave of the passions” (David Hume, Treatise of Human Nature, 1739-40).

One can therefore speak of a marginalist revolution because an entirely new explanation of income distribution was presented that sought to explain all rates of remuneration (wages, profits, land rents) in a symmetrical way in terms of a single principle – the principle of marginal productivity with respect to each factor of production, labour, capital and land. The explanation under consideration presupposes that all factors are fully employed. Marginal productivity theory and Say’s law (understood by the marginalists as implying a tendency towards the full employment of all productive resources) thus turn out to be Siamese twins. In classical theory, by contrast, only land rent is considered to reflect the scarcity of particular qualities of land. Profits are explained in terms of surplus theory, which takes the real wage rate as given and then for a given system of production explains property incomes such as profits (and rents) as residuals. Capital goods, unlike land, can be produced and reproduced and therefore can be scarce only in the short run. And according to the classical economists Say’s law only implied that commodities produced with the aim of making profits can be expected to find a market; labour power is no such commodity, because people are not generated with this motive in mind.

Marginalism was designed to replace earlier streams of thought, especially David Ricardo’s political economy, and to ward off socialist and Marxist attacks on the current social order, which saw profits (and all property incomes) as rooted in the exploitation of workers.  The marginalists maintained that profits reflect the marginal contribution of capital to the product. The politico-ideological element played a particularly important role in the contributions of the Austrian economist Eugen von Böhm-Bawerk who sought to refute Karl Marx’s construction.

For the marginal productivity theory to hold, bold assumptions have to be met. These include constant returns to scale in order for Leonhard Euler’s Theorem concerning the exhaustion of the product to apply. With non-constant returns the product is either not fully distributed to the claimants (diminishing returns) or the aggregated claims exceed the product (increasing returns). The Swedish economist Knut Wicksell was the first to point this out. Classical economics with its asymmetrical treatment of the distributive variables – taking real wages as given and determining rents and profits residually – was not under the spell of this assumption. Wicksell also realised that in order to ascertain the quantity of capital as a whole in the economy, which was needed as the basis from which to determine the marginal productivity of capital heterogeneous capital goods had to be aggregated using prices. However, prices cannot be calculated without knowing the rate of profits. This rate, however, was supposed to be determined by capital’s marginal productivity. Since the latter presupposes a knowledge of the former, the theory is stuck in a vicious circle.

While the classical economists had started their analyses by taking into view society as a whole, stratified by social class, the marginalists began their analysis from the needy individual and sought to reconstruct society from there, describing in abstract terms the needs and wants of agents and their interaction in interdependent markets. Hence, society and the economy were the result rather than the starting point of the enterprise. Joseph Schumpeter called this approach to economic phenomena methodological individualism. As his Austrian peer Carl Menger had insisted, basing the analysis on the figure of Robinson Crusoe before he met with Friday defined the appropriate perspective on economic matters, because it allowed one to analyse the economic behaviour of the individual as if in a vacuum. Social and economic relations were thus telescoped back to single agents.

While some Austrian economists like Menger and Ludwig von Mises advanced the thesis that all value (and cost) is ultimately derived exclusively from the subjective evaluations of individuals, Marshall’s insisted that a complete theory of prices and income distribution must take into account both objective and subjective factors or forces – that of supply and demand, or the two blades of scissors. The classical economists are said to have developed only the supply side and have left the demand side in a very rudimentary state. On the basis of this view, some marginalists (Jevons, Walras) claimed that the classical authors had promoted an underdetermined system in which the number of unknowns is smaller than the number of equations available to ascertain them. However, a logically coherent formulation of the classical approach shows that this is a misunderstanding. The classical economists’ explanation of the rate of profits and prices differs fundamentally from the marginalist one, but is not incomplete or indeterminate.

Partial equilibrium studies single markets in isolation, using the ceteris paribus assumption. This is, however difficult to sustain, because changing one price for example will typically involve the change of at least one other price. The theory of general equilibrium, championed by Walras and Vilfredo Pareto, also discusses the effects a change in a particular market has on other markets and the response this may generate. It is assumed that all responses of agents to market signals are known. In other words, agents are as open secrets. Much of the analysis assumes perfect competition, which is a state of affairs in which no agent wields any economic power whatsoever. This differs markedly from the classical economists, who saw the economy permeated by power relationships. Adam Smith was convinced that wealth is power, and unequal wealth is unequal power.

Suggested reading:  The following journal articles will be of use here: Andrea Maneschi’s “Jules Dupuit: A sesquicentennial tribute to the founder of benefit-cost analysis”, Philippe Steiner’s “The creator, human conduct and the maximisation of utility in Gossen's economic theory”, Ian Steedman’s “Jevons's Theory of Political Economy and the ‘Marginalist Revolution’” and Ariel Dvoskin and Andés Lazzarini’s “On Walras's Concept of Equilibrium”. Alfred Marshall’s contribution is discussed at length by Tizioano Raffaeli in “Whatever happened to Marshall's industrial economics?” and “Marshall on mind and society: neurophysiological models applied to industrial and business organization” and also by Peter Groenewegen in “Alfred Marshall and the Labour Commission 1891–1894” and “Marshall’s Treatment of Technological Change in Industry and Trade". See also The Equilibrium Economics of Léon Walras and The Economics of Vilfredo Pareto by Albert Jolink and Austrian and German Economic Thought by Kiichiro Yagi.