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History of the Economy

9th Cambridge School Part II

Outline:

1st Problem definition

2nd The most important representatives

3rd Household demand for consumer goods

4th The concept of consumer surplus

5th The supply of goods by a company

6th The aggregation of supply and demand

7th The equilibrium theory of the market

8th The concept of elasticity

9th Short and long-term offer

10th The marginal productivity theory

11th The theory of work suffering

12th The exhaustion theorem

6th The aggregation of supply and demand

After we have shown how within the Marshall system the individual demand curves of households for consumer goods can be derived from the utility functions and the individual supply curves of enterprises from the cost functions, the next step is to aggregate the demand functions of the individual households into an overall demand function of all households and, in a similar way, to combine the supply functions of the individual enterprises into a single supply curve.

Let us start with the aggregation of the individual demand functions. In order to show the way of aggregation, we limit ourselves to two households and show how these two individual demand functions can be transformed into an overall demand function of a single market. In a third diagram, we enter for each possible price the demand expressed by household 1 and household 2 at that price. We first add up the individual demand quantities and then subtract the sum of all demanded goods on the abscissa axis at the assumed price level. When we have determined the demand totals for each possible price and transferred them to the third diagram, we have thus obtained an overall demand function for the entire individual market. The total demand function has a kink here, since household 2 from a certain price on no longer exerts any demand at all for this good.

In a similar way, we can construct a total supply curve from the multitude of individual supply curves if we determine the individual offers for each possible price, add them up and transfer the resulting sum to a new diagram whose abscissa comprises the total supply of this market.

Enrico Barone has now developed a slightly different method of aggregating the individual cost and supply functions of the individual enterprises. In a first step, he determines the unit costs at which the individual companies can produce a certain good. It is assumed that the individual enterprises differ in the height of these unit costs. It arranges now the individual enterprises after the height of these unit costs and draw in a diagram, on whose abscissa the production quantity X and on whose ordinate the commodity price as well as the unit cost height are taken off, the unit costs of the individual enterprises starting from the enterprise with the smallest unit costs sequentially. The unit costs of the individual companies are shown on the ordinate and the respective production capacity on the abscissa.

In this way, a step-like graphic is created, and we can transform this stair-like structure into a steady, ascending curve, if we assume that the capacity of the individual enterprises is infinitesimal in comparison to the total production of this good. The area under this new curve indicates how high the total costs of the market are for alternative production quantities.

7th The equilibrium theory of the market

We now come to the heart of the neoclassical market theory. At the core of this theory is the thesis that in free markets imbalances between supply and demand are reduced by themselves without state intervention. Free markets are automatically cleared.

This theory of equilibrium contains two parts, a first part, in which the question of the existence of an equilibrium is asked and a second part, which investigates whether there is also a tendency towards this equilibrium.

The first part of this theory is static in nature, it cannot say anything about whether in reality the actual price corresponds to this equilibrium price, this part of the neoclassical market theory is limited to the question whether there is a price where supply and demand match. At the same time the question should also be answered, at which quantity of goods and at which price the market could be cleared and finally which conditions must be fulfilled, so that a price can be determined, at which supply and demand correspond.

To answer these questions, we turn to the diagram developed in the previous section, on the abscissa of which the quantity of goods is plotted and on the ordinate of which the respective price of goods is plotted. In the last section, we have shown how we get from the microeconomic response curves to an aggregated demand and supply curve of an individual market. For the sake of simplicity we now draw the supply and demand curve linearly. In itself, we can assume that both functions are curved, because the supply curve is derived from the marginal cost curve, the demand curve from the marginal utility curve and both basic functions are non-linear. The considerations, which we make at this point, do not depend on the question, if the curves are linear or nonlinear, so that we do not make any serious mistakes, if we draw both market curves linear - as it is common practice - for the sake of simplicity.

Under normal conditions we can assume that the supply curve has a positive slope, but the demand curve has a negative slope. This is the consequence of the assumption that when prices rise, suppliers normally expand their supply, as they hope to increase their profits. Furthermore, we can expect that demand normally falls when prices rise, as it becomes more appropriate for households to switch to other consumer goods.

Under these assumptions we can assume that there is usually an intersection point between supply and demand curve and this means that supply and demand ex definitione correspond exactly in this intersection point, i.e. that there is an equilibrium at which the market is cleared.

Of course, cases are conceivable in which there is no intersection point between the two curves and thus no equilibrium price exists, this is always the case if both sides of the market do not react to price changes at all, in this case both market curves run parallel to the ordinate axis and thus also parallel to themselves. In fact, there is no intersection of the supply and demand curve and therefore no equilibrium price, if we disregard the case that supply and demand curve show an identical course.

There are no limits to the imagination when looking for further conditions under which there is no intersection of both response curves. For example, it would be conceivable that both reaction curves run normally, but have only a slight slope, with the consequence that the intersection of supply and demand curve is at a negative price or at a negative quantity of goods or finally at a level of a price or a quantity of goods, which cannot be reached in reality. But we can assume that in most cases there is an intersection between supply and demand curve, which lies in a realisable space.

Let us therefore turn to the second part of neoclassical market theory, the question of whether the free market is itself capable of approaching the equilibrium point from any starting point (imbalance). This is an approach that goes beyond the limits of a static theory and turns to a dynamic approach. However, we have to realize that in its early days (i.e. with Alfred Marshall) the Cambridge School was not yet able to develop a dynamic theory in the strict sense of the word. According to the concepts presented by Erik R. Lindahl and Erik F. Lundberg, we speak of a dynamic theory only when the economic variables of the present period are seen in relation to economic variables of the previous period (or another period). Such a refinement of the analysis did not take place in the early beginnings of the Neoclassical period.

Under what conditions can we expect the market to approach the equilibrium price? This adjustment process takes place in several steps. Let's assume that a market is in equilibrium, but that data changes occur which directly lead to an imbalance in the market under consideration. Changes in data can be a change in the demand structure, in the supply of available resources, in the applied production technology or in the economic policy order. Let us assume, for example, that an autonomous change in demand suddenly leads to a lower demand for the consumer goods examined here than before. The reduction in demand initially leads to a supply surplus with the same supply price.

This imbalance that has thus arisen generally triggers a price change, whereby a normal reaction is to be spoken of when a supply surplus triggers a price reduction, whereas a demand overhang triggers a price increase.

There are good reasons why, in a free market, prices react to an imbalance in this sense, i.e. that price flexibility exists. If there is a surplus of supply, the suppliers have to fear that they will be left sitting on the goods and thus incur high losses. In such a situation the individual entrepreneur is still better off if he is satisfied with a lower price. Conversely, if there is a surplus of demand, the demanders run the risk of going away empty-handed and are therefore willing to accept higher prices, because in this way the loss of benefit is still less than if no purchase of this product is made.

Nevertheless, in reality we have to expect that prices will either not react to imbalances at all or at least react with a considerable delay. However, this deficiency usually does not lie in the nature of the market participants, but rather arises from the fact that contracts are concluded, mostly for socio-political reasons, which only allow a price change after a longer period of time. What is decisive here, however, is that this price inflexibility is not in the nature of the markets, but was caused precisely by the state overriding parts of the free market. It is usually not the free market that causes price inflexibility.

In a next step, market theory assumes that the market partners react to these price changes, normally in such a way that price increases cause an increase in supply for suppliers and a decrease in demand for consumers. The same applies mutatis mutandis to a price reduction (decrease of supply, increase of demand).

These reactions already result from the slope of the response curves. A supplier, for example, has an interest in expanding its supply when prices rise because in this case he makes additional profits, even if the expansion of production leads to an increase in marginal costs. A consumer - to give a second example - has an interest in expanding demand when prices fall, because now more units of goods are purchased with the same purchase sum and thus, on balance, an increase in utility can be achieved in any case when demand expands, because now, if income portions from other goods are deducted, the same loss of benefit as before corresponds to a greater gain in benefit from the additional purchase of the discounted goods.

So, although market partners generally have an interest in reacting normally to price variations, in reality we must again expect that this price flexibility of demand or supply will not occur. For example, contracts often provide for longer termination periods, which prevent the quantity offered or demanded from being adjusted immediately after the price change in the event of price changes. But here, too, the real reason for low price elasticities is not the characteristics of the free market, but the fact that the legislator in turn abolishes parts of the free market, mostly for socio-political reasons.

It now depends on the elasticity of supply and demand how quickly imbalances are reduced. In general, neoclassical theory now assumes that the adjustment takes place in very small steps, so that there is no danger that the equilibrium process will overshoot its goal and that a supply overhang will turn into a demand overhang vice versa. Only later in the course of the dynamic theory it was shown that under certain conditions there is a real danger that the actual price will oscillate in waves around the equilibrium price, and even cases are conceivable in which the current price moves away from the equilibrium price. In the second part of this lecture we will come back to these relationships in the presentation of the dynamic theory.

However, the existence of an equilibrium price is a necessary but by no means sufficient condition for the free market to move towards this point of equilibrium. Let's take the case that the supply reacts anomalously, e.g. reacts to price reductions with an extension of the supply. Such behavior has been empirically proven for small ship entrepreneurs, for example. These entrepreneurs earn an income that just corresponds to the minimum subsistence level. If now the price would sink and these entrepreneurs would react normally, thus reduce their offer, then they would not reach any longer on an income at height of the subsistence level. These entrepreneurs will therefore even extend their offer, in order to compensate the loss with the individual order by the fact that they implement more orders than before.

If supply reacts anomalously and if demand reacts normally, but with smaller steps than supply, the price reductions will necessarily lead to an even greater imbalance. Let's take the case that a price reduction of 10% leads to an increase in supply of 20 units and at the same time to an increase in demand of 10 units. In this case the excess supply still increases by 10 units. The normal price reactions to data changes lead away from equilibrium, the market is not able to clear the market on its own.

Our considerations show that an equilibrium tendency can only be expected if, firstly, prices react normally to the imbalances, secondly, the equilibrium process does not overshoot its target because the reactions are too strong, and, thirdly, supply and demand react normally to price variations. In individual cases, an equilibrium tendency can still be expected if one side of the market behaves abnormally, but the changes in the market are overcompensated by a normal and relatively strong reaction from the other side.

Even if all these three conditions are fulfilled, this does not necessarily mean that in reality the equilibrium price is always reached. We have to assume that this process takes time, time passes until prices react due to an imbalance and again time passes until suppliers and demanders adjust their supply or demand due to these price changes. Thus it is always to be expected on the fact that at the end of a period the adjustment process did not reach the equilibrium condition yet. A reduction of the imbalance took place, but at the end of the period a reduced, but still existing imbalance remained.

We now have to assume that in almost every period data changes are to be expected, which then also cause a new imbalance in every period and this means, if the previous imbalance has not yet been completely removed, that the imbalance will always increase. It is therefore quite conceivable that the market reacts normally and is able to reduce imbalances, but that nevertheless a complete equilibrium is not achieved in any period, and even that the imbalance increases from period to period.

In order to prevent this from happening, certain conditions are obviously required when data changes occur. One could first of all try to reduce the extent of data changes by political means in order to reduce the extent of the arising imbalances. However, this would be highly detrimental to the welfare of a population. It is the data changes that create the conditions for welfare increases. This is true for technical progress, for the expansion of resources, for economic policy measures that reduce injustices and inefficiencies, and even for the change in demand that enables individuals to find a demand for individual goods in an trial and error process that enables them to optimize their own well-being.

If it does not make sense to reduce the amount of data changes, one could ask oneself the question whether it is perhaps also due to the way data changes occur, how large the imbalances caused by this are. In this context, the most important question is how atomized an economy is. In the one extreme case, all important decisions are made by a single government agency. They cause almost all economic units to fulfill certain regulations of the state at the same time, whereby these actions always point in the same direction, i.e. all of them cause e.g. a one-sided increase in supply.

In another extreme case, the relevant economic decisions are made by a large number of individual companies and households, whereby it can be assumed that the reactions of these individuals to certain data changes occur at different times and do not always point in the same direction. Let us take the case of a general decline in stock market prices as an example. To this event, stock market participants react quite differently. Especially individuals, who do not have an overview of the real situation, will respond to these price drops by selling their securities and thus fuel the price drop even more. Professionals react differently to a reduction in prices, depending on whether these price drops were triggered by real changes or not. If the real conditions have not changed, the professional can assume that sooner or later the prices will rise again. For him it is even worthwhile to buy securities in order to be able to sell them again later at a higher price.

If, therefore, with the greatest possible atomization of economic decisions, the reactions are spread out over time and, in addition, a large proportion of the reactions cancel each other out (one buys, the other sells securities), the market is much better able to reduce imbalances and thus reduce the danger of a large, lasting imbalance. The market then behaves like a sewerage system that normally channels rainwater into the sewerage system, but which is overburdened during a downpour when a great deal of rainwater falls from the sky in a very short time and on a limited territory, and as a result is unable to prevent the rainwater from remaining in the streets for a certain time.

To be continued!