Neoclassical

Alfred Marshall
• English; studied philosophy and economics at Cambridge; Professor of Political
Economy in 1884; master of Keynes and the Cambridge School
• Founder of neoclassical economics
• Principles of Economics (1890), one of the most successful textbooks of all time
• Known for partial equilibrium analysis, Marshallian cross, demand elasticity,
economics of scale,…
Marshall’s methodology
• “The Mecca of the economist lies in economic biology rather than in economic
dynamics…The main concern of economics is thus with human beings who are
impelled, for good and evil, to change and progress.”
• “Economists have accordingly now learnt to take a larger and more hopeful view
of the possibilities of human progress. They have learnt to trust that the human
will, guided by careful thought, can so modify circumstances as largely to modify
character; and thus to bring about new conditions of life still more favourable to
character; and therefore to the economic, as well as the moral, wellbeing of the
masses of the people.”
• Money as a unit in measuring satisfactions
The neoclassical project
• Rebuilds Mill (classicists) and Jevons (marginalists) into equations
• Constructs abstract economic principles and research agenda
• Utilitarianism (equity) vs. liberal ideology (efficiency)
• Contains moral components concerning poverty and competition. Stands against
radical solutions and support individual liberty.
1. Theory of consumption and demand Components: Gossen’s first law and
second law, elasticity, constant marginal utility of income, consumer surplus
2. Theory of production and supply Components: law of diminishing returns,
marginal productivity principle, short run and long run, returns to scale, internal
and external economies, producer surplus
Real costs: (1) disutilities of labor and (2) waitings for saving the capital, and
money costs from prime costs and supplementary costs
3. Theory of price determination (reading)
The Marshallian cross: “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 us governed by utility or cost of production.”

• Equilibria in demand and supply (reading):

1. Immediate-present (market) eq.: y fixed -> full D driven
 2. Short-run eq.: variable costs adjustable -> D and S driven
3. Long-run eq.: y adjustable -> full S driven
• Partial equilibrium theory (PET): The ceteris paribus (other things be equal)
clause: “The exsistence of other tendencies is not denied, but their disturbing
effect is neglected for a time. The more the issue is thus narrowed, the more
exacly can it be handled: but also the less closely does it correspond to real life.”
• Perfect competition as “economic freedom” and “natural selection”
• Theory of factor-price determination: “…the uses of each agent of production
are governed by the general conditions of demand in relationship to supply:
that is, on the one hand, by the urgency of all the uses to which the agent can be
put, taken together with the means at the command of those who need it; and, on
the other hand, by the available stocks of it. And equality is maintained between
its values for each use by the constant tendency to shift it from uses, in which its
services are of less value to others in which they are of greater value, in
accordance with the principle of substitution.”
• The effect of taxation (reading)
PET vs. GET
• comparative static vs. everything adjusts
• ceteris paribus method vs. simultaneous equations method
• time involved vs. immediate adjustment
• price adjusts in short run vs. quantity adjusts
• biological/evolutionary/real vs. mechanical/ideal
• real natural world vs. idealized hypothetical world
• models in diagrams vs. mathematical proofs
Marshall’s role
• From the “old” political economy to “new” economics
• Focus on (1) competition and welfare maximization, and (2) the individuals (not
classes) and the market (not the national economy)
• Relaxing Marshallian economics
1. Welfare and public economics
2. Imperfect competition
3. Monetary economics
4. Macroeconomics and disequilibrium analysis

Arthur Pigou (1877–1959)

• English; studied history and literature at Cambridge; Marshall’s pupil; lectured
economics from 1904; Professor of economics in 1908–43
• Marshallian; second leader of the Cambridge school
 • Economics of Welfare (1920); A Study in Public Finance (1928)
• Founder of modern welfare economics; known for his analysis on market
failure and public finance, Pigouvian tax, and Pigou effect
Pigou on utilitarianism
• “Any transference of income from a relatively rich man to a relatively poor
man of similar temperament, since it enables more intense wants to be
satisfied at the expense of less intense wants, must increase the aggregate sum
of satisfaction. The old “law of diminishing utility” thus leads securely to the
proposition: Any cause which increases the absolute share of real income in
the hands of the poor, provided that it does not lead to a contraction in the size
of the national dividend from any point of view will in general, increase
economic welfare.”
• Assumption: as income ↑, personal productivity ↓ -> the trade-off between
efficiency and distributive justice.
Pigou on market failure
• Marginal net product (MNP) is the value of an extra unit of resources that is
made available for production.
• Social and private MNP
1. SMNP = PMNP: private’s cost = benefit (market eq.)
2. SMNP ≠ PMNP: private’s cost > or < benefit (market failure), e.g.,
monopoly, air pollution, rent seeking…
• Pigouvian tax (on environmental policy) to equalize (1) marginal social and
private cost, (2) marginal social and private benefit
Critiques on the Pigouvian approach
• Frank Knight (1885–1972), “Fallacies in the Interpretation of Social Cost”
(1924): market failure is indicative of the failure of government to establish
and protect private property rights.
• Ronald Coase (1910–2013), “The Problem of Social Cost” (1960): “The
[Pigouvian] approach has tended to obscure the nature of the choice that has to
be made. The question is commonly thought of as one in which A inflicts harm
on B and what has to be decided is: how should we restrain A? But this is
wrong. We are dealing with a problem of a reciprocal nature. To avoid the
harm to B would inflict harm on A. The real question that has to be decided is:
should A be allowed to harm B or should B be allowed to harm A? The
problem is to avoid the more serious harm.”
Francis Edgeworth (1845–1926)
• Irish; studied at Dublin and Oxford; turned to economics because of Jevons
Professor of Economics at Oxford 1891– 1922; edited the Economic Journal
with J. M. Keynes
• Influenced by Bentham’s utilitarianism
 • New and Old Methods of Ethics (1890) and Mathematical Physics (1881)
• Known for the Edgeworth Box, cardinal utility theory and the concept of
indifference curves
Edgeworth on utilitarianism
• Utility is measurable and comparable between individuals: “We cannot count
the golden sands of life; we cannot number the “innumerable smile” of seas of
love; but we seem to be capable of observing that there is here a greater, there
a less, multitude of pleasure-units, mass of happiness; and that is enough.”
• “Exact” formulation of utilities -> consumption and income
• What income distribution creates the greatest possible happiness? <->
decreasing marginal utility of income
Edgeworth on exchange
• Isolated economy: Robinson Crusoe and his right-hand man
Friday
• Two commodities: Crusoe owns money (x1) and Friday sells
labor (x2")
1. Crusoe’s indifference map (I, II, III)
2. 2. Frida’s indifference map (1, 2, 3)
• Contract curve: A-B-C; D: increase someone’s utility while
fixing another’s
The Edgeworth Box
• First drawn by Vilfredo Pareto
• Assumptions:
1. Utility function: U = u(x) + v(y) -> U = U(x, y)
2. Complements or substitutes
3. Convex indifference curves
4. No constraints on the transactions
• Exchanges based on contracts and negotiations: as
numbers of agents ↑ -> perfect competition
Vilfredo Pareto (1848–1923)
• French-Italian; studied science and engineering; engineer of a railway
company; successor of Walras’s position at Lausanne in 1898–1907
• Pacifist, anti-imperialist and republican
• Cours d'économie politique (A Course of Political Economy, 1896–97);
Manuale di economia politica (Manual of Political Economy, 1909)
• Known for Pareto efficiency/optimality, Pareto distribution, and Pareto’s law
Pareto on utility
• Normative (Edgeworth) and positive (Jevons…) theory of utility
• Utility is real vs. utility as a tool of representing preferences
 • Not “measurable” utilities (cardinal) but ranks (ordinal) of individual
preferences: “[Edgeworth] assumed the existence of utility (ophelimity) and
deduced the indifference curve from it…I consider the indifference curves as
given, and deduce from them all that is necessary for the theory of equlibrium,
without resorting to ophelimity.”
• Convex indifference curves <-(present) decreasing MU
Pareto on optimality
• “The utility…for one individual, and the utility…for another individual, are
heterogenous quantities. We can neither add them together nor compare
them…A sum of utility enjoyed by different individuals does not exist; it is an
expression which has no meaning.”
• Pareto optimality: “…maximum utility in a certain position when it is
impossible to find a way of moving from that position very slightly in such a
manner that the utility enjoyed by each of the individuals of that collectivity
increases.”
• “The pure theory of economics does not give us a truly decisive criterion for
choosing between an organization of society based on private property and a
socialist organization. This problem can be solved only by taking other
characteristics of the phenomena into account.”
Pigou vs. Pareto
Both are utilitarians and interested in income distribution.
• Cambridge vs. Laussane School
• Practical vs. theoretical welfare economics
• Cardinal vs. ordinal utility
• PET vs. GET
• Market failure vs. “almost” success
• Intervention vs. competitive equilibrium

The Hicksian solution

• John R. Hicks (1904–89), Value and Capital, 1939; Hicks and R. G. D. Allen,
“A Reconsideration of the Theory of Value”, Economica, 1934.
• Introduction of budget line under the Paretoan framework (reading)
• Derivation of demand curve from the indifference map
• No assumptions of (1) diminishing MU and (2) cardinal utility. Replacement
of MU with marginal rate of substitution (reading)
• Seperation of income effects and substitution effects by measuring the
compensating variation.
• Minimum assumption about preference vs. the “law” of diminishing MU
The new welfare economics
• Emphasizes competitive equilibrium in exchange and production
• The production isoquant as the analytical counterpart of the indifference curve
regarding producer behavior.
 • Consider an economy of two people (A and B), two commodities (x and
y),and two resources (labor and capital), the Pareto optimality implies that
MRSxyA = MRSxyB,
MRTSlk x = MRTSlk y,
MRSxy= MRTxy,
• where MRT is the marginal rate of transformation.
Further thoughts
• How did Marshall reconcile the classical cost of production theory of value
with that of Jevons? How does time relate to the relative importance of
demand and supply?
• Explain why Marshall maintains that the marginal productivity principle is not
a theory of distribution. How does it apply in the labor market?
• How does Pigou justify the model of Pigouvian tax?
• To what extent Pareto’s welfare analysis is Walrasian, whereas Pigou’s welfare
analysis is Marshallian?
• Is the comparability of utility a crucial assumption for Edgeworth, Pareto,
Pigou, and Hicks?

Wicksell‘s theory of capital demand

• A case of wine company: grape -> wine: (1) brewing cost at a rate of interest r,
(2) as time T goes by, price of wine p ↑, (3) The value of wine is discounted to
the present by r
• What determines the optimal capital stock? A revised and mathematical version
of Böhm-Bawerk’s theory of capital
1. Optimal sales time at MPK = dp∗/dT∗ = r, as r ↑, T∗ ↓, p∗ ↓.
2. Total stock of real capital = the total amount of wine that is tied up in the
production process
-> as r determines T∗ and then p∗, r ↓ -> capital stock ↑
Wicksell‘s theory of interest and prices
• The natural (normal) rate of interest rn" vs. the bank rate rb
• Lower rate of interest stimulates the “cumulative process” of capital
• But what determines rn"? (1) demand side: potential profit or MPK, and (2)
supply side: saving
• “If the prospects of the employment of capital become more promising, demand
will increase and [quantity demanded] will at first exceed supply [quantity
supplied]; interest rates will then rise and stimulate further savings at the same
time as the demand from entrepreneurs contracts until a new equilibrium is
reached at a slightly higher rate of interest” (1906).
Wicksell‘s theory of interest and prices
• Bank rate: the market determined by the banking system
1. If rb < rn", saving ↓, inflation
(1) demand for consumption ↑ -> demand for investment ↑-> income ↑ ->
price of consumer goods ↑
(2) Anticipations of price increases
2. If rb > rn", saving ↑, deflation
• Unstable interest rate policy creates unintended redistribution of income between
groups in society.
Wicksell on the role of central bank
• Most favorable rate of inflation by controlling rb
• “The procedure should rather be simply as follows: So long as prices remain
unaltered the banks’ rate of interest is to remain unaltered. If prices rise, the rate
of interest is to be raised; and if prices fall, the rate of interest is to be lowered;
and the rate of interest is henceforth to be maintained at its new level until a
further movement of prices call for a further change in one direction or the
other” (1898).
• “…the banks’ prime duty is not to earn a great deal of money but to provide the
public with a medium of exchange—and to provide this medium in adequate
measure, to aim at stability of prices” (ibid).
Fisher’s theory of saving and investment
• A model of one rational consumer, one consumption good, two time periods, one
borrowing and lending rate of interest r
-> discounted value of consumption = presented value of income
-> MRS between present and future goods = r/(1 + r)
• Replaces Böhm-Bawerk’s “deficient telescopic faculty” with impatience and
consumer’s rate of time preference (reading)
• A theory of saving behavior: expectation for future
-> life-cycle theory and permanent income hypothesis
Fisher’s theory of saving and investment
• A model of “rational” investment in a “perfect” capital market AA’:
the real investment carried along
YY’: budget line
-> P is a profitable investment where MPK = r
UU’: utility curve
-> Given this person’s time preference, C is the utility-maximizing
consumption profile.
Equations after Fisher
• Fisher’s quantity equation: (M + M’)V = PT
where M and M’ are the quantity of money, P the price level, T the real value of
the national product, V the velocity of money.
• T from real production, investment, and consumption; V approximately constant
over time -> M causes P
• The Fisher equation: real rate of interest = nominal rate of interest − rate of
inflation
• The creation of Fisher’s ideal index
Fisher on monetary policy
• Aim: price stability
• Pre-1929: “I…have no faith whatever in ‘the’ business cycle…. after any
disturbance in one direction or the other business tends to swing back to
normal…just as does the tree” (1920)
1. Replace gold standard with an international paper standard
2. Stabilize money supply (open market operation)
• Post-1929:
Fluctuation in demand deposits (M’) -> 100% percent reserves
Marshall’s theory of money
• Money, Credit and Commerce (1923)
1. Emphasis on the use of money
2. People have preferences for liquidity.
3. Marshall’s k = 1/V (the demand for cash, a stable factor), thus M = PTk.
• Holding cash as an asset is irrational. However, in most situation people will
adjust so the money market clears itself.
• The money market is seperated from other commodity market.
-> Say’s law and the full-employment doctrine
Dark spots in the Marshallian theory
• Pierro Sraffa (1898–1983), “The Laws of Return under Competitive Conditions”
(1926, Economic Journal)
• Perfectly elastic demand curve under perfect competition
• Product differentiation will (1) lead the demand curve to diverge from the
horizontal line, and (2) make a firm’s demand and cost interdependent (e.g.,
advertising).
• The source of increasing returns: external or internal economies? Sraffa:
internal to the industry but external to the firms -> towards a theory of
monopoly in understanding the reality
Two theorists of imperfect competition
• Edward Chamberlin (1899–1967): American; long-term professor at Harvard;
conducted the first ‘classroom’ experiment; The Theory of Monopolistic
Competition (1933)
 • Joan Robinson (1903–1983): English; lecturer and then professor at Cambridge;
Marxist; Economics of Imperfect Competition (1933)
• “Simultaneous discovery” (?) between competition and monopoly
• “[The theory of perfect competition] are based on the supposition that each seller
accepts the market price and can dispose of his entire supply without materially
affacting it. Thus there is no problem of choosing a price policy, no problem of
adapting the product more exactly to the buyers’ (real or fancied) wants, no
problem of advertising in order to change their wants” (Chamberlin, 1933).
• “…its [demand] elastisity will depend upon many factors, of which the chief are
the number of other firms selling the same commodity and the degree to which
substitution is possible, from the point of view of buyers, between the output of
other firms and the output of the firm in question” (Robinson 1933).
Chamberlin on equilibrium of the group
• Monopolistic competition: a theory between monopoly and
perfect competition
• “A network of related markets, one for each seller”: Firms sell
similar but heterogeneous goods due to product differenciation
and advertising.
• dd: how much the firm of a large group can sell while fixing
other firms’ price (competitive)
• DD: how much the firm of a small group can sell while fixing
other firms’ price (less competitive)
Chamberlin’s equilibrium analysis
• Free entry will put demand downward until pure profit is
eliminated. Product diffreciation and advertising will shift
or turn D.
• A: monopolistic competition; B: monopoly; C: perfect
competition (n.b., no MC curve in the original analysis)
• Comparing with perfect competition, equilibrium price is
higher, and output is lower.
• In the long run, profit of a large group tends to be zero and
profit of a small group persists.
• The distinction between individual (advertisement) and
group (close substitute) equilibrium
• “The theory [of monopolistic competition] affords an explanation of such wastes
in the economic system—wastes which are usually referred to as wastes of
competition’…They are wastes of monopoly—of the monopoly elements in
monopolistic competition” (1933, 109).
• Some unrealistic assumptions:
1. Cost curves of each firm are the same.
2. Each firm can reach economies of scale.
Robinson on equilibrium of the firm
• Using marginal revenue and cost as conceptual tools
• First-order conditions: (1) perfect competition: P = MR = MC, and (2)
monopoly: P > MR = MC
• Second-order condition: MC is increasing or at least decreasing less rapidly than
MR.
 • Third-degree price discrimination with aggregate MR
• If production takes place under decreasing AC, monopolistic price
discrimination contributes to the welfare of consumers (more output with lower
price).
Robinson’s theory of monopsony
• Exploitation (from A. C. Pigou): a laborer receives less payment
than its marginal physical product valued at its selling price.
• Labor demand is the marginal revenue product MRP and labor
supply is W = AC.
• Competitive factor buyers (facing AC1) hire at W’
where MC1 = MRP.
• Monopsonistic factor buyers (facing AC2) hire at P where MC2 =
MRP.
Robinson vs. Chamberlin
• Find their differences from the readings:
1. Use of MR = MC (ideal) vs. product differentiation (real)
2. Analysis of monopoly/monopsony vs. duopoly/oligopoly
3. Both have an equilibrium at the tangency of AC and demand
• Robinson moves on to heterodox economics, while Chamberlin resists the
precedential value of his work.
• Modern microeconomics synthesizes Chamberlin’s product differentiation and
Robinson’s marginal analysis.
Further thoughts
• How do Böhm-Bawerk (recall last semester), Wicksell and Fisher use different
assumptions to justify the rate of interest?
• Discuss: Wicksell felt that the focus of monetary policy should be on the interest
rate; Fisher believed that it should be on the stock of money.
• What are the idea of economic inefficiency for Chamberlin and Robinson?
• In what respects are Chamberlin and Robinson clearly in the marginalist or
neoclassical tradition? In what respects are they outside the mainstream of that
tradition?
• Is Robinson’s idea of exploitation different to Marx’s?

The soul of the Institutionalist School

1. Holistic economy: politics, law, custom, ideology, tradition,…
2. Focus on institutions: habits, customs, ways of living,…
3. Darwinian approach: history, cultural anthropology, sociology,..
 4. Rejecting the equilibrium principle: business cycles, depression
5. Clashes of class interest: collective action as unit of analysis
6. Liberal and democratic reform: minimal-wage law, equality,…
7. Rejection of utilitarianism
Thorstein Veblen (1857–1929)
• Norwegian-American; Ph.D. in philosophy at Yale; taught at Cornell,
Chicago,…; unconventional academic; satirical and polemical writer
• Interested in economic sociology that combines economics, sociology,
philosophy, and history
• Main critic of formal economic analysis; founder of theAmerican institutional
economics
• The Theory of Leisure Class (1899), The Theory of Business Enterprise
(1904),…
Veblen’s critics on rationality principle
• Are markets and competition efficient?
• The “evolutionary” economy: not “what is?” but “how did we get here, and
where are we going?”
• Rational and calculating agent vs. intincts and habits by the state of technology
• Humans struggle for their existence and adapt to changes.Institutions (”habits of
thought”, beliefs) are created duringthe process.
• Institutions are deeply embedded in customs and habits.
The Theory of Leisure Class (1899)
• Wealth (1) exists not only for physical wants but spiritual, esthetic, and
intellectual wants, and (2) indicates power, prestige, honor, and success in the
capitalist society.
• “These occupations are government, war, sports, and devout observances… the
ordinary and ostensible motive of the leisure class in engaging in these
occupations is assuredly not an increase of wealth by productive effort… These
occupations are of the nature of predatory, not of productive, employment” (40).
• The leisure class who desires for social recognition and prestige
-> conspicuous consumption and luxury good (reading)
Veblen’s critics on business leadership
• People’s work for achievement -> instinct for workmanship
• “The business man’s place in the economy of nature is to ‘make money,’ not to
produce goods….The highest achievement in business is the nearest approach to
getting something for nothing.
• “Absentee owners” (e.g., shareholders, financial specialists) vs. engineers and
workers
• A twisted relation: overemphasis on raising prices (profits) but not lowering
costs (of production) -> unnecessary productions and the problem of cartels ->
economic inefficiency
Veblen on business cycles
• Why does an economic crisis occur?
1. Banks rely on credit records when lending money.
2. If rate of profit > rate of interest, then an enterprise will borrow money.
 3. Money may be used unproductively (e.g., housing mortgage).
-> low rate of interest -> more borrow -> more mortgate -> credit expansion
(bubble) -> inconsistecy between capital and profit (decreasing rate of profit)
-> crisis and depression
• Ways to mitigate the crisis but impossible to solve it: (1) speculative increases in
prices, (2) conspicuous consumption, (3) monopoly,…
• The “class” conflict between industry (engineers and technicians) and business
(businessman, financiers, absentee owners)
• The engineers and technicians lead the social revolution and operate industry
because that
1. capitalists and laborers cooperate.
2. technicians without self-ineterst are the actual leaders of firms who own the
instincts of workmanship.
-> A soviet of technicians to improve the problematic conditions under
capitalism
Veblen on conventional economics
• Veblen critiques on classical and neoclassical economics (1898, “Why is
Economics not an Evolutionary Science?”, reading)
• Human nature as given (“nature”, “laws”, “truth”, “tendency”, “equilibrium”) vs.
changing in response to material conditions
• Pleasure-pain calculation vs. collective/ anthropological/social processes,
changing habits and behaviors, path-dependent institutions
• Critics on other schools of thought
• Taxonomy vs. evolutionary biology
• Newtonian mechanics vs. models of evolutionary biology
Further thoughts
• To what extent institutions matter in explaining economic phenomena?
• Both fascinated with evolutionary biology, what are the main differences
between Veblen and Marshall?
• What is Veblen’s distinction between making money and making goods? Is it
possible to make more money by producing fewer goods?
• Compare Veblen’s and Marx’s ideas on class conflicts.

John Maynard Keynes (1883–1946)

• English; educated at Cambridge under Marshall and Pigou; son of John Neville
Keynes; civil servant at the India Office and the Treasury; fellow of the King’s
College; economic and political advisor to the British government; edited of the
Economic Journal, 1911–45
• Revived Malthus idea of effectual demand; advocated for an international
monetary authority after WWII
• A Treatise on Probability (1909); The Economic Consequence of the Peace
(1919); A Treatise on Money (1930); The General Theory of Employment,
Interest and Money (1936) 4 Source: the Independent
The soul of the Keynesian School
1. Humans are irrational animals
2. Macroeconomic emphasis: focus on the aggregates
3. Demand orientation: focus on the effective demand
4. Economic disequibruim
5. Wage and price rigidity
6. Active fiscal and monetary policies by the government to achieve full
employment, price stability, and economic growth
The General Theory
• Points from the reading (Ch. III):
1. The demand for labor is detemined by the demand for consumption and
investment goods.
2. National income = national expenditures, i.e., Y = C + I.
3. The “fundamental phychological law”: the marginal propensity to consume
(MPC)
4. The mechanism of Great Depression: high demands for money under people’s
liquidity preference → changes in C; low expected rate of profit and rate of
interest → changes in I.
• Central message: the price and wage mechanism does not function in a way that
leads to full employment.
• “…its main purpose is to deal with difficult questions of theory, and only in the
second place with the applications of this theory to practice”
• Points from the reading (Ch. II):
1. The “classical” assumptions of labor market eq.: (1) w = MPL, and (2) w =
marginal disutility of labor at any level of employment
2. The supply of labor depends both on the real w and nominal w.
3. Wage rididity: the nominal w is inflexible downward.
• Money illusion: people respond to a monetary magnitude rather than its
equivalent in real terms.
• Wage rigidity as a feature that delays the normal adjustment to the market
equilibrium (Classicals) or an equilibrium phenomenon (Keynes)
• The Keynesian consumption function: MPC lies between zero and one.
• Investment demand is a decreasing function of the interest rate (Fisher), but
Keynes focuses more on uncertainty and expectations.
• Y = C + I -> S = Y − C -> S = I. In depression, demand for C and I ↓, Y ↓,
demand for labor ↓, under wage rigidity, unemployment ↑.
• The transition mechanism: the multipliers (Richard Kahn, 1931) -> I ↑, Y ↑, C ↑
(times MPC), demands for labor ↑, employment ↑.
• The demand for money (Marshall’s k) is determined by the rate of interest
(investment purposes) and by real income (a liquid asset for speculative
purposes) -> but in Keynes’s theory the latter is not stable.
• According to the liquidity preference, the rate of interest ↑, demand for money ↓.
Thus, if money supply ↑, the rate of interest ↓, I ↑
• However, monetary expansion would not be recommended when (1) I is
relatively insensitive to the rate of interest, and (2) the rate of interest has a lower
bound (liquidity trap).
Keynesian stabilization policy
• Increase public expenditure to counteract deficient investment
 • Lower taxes to stimulate private consumption
• The classical attitute: the “crowding out” effect
• Imply an increasing degree of socialization of investment to counteract
decreasing rate of return on capital
• Is Keynes a socialist? “…apart from the necessity of central controls to bring
about an adjustment between the propensity to consume and the inducement to
invest, there is no more reason to socialise economic life than there was
before…”
Neo-Keynesian economics
• “It is a badly written book, poorly organized; any layman who,
beguiled by the author’s previous reputation, bought the book
was cheated of his five shillings…It is arrogant, bad tempered,
polemical and not overly generous in its acknowledgements. It
abounds in mares’ nests and confusions…In short, it is a work
of genius” (Paul Samuelson)
• J. R. Hicks ”Mr. Keynes and the ‘Classics’” (1937) and F.
Modigliani “Liquidity Preference and the Theory of Interest
and Money” (1944); two equations: (1) Investment = planned
saving; I (i) = S(Y) and (2) Money demand = money supply;
L( i,Y ), = M
• Hansen: professor at Harvard; the “American Keynes”; A
Guide to Keynes (1953); known for developing the ISLM model (Hicks-Hansen
synthesis)
• Samuelson: professor at MIT; The Foundation of Economic Analysis (1947);
Economics: An Introductory Analysis (1948), nineteenth edition in 2009; 1970
Nobel prize; known for writing on everything Paul Samuelson (1915–2009)
Alvin Hansen (1887–1975) Neo-Keynesian economics Neo-Keynesian
economics
• Samuelson’s 45-degree diagram
Y∗: equilibrium of Y; Yf: equilibrium of Y under full
employment; Y = f(C) (MPC < 1)
• Assumptions: (1) Exogenous demand for investment, (2)
Effect of interest rate on investment and consumption is
negligible, (3) Vertical IS curve
• No labor market analysis in the models of Hicks-Hansen
and Samuelson
The Keynesian Revolution
• Is the Keynesian Revolution a Kuhnian revolution?
1. Old paradigm: classical/neoclassical economics
2. Crisis after the Great Depression
3. A new paradigm shift to the macroeconomic relations
4. New normal sciences and new exemplars in textbooks
-> Is the Keynesian paradigm a new way to see the world?
-> Is classical economics incompatible with Keynes?
The Keynes-Hayek controversy
• F. A. Hayek, Prices and Production, 1931.
• The instability of bank credit as the cause of business cycles
 • The theory that explains the extraordinary variation in the production of capital
goods.
• The idea of roundabout production
• “Overinvestment” in the capital goods
• Money plays a decisive role in bringing about the cycle and periodically causing
real maladjustments. 15 The Keynes-Hayek controversy
• J. M. Keynes, A Treatise on Money, 1930.
• From the overinvestment theory, when I > S → inflation.
• Investment as the “value of unconsumed output”
• Available (C) and non-available (I) output
• The relationship between price level, saving and investment
• The Stockholm School: the difference between ex-ante (“expected”) and ex-post
(“realized”) manifestations
• Why is Keynes often compared with Hayek?
• Debates on the role of interest rate in Keynes’s A Treatise on Money (1930);
Keynes review on Hayek’s Prices and Production (1931); Hayek’s Profits,
Interest, and Investment (1939)
• Hayek on crisis: “But the mere fact that entrepreneurs do make errors can hardly
be regarded as a sufficient explanation of crises. Erroneous dispositions which
lead to losses all round will appear probable only if we can show why
entrepreneurs should all simultaneously make mistakes in the same
direction…they may all be equally misled by following guides or symptoms
which as a rule proved reliable” (1939, 141).

The Keynes-Hayek contrast

• Humans are imperfect and subjected to animal spirits.
• Optimism vs. pessimism
• Eliminate employment vs. prevent inflation
• Boost right investment vs. boost wrong investment
• Improve economic growth vs. prevent economic fluctuations
• Fiscal policy vs. stabilized monetary policy
• 蔣王論戰：蔣碩傑（1918–93）vs. 王作榮（1919–2013
蔣王論戰
• 1981–2: Hayek vs. Keynes?
• 王：低利率、增加貨幣供給
• 蔣：控制貨幣供給與利率
• 「假使有人既不從事生產或服務，又不肯 以適當之代價向人告貸，而私自
製造一 批貨幣，拿到市上來購買商品，那就等 於憑空將別人的生產成果攫
奪一份去了 一樣。這不是和竊盜行為一樣麼？」（蔣 碩傑 ，1982） 19 蔣
碩傑（1918–93） 王作榮（1919–2013）
Further developments
• The AD-AS model in the late 1940s
• The New Keynesian School (the Keynesian model with microeconomic
foundations): Joseph Stiglitz (1943–; Nobel prize 2001), Oliver Blanchard
 (1948–), George Akerlof (1940–; Nobel prize 2001), Ben Bernanke (1953–),
Janet Yellen (1946–),…
• The Fleming-Mundell model: the IS-LM model in an open economy -> balance-
of-payments (BP) equilibrium
• The Post-Keynesian School: Piero Sraffa (“the Neo-Ricardian”, 1898–1983),
Nicolas Kaldor (1908–1986), Joan Robinson (”the left-wing Keynesian”)
Further thoughts
• What are the crucial assumptions and major components of the General Theory?
How is that different to neoclassical economics?
• What did Keynes mean by involuntary unemployment? How does it differ from
“frictional” and voluntary unemployment?
• How does Keynes integrate monetary theory into the theory of employment and
output?
• How did macroeconomic models evolve from Keynes to the neoKeynesians?
Are neo-Keynesian theories consistent with Keynes’s theory?
• To what extent was the General Theory a scientific revolution?

Two LSE philosophers

• Karl Popper (1902 –94): Austrian; professor at the London School of
Economics;The Open Society and Its Enemies (1945); The Logic of Scientific
Discovery (1959); Conjecture and Refutation (1969)
• Imre Lakatos (1922 –74): Hungarian; professor at the London School of
economics ; Proofs and Refutations (1976); The Methodology of Scientific
Research Programmes (MSRP, 1978)
Popper’s falsificationism
• The problem of demarcation (logical positivism): a theory is scientific when it
can be confirmed and inducted by evidence.
• Physics, Marx, psychology, and western astrology
• 「我雙魚，為什麼天蠍要恨我？」 — 楊乃文 《證據》
• Popper’s solution of demarcation problem: theories that can be falsified
(science) vs. covering-all theories (pseudo-science)
• Three contents: (1) A scientific theory can only be falsified but not confirmed;
(2) A scientific theory contains falsifiability; (3) Better theories contain higher
degrees of falsifiability. 4 Popper’s falsificationism
• Degree of falsibility and empirical content: (1) It will be raining or not raining
tomorrow, (2) It will be raining or sunny tomorrow, (3) It will be raining
tomorrow, (4) It will be raining tomorrow afternoon, (5) It will be raining on
12:30 pm tomorrow.
• A good scientific theory pursues ”truthlikeness” which contains a higher “degree
of corroboration.”
 • Popper’s bad science: (1) Ad hoc hypothesis (e.g., ceteris paribus clause); (2)
probabilistic statements
• Some features of a better theory: (1) simplicity, (2) generality, (3) preciseness,
(4) novel prediction, and (5) unity
Lakatos’s scientific research programs
• Lakatos’s critiques on Popper and Kuhn:
1. Normative vs. positive philosophy of science
2. Popper did not consider non-social aspect of knowledge.
3. Kuhn’s revolution indicated science as an irrational enterprise.
-> Lakatos: rational normal sciences have co-exsisting families
• “Popper 1” as naïve falsificationism, which refutes a theory
• “Popper 2” as sophisticated falsificationism (MSRP), which refutes a series of
theories.
Lakatos’s scientific research programs
• Contents of a research program:
1. Hard core: irrefutable and inadjustable elements
2. Protective belt: adjustable elements (e.g., auxiliary hypothesis, observational
hypothesis, and initial conditions)
3. Positive heuristics: guidelines of adjustment
4. Negative heuristics: defences of hardcore
5. Problem shift: theoretical/empitical, progressive/degenerative
• “Ocean of anomaly” continues to challenge the whole research program.
• Progression and degeneration in the problem of demarcation
• Popperian instant rationality vs. Lakatosian long-term rationality
• Definitions of ad hoc assumption: (1) amendment that prevents theoretical
progressive problem shift, (2) amendment that prevents emprical progressive
problem shift, (3) “patched up” amendment that is irrelavant to positive
heuristics
• From Ptolemaeus to Copernicus: (1) hard core: perfect celestial object,
geocentric theory (Ptolemaeus), only stars are perfect objects (Copernicus); (2)
novel fact: phases of Venus 8 Lakatos’s scientific research programs
• The hard core of MSRP (Blaug, 1975): “scientists are rational and accept or
reject ideas for good reasons”.
• The protective belt: (1) scientists want to test their theories but do not discard
theories immediately; (2) “scientists appraise programs, not theories”; (3)
scientists appraise programs historically and continue to revise their appraisals;
(4) scientsits tend to retain a program if no alternatives are available
• The positive heuristic: (1) collect theories that matter; (2) spell out the crucial
elements; (3) examine the efforts of testing theories, (4) trace the anomalies and
scientists’ judgements,…
A Popper-Kuhn-Lakatos overview
Protective Belt Hard core Empirical Evidence Popper: Falsify and discard Lakatos:
Refute and modify Kuhn: Normal science or Crisis Lakatos: Problem shift or
Hardcore amendment Novel Facts
Meanwhile, in economics…
• Milton Friedman’s Essays on the Methodology of Positive Economics (1953)
• Instrumentalism: “Truly important and significant hypotheses will be found to
have ‘assumptions’ that are wildly inaccurate descriptive representations of
reality, and, in general, the more significant the theory, the more unrealistic
the assumptions.”
• A better economic theory provides more accurate predictions but not
explanations and representations.
• An example of leaves around a tree
Appraising economic theories
• Neoclassical and Keynesian economics as Lakatosian SRP (reading)
• The hard core of neoclassical program: (1) rational economic calculations, (2)
constant tastes, (3) independence of decision making, (4) perfect knowledge, (5)
perfect certainty, (6) perfect mobility of factors,…
• Positive heuristic: (1) divide markets into consumers and producers; (2) specify
the market structure, (3) create ideal definitions of behavioral assumptions; (4)
set up the ceteris paribus conditions; (5) translate the problem into calculus,…
• How do works by other economists respond to this framework? What hard cores
are aimed to be protected? 12 Appraising economic theories
• The hard core of Keynesian economics: (1) propensity to consume (fundamental
psychological law), (2) theory of liquidity preference, (3) underemployment
equlibrium, (4) marginal efficiency of capital,…
• Protective belt: (1) the consumption function, (2) the multiplier, (3) the concept
of autonomous expenditures, (4) speculative demand for money,…
• Positive heuristic: (1) statistical estimation of consumption function, (2)
statistical estimation of the multiplier,…
• Novel facts: the tendency of competitive markets to generate “underemployment
equilibrium” -> theoretical progressive problem shift
 • A Kuhnian Revolution? Keynesian economics was a theoretical progress but not
an entirely new practical proposal.
• The degeneration of Keynesian SRP in the 1950s and 1960s
• The Marginal Revolution could be a hare core change in England, and
progressive problem shift in Continental Europe
• Latsis (1972) on the theories of perfect competition: (1) hard core:
profitmaximization, perfect knowledge, independence of decisions, perfect
markets; (2) protective belt: product homogeneity, large numbers, and free entry
and exit; (3) the analysis of equilibrium conditions as well as comparative
statics…
Further thoughts
• Evaluate the theories of scientific progress proposed by Popper, Kuhn, and
Lakatos and elaborate your preference.
• To what extent do you agree with Friedman’s instrumentalism?
• What is the “hard core” that Marx and his followers apply? How about the
Austrians and American institutionalists?
• Can the Lakatosian MSRP be applied in understanding the evolution of
neoclassical economics?