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Chapter One: The Neoclassical School

1.1. The Neoclassical School- Pure competition
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.

Neoclassical economics dominates microeconomics, and together with Keynesian

economics forms the neoclassical synthesis which dominates mainstream
economics today. Although neoclassical economics has gained widespread
acceptance by contemporary economists, there have been many critiques of
neoclassical economics, often incorporated into newer versions of neoclassical
theory. Today it is usually used to refer to mainstream economics, although it has
also been used as an umbrella term encompassing a number of other schools of
thought, notably excluding institutional economics, various historical schools of
economics, and Marxian economics, in addition to various other heterodox
approaches to economics.

The central assumptions of the Neoclassical Theory

1) Rationality: The first assumption made is that people are rational and prefer more
valuable goods and services or leisure to less. Rational economic man has objectives
and attempts to maximize them. In neo-classical economics, that tends to get
narrowed down to maximizing one thing: • consumers allocate their incomes in order
to maximize their satisfaction (or utility) • producers allocate resources in order to
maximize their profits producer decisions are taken by managers, not by owners.
2) Perfect Knowledge: More contentious is the second assumption of the neo-
classical model, that economic agents act in the light of perfect knowledge. Buyers
and sellers know all the prices of all the goods in the market, know everything they
need to know about the quality of goods, the character of the other economic
agents, what the government is going to do next, and so on.
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3) Diminishing Returns: The third neo-classical assumption is more properly called

a behavioral hypothesis, because it can be tested. Since hardly anyone bothers to test
it, it is often called an assumption. The hypothesis is known as the Law of
Diminishing Returns. It is essential because it means that on the buyer’s side, the
more and more they buy, the smaller and smaller the increment in satisfaction
becomes.
4) Equality of Sales and Purchases: We must assume that whatever is bought
equals whatever is sold. If goods are put into store, we must count them as either
being part of what is bought, or exclude them from the market calculation all
together. Otherwise, equilibrium will never be discovered.

5) Unique Equilibrium: Equilibrium is reached when all economic agents are

content with their actions and feel no reason to change them. In the neo-classical
model, price changes until sellers are happy to sell what they sell, and buyers are
happy to buy what they buy. It is this concept of equilibrium which distinguishes
the neo-classical approach.
6) Many participants, Freedom of Entry and Exit: These assumptions ensure
that a market is freely competitive. If a few buyers or seller dominate, this means
the outcome may be equilibrium, but it may not be the best, or optimal, outcome
for the economy as a whole. It is an inefficient equilibrium.

7) Independence of Demand and Supply: The last assumption could be relaxed but
seldom is. We assume that buyers are quite distinct from sellers, so that the act of
buying does not affect selling, and selling does not affect buying, except through the
mechanism of the market. The time when it does get relaxed is in the analysis of
peasant farms which are partially self-sufficient. In this case the farm is responsible
for supplying the household and the market, so the household is both a buyer (from
its farm and from the market) and a seller.

 People have rational preferences between outcomes that can be identified and
associated with values. New classical economics is based on Walrasian
assumptions. All agents are assumed to maximize utility on the basis of rational
expectations. At any one time, the economy is assumed to have a unique
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equilibrium at full employment or potential output achieved through price and

wage adjustment.
 From the basic assumptions of neoclassical economics comes a wide range of
theories about various areas of economic activity. For example, profit
maximization lies behind the neoclassical theory of the firm, while the
derivation of demand curves leads to an understanding of consumer goods, and the
supply curve allows an analysis of the factors of production. Utility maximization
is the source for the neoclassical theory of consumption, the derivation of demand
curves for consumer goods, and the derivation of labor supply curves and
reservation demand. Market supply and demand are aggregated across firms and
individuals. Their interactions determine equilibrium output and price. The market
supply and demand for each factor of production is derived analogously to those
for market final output to determine equilibrium income and the income
distribution. Factor demand incorporates the marginal-productivity relationship
of that factor in the output market. Neoclassical economics emphasizes
equilibria, where equilibria are the solutions of agent maximization problems.
Regularities in economies are explained by methodological individualism, the
position that economic phenomena can be explained by aggregating over the
behaviour of agents.
Alfred-Marshall(1842–1924)
Marshall appeared on the economic scene at a time when the classical school under
heavy criticism for its objective approach of analysis as distinct from the subjective
approach of the modern economists. The economics discipline as such was passing
through a crisis and was termed as a ‘dismal science’. Marshall presented a synthesis
through his writings, a proper blending of the classical doctrines and the marginal
utility analysis of the subjectivists.
Marshall was born in London. He was chiefly interested in mathematics and later
developed interest in metaphysics and ethics and also in political economy. He
began his economic studies at a time when Mill was still alive and when Menger,
Jevons and Walras were not yet on the scene. It is known that by 1871, the year in
which Jevon’s ‘Theory’ and Menger’s ‘Groundatze’ were published. Marshall had
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already developed a similar approach. Under the influence of Cournot and

Bentham and his own mathematical background he translated many of the
theorems of Ricardo and Mill in to diagrammatic language. Even though he had
worked most of his economic ideas earlier, because of his shyness, he did not make
his findings public.
Marshall is claimed to have established the Cambridge school of thought and also
the neo-classical school. This school has certain distinct characteristics as
compared with the other schools of thought like Austrian and Lausanne. These
schools were dealing with certain partial modifications or replacements of the
classical tradition as established by Ricardo and restated by Mill. With these
modifications these schools claimed to have launched an intellectual revolution in
economic thought. Marshall did not claim such revolution and according to him it
is an evolution that is taking place and through the re-building of the classical
material he is said to have established the neo-classical school. He was instrumental
in establishing the British Economic Association (Later Royal economic society),
which founded the Economic Journal.
Alfred Marshall Theoretical Contributions considered to be one of the most
influential economists of his time, largely shaping mainstream economic thought
for the next fifty years, and being one of the founders of the school of neoclassical
economics. Although his economics was advertised as extensions and refinements
of the work of Adam Smith, David Ricardo, Thomas Robert Malthus and John
Stuart Mill, he extended economics away from its classical focus on the market
economy and instead popularized it as a study of human behavior. He downplayed
the contributions of certain other economists to his work, such as Léon Walras,
Vilfredo Pareto and Jules Dupuit, and only grudgingly acknowledged the influence
of Stanley Jevons himself.
His Utility and demand
On Marginal Utility: According to Marshall, demand is based on the law of
diminishing marginal utility. "The marginal utility of a thing to anyone diminishes
with every increase in the amount of it he already has.” Marshall introduced two
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important conditions for the law to apply. First, the period is just a moment in time,
which is too short an interval to consider any changes in character and tastes of a
particular person. Second, those consumer goods must be indivisible.
On Measurement of Utility: Marshall was one of those who used utility analysis,
but not as a theory of value. He used it as a part of the theory to explain demand
curves and the principle of substitution. Marshall's scissors analysis – which
combined demand and supply, that is utility and cost of production, as if in the two
blades of a pair of scissors – effectively removed the theory of value from the
center of analysis and replaced it with the theory of price. The utility approach of
the Marshallian system dealt with pleasures and pains, desires and aspirations, and
incentives to action. How can we measure the utility of such intangibles? Marshall
boldly said, "with money." The earlier marginalists said that the strength of a
person's preferences determines the amount of money the person is willing to
spend to acquire some product or the amount of labor the person is willing to sacrifice
to achieve some goal. Marshall, however, turned the relationship around so as to
measure preferences according to the financial scale of payments. The earlier
marginalists would say that if shoes are twice as useful to you as a hat, you are willing
to pay twice as much for shoes—for example, $40 versus $20. Marshall would say
that because you are willing to pay twice as much for shoes as far the hat, we can
conclude that the shoes yield twice as much utility to you.
On Law of Demand: Marshall's law of demand follows directly from his notions
of diminishing marginal utility and rational consumer choice. Suppose that a
consumer's expenditures are in equilibrium such that the last dollar spent on each
of several products yields identical marginal utility'. That is, suppose that MUx/Px =
MUy/Py=--------= MUn/Pn. How will this consumer react if the price of product X
falls while the prices of the other goods remain constant? Marshall reasoned that
the rational consumer would buy more of product X. Why is this so? The answer
is that, following the decline in the price of X, the ratio MUx/Px will exceed the MU/P
ratios for the other goods. To restore a balance of expenditures, the consumer will
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substitute more of X for less of Y, Z, and the like. As this substitution occurs, the
marginal utility of X will fall, and the marginal utility of the other goods will rise.
At some point the now-lower marginal utility of X, in relation to the lower price of
X, will yield a ratio equal to the MUy/Py, and the MUZ/PZ. Thus, equilibrium will be
restored. Therefore, in Marshall's words: "the amount demanded increases with a
fall in price, and diminishes with a rise in price." This is the now-familiar law of
downward sloping demand.
Marshall illustrated the law of demand with both a table and a demand curve. He drew
his demand curve by assuming that the period of time is sufficiently short to justify a
ceteris paribus assumption. We have already observed that he held tastes or
preferences constant. Other variables that he held constant were the person's wealth,
the purchasing power of money, and the price of substitute commodities. Today such
"other things equal" constitute what we call the determinants of demand. In the long
run these determinants can change, and when they do, the entire demand curve
shifts either leftward or rightward. Thus, Marshall had a clear conception of
differences between changes in the quantity demanded (measured along the horizontal
axis) and changes in demand (shift of the entire curve).
Consumer's Surplus: Unlike the Austrians, Marshall asserted that the total utility
of a good is the sum of the successive marginal utilities of each added unit.
Therefore, the price a person pays for a good never exceeds, and seldom equals,
that which he or she would be willing to pay rather than go without the desired object.
Only at the margin will price generally match a person's willingness to pay. Thus,
the total satisfaction a person gets from purchasing successive units of a good
exceeds the sacrifices required to pay for the good. Recall that this excess of utility
over expenditure is called consumer surplus. Although Dupuit was the one who first
noted this concept Marshall is credited for naming the concept "consumer's surplus"
and systematically exploring it.
Elasticity of Demand: Marshall was far superior to his predecessors in handling
elasticity of demand, analyzing the subject verbally, diagrammatically, and
mathematically. The only universal law pertaining to a person's desire for more of a
commodity, Marshall said, is that, other things being equal, it diminishes with
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every increase in his supply of that commodity. It follows, therefore, that the lower
the price, the more the consumer will buy. That is why the demand curve slopes
downward to the right. Elasticity of demand tells us whether the diminution of desire
(marginal utility) is slow or rapid as the quantity increases. It relates the percentage
drop in price to the percentage increase in quantity demanded, which, of course, is
based on diminishing marginal utility of the good.
Marshall also discussed what we now call the determinants of the elasticity of
demand. Elasticity of market demand tends to be great when a good has a high
price relative to the size of the buyers' incomes. Marshall said that a lowering of
the price results in many more buyers being able to afford the product. On the other
hand, when the price of a product is low relative to people's incomes, a similar per-
centage change in price will not result in much of an increase in purchases.
Generally, Marshall distinguished five degrees of elasticity;
1) Absolutely Elastic
2) Highly Elastic
3) Elastic
4) Less Elastic
5) Absolutely Inelastic
He also laid that demand for luxury products as highly elastic demand, comfort
products as elastic and necessary products as inelastic.
His Theory on Supply
Supply, said Marshall, is governed by cost of production. Marshall conceived of
supply not as a point or single amount but rather as a curve. Supply is a whole
series of quantities that would be forthcoming at a whole series of prices. For
purposes of exposition, Marshall divided time into three periods: (1) the immediate
present, (2) the short run, and (3) the long run and (4) secular.
1) Immediate Present: Market prices refer to the present, with no time allowed for
adaptation of the quantity supplied to changes in demand. The corresponding
market period which may be as short as one day, is defined as that period during
which the quantity supplied cannot be increased in response to a suddenly
increased demand. Nor can the quantity supplied be decreased immediately in
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response to a decline of demand, because it takes time for production to be

curtailed and inventories reduced. Very short period in which supply is fixed
(perfectly inelastic).
2) Short Run: To analyze the period that Marshall referred to as the short run, he
divided costs into two types, which he called supplementary costs and prime costs.
Supplementary costs are now known as fixed costs; prime costs are known as
variable costs. Fixed costs, or overhead costs, such as top executive salaries and
plant depreciation, are constant; they cannot be changed in the short run. In
fact, the short run is defined as that period during which tile variable inputs can be
increased or decreased, but the fixed plant costs cannot be changed. The short-run
supply curve slopes upward and to the right—the higher the product price,
the larger is the quantity' supplied. Modern economics views the short-run
supply curve as a marginal cost curve. Therefore, higher market prices enable
firms to profitably expand their output.
In other word, short run is a period in which the firm can change production and
supply but cannot change plant size. Higher prices cause larger quantities to be
supplied (upward sloping supply curve). Two components of total costs of the firm:
• prime costs - costs that vary with output (also called special or direct costs)
• supplementary costs - costs that do not vary with output (fixed costs).
3) Long Run: In the long run, all costs are variable, and they must all be covered
if the firm is to continue in business. If the price rises such that total revenue
exceeds total cost of production, capital will enter the industry, typically through
new firms, and market supply will increase. The entire supply curve will shift
rightward. If the price falls below the average cost of production, capital will
withdraw, probably by the exit of firms. Consequently, the market supply will
decline (the supply curve will shift leftward).
In other word, long run is a period in which Plant size can vary and all costs become
variable. Supply curve becomes more elastic because of firms’ adjustment in plant
size and can take 3 forms:
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• Increasing costs - slopes up and to the right

• Constant costs - perfectly elastic (horizontal)
• Decreasing costs - slopes down and to the right (unusual situations).
4) Secular period - (Very long run) Permits technology and population to vary.
His Theory on Equilibrium Price and Quantity
What determines market price?
The classical economists said, "Cost of production," meaning objective labor-time
cost, and the sacrifice of abstinence. "Demand," said the early marginalists. Marshall,
the great synthesizer, said, "Both supply and demand." Behind supply lie both financial
and subjective costs. Subjective costs refer to the personal value or perception of costs
that an individual assigns to a decision or action, which may not be easily quantifiable
or based on objective measures. Unlike objective costs, such as monetary expenses,
subjective costs can include factors like emotional stress, time lost, or personal
satisfaction. These costs vary from person to person, depending on individual
preferences, experiences, and circumstances. For example, someone might perceive
the subjective cost of attending a long meeting as high if they dislike meetings, even
if there are no monetary costs involved.
Behind demand lie utility and diminishing marginal utility. In the words of Marshall:
We might as reasonably dispute whether it is the upper or the under blade of a pair
of scissors that cuts a piece of paper, as whether value is governed by utility or cost
of production. It is true that when one blade is held still, and the cutting is affected
by moving the other, we may say with careless brevity that the cutting is done by the
second; but the statement is not strictly accurate, and is to be excused only so long
as it claims to be merely a popular and not a strictly scientific account of what
happens. Marshall illustrated the idea of equilibrium competitive market price and
quantity with both a table and a graph.
His Theory on Distribution of Income
The distribution of income in a competitive economy is determined by the pricing
of factors of production. Business people, said Marshall, must constantly compare
the relative efficiency of every agent of production they employ. They also must
consider the possibilities of substituting one agent for another. Horsepower
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replaced hand power, and steam power replaced horsepower. At the margin of
indifference between two substitutable factors of production, their prices must be
proportionate to the money value they add to the total product. The most striking
advantage of economic freedom is manifest when a businessperson experiments at
his own risk to find the combination of factor inputs that will yield the lowest costs
in producing the output. Entrepreneurs must estimate how much an extra unit of
any one factor of production will add to the value of their total product. They will
employ each agent up to that margin at which its net product would no longer exceed
the price they would have to pay for it. Marshall based this analysis on the
diminishing returns that result from the "disproportionate use of any agent of
production."
His Theory on Increasing & Decreasing Cost Industries
A key analytic device for Marshall was his concept of the "representative firm.,'"
which for him was the typical 19th century sole proprietorship. This abstraction
served, at least, three major purposes in his analysis. First, in speaking of the normal
cost of producing a commodity, he referred to the expenses of a representative
producer who is neither the most efficient nor the least efficient in the industry.
Second, this analytic device showed that an industry can be in long-period
equilibrium even though some firms are growing and others declining; they simply
neutralize each other. Third, even though the representative firm may not be
increasing its internal efficiency, it can experience falling costs of production as the
industry expands.
According to Alfred Marshall, representative firm characterized by;
1) The firm will be an average firm- it has a fair amount of internal and external
economies.
2) It is neither declining nor increasing in terms of production.
3) The management is neither very efficient nor inefficient.
4) it’s neither new nor old.
5) It is neither earning supper normal profits nor incurring losses.
6) there can be more than one such firms.
On Internal versus External Economies: Internal economies, said Marshall, are
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the efficiencies or cost savings introduced by the growth in size of the individual
firm. As the firm grows larger, it can enjoy more specialization and mass
production, using more and better machines to lower the cost of production.
Buying and selling also become more economical as a firm's size increases. Larger
firms can secure credit on easier terms, and they can use high-grade managerial
ability more effectively.
On the other hand, external economies come from outside the firm; they depend on
the general development of the industry, As the industry grows, suppliers of
materials build plants nearby to serve the expanding industry; these supplies
become cheaper both because transport costs are reduced and because they are
"lass produced in firms that are growing. Perhaps, in addition, providers of
transportation services emerge to meet the special needs of the burgeoning
industry, thus reducing the cost of delivering products to customers.
Marshall thought that an increased volume of production in an industry will
usually increase the size and therefore the internal economies possessed by a
presentative firm; it will always increase the external economies to which the firm
has access. Therefore, he said, die cost of production in terms of labor and sacrifice
will fall if the volume of output expands.
External economics are available to all firms in an industry. However, if internal
economies grow with the size of the firm, how can competition be maintained? If
as a firm becomes larger it becomes more efficient, will this not mean that
eventually there will be only a single firm in the industry (natural monopoly)?
Marshall's concept of the representative firm provided the answer. The decline and
death of the entrepreneur will lead to the decline and death of the firm. Individual
businesses, Marshall thought, will typically not last long enough to realize all the
benefits of an ever-increasing scale of production. New entrepreneurs will elbow
their way into the business arena and renew the process of increasing the size and
efficiency of their firms.
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On Increasing and Decreasing Returns to Scale: If all factors of production used

in an industry expand, will the cost per unit of output rise or fall? Marshall thought
that we generally have increasing returns to scale in industry; as labor and capital
expand, organization and efficiency improve. Only when we rely heavily on
nature, as in agriculture, do we have decreasing returns. Where the actions of the
laws of increasing and decreasing returns to scale are balanced, we have the law of
constant returns: Expanded output is obtained through a proportionate expansion of
both labor and the sacrifice of waiting.
Quasi Rent by Alfred Marshall
According to Alfred Marshall quasi rent the income earned from machines and other
appliances for production made by man. It is the surplus earned by the instrument
of production other than land. However, David Ricardo the term rent is applied to
income from land and other free gifts of nature, whereas quasi rent is the income
derived from man-made appliances and machines. The supply of these man-made
producer goods cannot be increased in short period even though the demand of them
many increases. Marshal therefore, coined the term quasi-rent for the earning.
Durable Factors of production: like machines, ships, house and even human skills
are similar to land whose supply is fixed in the short run. When the demand for them
increases suddenly their supply cannot be increased and they earn a surplus which
is not rent but it is similar to rent. Mashall preferred to call these earning in the short
period as quasi-rent. This is only a temporary surplus which goes to the owner of
capital equipment in the short run due to the possibility of increase in supply of
capital equipment in response to increase in demand.
Welfare Effects of Taxes and Subsidies: Marshall's analysis of constant,
increasing, and decreasing cost industries led him to the following novel policy
conclusions: (1) Either a tax or a subsidy will reduce net consumer utility in a
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constant cost industry; (2) a tax may add to net consumer.

Alfred Marshal Neoclassical school Summery

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 impatience
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rate and the investment opportunity rate. 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.
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. 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%. Lender’s 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: MV=PT. 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
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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.
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.
1.2. The Neoclassical School – Departure from pure Competition (Post –
Marshallian Developments)
The Post – Marshallian economic thought took a new direction starting from the
criticism of the market analysis of Marshall by Philip.H. Wick steed (1844 – 1927)
to [Link].
Wick steed was not a follower of Marshall but his contemporary and can be
included in the category of Mathematical economists. He is one of the economists
who developed new dimensions to the marginal productivity theory of distribution.
His most important writings are ‘Essay on the Co-ordination of the laws of
distribution (1894) and ‘The common sense of political economy’ (1910). His
major contribution to economic thought is that of extending the application of
marginal principle to every sort of resource allocation.
Its extents to the fields of consumption, production decisions, use of inputs, saving
and investment etc and also to the opportunity cost area also.
He also tried to co-ordinate the laws of distribution. The contemporary theory of
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distribution proceeded on the basis of determining the rate of payment to each

factor and then came to individual shares in national income on the basis of the
ownership of factors of production. He maintained that the traditional
classification of factors was irrelevant. The demand for factors of production was
derived from the demand for the commodities, which they produced. Like Jevons,
Wicksteed also believed that the marginal principle explain the factor prices
through the medium of the values of goods and services and hence through the
consumer’s utility. Therefore, the marginal productivity of a factor is not in
physical terms but in the marginal revenue productivity.
Regarding the post-Marshallian developments in the market analysis also
developed some new trends. Marshall viewed the economy as an organic whole
and in this economy though the industry may retain its overall character individual
firms may grow, become old and die. The new firms to begin with may face a
number of diseconomies. Because of these reasons most economists criticized his
way of equilibrium analysis and representative firm.
Imperfect and Monopolistic competition
It was Piero Sraffa who led the criticism of Marshall’s contention that increasing
returns and competition could go together. His criticism of Marshall’s
representative firm came in the work “The laws of Returns under competitive
conditions” published in the Economic Journal (1926). Here he argued that for
logical consistency we should either give up competitive market or the increasing
returns to get a stable long – term equilibrium. This new idea of Sraffa evoked
a new trend of analysis among economists in different parts of the world like F.
Harrod, Mrs. Joan Robinson and others in England, Edward Chamberlain and
Yntema in United States and J.K. Mehta in India to abandon the perfect
competition. The result was the development of two important pieces of work
namely (1) The economics of imperfect competition by Mrs. Joan Robinson and
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(2) The theory of Monopolistic competition by Edward Hastings Chamberlain and

both were published in 1933.
Oligopoly followed: by the development of two new market forms led to
the development of new ideas and an oligopoly market developed by Paul. M.
Sweezy in USA and Hall and Hitch in England. They came out with the theory
of kinky demand curve. There is a Kink in the demand curve for the individual
oligopolist’s product. A kink in the demand curve at the current price and the
slope of the demand curve above and below the kink are different. The kink
indicates the current market price. Above the kink the price has a high elasticity
and below low elasticity.
George A. Stigler carries this analysis a step further by developing the theories of
Sweezy, hall and Hitch by bringing in the question of Price leadership. His
contention is that if the sellers are very few or when they are many, the prices are
relatively flexible. But when the sellers are moderate in number (five to ten) price
rigidity develops. When the market has a price leader (they may be a group
of firms acting together) prices would be more flexible than if there is no price
leader. When different firms join hand to work together it become a monopoly,
the kink in the demand curve disappears and the prices will be more flexible.
Economic Dynamic

During the post – Marshallian period, we witnessed the working of the dynamic
economy and the dynamic tools of analysis. A dynamic economy is one in which
unpredictable change takes place and the end situation cannot be worked out with
the help of initial conditions. But in the important work of J.R. Hicks ‘Value and
Capital’ he shows that a dynamic economy need not necessarily be analyzed with
dynamic tools. The analytical tools suited to a static economy (The comparative
macro statics) can be fruitfully used here. Though he developed the method of
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Macro dynamic, he says that even in a dynamic economy the economy’s course
can be divided in to strips of small duration like days or weeks and there may not
be any violent changes, hence the initial condition and the end of the interval can
be worked out.
Roy.F. Harrowd explains that the concept of a static economy itself is meaningless.
There are certain forces, which are bound to make a modern economy dynamic.
When the changes in the economy became un predictable it becomes dynamic.
E.g., savings would imply a cumulative supply of capital and it makes the
economy dynamic, similarly growth in population, change in age composition,
change in the supply of natural resources, all elements of uncertainty makes an
economy dynamic.
Piero Sraffa (1898-1983)
Two conditions can break up the purity of markets (pure competition or natural
monopoly): A single producer can affect market price by varying the quantity of
goods it offers for sale. Each producer may engage in production under
circumstances of individual decreasing costs .Edward Hastings Chamberlin (1899-
1967) explains Theory of monopolistic competition, Product differentiation, Pure
competition results in a larger output, more efficient production and lower selling
prices than occur under monopolistic competition. But this conclusion requires two
qualifications. Chamberlin’s conclusions are built on the unrealistic assumption that
cost curves are the same in each situation. Economies of scale are assumed to
be achieved by all the firms. Monopolistic competition provides positive benefits
associated with product variety. Joan Robinson (1903-1983) Monopsony: a situation
in which there is either a single buyer in a market or a group of buyers acting as
one Product-market monopsony. Pure competition: buyer’s P=MU, Monopsony:
buyer’s MC=MU (Resource-market monopsony). Monopsonist will employ X
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workers, where MRP = MWC (Marginal revenue product = marginal wage cost).
Marginal revenue product (MRP), also known as the marginal value product, is the
marginal revenue created due to an addition of one unit of resource. The marginal
revenue product is calculated by multiplying the marginal physical product (MPP)
of the resource by the marginal revenue (MR) generated.
John Gustaf Knut Wicksell (1851-1926)
Wicksell had a good understanding of classical and neo-classical thought. He
made a thorough study of the economic theories of Mill, Menger and Bawerk. He
also attempted to present a synthesis of the marginal productivity analysis of the
Austrian school and the equilibrium theory of the Luanne
school.
Capital and Interest. -Wicksell made an important contribution by borrowing the
time element from Bom – Bawerk. According to him capital is stored up
productive power or stored up labor and land. It is separated from the current labor
and land through time element. Here Wicksell brings in the ‘period concept’.
The current years land and labor co-operate with stored up land and labor of
the previous year for the purpose of production. For the sake of continuity
in production out of the current years land and labor a part must be saved for the
next year’s capital. Now there is a difference between the marginal productivity
of the current year’s land and labor and stored up land and labor. This
difference in productivity is measured by using time element operates through
relative marginal productivities due to the variation in the supplies of capital or
productive power. If the supply of stored up land and labor equals with current
land and labor, interest would vanish and if there is a difference between these two
brings in interest.
Interest and Prices
The analysis of interest and price brings Wicksell’s famous distinction between
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‘natural’ rate of interest and ‘money’ rate of interest. The natural or normal rate
of interest according to him is the rate at which the demand for loanable capital
and supply of savings are equal. The natural rate of interest in Wicksell’s analysis
is equal to the marginal efficiency of capital in Keynes analysis (I.e. marginal
efficiency of investment, expected rates of return on investment as additional units
of investment are made under specified conditions and over a stated period of
time). It is a measure of expected yield from new investment.
This in turn corresponds to equality between saving and investment. Saving means
leakage from spending stream and investment means an injection to it. Therefore,
an equality of saving and investment means stable prices and incomes. But in
practice, natural rate may not bring equality between demands for loanable funds
and supply of saving, but between supply and demand of loanable funds. Equality
in terms of loanable funds need not bring price stability for the fact that bank credit
is a part of the supply of the loanable funds. Hence there may be an excess of
investment over savings.

Wicksell uses his natural and money rates of interest for explaining the movement
in price in the economy. The money or market rate of interest according to him as
the average of the rates at which banks are advancing loans to the potential
investors. If these two rates are not equal disequilibria starts and will reflect in the
variation of savings and investment and ultimately to the price level.
Saving and Investment
Wicksell does not agree with the walrasian general equilibrium analysis that with
a fall in price the purchasing power and hence the effective demand increases. He
believes that since the expenditure of one is the income of another, the aggregate
purchasing power would always remain the same. During normal conditions
aggregate income is equal to aggregate spending. I.e., the income not spent on
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consumption is spent on capital and the price level remains constant. When
conditions are not normal savings would not be equal to investment. Since the
decision to invest is taken by different people, investment does not only depend on
voluntary savings and in such a situation amount of savings exceed investment and
income would be reduced, consumption would decline and prices would fall. If
investment is more than savings, prices would rise. This type of situations would
be controlled by manipulating the bank rate so that the market rate of interest
should be above or below the natural rate to keep the prices rise or fall depending
on the situation, finally leading to a rise or fall in the market rate. This is known
as the ‘Cumulative process’ of Wicksell
Unlike the classical assumption that all savings are necessarily invested, Wicksell
found that these two are done by different categories of people and on the basis of
different forces. The factors like hoarding, dissaving and variations in bank credit
causes difference between saving and investment were brought to light by
Wicksell. He was a pioneer in exploring the use of these instruments for
investigation in financial markets. Modern economists recognized the importance
of the elements used by wick sell though he missed some areas in monetary
field like ‘liquidity trap’ and its influence up on practical monetary policy.
1.3. Sidgewick, 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
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Marshall was given.

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. Nicholson was a believer in government regulation and anti-
trust law, a bimetallist and a proponent of the under-consumption thesis of economic
fluctuations.
1.4. Wick Sell and the Stockholm School

The analytical approach in economics was that of a dichotomy between the

physical and monetary aspects of the economy and the link between these two was
established through absolute prices. Relative prices of goods and services are
claimed to be determined by the demand on the one side and cost of production on
the other. The monetary aspects of the economy could not affect the basic
functioning of the physical side of the economy. It was Knut Wicksell who started
a new line of exploration to find the relationship between the two dimensions
of the economy on a realistic approach.
The Stockholm or the Swedish school was founded by Wicksell, Lindhal, [Link]
and Gunnar Myrdal. Wicksell influenced economists of the Scandinavian
countries like Frisch in Norway, Zeuthen in Denmark and influenced the thought
of Hayek, Keynes and Hicks in England.
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
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its size.
➢ But Wicksell’s chief claim to fame lies in his contributions to monetary
economics.
➢ 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.
➢ 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 tries 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.
➢ Wicksell’s implication for public policy: Wicksell’s analysis of interest rates and
his predilection for reform led him to emphasize the role of government and the
central bank in promoting economic stability.
➢ In his Interest and Prices, published in 1898, he advocates stabilizing wholesale
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prices by controlling discount and interest rates.

➢ He was the first economist to advocate stabilizing wholesale prices by
controlling discount and interest rates.
➢ 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.
➢ 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.