Chapter 64: Economic Ideas (The Neoclassics)
Beginning in the 1870s, the Neoclassical School of Economics emerged. Borrowing the idea of marginal analysis from calculus, and applying it to the ethical theory of Utilitarianism, they revolutionized the way economics was discussed. Today, we discuss the various “Marginalists” of this school, and the impact they had on the history of economic thought.
Sources for this episode include:
“Alfred Marshall: British economist.” Encyclopaedia Britannica. Last updated: 5 Jan 2007. https://www.britannica.com/biography/Alfred-Marshall
“Carl Menger: Austrian economist.” Encyclopaedia Britannica. Last updated: 15 Apr 2019. https://www.britannica.com/biography/Carl-Menger
Cirillo, Renato. “Léon Walras and Social Justice.” The American Journal of Economics and Sociology, vol. 43, no. 1, 1984, pp. 53–60.
“Eugen von Böhm-Bawerk: Austrian economist and statesman.” Encyclopaedia Britannica. Last updated: 3 Oct 2018. https://www.britannica.com/biography/Eugen-von-Bohm-Bawerk
Jevons, William S. The State in Relation to Labour. 3rd Edition. Edited by Michael Cababé. MacMillan and Co. 1894.
“John Bates Clark: American economist.” Encyclopaedia Britannica. Last updated: 15 Nov 2017. https://www.britannica.com/biography/John-Bates-Clark
Kruse, Kevin. “The 80/20 Rule And How It Can Change Your Life.” Forbes. 7 Mar 2016. https://www.forbes.com/sites/kevinkruse/2016/03/07/80-20-rule/
“Léon Walras: French-Swiss economist.” Encyclopaedia Britannica. Last updated: 28 Sept 2018. https://www.britannica.com/biography/Leon-Walras
Marshall, Alfred. The Present Position of Economics: An Inaugural Lecture Given in the Senate House at Cambridge, 24 February, 1885. MacMillan and Co. 1885.
Screpanti, Ernesto and Stefano Zamagni. An Outline of the History of Economic Thought. Translated by David Field. Oxford University Press. 1993.
“Vilfredo Pareto: Italian economist and sociologist.” Encyclopaedia Britannica. Last updated: 26 May 2022. https://www.britannica.com/biography/Vilfredo-Pareto
Walras, Leon. Elements of Theoretical Economics (Or The Theory of Social Wealth). Translated and edited by Walker, Donald A. and Jan van Daal. Cambridge University Press.
“William Stanley Jevons.” Stanford Encyclopedia of Philosophy. Last updated: 12 Feb 2015. https://plato.stanford.edu/entries/william-jevons/
“William Stanley Jevons: English economist and logician.” Encyclopaedia Britannica. Last updated: 27 Sept 2018. https://www.britannica.com/biography/William-Stanley-Jevons
Full Transcript
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Back in Chapter 28, we talked about the Classical School of Economics. One of the topics covered in that episode was the philosophy of Utilitarianism, developed by Jeremy Bentham and promoted by his disciples, James and John Stuart Mill.
According to a strict Utilitarian, individuals and societies should make their decisions based on what will produce the greatest good for the greatest number of people. At the foundation of this principle is the concept of utility. Bentham used this word as a catch-all for everything good in the world. So, to increase utility, you want to try to maximize pleasure, benefit, happiness, etc., while minimizing pain, disadvantage, misery, etc.
This concept lay at the core of John Stuart Mill’s work, including his economic theories – notably, his 1848 treatise, Principles of Political Economy. By the 1860s, that book was considered the hallmark of economic thought across much of the world – the starting point for any conversation of liberal economics.
And then, beginning in the 1870s, a few scholars would pick up where Mill left off. Not only were they interested in the study of political economy, but also in disciplines like mathematics, physics, and other natural sciences. And it was the mathematical field of calculus, in particular, where they saw great promise.
Among other things, calculus looks at topics like optimization. It does not assume that one can reach an ideal function – only an optimal point. And to discover the optimal point of a function – that tippy top of a bell curve – one needs to apply something called “marginal analysis.” Using marginal analysis, the mathematician can discover the rate at which one variable shifts along with another variable. Charting it out, then, we can see what that optimal point is.
By using marginal analysis to find optimal rates of utility, these new economists were putting forth theories of what we call “marginal utility.” Thus, this moment became known as the Marginal Revolution (or the “Marginalist Revolution”, depending on the historian you’re reading). And these Marginalists, as they’re called, had a few goals in mind for their work.
First, they were generally opposed to socialism and very opposed to Marxism in particular. They were writing at a time when Marx was becoming the dominant thinker in socialist circles, and they were ideologically horrified by his writings. Far from accepting that industrial capitalism had created an entrenched bourgeoisie and an entrenched Proletariat diametrically opposed to one another, they believed the system was increasing everyone’s utility. At a minimum, they sought to explain how industrial capitalism had been generally good for the working classes, and they even went so far as to suggest that, in true economic liberalism, one would see a class-free system.
To them, socialism was a heretical divergence from the true religion of classical economics. And they traced this divergence back to a few culprits. As one Marginalist put it, “that able but wrong-headed man, David Ricardo, shunted the car of economic science on to a wrong line – a line, however, on which it was further urged toward confusion by his equally able and wrong-headed admirer, John Stuart Mill.”
And yet, the Marginalists too would shunt the car of economic sciences onto a new line – a line that diverged from the Classical school of Smith and Say and Malthus. Their “Neoclassical School” would be much more libertarian, much more laissez-faire.
And second, by taking ideas from calculus and applying them to the topic of political economy, these scholars wildly transformed the discipline. From here on out, it would not be referred to as political economy anymore. These scholars wanted to call it, simply, “economics.” Though they were opposed to Marx’s substantive conclusions, they – like him – believed that political economy was too caught up in abstract theories. They wanted to bring scientific rigor to economics. And they chose this name, “economics”, because it not only removed the word “political” (which suggested there was a collective angle to the economy – an angle that most of them were deliberately trying to avoid), but also because it sounded more like the word “mathematics.”
Now, to be sure, the ideas of these Marginalists were revised and fine-tuned in the years to come. But, it was the dominant school of liberal economic thought throughout the Second Industrial Revolution. And the theories the Marginalists developed still serve as the foundation of how economics is taught across much of the world to this very day.
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This is the Industrial Revolutions
Chapter 64: Economic Ideas (The Neoclassics)
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Okay, before we get into it, let’s cover a little admin.
First of all, a note about the title today. Way back when, I had this idea to gradually sprinkle episodes about the history of economic thought throughout the podcast, naming them all “Economic Ideas” and then adding a part number and subtitle. Chapter 9 was Economic Ideas (Part 1: The Oldies). Chapter 10 was Economic Ideas (Part 2: Adam Smith). And Chapter 28 was Economic Ideas (Part 3: The Classics). But then I got to the dawn of socialism and it all went haywire because those chapters didn’t only focus on economic ideas. But, we can say that Part 4 of “Economic Ideas” was covered in Chapter 42, when we discussed the Utopian Socialists and Part 5 was, of course, Chapter 49, when we discussed Marx.
So, if you want to know what part of “Economic Ideas” we’re on, it’s Part 6. And Part 7 will be next time.
Why all this focus on economic ideas? Well, for one, they have long been a personal interest of mine. But, more importantly, because these ideas would have a massive impact on the way the history of the industrialized world unraveled during the 20th Century. And we’re going to see some hints of that today.
Second of all, I want to thank all the wonderful people who support the podcast with financial contributions.
Special shout outs this time go to Harriet Buchanan and Kyle Laskowski, to new Patrons Madeleine Hill and Andrej Andrejkovič, and to John Bartlett, Adam Bibby, Chris Bradford, Elizabeth Brooking, Tara Carlson, “Dancer In The Dark”, Michael Hausknecht, Herbyurby, Eric Hogensen, Alonso Ibanez, Naomi Kanakia, Brian Long, Andrew C. Madigan, Martin Mann, Duncan McHale, John Newton, Emeka Okafor, Brad Rosse, Joshua Shanley, Kristian Sibast, Jonathan Smith, Russell Tanner, Ross Templeton, Seth Wiener, and Tanner. Thank you.
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The Marginal Revolution began in the 1870s thanks to three different books written by three different authors in three different countries. In fact, these three books didn’t have all that much in common. And the three authors were pretty much unaware of each others’ existence at the time.
The first was our old friend, William Stanley Jevons. We met him back in Chapter 50. He had already made a name for himself in Britain during the 1860s because he published that book, The Coal Question. Remember The Coal Question? That was the book in which Jevons rang the alarm bell about the country’s finite and dwindling supply of coal – predicting catastrophic prospects for future economic growth as a result.
Born in Liverpool in 1835, Jevons was the son of an iron merchant who went bankrupt when the railway bubble burst in 1847. This no doubt had a great influence on young Jevons, who was still able to pursue a future in academia, regardless of his family’s financial woes. Jevons was part of that growing number of bourgeois offspring who were afforded such educational opportunities, attending University College in London, where he studied the natural sciences, mathematics, and logic. After graduating and earning a master’s degree, he got a job as an instructor at Owens College – later called the University of Manchester.
Throughout the 1860s, most of his work revolved around mathematics, logic, and epistemological philosophy. But he also became interested in the ideas of Utilitarianism, Darwinism, and political economy. And a lot of these ideas were swirling around in his brain in the lead up to his most important work of economics, The Theory of Political Economy, published in 1871.
The second of these early Marginalists was Carl Menger von Wolfensgrün. Born in the Austrian-controlled part of Poland in 1840, his father was a lawyer from a minor noble family and his mother was the daughter of a prominent Czech merchant. In university he studied law. But, in an empire that had too many lawyers in it and not enough jobs for them all, he ended up starting his career as a journalist – specifically, as a financial journalist, covering market news.
It was in this work that Menger first started to realize that the activity he was observing in the markets didn’t really fit the patterns one would predict using classical economics as a guide. Eventually, he did get a civil service job. And it was while in this post that he published his Fundamental Principles of Political Economy in 1871. He would later take on a professorship at the University of Vienna, founding what came to be known as the “Austrian School” of Economics.
And finally, there was the ever-fascinating Marie-Esprit-Léon Walras. Born in Normandy in 1834, Walras was the son of an economist and school administrator who encouraged his son’s scholarly pursuits. However, it took a while for Walras to find his academic groove. He failed to pass the entrance exams to study at the École Polytechnique – not once, but twice. He then enrolled in the École des Mines to study engineering, but got bored with it and dropped out after a year. From there he tried writing romantic literature, but that soon spluttered out too.
Eventually, with his father’s encouragement, he began studying economics. But without a degree, there weren’t many jobs in that field, so he took various jobs to pay the bills – as a journalist, as a railway clerk, and even as a director of a co-operative bank. And even though he failed at all these things, he had built up enough of a résumé to get a job teaching political economy at the Academy of Lausanne in Switzerland. It was from this post he published his Elements of Pure Political Economy, with the first volume coming in 1874, followed by the second volume three years later.
These three thinkers didn’t share all the same views, nor was their approach to economic thought very consistent. But there were a few broad commonalities.
Most important among them was a Utility Theory of Value. Explaining “The nature of Wealth and Value” as “the consideration of indefinitely small amounts of pleasure and pain”, Jevons wrote, “In this work I have attempted to treat economy as a Calculus of Pleasure and Pain, and I have sketched out, almost irrespective of previous opinions, the form which the science, as it seems to me, must ultimately take.”
This thinking flew directly in the face of several previous economists, including Smith, Ricardo, and Marx, who shared a Labor Theory of Value. They believed that all value was derived from labor. The Marginalists, though, believed that value was derived from the utility of the consumer.
The three founders of the Neoclassical School all had problems with the Labor Theory of Value and, by extension, the implied “exploitation of labor” being necessary for capital accumulation. Remember, that’s to say that the only way employers can earn profits is by paying workers less than the value of the goods they are creating. The neoclassical economists instead explained that the workers were being paid the full value of their labor in that moment. Their wages were merely an investment made by the capitalist, and the profits said capitalist earns later represent the interest – the returns – on his investment.
In this regard, Menger actually went further than the rest of them, developing a supply-side Utility Theory of Value. Simply put, when an entrepreneur produces a good, there is an opportunity cost involved. Afterall, he could use that time and energy to produce some other kind of good. Thus, value must depend, at least in part, on the producer’s utility too.
Walras did not quite see it that way. He viewed value as being determined in a process of competitive bargaining, much like an auction, where an auctioneer shouts prices, looking for which buyers and sellers show interest. Eventually, he’ll hit a price point at which a transaction between the buyer and seller becomes possible. But in this system, only the buyers are maximizing their utility – the sellers are merely coordinating the production of the goods that will create value for the consumer.
But they all seemed to realize that, if value is derived from utility, then value cannot really be an objective measurement. Labor value was objective enough – you can measure it in terms of wages plus profits. But the value of utility depends on the needs and desires of each individual consumer. For example, there are people in this world who love cars like Lamborghinis. Then there are people like me, who really couldn’t care less about muscle cars. Obviously, the Lambo-lovers are going to place a higher value on these automobiles than I would.
The price, then, will ultimately be set at an equilibrium level, where the producers can earn the optimal profit within a large market of car buyers. Walras described this as a competitive equilibrium where all of the following apply: (1) The demand equals supply in the market; (2) Each agent is able to buy and sell exactly what he or she planned to; and (3) Buyers and sellers are able to exchange precisely those quantities of the goods to maximize their utility and profits, respectively.
Another thing these three thinkers held in common was an orientation toward individualism. If economic value was to be measured by the subjective pleasures and pains of individuals, then individuals (or, at most, small aggregates like families or firms) had to be the economic agents to focus on. Individuals made decisions to optimize their utility – not governments or institutions. So, the Marginalists were not interested in political or collective decision-making. And they were especially dismissive of topics like social classes. To them, conversations about the bourgeoisie and Proletariat belonged – if anywhere – in sociology, not in economics.
As Jevons put it, “The supposed conflict between labour and capital is an illusion” and that “We ought not to look at such subjects from a class point of view, and in economics at any rate should regard all men as brothers.” Walras similarly viewed all individuals as either (A) consumer-savers who try to determine the ratio of present consumption to future consumption, which will create the most utility for them overall, or (B) as entrepreneurs selling to the consumer-savers. Menger even believed concepts like national interest and collective wealth were impossible to analyze from any sort of scientific approach – only individuals could serve as free agents and, thus, only individuals were worth studying.
Class and collective goals were irrelevant in a competitive market. So too were ethics.
Now, if you remember back to Chapter 9, you may remember how the Scholastic School of Economics (from the Middle Ages) believed in concepts like just prices and just wages, or how they stood opposed to things like usury. While such specific dogmas like these had fallen out of favor across Western society during the Industrial Age, a general moral framework of economic thought had largely remained. Right and wrong still played a role in political economy. Well, the Neoclassical School sought to destroy that framework once and for all.
They viewed the economy as amoral and – by extension – believed the study of economics should be amoral. Menger called “The so-called ‘ethical orientation’ of political economy…a confusion in thought.” To Walras, the idea that a good had a natural price or a just price was absurd – there was only one price, and it was the market price.
But that’s not to say they were nihilists – far from it. They wanted to see good in the world – they just believed it would be most achievable within a competitive free market. Society is made up of individuals, and they believed that only individuals could determine what would best optimize their utility. By extension, when all (or at least most) individuals can buy stuff according to their individual needs and desires, it means utility is being optimized for society as a whole.
In fact, this rationale worked well for all three founders of Marginalism despite their very different worldviews. Menger was certainly the most nihilistic of the three, but he took risks advocating for a liberal economic outlook in a pretty illiberal Austro-Hungarian Empire. Walras was actually considered a socialist in his day, not only as a supporter of the co-op movement, but also as a Georgist. We’ll talk more about Georgism next time, and Patreon supporters will get to learn more about Walras’s brand of free market socialism in the footnotes at the end of this episode. And Jevons put a great deal of time and thought into essays about labor reform and conservation.
And the topic of conservation was one that concerned them all, to some extent, too. As Walras put it, “There are no products which can be multiplied without limit. All things which form part of social wealth: land, personal faculties, capital goods properly speaking, income of any kind, exist only in limited quantities.” Even in these years of growing productivity, the founders of Marginalism were concerned about scarcity and how scarce resources would be distributed.
And they were also concerned about anti-competitive practices. They did not agree with the prevailing capitalist sentiment of the time that feared “ruinous competition.” They opposed corporatist movements like gentlemanly pools and large corporate mergers – both of which would consolidate markets and raise prices. The Marginalists went to great lengths to discredit monopolies. And they applied this philosophy to the forces of labor as much as they did to the forces of capital. Walras supported the co-ops and Jevons even supported a certain role for trade unions (along the lines of the friendly societies of old), but they were adamantly against anti-competitive labor market practices like strikes and collective bargaining.
Still, their writings all had relatively little traction at first. Hardly anyone read these three books when they were published. But going into the 1880s and beyond, there was suddenly an explosion of economists who not only took note of these first three Marginalists, but expanded and crystalized their ideas further.
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The great wave of Marginalists between 1880 and 1920 came from all over the Global North – Austria, Britain, Italy, Sweden, and the United States. This wave included such names as Enrico Barone, Gustav Cassel, Francis Ysidro Edgeworth, Irving Fisher, Maffeo Pantaleoni, Arthur Cecil Pigou, Knut Wicksell, Philip Henry Wicksteed, and Friedrich von Wieser. But by far the most important were Alfred Marshall, Eugen von Böhm-Bawerk, John Bates Clark, and Vilfredo Pareto.
The most important of them, by far, was Marshall. Born in London in 1842, he was the son of a low-level clerk in the Bank of England. But he attended good schools and graduated from the University of Cambridge. Despite his aptitude for mathematics, Marshall became increasingly interested in philosophy – especially Utilitarianism – as well as Darwinism. Eventually, these three interests would be blended together in his approach to economics, much like with Jevons before him.
In 1890, Marshall published his Principles of Economics. It was so influential, it not only replaced Mill’s Principles of Political Economy as the de facto economic treatise found in schools across the West, its methodology is still commonly found in econ textbooks today.
One of his most important theories was that of diminishing marginal utility. As he explained it, “During the course of consumption, as more and more units of a commodity are used, every successive unit gives utility with a diminishing rate, provided other things remaining the same; although, the total utility increases.”
For example, if you are buying doughnuts for yourself to eat, the first doughnut is probably going to taste great. The second doughnut will also taste good, but it probably won’t give you the same rush of dopamine in your brain as the first. So, even though two doughnuts are better than one, the first is going to be better than the second. And by the time you’ve eaten four or five doughnuts, you’re going to start feeling sick and your overall utility may start to decline.
Marginal utility, therefore, can be charted as a downward-moving slope – or, as we call it, a “demand curve.” To convince consumers to buy more units of a given product, the seller needs to promise a lower price for the additional units. And because the diminishing marginal utility of a product or service varies from product to product or service to service, the shape of that curve is not always going to be consistent. Marshall called this the “price elasticity” of demand.
This all stands in contrast to the “supply curve”, in which a producer not only wants to fetch the highest price possible for her good, but also has rising costs of production to worry about.
Thus, put them together, and the supply curve and demand curve will crisscross. Marshall even described it as being like the “blades of the scissors.” And it is where the two curves intersect that you find the equilibrium price.
Now, this idea of supply and demand is so central to economics today that it could be easy to lose sight of how eye-opening Alfred’s work was. And although he was not the first to come up with this theory – it had origins going back more than a century – he is the one who popularized it. From here on out, the theory of supply and demand will become the foundational law of microeconomics.
The way Marshall imagined it, each buyer goes into a transaction with a “demand price” in mind, while the seller goes into it with a “supply price” in mind. To achieve price equilibrium then, they don’t rely on an auctioneer, like Walras imagined, or haggling, like others figured. Instead, the producer will simply adjust production levels to bring the price to the same level the consumer is willing to pay.
But in order for the consumer to optimize their utility in such a transaction, the market needs to be competitive. There needs to be a large number of agents (both buyers and sellers), and both the buyers and the sellers need to be competing with other buyers and sellers. To this end, he created examples of the supply-and-demand effect in both a competitive market and under a monopoly.
What Marshall did not put forward was a theory of value. Under his framework, value was not derived from labor, nor was it derived from the consumer’s utility, nor anything else. Value was irrelevant. Price was all that really mattered.
Surprisingly, though, Marshall did not see this theory of supply and demand as being the most important idea in economics. He insisted that the real issue was the allocation of scarce resources – or the “science of activities” as he called it. This is something he shared in common with the original Marginalists. But he wasn’t a big fan of the earlier wave.
In fact, he differed from most other marginalists when it came to the role of economics as an amoral discipline. As he put it, “There is wanted wider and more scientific knowledge of facts: an organon stronger and more complete, more able to analyse and help in the solution of the economic problems of the age. To develop and apply the organon rightly is our most urgent need; and this requires all the faculties of a trained scientific mind.” Marshall believed economists could go so far as to promote the redistribution of wealth from rich to poor as a social dividend, provided they could make a solid argument for it. And, indeed, his successor at Cambridge would go on to make such a case for a social welfare state.
Few economists would be more hostile to such thinking as our next guy.
Eugen Ritter von Böhm-Bawerk, was born in Brünn, Moravia (what is, today, the Czech city of Brno), in the Austrian Empire in 1851. His father, a senior government official in Moravia, died when Eugen was a young boy, and the family subsequently moved to Vienna.
And it was during his studies at the University of Vienna that Böhm-Bawerk came across the writings of a professor there – you guessed it: Carl Menger. Böhm-Bawerk became a fierce disciple of Menger and sought to expand Menger’s approach to economics into new areas, including macroeconomics.
Upon graduating, Böhm-Bawerk got a job at the Austrian Ministry of Finance and convinced them to let him go to various German universities to continue his studies. Over the next decade and a half, he worked on the two volumes of his most famous work, Kapital und Kapitalzins (or, as it’s called in, English, Capital and Interest).
The first volume, A Critical History of Economical Theory, mostly serves as an overview of economic thought up to that point. Böhm-Bawerk earned fame for this work, as it gave him the opportunity to do what he enjoyed most in his life: trashing Marxism. In fact, he became enemy #1 for contemporary Marxists, saw him as the “Karl Marx for the Bourgeoisie.” Not only did Böhm-Bawerk highlight the “great contradiction” Marx made between his price calculation ideas and his labor theory of value, he also reaffirmed Menger’s position of wages being a capitalist’s investment.
But where he took the theory further was by applying a time dimension to it. And, ultimately, this would come to be his most important theoretical contribution to economics. In his second volume, Positive Theory of Capital, Böhm-Bawerk explained that every productive activity uses capital as a series of time sequences. At each stage, the entrepreneur takes into account the costs of doing business – wages, land rents, and other input prices, as well as technological transformations. Interest, the return on an investment, can thus always be explained as a payment for a good in the current time sequence for a good produced in a previous time sequence.
Böhm-Bawerk made an impact on economics outside of his writings too. In the Finance Ministry, he pushed through tax reforms to directly tax income, rather than production. He subsequently served as Finance Minister on three separate occasions, where he pushed through adoption of the gold standard and fought for strict fiscal austerity. He also served for a time as ambassador to Germany and as a professor at the University of Vienna.
Few neoclassical economists were further to the right than Böhm-Bawerk. But one who arguably was further right was also seen as the world’s leading economist at the time – and is today viewed as being the leading figure of the Neoclassical School.
John Bates Clark was born in Providence, Rhode Island, in 1847. The son of a local merchant, Clark studied at Brown University and Amherst College before embarking on academic stints in Germany and Switzerland. Upon returning to the U.S., he got jobs teaching at Carleton, Smith, and Amherst colleges, and eventually Johns Hopkins and finally Columbia universities.
Interestingly, Clark started out as a socialist, arguing for state intervention in the economy and trying to formulate a theory of just wages. But by 1886, he had embraced the ideas of marginal utility with the zeal of a religious convert. In his 1899 treatise, The Distribution of Wealth, Clark argued that only way to achieve any sort of social cooperation or justice was through a free market of egoistic individuals in fierce competition with each other. Only through advancing each individual’s marginal utility could you accomplish greater utility for the society. And to this end, the only correct form of state intervention (beyond protecting property rights) was in passing anti-trust laws, so that the market would remain competitive.
In a lot of ways, Clark was writing along a lot of the same lines as the Marginalists who came before him. But he did make a few major contributions of his own – namely, by critiquing the idea of an exploitation of labor.
For starters, he addressed the idea from another angle. Whereas other Marginalists focused on the Labor Theory of Value being wrong, Clark realized that Ricardo’s Iron Law of Wages had been wrong. Remember, that was the idea that, in the long run, wages will never really rise above subsistence level for the vast majority of workers. It was borrowed largely from Malthus and was borrowed by Marx in turn. Employers knew how much money it took to keep their employees alive, and that was all they were willing to pay in wages. But by applying the theory of supply and demand to the labor market, and looking at how far employee wages had come in the 19th Century, Clark realized this theory either no longer applied, or was maybe never correct to begin with.
Second, he developed a Theory of Marginal Productivity. Essentially, in a competitive labor market, neither the employer nor employee would have enough power to dictate wage levels. The employer would worry that the employee could also go find a better job if he was paid too little, and the employee would worry that the employer would replace him if he demanded too much. Additionally, the wage must satisfy two fundamental principles – that of equity and of efficiency. Under these principles, each agent – the laborer and the capitalist – will receive an income related to their proportion of the output, their “marginal productivity”: One for supplying the labor, the other for supplying the capital.
In this, Clark viewed the distribution of income as governed by a certain “natural law” and, thus, any talk of “exploitation” (at least in this context) made no sense.
Clark also viewed capital differently. Unlike the Classical Economists and Marxists, he didn’t see much point in distinguishing between fixed capital and variable capital – at least not in trying to put together a theoretical economic framework. Fixed capital like machines, buildings, and equipment were usually considered separately because of their productive potential and because they were not as malleable and transferable as variable capital was. But to Clark, that was the problem. Fixed capital was usually too industry-specific and, as we’ve been starting to see over the course of the podcast, too time specific. (A certain machine might become irrelevant over time and lose its value.) Thus, all capital needed to be treated as essentially a question of dollars and cents. (Or fill in your currency of choice here.)
But to me, probably the most impressive economist of this time was our last guy today.
Vilfredo Federico Damaso Pareto was born in Paris in 1848, as his parents had fled Genoa earlier that year due to all the revolutions happening. (Shout out Chapter 47!) His parents, Genoese nobles, eventually moved the family back to Italy.
Like his father, a civil engineer, Pareto went to university to study engineering. After years working in engineering projects, he eventually served as the director of a railway and the manager of an ironworks. But by his mid-40s, he had become really interested in classical political economy, and he started writing on the subject – mostly attacking proposals for state invention in the economy. Over time, though, he became more and more excited by the opportunities to apply his knowledge of mathematics and the sciences to the study of economics as well. Eventually, he was chosen to succeed his mentor – Léon Walras – at Lausanne.
Nowadays, Pareto is probably best remembered for the Pareto Principle – also known as the 80/20 rule. Demonstrating that 80% of the land in Italy was owned by just 20% of the people, he subsequently realized this uneven distribution could be seen in other things too. For example, it turned out that 80% of industrial production was coming out of just 20% of companies. And, legend has it, he noticed that just 20% of the pea plants in his garden were producing 80% of the healthy pea pods. Now, Pareto never made too much of the 80/20 observation – he just thought it was an interesting trend – but years later, a management consultant read about it and started calling it the Pareto Principle. An extensive list of examples has been compiled by interested parties ever since.
That being said, Pareto was able to use this principle to build many of his economic models, including the Pareto Chart, distribution and density functions, Pareto interpolation, the Pareto Index, and the Pareto Priority Index. Now, mind you, he wasn’t the one attaching his name to all these breakthroughs, so don’t think of him as too vainglorious. But it was certainly important work which is still regularly used by economists, mathematicians, business managers, engineers, risk assessors, and others.
The other big breakthrough he had was the so-called Pareto Optimum.
To explain, we first need to discuss Pareto’s take on utility. Essentially, he believed that the other Marginalists (especially the British and Americans) had thought of it all wrong. The way he saw it, utility referred to something of benefit to society – not merely the satisfied whims of the individual. For that, he came up with a new word: “ophelimity” – from the Greek ophelos – which he explained as “the attribute of a thing capable of satisfying a need or a desire, legitimate or not.”
This was an important distinction. Having taken the place of Walras at Lausanne, Pareto was now on the forefront of welfare economics – how best to distribute economic gains among the population as a whole – and perhaps certain forms of it should take priority over others. For example, getting a shot with a vaccine in it doesn’t feel very good. In this way, it decreases, rather than increases, ophelimity. But it comes with a very obvious benefit to both the patient and the society as a whole. Therefore, it increases utility.
Thus, utility and ophelimity are not interchangeable and not a great way of trying to measure outcomes. Instead, Pareto turned to the idea of how to efficiently allocate scarce resources. He determined that a socio-economic system was most efficient – or optimal – when it was impossible to improve the welfare of one individual without worsening that of another.
Now, certainly there are situations when you can improve everyone’s welfare, or where you can improve the welfare of most people while only taking a little from a few. A Pareto-improvement is one in which some people can be made better off without anyone becoming worse off. And, generally speaking, we usually find ourselves in a Pareto-dominated situation – that is, situations where Pareto-improvements are possible. (And yes, I know, why oh why does the name of every one of Pareto’s ideas must begin with “Pareto”?)
Anyway, what we are striving for, then, is the Pareto Optimum, where everything is allocated as efficiently as is possible. And, as Pareto tried to demonstrate, such an equilibrium could only be achieved with a competitive market. In fact, he was able to show that market competition produced better results for social welfare than monopolies could.
Not only was the Pareto Optimum an important concept for the development of welfare economics – during a time when more and more countries were developing social welfare states – but it would have a great impact on the development of game theory later on as well.
And before we conclude this chapter, I think it’s worth our time to have a broader discussion on the legacy of the Marginal Revolution.
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The transformation of political economy to economics is a feature of the Marginal Revolution that’s impossible to ignore. Even the early Marginalists like Jevons were still writing treatises that looked only (ahem) marginally more scientific than those of Smith, Say, Malthus, Ricardo, or Mill. But by the time you get to Pareto, you’re not reading treatises like that anymore – you’re pouring through tables of data, complex mathematical equations, and endless graphs.
The Marginalists really did set the stage for everything that was to come in liberal economics ever since – from John Maynard Keynes to Milton Friedman and beyond. Both the New Deal Liberals of the left and Neoliberals of the right largely borrow from this tradition.
Which isn’t to say it should go without criticism.
First of all, it put far too much emphasis on the role of individuals in economic decision making. While this would be addressed somewhat with the rise of institutional economics and high economic theory later on, it has always been an unfortunately influential flaw.
Second, utility is a bit of a goofy concept, if we’re being honest. Now, Pareto did try to address this with the concept of ophelimity, but he may have only complicated and already dubious line of thought. Despite great efforts to do so, no one has ever really been able to measure utility in any reasonable way.
And even if you could measure utility reasonably, you are still dependent on the individual to increase his utility himself. Ultimately, Marginalism rested too much on the assumption that individuals were generally rational agents, capable of making the right decisions to increase their utility. And based on what we know today, that is a really, really bad assumption. Most people do not consistently make rational decisions. Many of our economic models then are not accurately describing the decisions made by homo sapiens, but by what economists now jokingly refer to as homo economicus – a perfectly rational species of human beings.
Plus, their focus on distribution of scare resources and wealth was strange, given the now-obvious trend of continuous, long-term economic growth. Make no mistake, their insights about scarcity – culminating with the Pareto Optimum – are very useful to us. But in a world where new wealth was constantly being created, the bleak, Marginalist concern over scarcity may have limited their insights.
But despite these flaws, the Marginal Revolution was super-important for the Neoclassical School of economics. If nothing else, it threw a wrench in the trend of corporatism during the late 19th Century. And it provided a reasonable counter to socialism. Which was not an easy sell – after all, socialism promised a romantic, egalitarian vision of the future. But the Marginalists made an effective argument for how competitive market economics might actually prove better for the working classes in the end.
Of course, it didn’t help the socialists that their ideas were all over the place during these same years. Different socialist schools had formed, advocating wildly different approaches for social transformation. And we’re going to talk all about them next time on the Industrial Revolutions.
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