THE APPROACH TO THE ANALYSIS OF PRICE
For Marshall - as well as for other contributors to the formulation of neo-classical thought - analysis of the functioning of a market system began with the behaviour of consumers and producers.
Throughout the discussion it was assumed that men acted rationally in pursuit of their own advantage. Consumers were held to seek maximum satisfactions; similarly, suppliers of productive services were expected to seek maximum rewards. It was not maintained, however, that economic motives were the only spurs to human action, nor that all men acted as homo economicus in the conduct of the day-to-day business of life. Most neo-classical writers - and Marshall with particular emphasis - insisted that their study was restricted to the economic aspects of human action, rather than the whole complex of man's aspirations. By the same token they did not wish to be interpreted as saying that all who participated in market transactions were rational calculators. Instead, they sought merely to establish that rationality as a behavioural postulate provided a realistic basis for the study of groups of people.This mode of reasoning can be readily observed in Marshall's formulation of the concept of demand. As he interpreted it, 'demand' referred to the relationship between quantities demanded and prices. Normally it could be expected that buyers would be prepared to purchase more of a particular good at lower prices than at higher ones. For each good a whole range of price and quantity combinations was conceivable. These combinations could be depicted diagrammatically as a schedule (or curve) by representing price on a vertical axis and quantity on a horizontal axis.
This view, of course, contrasted sharply with the classical interpretation of 'demand'. Within a classical frame of reference this term was construed largely in a 'logistical' sense:
i.e.
to refer to the quantities of goods required for particular purposes. It was on this basis that classical economists could assert that population growth would increase the 'demand' for subsistence goods (or of the quantum of subsistence goods required by the economic system). The effects of consumer preferences on transactions received little attention; in the main the dominant classical assumption had been that the tastes of the bulk of the population (i.e. of the working class) were fairly rigid and the more pessimistic prognoses about the prospects for suppressing population growth rested on this presupposition. Nor had classical writers stressed the point that quantities demanded would vary in response to changes in market prices. Their sights were too closely centred on the forces influencing the 'natural price' of commodities to make this question central to their analytical programme.4In neo-classical economics, the determination of market prices became the problem and the concept of demand as a schedule of price-quantity relationships was crucial to its solution. In Marshall's formulation, the construction of such a schedule proceeded in two stages. The first concerned individual consumers and rested on a notion labelled as 'diminishing marginal utility'. A consumer entered the market-place, it was maintained, in order to acquire satisfactions (or utilities) from his purchases. The amount of satisfaction obtainable from a unit of a commodity was closely related, however, to the number of units acquired. With the addition of each unit, it could be expected that the increment in total satisfaction (i.e. the additional or marginal utility) would decline. The rational consumer would thus be prepared to pay less for the last unit than for the preceding ones and a reduction in price would be necessary to induce him to buy more.
The full derivation of a market demand curve for a specific commodity involved a further step. The demand schedules of individual consumers had to be consolidated.
The price-quantity relationships likely to prevail in the market as a whole could then be depicted. It was important to note, however, that such a construction presupposed that a number of conditions remained unchanged: in particular, the tastes of consumers, their money incomes (through which their desires could be translated into effective demand),5 and the prices of other goods. Variation in any of these conditions would shift the demand curve to a different position.But this was not the end of the story. In a practical situation consumers have more than one good to choose from. If they were to maximize the utility obtainable from a given income they should adjust their spending patterns to ensure that no gain in satisfaction would be possible from an alternative allocation of their expenditures. The optimum result would be obtained when the last penny spent on any of the goods in question added an identical amount of satisfaction. Otherwise, a different allocation of expenditure would increase the consumer's total satisfaction. As Marshall expressed this proposition:
... good management is shown by so adjusting the margins of suspense on each line of expenditure that the marginal utility of a shilling's worth of goods on each line shall be the same. And this result each one will attain by constantly watching to see whether there is anything on which he is spending so much that he would gain by taking a little away from that
line of expenditure and putting it on some other line.6
This type of argument had been latent in economic discussion since the days of Benthamite utilitarianism. The only novelty in its application to neo-classical problems lay in the explicit introduction of the concept of marginal utility. Just as the notion of diminishing returns had been hit upon simultaneously by a number of writers in the early nineteenth century, so also was the concept of marginal utility formulated independently (and at about the same time) by a number of neo-classical economists: Jevons in England, Menger in Austria, and Walras in Lausanne.
Marshall, though he could legitimately claim to be among the innovators, could not support his case with published evidence. Characteristically he had chosen not to release his findings until they could be presented in a form intelligible to a lay audience.This approach to the demand side of price formation had an important consequence: it swept under the carpet some of the organizing concepts of classicism. To most classical writers it had been axiomatic that economic value could be attributed only to tangible objects. By contrast neo-classical economists insisted that the point of an economic system was not the production of commodities, but the production of satisfactions. The measure of value was what the public would buy. Services, fully as much as material goods, could pass this test. Indeed, the whole debate about material-non-material distinctions could be dismissed. Marshall stressed this point when he wrote:
Man cannot create material things. In the mental and moral world indeed he may produce new ideas; but when he is said to produce material things, he really only produces utilities; or in other words, his efforts and sacrifices result in changing the form or arrangement of matter to adapt it better for the satisfaction of wants....
It is sometimes said that traders do not produce: that while the cabinet-maker produces furniture, the furniture-dealer merely sells what is already produced. But there is no scientific foundation for this distinction. They both produce utilities, and neither of them can do more....7
Similarly, classical notions of productive and unproductive labour were eliminated:
We may define labour as any exertion of mind or body undergone partly or wholly with a view to some good other than the pleasure derived directly from the work. And if we had to make a fresh start, it would be best to regard all labour as productive except that which failed to promote the aim towards which it was directed, and so produced no utility.8
Demand alone, however, provided only part of the explanation of price.
No less important were the terms on which producers were prepared to make goods and services available for purchase. The neo-classical account of this aspect of the pricing process was developed in a manner analogous to the derivation of a demand curve. Just as consumers acquired utilities (though at a diminishing rate) through market transactions, producers suffered dis-utilities (and at an increasing rate) when making their services available. Inshort, production involved costs and sacrifices which, in most cases, were expected to rise as the quantity offered increased. It was recognized in passing that some persons might obtain positive satisfaction from work; nevertheless, supplies of the productive services of labour, land and capital were not likely to be forthcoming for long unless those in a position to offer them were compensated for their trouble.
This argument about the terms on which the services of land, labour and capital would be made available for production was reinforced by another consideration. In general it was presupposed that alternative uses of the various factors of production were available. Any individual buyer of these services would, therefore, be obliged to compete to acquire them. Firm X, for example, could not expect to acquire more land, labour, or capital for its purposes unless it was prepared to outbid other claimants for the same resources. The point at issue was described more formally in terms of ‘opportunity costs' - i.e. costs in the form of income the supplier of services was obliged to forego when committing himself to one activity, thus precluding other options. It was not always recognized within the neo-classical tradition, however, that this argument depended on conditions of full employment; otherwise some suppliers of productive services might have no readily available options. In such a situation the 'opportunity costs' of employment would be zero.
These considerations provided the raw materials from which a market supply curve could be constructed.
Inasmuch as it could normally be assumed that firms could obtain greater quantities of the necessary productive inputs (labour, land, and capital) only at increased cost, it followed that they could be expected to expand their offerings of outputs only when higher prices made this course of action worthwhile. In short, it was postulated that firms normally operated under conditions in which the addition to total costs associated with producing additional units of output (i.e. marginal costs) were rising. This conclusion was further buttressed by the view that the addition to the total product obtainable from adding a unit of one productive input (while the quantum of others was unchanged) was likely to decline. The structure of marginal costs, in turn, determined the shape of the supply curve. But, just as the demand curve was expected to shift should the conditions underlying it alter, the supply curve would also shift if costs of production changed. And, just as the market demand for a particular product was derived by aggregating the demands of individual consumers, a market supply curve could similarly be arrived at by consolidating the supply curves of firms producing identical outputs.The treatment of costs developed in this analysis could not stand in sharper contrast with the notions employed by the classical and Marxian traditions. Exercises in reducing costs to labour inputs now vanished from the scene. Their place was taken by the general account of sacrifices incurred in the supply of any of the productive services. In the neoclassical scheme the former primacy of labour in the explanation of costs was completely eliminated.
With his twin concepts of supply and demand, Marshall had the tools he needed for his explanation of price. It was at the point of intersection between these two curves that the equilibrium price (i.e. the price towards which the market would naturally tend to gravitate)
was established. A price above the equilibrium would produce, a situation in which sellers would be prepared to offer more than buyers would take; the resulting disappointments of sellers would, under competitive conditions, lead to reductions in the offer price to a level at which the market could be cleared. Conversely, a sub-equilibrium price would produce frustrations for some potential buyers; the normal path of adjustment would be one in which competitive bidding would push the market price towards equilibrium. Marshall likened these two curves to the blades of a pair of scissors and observed that 'we might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production'.9
To modern readers acquainted with the microeconomics section of a standard textbook the Marshallian account of price formation may now appear to be too familiar - perhaps even too self-evident - to require extensive defence or justification. At the time of its formulation, however, it was a considerable innovation. Not only was it a major departure from the classical and Marxian labour-based account of value, but it was also constructed to counter over-zealous reactions against classical approaches on the part of some early neoclassicists. Jevons, for example, had asserted that utility and demand considerations alone were sufficient for an adequate explanation of price. Marshall rejected both the classical and cruder neo-classical positions. Demand (based on utility) and supply (based on costs of production) were both indispensable to the explanation of market prices.
One further analytical consequence of Marshallian procedure deserves mention. From this perspective the distinction upon which so much classical discussion had turned - that between value (the natural price) and the market price - evaporated. The search for an invariant measure of value over prolonged periods was abandoned. What mattered were prices as they were determined in a competitive market process.
3.