Marginalist Hall of Fame: Austrian School

1. Marginalist Hall of Fame: Austrian School Carl Menger, 1841-1921 Eugen von Böhm-Bawerk, 1851-1914 Friedrich von Wieser, 1851-1926

2. The Marginalist Revolution: The Austrian School • Friedrich von Wieser, On the Origin and Principle Laws of Economic Value, 1884 • Marginal utility: Jevon’s “final degree of utility”  Grenznutzen  MU Austrian cost theory/Pricing factor services • Cost = Utility of 1st order goods foregone…opportunity cost concept • Utility + Technology Values of goods in equilibrium • Essentially demand and supply, but awkwardly avoided • Joint determination of outputs and shadow prices, obscured by causal analysis • Anticipation of linear programming

3. Aside on Linear Programming • Leonid Kantorovich, Soviet “Economist”, Nobel Prize, 1975 • Tjalling Koopmans, Yale Economist, Nobel Prize, 1975 • George Danzig, Stanford Mathematician, No Prize A linear programming problem: Optimize subject to constraints Max 4 x1 + 5 x2 + 9 x3 + 11 x4 s.t. 1 x1+ 1 x2 + 1 x3 + 1 x4 ≤ 15 Laborer-Days 7 x1+ 5 x2 + 3 x3 + 2 x4≤ 120 Machine Hours 3 x1 + 5 x2+10x3+ 15 x4≤ 100 Lbs of Raw Material Note: fixed coefficient technology…factor substitution not possible Solution: Optimal program • how much x1, x2, x3 and x4 to produce • shadow prices of resources  activities used in the solution operate at zero net profit  activities not in solution would operate at a loss.

4. The Marginalist Revolution: The Austrian School • Friedrich von Wieser, On the Origin and Principle Laws of Economic Value, 1884 • Marginal utility: Jevon’s “final degree of utility”  Grenznutzen  MU Austrian cost theory/Pricing factor services • Cost = Forgone utility…imputed opportunity cost • Utility + Technology Values of goods in equilibrium Essentially demand and supply, but awkwardly avoided Joint determination of outputs and shadow prices, obscured by causal analysis Anticipation of linear programming • B-B “loss principle”: price of commodity lost if factor withdrawn • Austrian methodology: • Step-by-step human action, not equilibrium of supply and demand • Market as information processor  price signals  learning • von Mises – Lange debate: could economic planning work? • Lange won on logic: • efficient market capitalism provides socialist planner with initial set of prices; • he just has to tweak them and tell managers to optimize • von-Mises won in fact … central planning didn’t work…info problem

5. From Keynes’ eulogy: [An economist] must be a mathematician, historian, statesman, philosopher – in some degree. He must understand symbols and speak in words. Keynes on Jevons – Marshall priority: [Jevon’s final utility] lives merely in the tenuous world of bright ideas … Jevons saw the kettle boil and cried out with the delighted voice of a child; Marshall too had seen the kettle boil and sat down silently to build an engine. • Student and teacher at Cambridge • Majored in math • Married Mary Paley, an economist • Teacher of teachers: Pigou, Keynes • …cool heads but warm hearts • Insecure in his writings: held back publication • Principles of Economics, 1890 (1st edition), 1920 (8th edition) • Neoclassical economics: marginalist – mathematical framework • Written for intelligent layman: graphs in footnotes; math in appendices • Account for the concrete: biological, not mechanical/mathematical, analogies Alfred Marshall, 1842-1924 Did Marshall crib from Austrians? B-B and Wieser were at school when I thought these things out. Marshall

6. Marshall’s Principles of Economics: Themes and Contents • Economics…a study of mankind inthe ordinary business of life ...pecuniary focus • Partial equilibrium analysis … representative agents and firms • Recognition of Walras’ general equilibrium framework…in Appendix • Focus on specific markets…constant MU of money…a “preliminary” analysis • Supply (costs) interact with demand (utilities) • Ceteris paribus conservative tilt: “Nature does not leap” Marshall • Partial analysis is less elegant than general equilibrium …but better for application • Supply and demand curves (the Marshallian cross) • Value determined by both blades of the scissors • Consumer and producer surplus • Reciprocal demand curves in trade (recall Mill) • Elasticity of demand • Price decline  increase in real income for elastic demand • Anticipates income and substitution effect analysis value quantity

7. Marshall’s Principles of Economics: Themes and Contents • Temporary, short-run and long-run supply – fixed and variable costs • Elasticity of supply increases with time as factors adjust • Value in short-run depends on demand • Value in long-run depends on supply • Quasi-rents: return of fixed capital (machines) • In short-period: • a rent determined by demand, as in classical econ. • not a cost-of-production • In long-period: • a measure of capital’s contribution to production • related to interest rate • Internal economies of scale  difficulties for competitive market paradigm • External economies (of industry scale): costs to all firms decline as industry expands • Earnings of the exceptionally gifted  National wealth & communications technology

8. Adherent to Say’s Law “Classical” foil for Keynes in General Theory Pigou response: Pigou effect = “Real Wealth” Effect P down  (M/P) up  Automatic adjustment to full employment (?!?) Arthur Cecil Pigou 1877 - 1959 • Economics of Welfare, 1920 … Reform, not Revolution • Economies and diseconomies of production • Divergence between private and social costs and benefits  Role for government • Make railroads liable for damage sparks do to forests • Subsidize smokeless smokestacks • Fine polluters Elaborated on externalities

9. Classical Economics Smith – Ricardo/Malthus – Mill Labor theory of value Malthusian population Say’s law Quantity theory of money Physiocrats – Marx Balanced growth/imbalance Concern: consequences of capitalist accumulation First Principles: Price independent of demand Labor theory of value Natural (long-run) prices equalize rates of profit Real wage = “subsistence” Wage fund – Iron Law Neoclassical Economics Marshallian economics Gossen/Jevons/Edgeworth Microeconomics Concern: allocation of scarce resources First Principles: Decision at margin Prices determined by interaction of supply (costs) and demand (utilities) Distribution accords with marginal productivities Classical – Neoclassical Economics: An Aside

10. Rags – Riches – Rags (not quite) • Top Yale graduate (math) and Professor • Married rich  Europe tour – networking/New Haven house • Illness  Health fetish (corn flakes!) • Inventor (card index system) – merged into Remington Rand  $$$$ • Merged into Sperry (UNIVAC) merged into Unisys • Index Number Institute (Purchasing Power of Money) • Employee pay tied to cost-of-living  “money illusion” when wages down • Stock market speculation  Crash  $ • Crusader: • Stable money • ...Forecast fluctuations • ...Tame business cycle thru discretionary M-policy • League of Nations • Calendar reform • Spelling reform • Esperanto • Environmental protection • Prohibition • Prohibition at its Worst  trick wets into reading it • Leading US economist/Public advocate/Government advisor • First President of Econometric Society, 1930 Irving Fisher 1867 – 1947

11. Rags – Riches – Rags (not quite) • Top Yale graduate (math) and Professor • Married rich  Europe tour – networking/New Haven house • Illness  Health fetish (corn flakes!) • Inventor (card index system) – merged into Remington Rand  $$$$ • Merged into Sperry (UNIVAC) merged into Unisys • Stock market speculation  Crash  $ • Crusader: stable money, League of Nations, calendar reform, spelling • reform, Esperanto, environmental protection, prohibition • Prohibition at its Worst  trick wets into reading it • Leading US economist/Public advocate/Government advisor • First President of Econometric Society, 1930 • Contributions to price theory • Consumption indifference curves/“utils” + Production possibilities frontier • Market equilibrium: MRT = dy/dx = px / py = MUx / MUy = MRS • Contributions to monetary economics • Ideal index numbers: geometric mean of Paasche and Laspeyres • Fisher effect: Nominal interest rate = Real rate + expected inflation (e) • Quantity Theory of Money: MV + M’V’ = PT • Velocity and Transactions independent of Money • If M up, P up, ceteris paribus • expectations lag  sticky nominalinterest rate (stickier than Price) gm up  π up  Real rate down  Investment spend up  EXPANSION • Intertemporal optimization, given interest rate (see diagram) Irving Fisher 1867 – 1947

13. Fisher’s Debt Deflation Theory of Depression • Easy money  over-indebtedness/speculation/boom – bubble • Bubble bursts  Debt liquidation  distressed sale of assets • Contraction of bank balance sheets  M down • M down  P down • P down  Profits down  Business net worth down • Liquidation does not liquidate but rather aggravates debt “The more debtors pay the more they owe.” • Output down / Employment down / Income down • Depression • Hoarding / reduced velocity of money / P down • Vicious spiral of deflation

14. Lecturer/Professional student – first job as economist at age 48 • Career at University of Lund • Social radical serving conservative (neoclassical) science • Champion of birth control (neo-Malthus), women’s rights, free love • Military nihilist (Sweden can’t defend self  disband army…Russify) • Jailed for sacrilege • Established marginal productivity theory of distribution • CompetitionLinear homogeneous (Cobb-Douglas) production function • Proposed Pareto optimal log-rolling before Pareto • Fiscal packages where everyone gains • Level the playing field: • inheritance tax! • public education!! • Market socialism!!! • Interest and Prices,1898,1924: • Cumulative process in full-employment economy using bank money … Say’s Law holds  real GDP steady Knut Wicksell 1851 – 1926

15. Wicksell: Pioneer of Aggregate Demand and Supply • A general rise in prices is only conceivable (if) the general demand has for some reason become, or is expected to become, greater than the supply…Any theory of money worthy of the name must be able to show how and why monetary or pecuniary demand for goods exceeds or falls short of the supply of goods in given conditions. • MV = “efficiency of money” (Karl Helfferich’s term) • In a pure credit system, MV is perfectly elastic, subject to the bank rate • The effective supply of money accommodates the demand for money…unless the bank rate set by the central bank imposes monetary discipline.

16. Wicksell’s Monetary Economics • Interest and Prices,1898,1924: Cumulative processin full-employment economy using bank money real GDP steady i= market rate of interest set by banks…credit and Ms adjust to Md at market rate i r = “normal” rate of interest—keeps P steady = “natural rate” = return on capital r = f(fundamentals, expectations) I/Y = Investment/Real GDP = F(i – r)demand for credit (remember, Y is fixed) $Y = $C + $I = PY Steady-state equilibrium($I = 0): $Y = $C = $Yt-1 Disequilibrium (r rises; i steady): $Y = $C + $I = $Yt-1+ $I  $I = Δ$Y = ΔPY = $S  Investment is financed out of forced saving owing to inflation (real C down) $I = PI = ΔPY  ΔP/P = I/Y = F(i – r) • In summary, if i<r, firms demand credit to finance investment …banks create money to meet demand for credit • Prices and wages rise (wages not as much as prices) Profit expectations rise  r remains > i  Demand for Credit Up Monetary equilibrium requires i = r Equilibrium reached when • Credit system is linked to convertible metal … demand for credit pushes i up Or … Central Bank management of i … goodbye laissez-faire

17. Wicksell’s interest rate rule for monetary equilibrium: Precursor of inflation targeting So long as prices remain unaltered the (central) bank’s rate of interest is to remain unaltered. If prices rise, the rate of interest is to be raised; and if prices fall, the rate of interest is to be lowered; and the rate interest is henceforth to be maintained at its new level until a further movement of prices calls for a further change in one direction or another. Wicksell, Interest and Prices, p. 189 quoted in Michael Woodford, Interest and Prices: Foundations of a Theory of Monetary Policy, p. 38

18. Monetary Theory • David Hume – specie flow, prices, and trade balance Of Money (1742) • Long-run neutrality: M  P But there’s an economic expansion story before the long-run is reached… …since the discovery of the mines in America, industry has increased in all the nations of Europe, except in the possessors of those mines…In every kingdom into which money begins to flow, every thing takes on a new face: labor and industry gain life; the merchant becomes more enterprising…and even the farmer follows his plow with greater alacrity…Though the price of commodities be a necessary consequence of the increase of gold and silver, yet it follows not immediately… At first no alteration [in prices] is perceived; by degrees the price rises, first of one commodity, then of another…When any quantity of money is imported into a nation, it is …confined to the coffers of a few persons who immediately employ it to advantage…They are thereby enabled to employ more workmen than formerly…who can now eat and drink better. [The workman] carries his money to market where he finds everything at the same price as formerly but returns with a greater quantity…The farmer and gardener, finding that all their commodities are taken off, apply themselves with alacrity to raising more… We may conclude, that it is of no consequence whether money be in greater or less quantity… Good policy consists only in keeping it, if possible, still increasing.

19. Monetary Theory People find it convenient to hold some fraction of their income in the form of money …varies with distribution of income. • David Hume – specie flow, prices, and trade balance • David Ricardo – The High Price of Corn : {Thornton, Senior, Tooke} • Alfred Marshall – Cambridge oral tradition: M = k PY Professor Irving Fisher has been the first, in several instances, to publish in book form ideas analogous to those which had been worked out by Marshall at much earlier dates. J.M. Keynes, Alfred Marshall, 1842 – 1924, p. 336 fn. • Ludwig von Mises –cash balance approach linked with marginal utility • Irving Fisher – Quantity Theory and Real Interest Rate • Knut Wicksell – Natural rate of interest/cumulative process • Gustav Cassel – Quantity Theory  Purchasing Power Parity • “Money doctors” • Gunnar Myrdal – Monetary Equilibrium: Ex ante – ex post • John Maynard Keynes • Tract on Monetary Reform (1924) • Cambridge k • Treatise on Money (1930) • The General Theory of Employment, Interest and Money (1936) • Liquidity preference and real balances • The General Theory of Employment, QJE, 1937.