Foundations of Marginal Analysis – “First Generation Marginalists”

1. Foundations of Marginal Analysis – “First Generation Marginalists” Chapter 8

2. What is Marginal Analysis? • A basic technique used in economics that analyzes small, incremental changes in key variables • A marginal change is a proportionally very small addition or subtraction to the total quantity of some variable. • In microeconomic theory, "marginal" concepts are employed primarily to explain various forms of "optimizing" behavior • Utility for consumers, profit for producers

3. Marginal Analysis • For the decision maker trying to determine how many units of a good to consume or provide to the market, net total benefits (benefits minus costs) will always be maximized at that level of consumption (or provision to the market) where the marginal benefit derived from adding the last unit equals the marginal addition to total costs of producing or acquiring that last additional unit

4. Marginal Analysis • Looked at another way, an additional unit should be consumed or produced as long as the marginal benefit > marginal cost • Maximization occurs when MB = MC

5. Jevons Quote • “In commerce, bygones are for ever bygones; and we are always starting clear at each moment, judging the values of things with a view to future utility.” • What does this mean?

6. Applications of Marginal Analysis • Supply • Demand • The first generation marginalists were almost exclusively concerned with demand and marginal utility

7. Components of the "marginalists'" critique of the Classical's value theory • Classical’s focus was on supply • Labor Theory of Value • Price depended upon the cost of production • And, these costs occurred in the past • Marginalists said that price depended upon the marginal utility accruing to consumers – focus on the future

8. Components of the "marginalists'" critique of the Classical's value theory • The question then arises – is the value (price) of final goods and services determined by the value of the factors of production, or does the price of final goods and services determine the value of the factors of production? • Are pearls valuable because people dive for them or do people dive for them because they are valuable (have utility)?

9. Components of the "marginalists'" critique of the Classical's value theory • The second criticism has to do with marginal utility vs total or average utility (see Table 8.1, pg. 227) • Diamond-Water Paradox • Diminishing marginal utility –water usage is high, so MU is low and price is low. Diamond usage is low, so MU is high and price is high

10. Utility • What is utility? • Not precisely defined, but it can be measured • It diminishes with additional units of a good or service • What is the utility maximization condition? • What does this assume?

11. Utility • A consumer can compare the utility of different goods and services • But what about interpersonal comparisons of utility? • What about the marginal utility of income?

12. Factor Prices • Factor prices are determined by the price of the final good • They are NOT price determining, but they are price determined

13. First generation marginalists and Classicals • Remember Mill’s three scenarios on page 177 • When supply is perfectly inelastic, price depends upon demand and supply • When supply is perfectly elastic, price depends upon supply only – in this case the Classicals’ focus on cost of production as determining price is correct • In the “normal case” price depends upon both supply and demand

14. First generation marginalists and Classicals • IN GENERAL • Classicals said value (price of final good or service) depends upon supply – costs of production – labor theory of value • First generation marginalists said that value depends upon demand – marginal utility • In fact, both analyses are deficient in that they are incomplete, and later economists cleared this up