2. Historical links
A. Forerunners of Marginal Analysis (1st Generation)
1. Concept of Utility
Aristotle - use value 310 BC
Jeremy Bentham – concept of utility in utilitarian
philosophy end of 18th century
19th century writers - concept of
diminishing marginal utility,
marginal productivity theory
3. 2nd Generation marginal utility theorists -
Jevons, Menger and Walras
(Menger - 1st generation Austrians)
A. A Revolution in Theory?
All 3 thought they had developed a revolutionary analysis of
the forces explaining the determination of prices (stressed
demand side).
Jevons - application of marginal analysis to the side of demand
Walras - application of marginal analysis to both demand and
supply, and the formulation of a general equilibrium model of the
Jevons, Menger and Walras
Menger - application of marginal analysis to both the demand
and supply side
4. Inadequacies in the Classical Theory of Value
1. Classical theory of value found inadequate to explain the
forces of prices (stressed supply side).
a) Cost of Production theory - lacked generality b/c could not
analyze prices some goods
1) Labor theory of value (Ricardo) and cost of production theories
(Senior & Mill) required separate explanation for goods with fixed
supply b/c value did not depend on production cost.
2) Theory suggested prices comes from cost incurred in the past. Jevons,
Menger and Walras said large production costs will not necessarily result
in high price.
5. B) Marginal utility theory - value depends on utility
(consumption) and comes from the future.
1) dead stock - goods for which demand so that prices <
cost of production.
2) Value of factors of production determined by marginal
utility received from consuming final product
C)Classicals used total or average utility (diamond-water
paradox), but it is marginal utility that is significant theory -
value depends on utility (consumption) and comes from the
future.
6. What is utility?
1. Utility - a psychological phenomenon with unspecified
units of measurement.
2. Jevons, Menger and Walras did not use term “marginal
utility”
3. Menger used “importance of satisfactions” instead of
“utility”
7. What is utility?
1. acquired utility -utility of goods consumed indirectly
(acquire utility from the consumption of goods for which
they are finally exchanged.
2. diminishing marginal utility -as the consumption of a
good increases, its marginal utility decreases
3. continuous functions - have smooth curves when plotted
(arise from continuously divisible quantity of goods
consumed and continuously divisible quantity of utility.
4. discontinuous functions - have steplike curves when
plotted (arise from nondivisibility)
8. Comparisons of Utility
Interpersonal comparisons of utility - comparing
the utility of different persons for a good (e.g., and
additional amount of income given to a person with
high income and to a person with low income) .
Jevons, Menger and Walras maintained interpersonal
comparisons not possible .
9. Utility Functions
Jevons, Menger and Walras : marginal utility depends only on
the quantity of a good consumed and does not depend on the
quantity of other goods consumed (substitute or complementary)
a) Therefore total utility is an additive function:
total utility = f1 (Qa) + f2 (Qb) + f3 (Qc) + . .
b) Modern however assumes:
total utility = f (qA, qB, qC, . . . )
10. Utility, Demand, and Exchange
1. What distinguished Jevons, Menger and Walras from
predecessors (except Gossen):
a) Attempted to determine the conditions that would hold
when a consumer is maximizing utility
b) Attempted to develop a theory of exchange
c) J. & W. investigated the relationship between utility and
demand
What distinguished Jevons, Menger and Walras from
predecessors (except Gossen):
d) Walras most successful of the 3 in these attempts b/c
of greater mathematical ability & better understanding of
interrelatedness of various sectors of economy
11. 2.Gossen’s 2nd Law: A consumer maximized utility by
spending a limited income so that the last unit if money spent
for any particular good yields the same marginal utility as the
last unit spent for any other good.
a
MUA = MUB = MUC
PA PB PC
d) Walras most successful of the 3 in these attempts b/c of
greater mathematical ability & better understanding of
interrelatedness of various sectors of economy
12. The Value of Factors of Production
Jevons and Menger: Factors of production are price-determined;
price of factors of production (called intermediate goods or good
of higher order) depends on the utility of the produced final good.
Causal relationship treated in partial equilibrium framework
Walras: Saw causal relationships more complex and formulated
consideration of value in general equilibrium analysis
13. Karl menger (1st generation Austrian)
Karl Menger was an Austrian economist and founder of Austrian
School of Economics. Menger contributed to the development of
theory of marginalism. which rejects the cost of production
theories of value. such as were developed by the classical
economists such as Adam Smith and David Ricardo.
After attending Gymnasium he studied law at the Universities of
Prague and Vienna and later received a doctorate in jurisprudence
from the Jagiellonian University in Kraków. In the 1860s Menger
left school and enjoyed a stint as a journalist reporting and
analyzing market news, first at the Lemberger Zeitung in Lwów,
Ukraine and later at the Wiener Zeitung in Vienna.
14. During the course of his newspaper work he noticed a
discrepancy between what the classical economics he was taught
in school said about price determination and what real world
market participants believed. In 1867 Menger began a study of
political economy which culminated in 1871 with the publication
of his Principles of Economics thus becoming the father of the
Austrian School of economic thought. It was in this work that he
challenged classical cost-based theories of value with his theory
of marginality – that price is determined at the margin.
15. In 1872 Menger was enrolled into the law faculty at the
University of Vienna and spent the next several years teaching
finance and political economy both in seminars and lectures to a
growing number of students. In 1873 he received the university's
chair of economic theory at the very young age of 33.
Menger used his “Subjective Theory of Value” to arrive at what
he considered one of the most powerful insights in economics:
both sides gain from exchange. Unlike William Jevons, Menger
did not believe that goods provide “utils,” or units of utility.
Rather, he wrote, goods are valuable because they serve various
uses whose importance differs. Menger also came up with an
explanation of how money develops that is still accepted by some
schools of thought today.
16. Karl menger’s contributions
1871 – Principles of Economics
1883 – Investigations into the Method of the Social
Sciences with Special Reference to Economics
1884 – The Errors of Historicism in German Economics
1888 – The Theory of Capital
1892 – Money
17. Second-Generation Austrians
Friedrich von Wieser (1851 - 1926)
Austrian school - began with karl Menger at University of Vienna
late 1800s . Wieser was a student of Menger, became professor
at University of Vienna (along with Eugen von Bohm-Bawerk)
and both taught Ludwig von Mises and Joseph Schumpeter.He
Used (Robinson Crusoe) verbal models instead of mathematics
.he was First to use the term “marginal utility”
Imputation -process by which factors of production receive value
from final goods (price-determined)
18. Intramarginal final goods - have higher relative marginal utility in
a set a goods; value depends on cost of production (price-
determining)
Marginal good - the good with the lowest marginal
utility in a set of goods; value depends on marginal
utility
19. Eugen von Bohm-Bawerk
Fellow student, friend and brother-in-law of Wieser; became
better known in Britain and U.S. than Wieser.He Used verbal
models instead of mathematics.
Profits and Interests
.Bohm-Bawerk perceived that marginal productivity theory failed
to explain profits and interest.
1)Difference between profits and interest had not yet been
distinguished. Roles of capitalist and entrepreneur were
combined in classical economic theory.
20. Profit Theory
Classical economists recognized 3 element of profits:
a payment for the use of capital (now classified as interest)
a payment to the entrepreneur for management services
rendered
a payment that compensated for the risks of business activity
2) J.B. Clark called payment for entrepreneur’s management
services and the assumption of risk a wage, not profit.
Eugen von Bohm-Bawerk saw a relationship between profits
and interest rates.He then dwelt on why interest were at the
level they were and concluded that there was three
psychological levels determining interest rates.
21. Present goods are worth more than an equal amount of future
goods ($1 today is preferred to $1 a year from now b/c $1
received today could be lent and thus worth more in the future.
3 reasons for interest rates:
Different circumstances of want and provision in the present
and in the future. Marginal utility decreases as goods
increase.
Systematic underestimation of future wants, and the goods to
satisfy them. Lack of imagination and willpower in
individuals, and uncertainty regarding length of life.
22. Interest exists b/c of the technical superiority of present good
over future goods. Goods produced by roundabout (capitalistic)
method gain technical superiority at every stage of production
and increases the flow of final goods as opposed to the direct
method (e.g., catching a fish by hand involving no capital goods).
