Historical background & conformation of neoclassical school
During the first half of the 19th century a fierce confrontation developed between the industrial bourgeoisie and the old landed aristocracy. The political discussion was marked by the confrontation between the protectionists and the free traders, between the countryside and the industry, that is, by the brawls typical of the period of consolidation of capitalism. Gradually, along with the advance of capitalism, the axis of the conflict between the classes continued moving until it took the form of an increasingly open conflict that has the working class as one of its protagonists.
In its beginnings, the conformation of the factory system had found an almost inexhaustible deposit of peasants, serfs and vassals expelled from their lands and impoverished artisans to fuel the “deposits” of an eminently weak and disjointed proletariat. The so-called “original accumulation”, the starting point of the capitalist regime, was marked by unlimited exploitation of the new salaried workers, whose associations were prohibited and their claims were persecuted and punished. It was not until the third decade of the 19th century that the working class began a resistance movement.
Arguably, economic theories were forced to accompany this system changing cycle. Indeed, in the field of economic thought, the period began with the agitated controversies between supporters and detractors of the Ricardian system, the one that has consolidated as the hegemonic orthodoxy.
Throughout the second half of the 19th century, from 1850 to 1870, the political economy seemed to stabilise, forming an orthodoxy with Ricardian roots and with John Stuart Mill, Ricardo’s pupil, as the dominant figure. However, under the surface of broad consensus, the two new theoretical systems that would mark the theoretical terrain during the 20th century were developing: the Marginalist system and the Marxist system (parallelism already introduced in the first section of Marx). Marginalism became a new orthodoxy that devoted many efforts, especially at the time of its consolidation, to confront the ideas of Marx.
This initial stage was a genuinely revolutionary stage for Marginalism, as its promoters set out to dethrone and displace the orthodoxy of that time, that is, the classical school of “Ricardo-Mill line”. With the difference of a few years, the three founding works that gave shape to the Marginalist movement were published. These books are the Theory of Political Economy by the British William Jevons (1871), the Principles of Political Economy by the Austrian Carl Menger (1871), and the Elements of Pure Political Economy by the French Leon Walras (1874).
The ideas of the ‘marginal economists’ gradually formed an integrated theory, which has been called neoclassical economics. The triumph of the movement, nevertheless, was not achieved by the three founders but came by the hand of Alfred Marshall. In 1890 Marshall publishes his Principles of Economics, giving a more mature and complete expression to the contributions of marginalism; but, this maturity was reached at the cost of smoothing out certain “rough spots” and attenuating – even making it disappear completely in some cases- the polemic argumentations of the three Marginalist predecessors. Marshall proposed a kind of synthesis between the Marginalists and the classics becoming, therefore, the architect of the neoclassical school of thought. Marshall argued that the ideas of the marginal economists are merely the evolution of the classical economists and in this sense they are Neoclassical economists.
From the labour value theory to utility theory
In our discussion of the structure of the classical theory, we found that the core of this theory is based on the theory of value based on the labour time, or in other words the labour value theory that explained the value-exchange (price) of commodities. In order to understand what led to the replacement of this theory by the neoclassical theory based on utility, we need to bear in mind the intellectual atmosphere that was developed in the middle of the nineteenth century. During this time period there was a rising concern with the labour theory of value as it was attracting discontent from the establishment that thought that the theory was bringing socially dangerous conclusions and finding strong support among a number of socialists and, in general pro-labour, economists. Looking backwards, we can understand how the new neoclassical utility theory’s very purpose (stated or not) was to set aside the classical approach because of its disturbing political implications emanating from the labour theory of value and its association with Marxism and socialism. The idea that the value of commodities is determined by their labour content was too challenging for a system that underwent a structural transformation.
Around 1870, the classical theory of value had, strictly speaking, two different versions: the determination of value by the quantity of labour (Ricardo) and the more widespread determination of value by the costs of production (Mill). Opposed directly to the production-value theory, the axis of Marginalist analysis consists in studying the determination of value exclusively at the moment of the exchange. The subsequent ideological and theoretical controversy crystallised by the marginalism, affected the theoretical consideration of labour. What Marginalist claimed was that, instead, the value of a commodity was determined by its utility, a concept that refers to the satisfaction of an individual that derives from the consumption of a good or the use of a service.
So what “gives value” to objects, is the way in which men “value” goods as objects destined for consumption, capable of satisfying their tastes and needs. A substantial difference, of origin, is thus established with the classical system, where it was assumed that the goods arrived at the exchange process with a “value” determined by the conditions of production (either by the amount of labour or by costs of production). By replacing the centrality of value in order to make it of utility, the centrality of labour in economic discourse was lost and theoretical analysis could ignore the problem posed by considering the distribution (wage/profits) of the surplus in the manner of the classics.
The major contribution of the Marginalists, and the reason that gave them that name, was the concept of marginal utility, upon which the definition of the demand curve was shaped and remains until our days as the basis of the microeconomic line. For the Marginalists, the demand depends on the marginal utility, that is, the utility derived from the consumption of an additional unit of the good in question. It was claimed that as the consumption of a good increases, the satisfaction that a consumer derives from the consumption of successive units of the good in question progressively diminishes. Consequently, the consumer would be willing to pay a lower price for higher quantities of the same good. Thus, we may construct a typical demand curve, that is, a schedule between prices and quantities, with a negative slope precisely because it reflects the law of ‘diminishing marginal utility’. Hence, the value comes entirely from marginal utility, which is a “measure” of the pleasure that its consumption provides, a pleasure that is reduced when the quantity consumed increases. The next step is to aggregate these individual demand curves to arrive at the market demand curve.
The Marginalist theory of value should have been complemented by a Marginalist theory of distribution, that is, by the set of laws that govern the determination of wages, profits and rent. The truth is that the first three Marginalists failed to reach an agreement on these new laws, as opposed to the unanimity reached with marginal utility theory. It is precisely in this less complete segment of Marginalist theory that Marshall comes to the rescue to offer us his theory of value (closer to Classic school) as we will see below.
Marshall value theory
When we examined the original “revolutionary” proclamations of the first three Marginalists (Jevons, Menger, and Walras), we reproduced some of the ideas with which they attacked the Ricardo-Mill school. As we mentioned in the introduction, for Marshall, the Marginalist and the classical are two partial and incomplete versions of the same theory of value. Marshall’s goal was, then, to reconcile the classical school with the novel theory of marginal utility. For Marshall, the main contribution of the Marginalists is limited only to the study of the foundation of the downward sloping demand curve based on the marginal utility theory. However, he argues, the principle of marginal utility cannot be taken as a law of value.
Instead, Marshall affirms following the classical line, that to make the decision regarding the quantity to be produced and brought to the market, the producers do nothing other than estimate their profits calculated as the difference between the price of the demand (how much they would be paid) and the cost price, including wages and profits in the latter.
The principle of cost of production and that of final utility are undoubtedly component parts of the general law of supply and demand; each of them can be compared to a blade from a pair of scissors. (Marshall [1890] 1948a: 682).
Following this line, Marshall then faced the question of determining the “costs of costs”, or in other words the real costs of production. Here lies the most profound content of Marshall’s theory of value: hidden behind the prices of all commodities are, the two original types of “sacrifices” that men must go through to produce them, the sacrifice of labour and the sacrifice of waiting. The idea that labour is a source of value, as we saw, has a classical ancestry, although here the emphasis is not on work as a “cost” due to the physical exhaustion or to the expenditure of energy, but to the “psychological” sacrifice that means to work. More specifically, wages are no longer theorised as the cost of reproduction of workers – clearly, a classical idea – but rather as the “disutility” that a worker suffers by offering his labour services. Along with the sacrifice of the worker comes that of the capitalist. “The wait” to indicate that when a capitalist allocates his wealth to production and not to consumption he experiences suffering and, therefore, deserves a retribution (the interest rate). Then, profits are viewed as the disutility of the entrepreneur, who by abstaining from consumption manages to save resources in order to invest them and profits are the compensation for this sacrifice.
Thus, according to Marshall, the “effort” of working and the “sacrifice” of waiting are the elements that ultimately provide value and price to objects. If the cost is expressed as disutility, then it can be balanced by the utility of demand. As a result, for the first time, an adequate interpretation of the equilibrium price through the forces of demand and supply was given, since both of these forces could be evaluated through utility (positive or negative). This scenery can be illustrated by a graph devised by Marshall and which will become another of his trademarks: the “cross” of supply and demand, which represents the bid price (increasing) and the ask price (decreasing) to each quantity, such as those that appear in Graph No 1.
Figure 1. Marshall’s graphical representation of the supply and demand curves
For Marshallian, the price of all products and all factors (wage/capital) was such that the respective markets always tended to an equilibrium position. Now, in equilibrium, supply equals demand, which means that the entire mass of the products and all the factors offered can be placed on the market. This means, in turn, that anyone who wants to sell their products or services at the prevailing equilibrium price can effectively do so.
Among the premises of the neoclassical theory is that there is an automatic and magnetic tendency that pushes the system to equilibrium and does not rest until it reaches that state. This tendency to the equilibrium in all the markets of the economy is known as Say’s law of markets. Jean Baptiste Say (1767–1832) expressed an idea that was based on the principle that all individuals are both producers and consumers, since each producer intends to spend the surplus of his product on the purchase of other products. Thus, the production of each producer is essentially the demand for the products of other producers. Say’s law appears quite frequently under the catch- phrase ‘supply creates its own demand’. Thus, equilibrium is synonymous with full employment. In this way, full employment becomes a true premise of classical theory as we shall see below.
The creation of a labour market
It is natural that Marshall, by relying on a theory of production costs, was forced to advance more decisively than the early Marginalists in the study of the laws of distribution, since prices of the factor of production become a central element of his value theory.
Marshall’s solutions were based on his general idea that all prices are the result of the reciprocal action of supply and demand. Therefore, Marshall creates two different markets to solve the issue, the labour market and the capital market, which operate in the image and similarity of the market of any other good.
In the labour market, the labour supply curve is upward sloping. This answers to the idea that the workers will offer more work the higher the salary, since for them working one hour more constitutes an increasing sacrifice, which is only compensated by the payment of a higher salary. The supply curve then meets the points where the wage equals the marginal “disutility” of working. In other words the supply curve is the representation of the decision made by workers between the utility reported by the salary obtained for their work versus that provided by the leisure to which they can dedicate their time if they don’t dedicate it to work. Furthermore, the labour supply curve of the economy as a whole will not be more than the result of the simple aggregation of those of all workers.
The labour demand curve of entrepreneurs, on the other hand, has a negative slope because Marshall applies here the law of diminishing returns to the employment of all productive agents equally. The idea behind it is that the additional produced product is lesser as occupancy increases. The demand has then a negative slope and shows the points where the wage is equal to the productivity of labour. In equilibrium, the supply of labour is always equal to the demand for labour, and together determine the wage for which both the disutility of labour and the productivity of labour, are equal.
By considering labour as a pure commodity to be analysed in market terms of equilibrium as any other commodity, the problem of distribution was then formulated as a mathematic equation and stopped being on “social contingency”. This change in approach resulted in three important new hypotheses:
a) Labour is a commodity and the amount in which it will be hired depends, as in other cases, on the supply and demand that exists for it in the market.
b) The labour market is, or should be achieved, under the conditions of perfect competition.
c) The functioning of the labour market under these conditions automatically leads to full employment of the labour factor at the point corresponding to the wage that balances supply and demand for it.
For Marshall, as long as the system is in equilibrium, there will be full employment. Moreover, his theory presupposes that there is an automatic and magnetic tendency that pushes the system and does not rest until it reaches that equilibrium state. Thus, equilibrium is synonymous with full employment.
The neoclassical understanding of unemployment
With the above general conditions, a completely decentralised decision-making process and an institutional framework of total flexibility that allows wages to rise or fall without restrictions will guarantee the achievement of full employment . And this situation will remain constant as long as the structural conditions of the economy, including general levels of productivity, do not change. A conclusion of this nature had and has, even at the intuitive level, obvious theoretical and normative implications:
- a) The existence of a real equilibrium wage above which it is not possible, at the microeconomic level, for an individual to find employment and, at the macroeconomic level, for the employed population to increase.
- b) Attempts to increase the demand for labour by other means that do not reduce wages will be doomed to failure.
- c) The existence of an unemployed population can only be the result of workers voluntarily refusing to be employed at lower wages. Unemployment is always voluntary and therefore there is no room for permanent situations of massive unemployment.
Following Marshall’s theory, unemployment is essentially a phenomenon that belongs to the labour market, because unemployment is by definition an excess labour supply, or in other words unemployment is a transitory disequilibrium state. The Marshallian theory of wages and unemployment predicts, however, that wages will fall to equilibrium, thus ending unemployment. From this it follows that unemployment can only be perpetuated if there is some obstacle that prevents the reduction of wages. It is not at all surprising that orthodoxy, relying on this explanation, has blamed for unemployment the workers unions that refused to see their wages reduced and the labour legislation that also placed limits on wage reductions. In short, only when the wage is “rigid”, that is, when some extra-economic factor prevents it from being freely reduced, can unemployment be long-lasting.
