Chapter Four

The Development of Modern

Microeconomic Theory

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 Outlines
 The Development of Modern Microeconomic Theory
The Movement Away from Marshallian Economics
The Monopolist Competition Revolution
Milton Friedman and the Chicago approach to
Microeconomics
Topics in Modern Microeconomics

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 The Movement Away from Marshallian Economics
The Movement Away from Marshallian Economics
 The movement away from Marshallian economics
marked a significant evolution in economic thought during
the 20th century, as scholars sought to address the
limitations of Alfred Marshall's framework and
incorporate new tools and ideas.
Limitations of Marshallian Economics
 Partial Analysis: Focuses on isolated markets, ignoring
interdependencies.
 Static Nature: Insufficient to analyze dynamic economic
systems.
 Neglect of Macro Issues: Limited insights into aggregate
demand, monetary policy, and economic cycles.
Note: Insights from Marshallian principles still applied in
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 Cont’d…
Movements Away from Marshallian Economics
1. Rise of Keynesian Economics
 John Maynard Keynes emphasized aggregate demand and
macroeconomic equilibrium.
 Critique of laissez-faire policies.
2. General Equilibrium Theory
 Léon Walras introduced the idea of interdependence in
markets.
 Transition from partial to general equilibrium analysis.
3. Influence of Institutional Economics
 Thorstein Veblen and the Institutionalist Perspective:
 Emphasis on social, cultural, and institutional factors.
 Economics seen as an evolving process, not static.

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4. Behavioral Economics
 Herbert Simon and Bounded Rationality:
 Critique of the assumption of perfectly rational behavior.
 Exploration of psychological influences on economic
decisions.
5. Evolution of Economic Methodology
Mathematical Rigor: Arrow and Debreu's formalization of
economics.
Game Theory: Contributions by John Nash and others to
strategic decision-making.
Experimental Economics: Real-world validation of
economic models.

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6. Modern Economic Schools of Thought
Neoclassical Synthesis: Integration of Keynesian and
classical approaches.
New Institutional Economics: Douglass North on
institutions shaping economic performance.
Complexity Economics: Focus on adaptive systems and
emergent phenomena.

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 Cont’d…

The Monopolist Competition Revolution

 Monopolistic Competition is A market structure
combining elements of monopoly and perfect
competition.
 Significance of the Revolution: Redefined
understanding of real-world market dynamics.
Pre-Revolution Market Structure Theories
 Perfect Competition: Homogeneous products, price
takers, no barriers to entry.
 Monopoly: Single seller, price maker, significant
barriers to entry.

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Key Contributors to the Revolution
Edward Chamberlin (1933):
 Introduced the concept of product differentiation.
 Published The Theory of Monopolistic Competition.
Joan Robinson (1933):
 Developed The Economics of Imperfect Competition.
 Explored price and output decisions in imperfect markets.
Features of Monopolistic Competition
 Product differentiation.
 Many sellers and buyers.
 Freedom of entry and exit.
 Non-price competition (e.g., advertising, branding).
 Downward-sloping demand curve for individual firms.

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Theoretical Contributions
 Product Differentiation: Role of branding, quality,
and innovation.
 Market Power: Firms have some control over
pricing but face competition.
 Economic Efficiency: Neither perfectly efficient
(like perfect competition) nor entirely inefficient (like
monopoly).

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Applications of Monopolistic Competition
Real-World Industries: Restaurants, retail, fashion,
technology.
Policy Implications: Competition policy and antitrust
regulations.
Business Strategies: Importance of branding, innovation,
and customer loyalty.
Modern Developments
 New Trade Theory: Paul Krugman’s work linking
monopolistic competition to international trade.
 Economies of scale and product variety in global markets.
 Behavioral Economics: Exploring consumer decision-making
in differentiated markets.

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Milton Friedman and the Chicago approach to

Microeconomics
 Milton Friedman is Economist, statistician, and leading
figure in the Chicago School of Economics. Nobel Prize in
Economics, 1976.
 Chicago Approach: Focus on free markets, rational choice,
and limited government intervention.
Principles of the Chicago Approach
 Emphasis on Free Markets: Markets allocate resources more
efficiently than governments.
 Rational Choice Theory: Individuals act to maximize utility.
 Minimal Government Intervention: Advocated for
deregulation and privatization.
 Empirical Validation: Heavy reliance on data and statistical
methods to support theories.
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Friedman's Microeconomic Contributions

 Price Theory: Prices serve as signals for resource
allocation. Importance of competition in regulating
markets.
 Consumer Behavior: Developed the permanent
income hypothesis for consumption patterns.
 Critique of Keynesianism: Questioned government
spending and intervention as solutions to market
failures.
The Chicago School
 Focus on Market Efficiency: Markets are self-
correcting in the long run. "Invisible hand" of
competition ensures optimal outcomes. 1
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 Support for Monetarism: Advocated for controlling
money supply rather than fiscal stimulus.
 Applications in Public Policy: Deregulation of
industries (e.g., telecommunications, airlines). School
voucher programs for education reform.
Critiques of the Chicago Approach
 Over-Reliance on Rationality: Behavioral
economics highlights deviations from rational
behavior.
 Insufficient Attention to Inequality: Focus on
efficiency sometimes overlooks equity concerns.
 Market Failures: Critics argue for stronger
government intervention in cases of externalities and
public goods.
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Case Studies of Chicago Microeconomics in Action
 Antitrust Policy: Friedman’s defense of corporate mergers
based on consumer welfare.
 Privatization: Advocacy for privatizing public services
(e.g., postal services, healthcare).
 Deregulation: Examples: Airline deregulation in the 1970s,
financial deregulation in the 1980s.
Influence on Modern Economics
 Law and Economics Movement: Richard Posner and the
application of economic principles to legal systems.
 Behavioral Counter-Revolution: Emergence of behavioral
economics as a challenge to the Chicago model.
 Global Impact: Chicago-trained economists influencing
policies worldwide.
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Topics in Modern Microeconomics

 Modern Microeconomics: The study of individual
behavior, firms, and market structures with advanced
tools and theories.
 Why Study It? To understand and address complex
real-world problems
Key Themes in Modern Microeconomics
 Behavioral Economics
 Game Theory
 Information Economics
 Experimental and Empirical Microeconomics
 Market Design and Mechanism Design
 Environmental and Resource Economics
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Behavioral Economics
 It is the Study of psychological influences on economic
decisions. Bounded rationality, biases, and heuristics.
Prospect theory (risk aversion and loss aversion).
 Basically it is important for Marketing and consumer
behavior analysis, public policy analysis.
Game Theory
 Is analysis of strategic interactions among rational
decision-makers. Nash equilibrium, Dominant and mixed
strategies and Cooperative vs. non-cooperative games.
 It is applicable for Auction design, business competition,
and international trade.

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Information Economics
 Study of decision-making under asymmetric or incomplete
information. Adverse selection, Moral hazard and Signaling
and screening.
 It is important on Insurance markets, job markets, and
financial systems.
Experimental and Empirical Microeconomics
 Experimental Economics: Controlled experiments to test
economic theories.
 Empirical Economics: Use of real-world data and
econometrics for validation.
 Applications: Testing auction designs, consumer preferences,
and policy impacts.

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Environmental and Resource Economics

 Efficient allocation of natural resources and
environmental sustainability. Externalities and carbon
pricing and Tradable permits and cap-and-trade
systems.
 Applications: Climate change policies, renewable
energy incentives.
Challenges in Modern Microeconomics
 Incorporating computational complexity in models.
 Addressing global challenges (inequality,
sustainability).
 Bridging theory with practice in dynamic, real-world
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 The development of new generation of economic model
include
the topics of consumer and producer choice,
decision under uncertainty, and
 resource allocation under different market structures such
as competition, monopoly, and oligopoly as well as
 some newer innovations to the theory, including
 the role of politics in the determination of economic
policy,
 the impact of spillovers and
 network externalities in the information economy, and
psychological and behavioral factors in individual decision
making.

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 Thank you for all!!!

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