Aug 11

Neoclassical Economics

Modern economics would look nothing like what they do without neoclassical economics which, for instance, implemented rigorous mathematical analysis into economics. Most of what we absolutely take for granted was discovered by the great economists of the time, and they are also responsible for providing enough of a framework to raise a century long controversy with the other great school of the 20^th century.

Neoclassical economics is really the birth of mathematics as an inescapable tool for constructing theories that are internally coherent (that is, explained in and of themselves without requiring casuistic examples), escaping the slightly lackadaisical approach of many classical economists like the great Ricardo. This allowed Economics to develop at a much faster pace, and provided the basis for how Economics is studied and investigated today.

Neoclassical economics also sees the first clear distinctions between branches of Economics, previously grouped together in the ever present “Principles of Economics” manuals. It sees the basis of the modern didactic framework that we still classify Economics under, and is, in short, the first time that Economics looks like something we might recognise today: consistent theories built upon a solid mathematical framework that aim to underpin the casuistics of what goes on around us.

Marginalism:

Marginal Revolution, around 1870, brought the prevailing classical view of value theory to an end.

William S. Jevons, who devised the concept of marginal utility.

Carl Menger, one of the founders of the Austrian school.

Léon Walras and his concept of “tâtonnement” revolutionized the study of general equilibrium.

Main neoclassical economists:

Alfred Marshall, the true founder of the neoclassical school of economics.

Francis Y. Edgeworth, whose mathematical contributions to economics are of great importance.

Arthur C. Pigou, precursor of welfare economics.

Vilfredo Pareto, who specially focused on allocation and efficiency matters.

Irving Fisher, the main American neoclassical economist.

Main neoclassical schools:

Although not included in this Learning Path (in order not to overwhelm you!), it is interesting to learn about the three main schools at the time: Cambridge school, Lausanne school and the Austrian school. Reading about these will help you put into context everything you’ve learned during this Learning Path.

Aug 11

Lope Gallego

Economic region of production

The economic region of production shows the combinations of factors at a certain cost that make economic sense. Areas outside the economic region of production mean that at least one of the inputs has negative marginal productivity. This region is marked by what are called ridge lines, which are simply the boundaries beyond which one of the two factors is being overused. Therefore, outside the economic region of production, there is clear inefficiency, and the company would be better off using less of one of the two factors, bringing costs down whilst maintaining equal production output. Graphically:

Video – Economic region of production:

Aug 11

Lope Gallego

Isoquant

An isoquant shows the different combinations of K and L that produce a certain amount of a good or service. Mathematically, an isoquant shows:

f (K,L) = q₀

Graphically, the shape of an isoquant will depend on the type of good or service we are looking at. The shape of isoquants is also in close relation with the terms marginal rate of technical substitution (MRTS) and returns to scale.

The first example of isoquant map showed in the adjacent graph is the most common representation. It shows four convex isoquants (green), showing each curve what amount of capital K the producer can stop applying when increasing the amount of labour L, while maintaining the quantity of output produced constant. This relation gives us the MRTS between these inputs, which is the slope of the curve in each of its points.

Our second example is an isoquant map with four parallel lines (cyan). This is the case for inputs which are perfect substitutes, since the lines are parallel and MRTS = 1, that is the slope has an angle of 45º with each axis. It can also be the case for inputs that are perfect substitutes but in different proportions. In that case, the slope will be different and the MRTS can be defined as a fraction, such as 1/2 ,1/3 , and so on. For perfect substitutes, the MRTS will remain constant.

Our third example shows an isoquants map with four isoquants (red) that represent perfect complementary inputs. This is, there will not be an increase on the amount produced unless both inputs increase in the required proportion. The best example of complementary inputs are shovels and diggers, since the amount of holes will not increase when there are extra shovels without diggers. Notice that the elbows are collinear, and the line crossing them defines the proportion in which each input needs to increase in order to have an increase in the production. In this case the horizontal fragment of each isoquant has a MRTS = 0 and the vertical fractions a MRTS = ∞.

Isoclines are lines which ‘join up’ the different production regions. Having defined and decided the optimal levels of K and L we need to produce the different quantities, the line that passes through these optimal levels is an isocline (cyan). In other words, it is the line that joins points where the MRTS of each isoquant is constant:

Video – Isoquants:

Aug 10

Lope Gallego

Isocost

Isocost lines show combinations of productive inputs which cost the same amount. They are the same concept as budget restrictions when looking at consumer behaviour. Mathematically, they can be expressed as:

rK + wL = C

Where r is the cost of capital and w is the cost of labour. Generally, we think of r as the interest rate the financial markets offer, as capital requires investment. Even if the capital can be paid for using a company’s own resources, r is still equivalent to the opportunity cost of having the money tied up in investments rather than in liquid assets which offer a return (r) by lending it to the markets. The cost of labour (w) is the salary paid to employees per unit of time.

Isocosts are usually represented graphically together with isoquant lines (which are combinations of productive inputs which produce a fixed quantity of outputs). The two have a tangency point, which determines the optimal production (where production is maximised or cost minimised).

Video – Isocosts:

Aug 10

Lope Gallego

Marshallian and Hicksian demands

Marshallian and Hicksian demands stem from two ways of looking at the same problem- how to obtain the utility we crave with the budget we have. Consumption duality expresses this problem as two sides of the same coin: keeping our budget fixed and maximising utility (primal demand, which leads us to Marshallian demand curves) or setting a target level of utility and minimising the cost associated with it (dual demand, which gives us Hicksian demand curves). We must also look at the Lagrangian functions where we obtain the first derivatives.

This leads us to the main difference between the two types of demand: Marshallian demand curves simply show the relationship between the price of a good and the quantity demanded of it. Hicksian demand curves show the relationship between the price of a good and the quantity demanded of it assuming that the prices of other goods and our level of utility remain constant. This makes sense when we look at consumption duality: for dual (Hicksian) demand, we maintain a fixed level of utility, and so our level of wealth, or income, must remain constant. We simply cannot be as satisfied if we do not maintain equal purchasing power.

Marshallian and Hicksian demand curves meet where the quantity demanded is equal for both sides of the consumer choice problem (maximising utility or minimising cost). For prices above this equilibrium point, consumer wealth is higher with Hicksian demand curves than Marshallian demand curves, because to maintain utility constant, Hicksian demand curves assume real wealth remains unchanged. Marshallian demand assumes only nominal wealth remains equal. The opposite is true for prices below this point: Marshallian demand assumes that as nominal wealth remains the same but price levels drop (negative inflation), the consumer is better off. Hicksian demand assumes real wealth is constant, so the individual is worse off. This is why Marshallian demand curves are more ‘stable’: they reflect both rent effect and substitution effect. Hicksian demand curves only show substitution effects (utility is constant, therefore rent must remain constant), which means that demand varies with price only because other options become more attractive.

Formally,

Marshallian demand (dX₁) is a function of the price of X₁, the price of X₂ (assuming two goods) and the level of income or wealth (m):

X*=dX₁(PX₁, PX₂, m)

Hicksian demand (hX₁) is a function of the price of X₁, the price of X₂ (assuming two goods) and the level of utility we opt for (U):

X*=hX₁(PX₁,PX₂,U)

For an individual problem, these are obtained from the first order conditions (maximising the first derivatives) of the Lagrangian for either a primal or dual demand problem.

Marshallian demand makes more sense when we look at goods or services that make up a large part of our expenses. Here, the income effect is very large. However, for smaller purchases, we are willing to spend more or less any amount as long as we derive the utility we expect to.

Video – Marshallian and Hicksian demand curves:

Aug 10

Lope Gallego

Kenneth Arrow

Kenneth Joseph Arrow, born in 1921, is an American economist and Professor at Stanford University. In 1972 he was granted the Nobel Prize of Economic Sciences along with John Hicks for their pioneer contributions to general equilibrium theory and welfare economics. Arrow emerges as a great economist during post-World War II, and collaborates in the U.S. government during the 60s.

In his key work “Social Choice and Individual Values”, 1951, Arrow popularized his Impossibility theorem(firstly exposed in his Ph.D. thesis), which concludes it is not feasible to develop a social welfare function from individual welfare functions without breaking certain minimum conditions of rationality and equity. He is considered as the founder of modern economic theory of social choice and his theory has been of paramount importance in welfare economics.

Arrow, jointly with Gérard Debreu, first formally demonstrated the General Equilibrium theory, using mathematical analysis. Their work shows the existence of market clearance equilibrium if certain restrictive assumptions are met. Their work is explained in the treaty “The Existence of an Equilibrium for a Competitive Economy”, 1954.

Aug 9

Lope Gallego

Lawrence Klein

Lawrence Robert Klein, born in 1920, is an American Economist and was Professor at the Wharton School of the University of Pennsylvania. In 1980 he was awarded the Nobel Prize in Economic Sciences, for the creation of economic models, and their application to the analysis of economic fluctuations and economic policies. His models based in economics have been widely used by economists throughout the world.

Klein specialized in econometrics, statistics and economic cycles and, above all, he focused in the forecasting area. His “A Textbook of Econometrics”, 1953, can be highlighted as his key work, and is the basis of econometrics studies nowadays.

Aug 9

Lope Gallego

Simon Kuznets

Simon Smith Kuznets, 1901-1985, was a Russian born American economist, Professor at Harvard University. His main works were related with the economic growth of nations. He won the Nobel Prize in Economic Sciences in 1971. Kuznets was granted this award for the use of empirical methods in order to understand better the economic and social structure and economic growth. His works helped to understand the behaviour of economic cycles and described an economic cycle of 15-25 years known as the Kuznets Swing.

Kuznets developed a series of empirical studies using statistic models that supported J.M. Keynes ideas initially, but then redesigned his studies in order to analyse a longer period of time, and his conclusions differed from the previous ones.

Other studies by Kuznets deal with inequality in wealth distribution. As the Kuznets’ curve shows, inequality increases in the short term of economic growth, but it ends up decreasing in the long term. He frequently expressed his opinion that GDP per capita was not an accurate measure of welfare.

In 1940 he stated that the US economy was not working at its full capacity and was one of the designers of the Victory Plan in order to maximize the war economy during World War II.

Aug 9

Lope Gallego

Edmund Phelps

Edmund Phelps Edmund Strother Phelps, born in 1933, is an American economist and an advocate of New Keynesian Economics. He is a Professor at Columbia University, where he imparts Political Economy. In 2006 Phelps won the Nobel Prize in Economics Sciences, due to his analysis of inter-temporal tradeoffs in macroeconomics, along with their effect on economic policy in the short and long run.

In his paper “Money-Wage Dynamics and Labor Market Equilibrium”, 1968, Phelps established a link between employment, wage setting and inflation, and defended the importance of expectations and imperfect information, in the setting of prices and wages.

In 1969, Phelps wrote “The New Microeconomics in Inflation and Employment Theory”, in which he explained how money surprises could have real effects in the absence of nominal rigidities, using as an example markets physically separated; this metaphor is nowadays known as Phelps’ island parable. Robert Lucas would later on use this paper to introduce rational expectations, which would change the outcome of this study.

He is attributed the term “Golden Rule” of accumulation, which Phelps put forward in his paper “The Golden Rule of Accumulation: a Fable for Growthmen”, 1961, at which savings are such that they optimize the growth of consumption.

Aug 9

Lope Gallego

Thomas Sargent

Thomas Sargent Thomas John Sargent, born in 1943, is an American economist who has been deeply involved in the new classical macroeconomics, researching the fields of macroeconomics, monetary economics and time series economics. It was in 2011 when he and Christopher A. Sims were awarded the Nobel Prize in Economic Sciences for the use of empirical research when explaining cause and effect in macroeconomics.

Sargent is considered to be one of the leaders in the rational expectations revolution that states that people respond strategically to changes in fiscal and monetary policy, and not passively, as previous models such as the adaptive expectations assumed. In this field, his works with Neil Wallace are of paramount importance, specially their paper “Rational Expectations and the Theory of Economic Policy”, 1976, which focuses on the application of rational expectations to analyze the outcome of monetary policies; and their paper “Some Unpleasant Monetarist Arithmetic”, 1981, which deals with the problem of monetarist arithmetic, and whose main conclusion is that issuing government debt to fund economic policies can cause as high an inflation as monetizing debt.

Sargent has also developed studies on the evolution of unemployment, comparing the United States with Europe, which conclusions are reflected in the work “Two Questions about European Unemployment”, 2007.