CHAPTER 7

Pre-1914 Variations on Neo-Classical Themes

The central nerve of neo-classical economics was the analysis of the behaviour of the market system and the mechanisms within it through which an equilibrium could be produced. Marshall occupied a commanding position in the development of the English tradition of neoclassicism and the sweep of his work was unmatched by other contributors to the neo-classical tradition. Variations on similar themes, however, were run elsewhere. The alternative approaches were inspired by considerations somewhat different from those that had prompted Marshall and often yielded slightly different results. The distinctive tracts of four additional strands of formative neo-classicism deserve inspection, if only in synoptic form: the contributions of the Lausanne, American, Austrian and Swedish traditions.

1. LEON WALRAS AND THE

NEO-CLASSICISM OF LAUSANNE

Leon Walras (1834-1910), a Frenchman who spent his professionally most productive years in Switzerland, approached the neo-classical problem along a path quite different from the one Marshall had chosen. For Walras rigorous, formal elegance - rather than contact with the practical problems of real life - was the target appropriate for the aim of economists. His concern was with pure theory which he defined as ‘the theory of determination of prices under a hypothetical regime of perfectly free competition'.1 He aspired to give economics a scientific status comparable to that enjoyed by the physical sciences and to distil its findings into the form of mathematical propositions. Walras was equally insistent that a sharp line of demarcation should be drawn between pure and applied economics. Though not himself indifferent to policy considerations, he vigorously maintained that the status of economics as pure science should never be compromised in the interests of bringing the work of the theorist closer to the problems of practical affairs. The contrast between the Walrasian and Marshallian intellectual styles could hardly have been more marked.2

Walras's career was filled with disappointments. Thwarted in his original ambition to study engineering (ironically, because he failed to satisfy the admissions board of the Ecole Polytechnique of his competence in mathematics), he meandered for more than a decade - with only meagre success - as a journalist, aspiring novelist, railway clerk, and bank employee. Meanwhile, he directed much of his leisure to the study of economics, a pursuit in which he received little encouragement in his native country. Lacking the proper credentials, he was unable to break into the French academic establishment. In 1870 fortune at last smiled. He was then appointed to the newly created chair in economics in the Faculty of Law at the University of Lausanne. While resident in Switzerland, he remained a loyal Frenchman, though he did not suppress a sense of irritation with French institutions.3

The prime objective of Walras's intellectual programme was to produce an exhaustive account of the implications of a regime of perfect competition. Part of the value of this exercise, as he saw it, lay in the fact that many economists had been too readily persuaded of the merits of laissez-faire. ‘How could these economists', he asked, ‘prove that the results of free competition were beneficial and advantageous if they did not know just what these results were? And how could they know these results when they had neither framed definitions nor formulated relevant laws to prove their point? . . . the fact that economists have often extended the principle of free competition beyond the limits of its true applicability is proof positive that the principle has not been demonstrated.'4

For his purposes, perfect competition was likened to a situation in which buyers and sellers could be brought together in a massive auction 'in such a way that the terms of every exchange are openly announced and an opportunity is given to sellers to lower their prices and to buyers to raise their bids'.5 These conditions were admittedly divorced from reality. He defended the procedure by asking: 'What physicist would deliberately pick cloudy weather for astronomical observations instead of taking advantage of a cloudless night?’6 In his view the case for a procedure which began with abstract general cases and took up the qualifications later was too self-evident to require further comment.

The basic problem to be solved within this hypothetical regime of pure competition concerned the manner in which the prices of the various inputs and outputs were established. Marshall had addressed the same issue by invoking supply and demand curves in various types of markets as the basis for the determination of equilibrium prices. His procedure, however, contained an awkward ambiguity. It will be recalled, for example, that his analysis of demand required the assumption that incomes were constant. Whether this condition was intended to refer to money income or real income was not entirely clear. In either case it could be objected - as Walras pointed out - that a reduction in any price (even when it could be represented as a movement from a higher to a lower point on the same demand curve) was unlikely to be accomplished without a change in someone's income. Barring the case in which the quantity sold increased by the same percentage as the price had been reduced, the income of sellers would necessarily alter. This, in turn, would imply a shift in the position of the original demand curve.

Marshall's formulation was thus too loose to meet Walras's standards of analytical rigour. And it was also too 'partial'. Marshallian procedure called for the investigations of conditions in individual markets on terms which largely isolated them from wider influences. Walras, on the other hand, sought to trace out the manner in which an equilibrium solution could be reached in all markets simultaneously. His target was a statement of the process by means of which a 'general' equilibrium - one which took into account the inter-dependence of all economic activities - was established. A later commentator has described the Walrasian perspective on the economic system as one in which 'no blade of grass can move without altering the position of the stars'.

As a first step toward demonstrating the possibility of a general equilibrium solution, Walras examined the case of the simplest economy imaginable. It possessed only two goods to be exchanged (identified as x and y). All persons were assumed to be buyers of one good or sellers of the other. On these assumptions, it could be argued that the supply of x and the demand for y (as well as vice versa) were interdependent because the market demand for y (or x) was derived from the incomes received by sellers of x (or y). Consistent with neo-classical procedure, it was, of course, assumed that the terms on which sellers were prepared to exchange were regulated by the marginal utilities of x and y. Through competitive bidding an equilibrium price ratio would be established.

The problem became more intricate, of course, when more than two goods were involved. In the three-commodity economy (with goods x, y and z), three price ratios could be established (x:y, x:z, and y:z). One of these ratios, however, would be redundant, adding no information that could not be derived from the other two. This example illustrated a larger principle: namely, that in a multi-good economy, the number of equilibrium price ratios required was always one less than the number of goods involved in exchange. Thus in an economy with n goods, (n-1) exchange ratios would have to be determined through competitive bidding. The redundant commodity could then be regarded as a standard - or a numeraire - in terms of which all other price ratios could be expressed. This standard commodity, whatever its identity, would possess all of the essential properties of money.

The Walrasian approach to the analysis of the competitive process had the considerable merit of lending itself neatly to presentation in the form of simultaneous equations susceptible to a determinate mathematical solution. This procedure also had an important recommendation in that it emphasized the interdependence of all prices within the economic system. At the same time, Walrasian general equilibrium dissolved the standard lines of demarcation between micro- and macro-theory. The activities of households, firms and industries could not be understood in isolation from one another or when detached from the economy as a whole.

This formal analysis of conditions required to produce an equilibrium was, of course, built on two important practical restrictions. The case of an underemployment of resources, for example, was obviously inadmissible. In fact, the whole argument rested on the assumption that full employment was the normal situation. The general equilibrium solution could be reached only when it could be supposed that all income was spent; otherwise the total interdependence between supply and demand could not be asserted. Indeed Walras's approach can be interpreted as a logical extension of the tradition Say established when he wrote that `goods constitute the demand for other goods'.

Nor was Walras's system equipped to handle the case of increasing returns to scale. If such production conditions prevailed, a determinate set of equilibrium prices could not be reached. Walras placed too much of a premium on rigorous and tidy solutions to resort to the tactics Marshall had adopted - an appeal to the ‘special' and imperfect markets of the everyday business world - when confronted with this complication.

If these cases could not be handled within his hypothetical r6gime of pure competition Walras's scheme could still throw some useful indirect light on practical issues. It could now be stated explicitly that laissez-faire would break down under conditions of increasing returns to scale. Alternative arrangements would then have to be devised. In his comments on this problem Walras provided few details beyond noting that the public services and the `natural' monopolies could not conceivably be conducted under the rules of pure competition. He did insist, however, that additional considerations were pertinent to an assessment of the social results of competition. The outcome of the competitive process, he noted, depended on the initial distribution of income and property. For this reason it did not necessarily follow that the results produced were ideal, nor the only ones conceivable. Different distributional systems, both for income and property, were always possible. Perfect competition, though it might be a reasonably satisfactory allocative device in the existing order, could claim neither perfection nor immortality.

While recognizing the possibility of different modes of economic organization, Walras maintained that judgements on their merits were beyond the competence of economists as scientists. The economist could, of course, point to the existence of alternatives. But discussion of the options best calculated to serve the community's interest fell within the realm of art and was outside the domain of scientific discourse. As citizens, economists might still hold private views about the desirability of particular institutional arrangements. Walras personally was sympathetic to a regime of small agrarian freeholders, an institutional arrangement likely to approximate perfect competition about as closely as any system imaginable.

2. JOHN BATES CLARK AND THE

AMERICAN STRAND OF EARLY NEO-CLASSICISM

The American strand of neo-classicism was partly a grafting of two quite different European roots - that of German and Austrian thought (to which a substantial number of the early American academic economists were exposed during graduate study in German universities) and Marshallian influences which flowed easily across the Atlantic on the English language wave. But there were also distinctive indigenous elements in the approach to the neo-classical problem devised in the United States. Most of the important figures in this formative period managed to blend an ethical concern and a native-soil political radicalism into their theoretical systems. Thus the charter members of the American Economic Association - most of whom were unsympathetic to laissez-faire - declared in its original statutes that: 'We regard the State as an agency whose positive assistance is one of the indispensable conditions of human progress.' This language, however, was soon withdrawn on the grounds that a pre-disposition to a policy position was unfitting to an organization dedicated to scientific inquiry.

John Bates Clark (1847-1938) was not only a giant among American neo-classicists but he was also the first genuinely original theorist of the first rank to emerge in the New World. As a young man, he followed the course recommended for many promising students of his generation by pursuing graduate study in European universities (in Clark’s case at Heidelberg and Zurich). On his return to America, he settled into an academic career which was climaxed in 1895 by his appointment to a chair in economics at Columbia University.

Clark’s major original contribution to the sharpening of neo-classical analysis was his pioneering work on the theory of production and distribution. Two considerations influenced this concentration of his theoretical energies. One was a deep-seated moral concern which inspired him to search for criteria of distributive justice in an economic environment made increasingly complex by industrial concentrations and by the rise of labour unions. In addition, his dissatisfaction with a popular view that wage levels (and the distribution of income generally) were determined primarily by the real income available to labourers on rent-free land stimulated him to produce an alternative analysis of income distribution.7

Clark applied the tools of marginal analysis – including some of his own invention – to this task. As was characteristic of this tradition, he proceeded first on the assumption that conditions of perfect competition prevailed. The rational producer would then engage each of the three productive factors to the point at which the price of the marginal unit of each factor was equal to its marginal product. These production rules simultaneously determined the distribution of income between the various functional shares. In the absence of abnormal profits under perfectly competitive equilibrium the resulting distributional solution – as Clark was among the first to demonstrate – would exhaust the value of the total product. This conclusion holds, however, only so long as constant returns to scale prevail (i.e. the situation in which a doubling of the size of plant would produce no change in unit costs). It would be vitiated in the case of economies of scale that lowered unit costs.

Conditions in the real world, of course, were likely to depart from the perfectly competitive standard. Indeed, when employers enjoyed a bargaining advantage, they would probably exploit it by paying wages at rates less than the value of labour’s marginal product. In Clark’s judgement, this amounted to ‘institutional robbery’ which occurred in any ‘plan of living that should force men to leave in their employers’ hands anything that by right of creation is theirs’.8 But it was also possible that tightly organized trade unions might exact – if only temporarily – wage rates in excess of labour’s marginal product. This situation was also socially ‘unjust’; Clark believed that it could be avoided by denying unions any powers to restrict the supply of labour (such as those that would be possible under closed shop arrangements).

Using marginal productivity techniques, Clark had, in effect, devised a neo-classical definition of `exploitation’ – but one which was totally alien to the Marxian use of the same expression. As Clark saw the matter, economic exploitation was a real possibility but not inherent in the capitalist process. Only when the system departed from the perfectly competitive standard did exploitation arise. Nor was the exploitation of labour by capitalists the only possible deviation from distributive justice, though it might be the most probable. At least in principle, labour could exploit capital if its claims resulted in sub-marginal product rewards to capital.

The programme for the analysis of the practical attainability of distributive justice required, of course, an inspection of the actual competitive order – and, in particular, of the implications of industrial concentrations – before it could be rounded out. Clark’s initial position was quite unsympathetic to the moral ethos of industrial capitalism, an order he interpreted as being built on lust for private gain rather than the promotion of social virtue. But if unrestrained competition was socially abusive, monopoly was likely to be even more so. Personally, he supported the promotion of producer co-operative organizations.

He later modified these views substantially. The threat of monopoly no longer loomed so large in his thoughts as, under dynamic conditions, he maintained that technical innovation would constantly challenge established concentrations of market power. Size per se was not sufficient as a basis upon which to judge the social effects of an industrial organization. So long as there were no barriers to the entry of new competitors and so long as collusive Agreements between producers were prohibited, most of the socially desirable features of perfect competition could still be obtained in a dynamic and expanding economy. On this matter Clark’s views anticipated the ‘workable competition’ doctrines now current which maintain that industrial organization should be judged more by performance tests (e.g. technical progressiveness, restraint in price-setting, etc.) rather than by structural tests (e.g. size, share of the market, and the number of rival producers).

3. EUGEN VON BOHM-BAWERK AND THE AUSTRIAN SCHOOL

Between 1870 and the outbreak of the First World War, Vienna was the site of one of the most flourishing schools of neo-classical teaching. Though this tradition of neoclassicism was launched by Carl Menger - who was among the first to bring marginal concepts to bear on the analysis of market equilibrium - the towering figure of this period was Eugen von Bohm-Bawerk (1851-1914).

In his professional career Bohm-Bawerk combined academic and official duties. He was first called from a university post to the Ministry of Finance in 1889 to work out a projected currency reform and rose to serve three appointments as the Austrian Minister of Finance. From this position he fought effectively for balanced budgets and a stable currency linked to the gold standard. Meanwhile, he maintained contact with university life, though he was able to devote substantial time to teaching and research only after resigning his ministerial post in 1904.

Bohm-Bawerk's theoretical writings were concentrated on the nature of capital and interest. At first glance, these problems, though important, might appear to be limited in range. In fact, as he treated them, they were all-embracing. He held that the analysis of capital and interest constituted `the focal point about which attack and defence rally in the war in which the issue is the system under which human society shall be organized'.9 Indeed, as his ablest pupil has observed, the scale of the canvas on which Bohm-Bawerk painted justified describing him as a ‘bourgeois Marx'.10

Bohm-Bawerk's procedure was heavily formal and deductive. Consistent with his view of economics as an exact science, he claimed to offer a correct and comprehensive view of the nature of capital and its role in the productive process. From his perspective, earlier traditions had provided only a partial account. The Physiocratic interpretation of the productive process, for example, had regarded only one factor of production - land - as crucial. The classical tradition, while eliminating this error, had bred another by holding that labour was the basic productive factor. Only in neo-classical thought was capital given an autonomous status. Even so, the existence of capital was not independent of other factors of production. In his view', it could arise only through the earlier cooperation of the two original factors, labour and land.

Nevertheless, in Bohm-Bawerk's scheme of things, all forms of production (with the exception of the most primitive in which no implements whatsoever were used) involved indirect and roundabout methods. They were thus `capitalistic' in nature. In his terms the `method of production which wisely follows an indirect course is nothing more nor less than what the economist calls capitalist production.... Capital is nothing but the sum total of intermediate products which come into existence at the individual stages of the roundabout course of production.'11 Roundabout methods were used for the obvious reason that production assisted by capital instruments could produce more than could land and labour unaided. The effects of capital on output, however, were delayed; capital goods took time to construct and to be absorbed into the productive process. But no less important to an understanding of the nature of capital was the fact that the community was obliged to save before the capital stock could be enlarged. The basic problem in the analysis of production was thus one of reconciling two opposing considerations: the disadvantages of restraining consumption, on the one hand, against the advantages of future expansions in output, on the other. How was a solution to this problem to be reached?

Part of Bohm-Bawerk's explanation rested on the premisses of Austrian subjective value theory. It was assumed that economic man was motivated by the desire to maximize utility. But in this case the maximization problem had to be viewed over a span of time in which present and future satisfactions were weighed against one another. Bohm-Bawerk maintained that most men were likely to prefer the bird in the hand to the one in the bush - i.e. to over-value the present relative to the future and to underestimate the strength of future wants. For these reasons people had to be rewarded - through the payment of a rate of interest - for saving and parting with present satisfactions.

The other side of this coin was the willingness of those who purchased capital goods to pay for the means to acquire them. From the producer's point of view the desirability of additional capital goods was self-evident because of the additions to output their use permitted. For this reason borrowers were enabled - and prepared - to pay an interest charge. At the same time the existence of a positive rate of interest meant that the roundaboutness of the productive process would not be extended to infinity because additions to the capital stock were subject to diminishing returns. The existence of a rate of interest thus assured an equilibrium between saving and investment.

Bohm-Bawerk's analysis was clearly at one with the general neo-classical conviction that thrift and the productivity of capital determined the rate of interest and regulated decisions to save and to invest. In his hands, however, the argument did more: it became a powerful weapon in ideological combat. If his definitions were accepted, it was both pointless and an abuse of language to differentiate - as Marx had done - between various historical stages in which different rules for the conduct of economic life applied. Any tool-using society was, by definition, 'capitalistic' and subject to the same universal and timeless principles. Bohm-Bawerk, in fact, wrote a lengthy critique of Marxian analysis in which he maintained that Marx's basic error stemmed from a misguided labour theory of value that blinded him to a 'correct' view of the nature of capital. Though the assault on Marx took precedence, Bohm-Bawerk's vigorous assertion of the validity and value of universal, formal categories was also aimed at another group of intellectual adversaries - i.e. those members of the German historical school who had maintained that abstract reasoning had little to contribute to an understanding of the economic process and distracted attention from 'the facts'.

4. KNUT WICKSELL AND THE SWEDISH BRAND

OF NEO-CLASSICISM

In a discipline that has been rich in eccentrics, Knut Wicksell (1851-1926) must rank near the top of any list of unforgettable characters. By his own admission he displayed a 'contrary disposition' from an early age and throughout his life he was a vigorous opponent of social conventions. When he married he spurned both church and state and simply announced that he and a remarkable woman had been 'united' through a private exchange of contracts. In his late forties he placed in jeopardy his first opportunity for professional recognition and for escape from the financial insecurity of free-lance lecturing and pamphleteering by refusing to follow the procedure prescribed for appointees at Swedish royal universities. So intense were his republican views that he could not bring himself to use the expression 'Your Majesty's most obedient servant' when petitioning the king for formal appointment to the chair of economics at the University of Lund. Victory in these battles did not diminish his delight in 'setting the cat among the pigeons' by championing unpopular causes.

In his theoretical writing Wicksell polished and refined the marginal approach to the analysis of value and distribution. He did not emerge with the conclusion (as some of his neo-classical contemporaries had done) that the allocation of resources produced by free competition would be socially optimal. He did not deny that a regime possessing the conditions required by pure competition would tend to yield an outcome in which the prices of productive factors would be equated to the value of their respective marginal products and the prices of outputs made equal to the marginal costs of production. Nor did he deny that these results suggested that no gains in output could be accomplished through a re-allocation of a given stock of productive resources. He insisted, however, that the social desirability of this outcome could not be judged in isolation from the distribution of income and wealth. On this point he once wrote:

As a matter of fact all argument in favour of free competition rests on one tacit assumption, which, however, corresponds but little to reality, namely that from the beginning all men are equal. If that were so, everyone would be equipped with the same working power, the same education and, above all, the same economic assets, and much could then be said in favour of free, unhampered competition; each person would have only himself to blame if he did not succeed.

But if all conditions are basically unequal, if some people have good hands from the beginning and others hold only low cards, free competition does nothing to stop the former from winning every trick while the latter pay the table.12

It did not follow, Wicksell maintained, that the means of production should be socialized. He saw little prospect that public ownership could improve on the productive performance of the free market system. He elaborated this position with arguments similar to those Bohm-Bawerk had used to demonstrate that all societies beyond the most primitive faced the same fundamental problems of 'capitalistic' production. The attention of the state, as he saw it, should be directed to reducing the handicaps suffered by the weak in the competitive struggle by making opportunities freely and universally available and by levying heavy inheritance taxes.

The most novel of Wicksell's analytical contributions lay in the area of monetary theory. Orthodox neo-classicism, it will be recalled, treated monetary questions as matters of distinctly secondary concern. Money, of course, was essential as a circulating medium in an exchange economy, but it was still only a ‘veil' covering exchanges of goods. Wicksell contended to the contrary that money and credit had a crucial bearing on the level of economic activity. Moreover, these matters grew in importance and complexity with the increasing reliance on banks as creators of means of payment. The amount of credit banks supplied was, of course, determined primarily by the demand for loans which, in turn, derived from the net gains a borrower anticipated from the use of credit. But it did not necessarily follow that the interest rate charged by banks (i.e. the market rate) coincided with the normal (or real) rate of interest corresponding to the marginal productivity of capital and to an equilibrium between saving and investment. Should, for example, the market rate be less than the real rate of interest, then:

. . . saving will be discouraged and for that reason there will be an increased demand for goods and services for present consumption. In the second place, the profit opportunities for entrepreneurs will thus be increased and the demand for goods and services, as well as for raw materials already in the market for future production, will evidently increase to the same extent as it bad previously been held in check by the higher rate of interest. Owing to the increased income thus accruing to the workers, landowners, and the owners of raw materials, etc., the prices of consumption goods will begin to rise, the more so as the factors of production previously available are now withdrawn for the purposes of future production. Equilibrium in the market for goods and services will therefore be disturbed. As against an increased demand in two directions there will be an unchanged or even diminished supply, which must result in an increase in wages (rent) and, directly or indirectly, in prices.13

In short, Wicksell's analysis pointed to the possibility that the behaviour of interest rates - rather than tending automatically to assure aggregative equilibrium - might instead generate cumulative movements away from equilibrium. Moreover, in a system with a highly elastic supply of bank credit, there was no reason to expect these fluctuations to be self-correcting without considerable dislocation. The indirect connexions Wicksell established between the monetary system and the level of economic activity via the rate of interest foreshadowed a major revolution in economic thinking which in the 1930s shook the very foundations of neo-classical economics.