Perspectives

Alfred Marshall

Published: Apr 2013

Like many of the great economists, Alfred Marshall has sometimes been a victim of mistaken and superficial characterisations. The image which dominates today is of a dreary 19th Century mathematician. A man who lived completely in the thrall of mathematics and an advocate of a rigid strand of economics that sought to reduce all market interactions into abstract graphs and equations.

But this particular caricature is rather unfair on the founding father of neo-classical economics. Marshall did indeed give birth to what Maynard Keynes referred to as “diametric economics” – that is the representation of concepts as simple graphs. But his interest in the science stemmed principally from moral considerations, above all, his desire to help the poorest in society. In contrast to a number of his contemporaries on both the left and right, Marshall did not think of economics as a zero-sum game in which some people had to endure severe poverty for others to prosper. He believed that in a perfectly formed, competitive economy, living standards should rise for everyone. He promoted the theory that competition begets innovation, which in turn leads to greater productivity and drives up wages. Hardly a ground-breaking idea today. But in the era in which Marshall first expressed it, the theory was truly revolutionary.

Background

Marshall was born in London in 1842. He came from a middle class background, although he was not particularly wealthy or privileged. His parents believed strongly in the value of education and endeavoured to send him to reputable schools. His father was said to have been keen for him to excel in theology, classics and languages. Marshall, however, was drawn to mathematics. Resisting his parents ambitions for him to join the ministry, Marshall became a student of mathematics, along with philosophy and political economy at St. John’s College, Cambridge. His academic interests began with a focus on metaphysics – that is “the philosophical foundation of knowledge” – before moving to the study of ethics and a specific variant of utilitarianism. In 1868 he became a lecturer of political economy at St. John’s, and began his career-long work of developing the subject and helping to transform it into a new science – economics.

His interest in ethics continued to shape Marshall’s thinking. Indeed, if you read Keynes’ famous obituary of Marshall, it seems ethical concerns were one of the original motives behind his decision to become an economist. In the eulogy Keynes wrote for his former Cambridge tutor, he recounted how Marshall was moved by his walks through “the poorest quarters of several cities… looking at the faces of the poorest people”. So, economic theory appealed to Marshall principally because he saw it as a means to improve the conditions of the working classes and create a fairer, more equitable society.

In 1877, Marshall was forced to leave Cambridge following his marriage to Mary Paley, a student in his political economy class, which contravened the university’s regulations. However, he would return to Cambridge less than a decade later to take the chair as Professor of Political Economy in 1884, where he began working on his most influential work Principles of Economics. The book, published in 1890, had a profound influence on the study of economics in English speaking countries, helping to establish Marshall as the pre-eminent economic thinker of his day. Marshall retired from academia due to ill health in 1908, although he continued to write prolifically even after he had stepped down. His last two major works were Industry and Trade, published just following the end of the Great War in 1919 and Money, Credit and Commerce, a collection of older, unpublished essays and ideas published in 1923.

Contributions to economic theory

No feature on Alfred Marshall would be complete without a brief explanation of his most notable contribution to economic thinking – the supply and demand curve. Marshall’s attention as an economist was focused on the workings of individual markets and industries in isolation, and largely ignored the question of how entire economies function. Unlike his contemporary Leon Walras, who pioneered analysis of the interrelationships among all markets, in Marshall’s work the impact one market has on another market was not taken into account. With this approach, he laid the foundations of what economists today refer to as “partial equilibrium analysis”.

Marshall’s basic argument was that prices would always be forced towards their equilibrium by the nature of competition. If prices were below their equilibrium then shortages inevitably result, and as companies begin to sell out of the particular goods, this will put up the price and increase production. Conversely, if the price of the given product is above the equilibrium level then the companies selling the product will see their inventories swell. In these circumstances, the rational response for business is to lower prices and cut production. However, Marshall recognised his supply and demand chart was not, by any means, a simple construction and hence required a more detailed explanation.

Demand, he argued, was governed principally by utility – that is the satisfaction a consumer receives from the purchase of a good. In a market, consumers are perennially attempting to acquire the greatest level of utility from the products which they purchase and consume. As a result, whenever confronted with a decision of what to purchase, consumers compare the utility which they receive from one purchase with that which would result from an alternative. When the price of a good is very high, sales are typically lower because consumers recognise that they can get greater utility by buying a larger quantity of lower priced goods.

A shift in the supply and demand curves occur when consumers purchase more or less of a good when the price remains the same. Marshall identified four main factors which he thought could create shifts in demand:

  1. Wealth.
  2. Changes in taste, growth or decline in population.
  3. A change in the price of other goods.
  4. Expectations about future prices.

Firstly, if the wealth or the size of the population increases then demand will naturally increase too. Secondly, tastes may change as a result of advertising or because of a certain event – for a recent example of this we need look no further than the recent scandal involving horsemeat in beef products, which according to recent reports has altered the buying habits of around 60% of consumers. Thirdly, the public suspect prices to rise in the future then that will also stimulate demand as people rush to buy products at their current lower price. The final factor is a change in the price of another product.

The impact that Marshall identifies is rather complex. If the price of say, an electric guitar, increases, other goods will in most cases rise. However, there are some examples in which this does not happen. One is with respect to ‘complimentary goods’ that is, goods which are often bought or consumed together. So, to return to the example of the guitar – an amplifier manufacturer may well experience a dip in sales if the prices of guitars went up, and consumers would buy fewer guitars and hence have less need for an amplifier.

Supply is instead controlled by the cost of production. Producers will always attempt to maximise profits in much the same way as consumers strive to maximise utility. But the law of diminishing returns acts as the constraining factor on production – an increase in production inevitably means an increase in costs – the supply curve is positively sloped to reflect the fact that businesses will only produce more goods if they receive a higher price. Again, Marshall identifies that supply can shift and that more or less goods are produced and sold at each price.

The main factor causing supply to shift is a change in the cost of production, for example higher wages. If wages are forced up – say through negotiation or legislation such as a minimum wage – the only way for a business to make the same level of profit is to put up prices and pass the cost on to the consumer. An increase in the costs of production, therefore, will inevitably push the supply curve to the left.

Emergence of corporations

It was at the beginning of the second industrial revolution when Marshall began developing his economic theories. This was a time of great economic upheaval in the UK. The typical business organisation in England during the 19th Century was the small firm owned and managed by families and partnerships. But as the new century approached, this type of company was beginning to give way to a new type of business – the big corporation. New technologies helped the development of large-scale economies and this in turn helped to pave the way for professionally managed businesses in which the ownership resided with shareholders.

This raised a question that had been troubling economists since the era of Adam Smith – namely, can increasing returns be reconciled with competition?

Marshall did not see the decline of the family run business and the emergence of corporations as necessarily a monopolistic threat to competition. As Jaques Kerstenetzy explains in an article published in the Cambridge Journal of Economics in 2010, Marshall’s view was that increasing returns were an unavoidable facet of competition, although something “neither accessible to all firms nor instantaneously accessible to any firm”.

Marshall recognised large companies would become more widespread in the 20th Century. But rather than nostalgically arguing for a return to the model of the small family-owned business of the Victorian era, he instead focused his attention on analysing the monopolistic tendencies of this type of organisation and exploring theoretically how regulation could be used to keep such ambitions in check.

Supply and demand

Like John Locke and David Ricardo before him, Marshall was aiming to develop a theory that comprehensively explained pricing and value. To understand how prices worked in individual markets he analysed supply and demand and ascertained that the relationship between the two market forces could be expressed as a simple chart.

  • The law of supply is represented by the upward sloping curve. When prices increase companies respond by producing more, thereby increasing the level of goods available on the market.
  • The law of demand is represented by the downward sloping curve. If prices fall then consumers respond by purchasing more of the given product.
  • The natural price of a good (or market equilibrium) is where the two ‘scissors’ intersect.
  • Marshall’s analysis differed from the value theories of Jevon (demand driven) and Ricardo (supply driven) in that he argued prices were determined by both supply and demand, not one factor alone.

The theory rests on three basic principles:

  1. Individuals have rational preferences between different outcomes.
  2. Individuals attempt to maximise utility, while businesses wish to maximise profits.
  3. Consumers act independently and with all the correct and relevant information – cases in which this last principle is not the case are referred to as ‘market failures’.
Diagram 1 – The price and value theory

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