History of Economic Thought

Lecture 10
Giorgi Bakradze
 Early Marginalists
• Antoine Augustin Cournot (1801 – 1877)
• Arsene-Jules-Emile Dupuit (1804 – 1866)
• Herman Heindrich Gossen (1810 – 1858)
• Johann Heinrich von Thunen (1783 – 1850)
 Marginalism
• William Stanley Jevons (1835 – 1882)
• Carl Menger (1840 – 1921)
• Friedrich von Wieser (1851 – 1926)
• Eugen von Bohm-Bawerk (1851 – 1914)
 The Historical Background
• Serious economic and social problems
• Widespread poverty despite gains in productivity
• Industrial accidents, long hours of labour, dangerous working
conditions
• Classical economic thinking couldn’t answer all the questions
any more
 The Historical Background
• Three approaches prevailed
– Socialism
– Trade unionism
– Demanding government action
• Marginalists opposed all three
– Value and distribution theories of classical economists were inaccurate
– Their policy views were correct
– Defended market allocation, deplored government intervention,
denounced socialism
 Major Tenets
• Focus on the margin
• Rational economic behavior
• Microeconomic emphasis
• Use of deductive method
• Pure competition emphasis
• Demand-oriented price theory
• Subjective utility
• Equilibrium approach
• Lumping land and capital together
• Minimal government involvement
 Whom Did the Marginalists Benefit
or Seek to Benefit?
• Advancing the interest of all of humankind through promoting
a better understanding of a market system
– To a great extent – success
• Countered the Marxian call for revolutions by showing the
competitive wage of the worker
• Also benefited the status quo supporters
 How Was the Marginalist Schools Valid,
Useful or correct in Its Time?
• New and powerful tools of analysis
– Diagrams and math
• Conditions of demand were given importance (finally)
• Emphasized the forces of individual decisions
• Explicitly stated fundamental assumptions
• Method of partial equilibrium proved to be useful
– Ceteris paribus
• Microeconomic view complements the macroeconomic one
 Which Tenets of the Marginalist School
Became Lasting Contributions?
• Some tenets were criticized and then rejected
– Fallacy of composition
– Pure competition probably doesn’t exist today apart from few sectors
– Externalities and other market failures
– They failed to explain economic growth
 Which Tenets of the Marginalist School
Became Lasting Contributions?
• Many theories are still valid and an important part of the
economic mainstream
– School was eventually absorbed by the neoclassicals
– Mathematical economics, diminishing marginal utility, rational
consumer choice, returns to scale, work-leisure choice analysis, etc.
ANTOINE AUGUSTIN COURNOT
(1801-1877)
 Antoine Augustin Cournot
(1801-1877)
• Researches into the Mathematical Principles of Wealth
(1838)
• First economist to apply math to economic analysis
– Was neglected after death
• Concise models of monopoly, duopoly and pure
competition
• Derived demand of resources
• Focused on changes to total cost and total revenue
– Marginal cost and revenue
Antoine Augustin Cournot
 Theory of the Firm
• Cournot pioneered the modern price theory for industries
consisting of profit-maximizing firms.
– This is basically the theory taught today in introductory
microeconomics courses

Antoine Augustin Cournot

 Mathematical Methods
• He introduced differential calculus and the associated
mathematics of maximization into economic analysis.
• These eventually became the indispensable tools of economic
analysis.

Antoine Augustin Cournot

 Demand
• Cournot introduced the demand function…
– This is a mathematical function, Q(p), that represents the idea that
the quantity demanded depends on the price
• …and the familiar demand curve.

Antoine Augustin Cournot

 Monopoly
• Cournot derived the rule that a profit-maximizing monopolist
would follow in deciding what price to charge.
– This one-good-at-a-time approach is called partial equilibrium
analysis.
• The monopoly pricing rule is the familiar condition that the
price must be such that Marginal Revenue = Marginal Cost.

Antoine Augustin Cournot

Profit Maximization by a Monopoly
Costs and
Revenue

Price

Marginal
cost
Marginal Demand
revenue

0 Monopoly Competitive Quantity

quantity quantity
Antoine Augustin Cournot
 Monopoly and Costs
• Cournot showed that an increase in production cost (more
precisely, the cost of producing an additional unit, the marginal
cost) would raise the price charged by the monopolist
•  and that the price increase could be smaller than or greater
than the increase in cost.

Antoine Augustin Cournot

Profit Maximization by a Monopoly and Cost Increase
Costs and
Revenue

Price

Marginal
cost
Marginal Demand
revenue

0 Monopoly Competitive Quantity

quantity quantity
Antoine Augustin Cournot
 Monopoly and Taxes
• Lump-sum taxes (that is, taxes that are not dependent on the
monopolist’s decisions) do not affect the monopolist’s
decisions.
– This may sound simpler than it really is!
• Cournot showed that an excise tax (on sellers) and a sales tax
(on buyers) are equivalent.
• These are in turn equivalent to an increase in cost or a
decrease in demand.

Antoine Augustin Cournot

Profit Maximization by a Monopoly
Costs and
Revenue

Price

Marginal
cost
Marginal Demand
revenue

0 Monopoly Competitive Quantity

quantity quantity
Antoine Augustin Cournot
 The Duopoly Problem
• Two firms sell the same product.
• If they together produce a high output, the price of the product will be
low; if they together produce a low output, the price will be high.
• Each firm independently decides what amount to produce.
– That is, no firm knows the other firm’s output decision before making its own.
• So, what reasoning would each firm use to decide what output to
produce?
• And, how will the duopoly outcome differ from the monopoly outcome?

Antoine Augustin Cournot

Duopoly
 Duopoly
• Cournot’s solution to this duopoly problem is the same as the
solution now called Nash Equilibrium in modern game theory.
– Keep in mind that Cournot wrote in 1838.

Antoine Augustin Cournot

 Duopoly and Monopoly
• Cournot showed that the output will be higher and the price
will be lower in duopoly than in monopoly.

Antoine Augustin Cournot

 Cartel Formation
• The total profit of the two firms in a duopoly will be lower than profit of
the one firm in a monopoly.
– Why?
• Nevertheless, the duopolists will not be able to coordinate their
decisions to simulate the monopoly outcome.
– Even if they agree to restrict their joint output to the monopoly output, they will
have huge incentives to secretly renege on the agreement.
– This was an early example of the Prisoners’ Dilemma.

Antoine Augustin Cournot

 Pure Competition
• Cournot derived the familiar profit-maximization condition:
Price = Marginal Cost.

Antoine Augustin Cournot

Profit Maximization for a Competitive Firm
Costs
and The firm maximizes
Revenue profit by producing
the quantity at which
marginal cost equals MC
price.
MC 2

ATC
P = MR 1 = MR 2 P = AR = MR
AVC

MC 1

0 Q1 Q MAX Q2 Quantity
Antoine Augustin Cournot
 Price Theory Pioneer
• Way back in 1838, Cournot single-handedly created most of
the price theory that economics relies on today.

Antoine Augustin Cournot

ARSENE-JULES-EMILE DUPUIT (1804 – 1866)
 Willingness-to-pay and utility
• Dupuit argued that utility (or, happiness) can be measured by
willingness to pay.
– Bentham introduced the idea of diminishing marginal utility
– Dupui linked it to “curves of consumption” (essentially – demand)
 Willingness-to-pay and demand
• Dupuit derived the downward-sloping demand curve from
willingness to pay
• The height of Dupuit’s demand curve equals marginal utility
– So, his demand curve is the marginal utility curve
– Leon Walras criticized Dupuit later for not clarifying the difference
between the demand curve and the marginal utility curve
– Dupuit implicitly assumed the existence of a product with constant
marginal utility
 Willingness-to-pay and demand
• The area under Dupuit’s demand curve is a measure of total
utility.
• In this way the link between marginal utility (height) and total
utility (area) was clarified
 Consumer Surplus
• Dupuit defined consumer surplus as the excess of the total
utility from a purchase over the consumer’s payment for the
purchase
• Dupuit showed that increases in price reduce the consumer
surplus
 Deadweight Loss
• Dupuit defined the deadweight loss of an outcome as the
extent to which total utility in the outcome is less than the
maximum attainable total utility
• The deadweight loss of a tax was graphically described
 Tax Policy
• Dupuit showed that, to reach a tax target, it is better to have
low taxes on many goods rather than high taxes on a few
goods.
– This is because the deadweight loss of a tax increases very rapidly as
the size of the tax increases.
• Dupuit explained the logic underlying what today is called the
“Laffer Curve”
 Price Discrimination Boosts Welfare
• For a natural monopoly, price discrimination can reduce
deadweight losses
– Dupuit was an engineer, working for the government and building
public works, such as the water supply, roads, and bridges
– Naturally, he wondered what price should be charged for the public
services and how the benefit to the public could be measured
 Cost-Benefit Analysis
• Dupuit pioneered cost-benefit approach to the optimum
provision of public goods
• He used no formal optimization; his results were usually
established through numerical examples
• Dupuit’s implicit assumption of constant marginal utility of
money obscures the trade-offs consumers deal with in making
choices.
HERMAN HEINDRICH GOSSEN (1810 – 1858)
 Equimarginal Principle
• Gossen introduced the equimarginal principle—also called
Gossen’s Second Law—of the theory of consumer behavior.
– First law is that of diminishing returns
• This is a rule that a consumer can follow to decide how much
of each good to consume.
• The consumer would then do so in a way that maximizes his or
her utility without going over-budget.
 Equimarginal Principle
• The
  equimarginal principle says that the consumer must spend
his or her money in such a way that the utility of the last dollar
spent on a good is the same.
 Applying the Equimarginal Principle
• Gossen applied the equimarginal principle to a problem in
which an individual figures out how to allocate a limited
amount of time among various activities so as to maximize
utility.
• This exercise served as a precursor for Gary Becker’s extension
of economic analysis to sociological issues in the 1960s.
 Further Developments
• Gossen had written in German, and in a highly mathematical
manner
• He went unnoticed, until his book was rediscovered by William
Stanley Jevons, who found that many of his own discoveries
were already known to Gossen
• Gossen’s equimarginal principle was further developed by
Jevons and Carl Menger
JOHANN HEINRICH VON THUNEN (1783 – 1850)
 Johann Heinrich von Thünen (1783-1850)
• The Isolated State (1826, 1863)

Thünen
 Theory of Resource Allocation
• Thünen pioneered the marginalist theory of the allocation of resources
to production.
• Assume that the prices of goods and of the resources used in production
are given.
• Then, how much of a good will be produced?
• What amounts of the various productive resources will be used in the
production of the produced good?
• These are the questions that Thünen tried to answer.

Thünen
 One good case
• Assume a central marketplace surrounded by agricultural land, all of
equal fertility
• There is one agricultural good, wheat
• Landowners hire workers to produce wheat
– L workers make Q(L) units of wheat
• The cost of transporting wheat to the market is t dollars per mile
– The market price of wheat is P dollars per ton
– Therefore, wheat grown d miles away from the market will earn P – (t × d) dollars
per ton

Thünen
 One good case
• Revenue earned = [P – (t × d)] × Q(L)
• Landowners pay each worker the wage w dollars
– Therefore, total wage payment = w × L
• Therefore, the landowner’s rent (or, profit) = [P – (t × d)] × Q(L)
–w×L
• The landowner chooses L to maximize this rent (or, profit)

Thünen
 One good case
• Adam Smith had discussed the idea of profit maximization. It
was Thünen who expressed the idea as a mathematical
problem, solved it using differential calculus, and derived
testable hypotheses from profit maximization

Thünen
 One good case
• Thünen defined the marginal product of labor MPL as the increase in
output Q when labor L increases by one worker
• He also assumed diminishing returns
– That is, MPL decreases as L increases
• He then showed that profit-maximizing landowners will choose L to
make
[P – (t × d)] × MPL = w
• This is the key idea of the marginal productivity theory of distribution

Thünen
 Profit Maximization
• How is a firm to decide how much of a resource to use?
• Profit maximization implies that the firm should follow this
rule:
– Marginal Product of a resource = Factor Price of the resource
(measured in units of the produced good).

Thünen
 One good case
• When the farm’s distance to the market d is greater, P – (t × d)
is smaller
• As [P – (t × d)] × MPL = w, MPL must be higher when d is
greater
• Diminishing MPL then implies that L must be smaller when d is
greater
• Notice that Thünen has used the idea of profit maximization to
derive a testable hypothesis: farms that are farther away from
the market will have fewer workers

Thünen
 One good case
• Moreover, farms that are farther away from the market will
earn lower rent (or, profit)
• Why?
– They pay more in transport cost t × d and, therefore, earn a lower
price P – (t × d) for wheat

Thünen
 One good case
There are two farms:
• [P – (t × d)] × MPL = w near (n) and far (f). The
Quantity of Wheat
near farm hires more
workers and earns more
in rent. The near farm
earns ABC in rent,
whereas the far farm
A earns only BC.
B
C
w
[P-(t × dn)] × MPL

[P-(t × df)] × MPL

MPL
Lf Ln L

Thünen
 One good case
• Graphically, the greater the distance Rent
between the farm and the central
market/city, the lower the rent
• Note that this theory of differential rent does
not assume that land varies by quality, as
Ricardo did

Distance, d

Thünen
 One good case
• Thünen also showed that if Rent
transportation cost t decreases, fields
that are farther off would be brought
into cultivation: another testable
hypothesis

Distance, d

Thünen
 Multiple goods case
• What if there are three goods: wheat, corn, and rice?
Rent
• The three crops will be cultivated in concentric
circles around the central market/city—another Wheat
testable hypothesis.
• This was the birth of location economics or
geographical economics
Corn

Rice

Wheat Corn Rice

Distance, d
Thünen
 Capital Theory
• What is the right time to chop a tree?
• Maximization of land rent income implies that the landowner
should follow this rule:
– Chop the tree when the highest possible Present Value obtainable
from the tree = Salvage Price of Tree.
• Thünen was analyzing actual problems of forestry when he derived this idea.
This an example of the importance of practical problem solving in the
progress of economics

Thünen
 Readings
• Brue, Grant – Chapter 12