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Chijklmno pqrstuvwxyz{|}~       $.%&I%).( ./0   9CD-)* +, 0" 5.    f^ 6k.@ !8(6:;<=>?B 125459!L2$q9)_{ 2$THKr&R{ "$0Z% "$(B<:< 7M 2$64iyh 2$*&6Sd>l#Xu3m 2$;}"V3g!jC\ 2$'yM. z7: 2$Pe~ SD$> G 2$xhl`Bj 2$Oel;{"9! 2$OvJj{$ĭ& 2$=g+רÏgS* 2$4yS =. 2$5J`~ B`I. $ $ $ 2$w~cxdX91 $ 2$bٔ{/ nA3pS.3 $ $ r$%oOyy@i6 "$x} M^\j6 s 3f8c?`f3f333f@f8 g4BdBdv 0ppp@ <4dddd` 0L`<4!d!d` 0L`uʚ;2Nʚ;<4dddd{ 0:2___PPT9/ 0? %O =-X Lecture Five  ;Neoclassicism Critiques of Neoclassicism The Rise of Keynes< 7Recap Neoclassical theory as developed by Jevons, Walras, Marshall effectively the same as taught in Microeconomics 2 strands Analysis of individual consumers & producers, integrated into analysis of individual markets ( Marshallian partial equilibrium) Analysis of overall coordination of multiple markets ( Walrasian general equilibrium) Many components common to both e.g., analysis of individual consumer, individual firm, aggregation of individual demands into market demand, individual firm supplies into market supply6xx~$      N   -)The First Zenith of Neoclassicism: Demand* MIndividual demand based on utility maximisation subject to budget constraint:&33N .Demand 6Individual demand curve derived by varying price ratio7 /)The First Zenith of Neoclassicism: Supply* Individual firm supply curve derived from production function combining (at least) one fixed input with (at least) one variable input result: diminishing marginal productivity productivity may rise as initial variable inputs added but eventually diminishing productivity sets inN*hg*hg  0Supply wFirm maximises profit by maximising distance between total revenue (straight line function for PC firm) and total cost:x 1Supply SRelationship between total cost and marginal cost, total revenue & marginal revenue&??T 2Supply hMarginal cost curve is not supply curve for monopoly because of downward sloping marginal revenue curve:$iOi 3.First Zenith of Neoclassicism: Supply & Demand/// GDiminishing marginal productivity generates rising marginal cost Horizontal marginal revenue ensures that marginal cost curve is the individual firm supply curve Sum of all firm marginal cost curves is market supply curve Price set by intersection of downward sloping market demand curve and upward sloping market supply curve:H BGeneral Equilibrium Walras (1870s) showed that general equilibrium feasible Number of equations equals number of unknowns Income and Expenditure equations consistent (see last year s notes, & slides at end of this lecture) However he assumed process: I.e., given that general equilibrium can exist, how do we get there? Must be able to go from initial disequilibrium prices to prices which result in equilibrium in all markets Walras model proposed hypothetical way this could occur:  tatonnement 8EkH/  EkHT   4   n General Equilibrium>Tatonnement  Auctioneer declares prices Buy & Sell bids recorded If Buy>Sell quantity for any stock, price adjusted up If Buy<Sell quantity, price adjusted down No trades allowed until all markets in equilibrium  Tatonnement --groping for equilibrium vector of prices Applied to model of exchange of given quantities of commodities (distribution taken as given) Extended to model of production from given resourcesH  P$  8HProblems I: Does  tatonnement work?*   Walras fiction of auctioneer and tatonnement auctioneer suggests initial prices, adjusts prices according to algorithm, & forbids trades until all markets in equilibrium needed to outlaw  out of equilibrium exchanges if disequilibrium trades allowed, income effects distort market outcome (those selling at above equilibrium prices have windfall gain, others windfall loss) clearly a fiction: disequilibrium trades occur in real world. But does the fiction itself work?: can Walras market  grope its way to equilibrium price vector from random initial prices? Walras believed so:L.}0m.}0mp     P   9$Groping towards general equilibrium?% r Once the prices & have been cried at random in terms of one of them selected as numeraire, each party to the exchange will offer at these prices those goods or services of which he thinks he has relatively too much, and he will demand those articles of which he thinks he has relatively too little for his consumption during a certain period of time& . [T]he prices of those things for which the demand exceeds the offer will rise, and the prices of those things of which the offer exceeds the demand will fall. New prices now having been cried, each party to the exchange will offer and demand new quantities. And again prices will rise or fall until the demand and the offer of each good and each service are equal. Then the prices will be current equilibrium prices and exchange will effectively take place. (Walras 1874)H:+5eFQ     :$Groping towards general equilibrium?% Initial stab at prices won t clear all markets Walras assumes process of adjustment will eventually get there but direct effect of reducing price of one commodity where supply exceeds demand could destabilise other markets (indirect effect) Walras assumed that direct effects would outweigh indirect effects: If demand for B < supply of B, reduce price of B change directly reduces oversupply of B indirectly alters demand for all other commodities increases demand for some, decreases demand for others Walras assumed some cancellation, so direct effect > indirect effect, process gradually converged:n1[7cn`F1[ 7cb/      ] ;$Groping towards general equilibrium?%  This will appear probable if we remember that the change from p b to p  b, which reduced the above inequality to an equality, exerted a direct influence that was invariably in the direction of equality at least so far as the demand for (B) was concerned; while the [consequent] changes from p c to p  c, p d to p  d, ..., which moved the foregoing inequality farther away from equality, exerted indirect influences, some in the direction of equality and some in the opposite direction, at least so far as the demand for (B) was concerned, so that up to a certain point they cancelled each other out. Hence, the new system of prices (p  b, p  c, p  d, ...) is closer to equilibrium than the old system of prices (p b, p c, p d, ...); and it is only necessary to continue this process along the same lines for the system to move closer and closer to equilibrium. (Walras 1874 [1954]: 171-172)|%5&H3!:~ z?            >      ?         ?$Groping towards general equilibrium?% =$Groping towards general equilibrium?% Mathematics of proof of this beyond Walras In 20th century, mathematical economists (see references at end) established: Two stability conditions on input-output matrix For stable growth, matrix must have key value ( eigenvalue ) less than one For stable prices, inverse of matrix must have key value less than one Both conditions can t be fulfilled (there is no number bigger and smaller than one), so  groping won t work In Walras terms, indirect effects outweigh direct effects Groping will never locate equilibrium vector If no trade till equilibrium found, trade will never occurvy0my0^-m b$       @&Groping away from general equilibrium!' >Groping towards disequilibrium?$     Tatonnement thus ineffective device to avoid out of equilibrium trades Price model therefore cannot avoid disequilibrium analysis Intersection of supply and demand curves for all markets at once cannot be found by market processes even if  no trades occur until equilibrium , because equilibrium won t be attained If system diverges from equilibrium, it will never return there if trades occur out of equilibrium, won t converge because trades will alter equilibrium simple techniques for one market ( ceteris paribus ) don t generalise to all markets So why do economists still use equilibrium models of prices?beA=)%A= *  [ AGroping towards disequilibrium?$    Most don t know literature (see references at end of lecture) Some who do know it believe result doesn t apply to model with flexible production functions They are wrong, it does Those who do, and know it applies in general, have given up on modelling process of reaching equilibrium process of reaching equilibrium ignored in favour of simply showing existence of equilibrium time (and therefore process of achieving equilibrium) completely abstracted from: Gerard Debreu s Nobel Prize-winning Theory of Value (see OREF III)iCi= b$   *  4 CRModern  Arrow-Debreu General Equilibrium*   \ For any economic agent a complete action plan (made now for the whole future), or more briefly an action, is a specification for each commodity of the quantity that he will make available or that will be made available to him, i.e., a complete listing of the quantities of his inputs and of his outputs&   For a producer, say the jth one, a production plan (made now for the whole future) is a specification of the quantitities of all his inputs and all his outputs... The certainty assumption implies that he knows now what input-output combinations will be possible in the future (although he may not know the details of technical processes which will make them possible)&   As in the case of a producer, the role of a consumer is to choose a complete consumption plan... His role is to choose (and carry out) a consumption plan made now for the whole future, i.e., a specification of the quantities of all his inputs and all his outputs. 0R"6MRFK  R   D)More problems with neoclassical economics*  Partial equilibrium building blocks of general equilibrium have also come in for criticism Derivation of downward sloping market demand curve invalid Logical basis of upward sloping supply curve unsound Demand  critique discovered by neoclassical economists (Gorman, Sonnenshein, Mantel, Debreu) Supply critique made by Piero Sraffa (and others) 6]]b       ETSmooth individual &  jagged market demand+ Remember  Engels curves ? Show how consumption on different commodities change as income rises Four possibilities Luxury: consumption rises proportionately as income rises Necessities: consumption falls proportionately as income rises  Giffen : consumption falls absolutely as income rises Neutral: consumption proportion remains constant:XXF     a FFeasible Engels curves*    AAll goods likely to fit 1st 3 cases: few if any likely to fit 4thB G'Engels curves for different individuals " Engels curves will differ between individuals because indifference curves differ between individuals Engels curves could only be identical if people were all clones of each other8 _  H HTThe  Sonnenshein-Mantel-Debreu conditions F     NDownward-sloping individual demand curve derived from individual indifference curves which are by definition smooth Can market demand curves be similarly derived? If and only if: All Engels curves are straight lines Slope of indifference curves the same for all individuals along Engels  curves DuuF  [   ITThe  Sonnenshein-Mantel-Debreu conditions F     jIndifference curves represent lines of constant  subjective utility like contour lines on map, different indifference curves represent different levels of utility Two different individuals will get vastly different levels of utility from same combination of goods Effect is like adding two different smooth hills together: composite  hill has abrupt jumps where two sets of contours intersect; resulting  social indifference curve has kinks, intersections  Community indifference and utility possibility loci are among the most useful concepts of welfare economics. Their great disadvantage is that they may intersect... Thus the analysis ... frequently becomes inconclusive. (Gorman 1953)`E_E_  JTThe  Sonnenshein-Mantel-Debreu conditions F     Changing price at kink & intersection points has unpredictable effect on demand Resulting market demand curve has flat bits, kinks, inversions: KTThe  Sonnenshein-Mantel-Debreu conditions F     Smoothly downward sloping demand curves only possible if All commodities are the same hence all Engels curves are straight lines All consumers are identical hence changing income distribution has no effect on demand Absurd conditions? Not too absurd for some economists!:  Suppose that all individual consumers indirect utility functions take the Gorman form... [where] ... the marginal propensity to consume good j is independent of the level of income of any consumer and also constant across consumers... This demand function can in fact be rationalized by a representative consumer&  (Varian 1984)9+;%K9+; % .*`   LTThe  Sonnenshein-Mantel-Debreu conditions F      The necessary and sufficient condition quoted above is intuitively reasonable. It says, in effect, that an extra unit of purchasing power should be spent in the same way no matter to whom it is given. (Gorman 1953)  Two criteria will be considered which lead to the possibility of aggregation: (1) identical preferences (hence identical demand functions), and (2) proportional incomes... These results have a number of interesting applications in the pure theory of international trade. (Chipman 1974)  There are several ways of  rehabilitating the Slutsky symmetry conditions... If consumers are grouped ... However, both of the above  grouping conditions come very close to simply assuming that the consumers in the aggregate have identical tastes and income. (Diewert 1977)b  7     M, General ? Equilibrium  Sonnenshein-Mantel-Debreu conditions needed even for Debreu s general equilibrium model Assumptions clearly unrealistic & more restrictive than those used in partial equilibrium analysis (where Engels curves can take any shape, differ between consumers) Normally defended on methodological grounds discussed in a few weeks time Explanation for upward-sloping supply curve has similar problems& ~         N@ Fixed factor in the short run&  ! Essential foundation for upward sloping firm supply curve is diminishing marginal productivity Essential foundation for diminishing marginal productivity is fixed factor in the short run Sraffa (1926) challenged validity of this on 3 grounds Broad definition and interdependence of supply and demand Narrow definition and availability of  marginal doses of fixed resource Actual behaviour of businesses 2 ways to define a factor of production or industry Broad e.g.,  Labour ,  Agriculture Narrow  e.g.,  Spanners ,  Barley `4G4G*  O O.Sraffa s Broad critique  If broadly define factor/industry, then can regard factor as fixed since attracting additional units difficult But increasing output of industry will affect incomes of all other industries/factors:*oZWZoW ef.Sraffa s Broad critique  VSraffa 1926: No input can feasibly regarded as fixed If define industry broadly (e.g., agriculture), increased usage of fixed resource (land) will increase price of land and change income distribution not all land used by agriculture (e.g., fallow, housing) increased demand for agriculture partly met by switching resources from fallow/housing prices of land, fertiliser will rise Supply and demand curves therefore not independent If not independent, can have indeterminate outcome No unique  equilibrium price because demand and supply interdependent:b fH fH  & gh0Sraffa s Narrow critique  Constant cost with narrow definition If use sensible definition (e.g., wheat industry), Increased demand for wheat will mean conversion of land from (e.g.) barley to wheat Negligible change in cost of land Fertiliser to land ratio remains constant Marginal product & thus marginal cost remains constant Conditions of supply thus determine cost independent of demand Conditions of demand determine quantity produced rather than price Contradicts neoclassical analysisv%47%4    Q0Sraffa s Narrow critique   If we next take an industry which employs only a small part of the  constant factor (which appears more appropriate for the study of the particular equilibrium of a single industry), we find that a (small) increase in its production is generally met much more by drawing  marginal doses of the constant factor from other industries than by intensifying its own utilisation of it; thus the increase in cost will be practically negligible&  (Sraffa 1926) *   ij 0Sraffa s critique & time  Many neoclassicals reject Sraffa critique because it ignores neoclassical treatment of time Short run: when one factor fixed Long run: when all factors variable Sraffa correct: neoclassical treatment of time inadequate. Consider  short run profit maximisation argument:6\En\Enb      g $0Sraffa s critique & time  +Profit a function both of quantity and time0,#333, %0Sraffa s critique & time  *This reduces down to (dropping (t) terms):++3+ &0Sraffa s critique & time  Static profit maximisation ignores time If we ignore time, can only maximise profit by varying quantity produced But time exists must consider both time and quantity when trying to maximise profit An analogy consider trying to conserve fuel while driving find most economical speed at which to drive if ignore time, simple: drive at zero kph if consider time, want to minimise petrol use while kph>0(ID /(ID /   '0Sraffa s critique & time   Have to work out how to minimise! #0Sraffa s critique & time  Interpretation? Maximising profit w.r.t quantity now leaves no  energy to devote to growth hence get maximum possible returns today, but have no resources left to invest, so no growth Time can t be neatly compartmentalised into short, medium, long run Time is continuous If theories ignore time, they are static, and cannot make observations about change over time Economic system is dynamic, necessarily changes over time, so static analysis of little or no relevance to economics And there are more problems with theory of the firm& check Debunking Economics Ch. 4 and websiteL]D5,!(]D 5D k <Sraffa s  real world critique  Robbins definition sees economy as  resource-constrained Robbins definition: resources the key constraint on output Sraffa instead argues that economy is demand constrained  Business men, who regard themselves as being subject to competitive conditions, would consider absurd the assertion that the limit to their production is to be found in the internal conditions of production of their firm, which do not permit the production of a greater quantity without an increase in cost (Sraffa 1926: 543). Instead limits to sales set by  the absence of indifference on the part of the buyers of goods as between the different producers (Sraffa 1926: 544).L:<9:<9bv  i     l <Sraffa s  real world critique  Numerous reasons why resources do not in general restrain output of capitalist firms: Excess productive capacity the norm investment plans anticipate growth, so plants built to cope excess capacity enables firm to take advantage of problems of competitors Macroeconomic: pressure to keep wages low suppresses aggregate demand; normality of involuntary unemployment; insufficient aggregate demand (as per later Keynes) the norm. :V$3V$3 m <Sraffa s  real world critique  Both a vice and a virtue: Demand constrained firm must innovate to remain competitive: high level of innovation Resource constrained firm does not need to innovate Demand constrained economy (capitalist) will have higher degree of innovation than resource constrained (socialist) thus higher rate of growth. Thus according to Sraffa (and today Kornai), Robbins definition thus fails to emphasise one of key virtues as well as vices of the market economy.Hc)FF    i Z<Sraffa s  real world critique  Empirical research supports Sraffa: Numerous studies (Meade, Tucker, Andrews, Eiteman, Guthrie) find firms  Administer prices (set prior to marketing) Endeavour to sell as much as possible at set price Perceive costs constant or falling with increased output E.g., Guthrie showed firms graphs of cost/quantity relation only 1 in 20 chose graphs showing rising marginal cost: v$G<8$G<8F  ,  $ [<Sraffa s  real world critique  According to Eiteman (1947), engineers design factories  so as to cause the variable factor to be used most efficiently when the plant is operated close to capacity. Under such conditions an average variable cost curve declines steadily until the point of capacity output is reached. A marginal cost curve derived from such an average cost curve lies below the average cost curve at all scales of operation short of capacity, a fact that makes it physically impossible for an enterprise to determine a scale of operations by equating marginal cost and marginal revenues. (Eiteman 1947):88F   )   \<Sraffa s  real world critique  If MC=MR doesn t determine price & quantity, what does? Sraffa & real-world researchers: price set by markup on average cost of production quantity constrained by heterogeneous nature of products and customers:>8!z8!zF8  (  g ]<Sraffa s  real world critique  RA picture of Sraffa s vision of the firm:*    ^N Supply and Demand after the critiques(  Market Demand curve can take any shape at all:  Unfortunately ... The aggregate demand function will in general possess no interesting properties... The neoclassical theory of the consumer places no restrictions on aggregate behaviour in general. (Varian 1992)&// REconomic Reaction? Conventional theory ignores critiques partial equilibrium neoclassical economics becomes ascendant under Marshall/Robbins general equilibrium ascendant under Walras Alternative  markup pricing school of microeconomics ignored Neoclassical microeconomics goes on regardless Meanwhile, on the national scale: Pre-Keynesian macro theory consistent with neoclassical micro: N&?&? F     } Neoclassical Economics in CrisispPredictions (full employment; no general gluts) and reality (30% unemployment; all markets depressed) completely out of whack Policy advice: reduce wages when already falling; lower price level will fix things when price level already falling& Economic theory and policy ripe for a change and along comes Keynes& &!!P(References on instability of tatonnement  |Blatt, J.M., 1983. Dynamic economic Systems, ME Sharpe, Armonk. Jorgenson, D.W., 1960.  A dual stability theorem , Econometrica 28: 892-899. 1961.  Stability of a dynamic input-output system , Review of economic Studies, 28: 105-116. 1963.  Stability of a dynamic input-output system: A reply , Review of economic Studies, 30: 148-149. Mas-Colell, A., 1986.  Notes on price and quantity tatonnement dynamics , in Sonnenshein, H.F., (ed.), Lecture Notes in economics and Mathematical Systems, Springer-Verlag, Berlin. McManus, M., 1963.  Notes on Jorgenson s Model , Review of economic Studies, 30: 141-147. Sargan, J.D., 1958.  The instability of the Leontief dynamic model , Econometrica 26: 381-392.<nn s      )    M  d  &     _References on pricing Bishop, R.L., 1948.  Cost discontinuities, declining costs and marginal analysis , American Economic Review 38: 607-617. Clapham, J.H., 1922a.  Of empty economic boxes , Economic Journal, 32: 303-314. 1922b.  The economic Boxes - A rejoinder , Economic Journal, 32: 560-563. Eiteman, W.J., 1947.  Factors determining the location of the least cost point , American Economic Review 37: 910-918. 1948.  The least cost point, capacity and marginal analysis: a rejoinder , American Economic Review 38: 899-904. Eiteman, W.J. And Guthrie, G.E., 1952.  The shape of the average cost curve , American Economic Review 42: 832-838. Langlois, C., 1989.  Markup pricing versus marginalism: a controversy revisited , Journal of Post Keynesian Economics 12: 127-151. Lee, F., 1998. 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