The one-handed economist

Book 5, Chapter 8

§1. “And again this demand [for an input], because it is so derived, is largely dependent on the supply of other things which will work with them in making those commodities [final goods]. And again the supply of anything available for use in making any commodity is apt to be greatly influenced by the demand for that thing derived from its uses in making other commodities: and so on. These inter-relations can be and must be ignored in rapid and popular discussions on the business affairs of the world. But no study that makes any claim to thoroughness can escape from a close investigation of them. This requires many things to be borne in mind at the same time: and for that reason economics can never become a simple science” [p 334 emphasis added].

§2. The demand (=price) of inputs that can be substituted for each other (e.g., steam vs horse-power) will depend on relative efficiencies, with exceptions for laws, custom and other frictions. A horse that produces 10% of a machine’s output will attract offers equal to 10% of that machine’s price.

§3. Businessmen are always experimenting with the mix of inputs required to get a desired output. Although accounting for marginal and capital costs (and depreciation) is not easy, prices and costs will, over time, tend to reflect each input’s value added.

§4. The balance among inputs of capital, labor and materials will tend to equate, at the margin, with their marginal products (i.e., ratios of values to costs). An over-application of any input is wasteful due to decreasing marginal returns (on that input) and opportunity costs (not using other inputs).

In a long footnote, Marshall argues against those who see any given input as “essential” in that a small reduction in its use (e.g., a worker who labors one hour less) will have dramatic effects on the productivity of other inputs.  While this might be true in the short run, Marshall argues that changes here  can be balanced by (continuous) adjustments elsewhere. This appeal to continuity underpins the use of calculus (finding minima and maxima by taking derivatives of functions), which makes sense in many circumstances. I disagree with the continuity assumption when it comes to constraints (an 8 hour shift) or innovations (the shift is eliminated). I assume Marshall would have agreed but modern (=mathy) economists may have forgotten those important caveats and exceptions.

§5. The decision to add/subtract inputs is made “at the margin” in terms of weighing additional profits (or value) vs costs. That calculation takes existing levels of inputs as given, which also means that removing a unit at the margin has a far smaller effect than removing an “inframarginal” unit. In this way, we can see how it might be ok to, say, skip another hour of sanding down a chair while it might be a bad idea to skip an hour of adding legs to that chair. Order matters.

§6. The rents (or interest) returned to “free floating” capital versus “invested” capital varies with the longevity and idiosyncrasies of investments, but they tend to converge.

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This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Book 5, Chapter 7

Marshall, like many of his contemporaries, used long titles. 

§1. How should one price two goods that share common elements in their costs (e.g., a machine or management time) but are sold into different markets (e.g., passengers and freight on ships). Pricing from the cost side is tricky. Pricing from the demand side (“what the market will bear”) makes more sense, but it’s ultimately linked to costs, since competing firms selling similar goods and services must also cover their costs.

§2. A manufacturer will want to allocate marketing expenses among goods in proportion to their marketing “needs” but that manufacturer may cut that allocation in the most competitive markets (e.g., for loss leaders). Manufacturers who achieve economies of scale will have falling per unit costs but rising marketing costs based on trying to differentiate similar goods (e.g., cola advertising).

§3. Insuring against risk is often wise but allocating those costs can be difficult when they rise and fall with other actions. The price of fire insurance, for example, will fall if a building is built to reduce fire risks. Are those additional building costs part of construction or insurance?

§4. Marshall points out that risk aversion (the loss of bad outcomes outweighing the gains from good outcomes) is more prevalent than risk seeking behavior (p332):

It is true that an adventurous occupation, such as gold mining, has special attractions for some people: the deterrent force of risks of loss in it is less than the attractive force of changes of great gain, even when the value of the latter estimated on the actuarial principle is much less than that of the former… But in the large majority of cases the influence of risk is in the opposite direction; a railway stock that is certain to pay four per cent. will sell for a higher price than one which is equally likely to pay one or seven per cent. or any intermediate amount.

Kahnemann and Tyversky rediscovered these principles in the 1980s.

§5. In some cases, the cost of reproducing a good will be similar to its cost of production, with both closely tracking its price, but that relation weakens if production technologies or input prices have changed, and it breaks down if demand races ahead of supply (e.g., “quinine on a fever-stricken island”).

Marshall ends the chapter with the advice that non-economic readers skip the next seven chapters (!), but I won’t. Fasten your seatbelts!

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This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Book 5, Chapter 6

§1. A consumer demanding a good from a producer thereby creates derived demand for the inputs to produce that good. In most cases, inputs are not interchangeable (100% substitutes), which means they are joint (or complementary) with other inputs, with all supplied in stable proportions. Thus, the absence of one input can halt overall production, e.g., trying to make beer without hops.

§2. A missing factor (production input) will lead to increased prices for that factor if (1) the factor cannot be replaced (no substitutes), (2) consumers cannot do without that good (thus, they will pay more rather than go without), (3) the missing input plays only a small part in the price (meaning producers able to find some of that input can pay more for it without raising the product’s final price by much), and (4) other inputs can be acquired for lower prices, leaving extra space to pay for the scarcer input. In sum, a scarcer input will still be used if it’s an essential but small part of the production process.

§3. Composite demand for an input results from the summation of demands from all producers using that input for their consumer products.

§4. A joint product produces different goods for different markets (e.g., oil can be cracked into gasoline and lubricants). If the price of one product is significantly higher than that of the other, then producers will focus on it over the other. If demand for the more valuable product collapses, then the less-valuable one will be more scarce, driving up its price.

§5. Marshall uses many figures and mathematical logic to explain joint and separate contributions to supply and demand, but I find these uninteresting. It’s important to understand complements and substitutes on the supply or demand side, but I think it’s quite difficult to work out their exact (financial or mathematical) relations, even with the best data.

§6. Those who demand or supply one input might benefit from lower (or higher) demand or supply for substitutes or complements, and they will lobby for laws and regulations to favor themselves, thereby distorting broader markets.

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This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Book 5, Chapter 5

§1. “Normal” prices in markets for goods, services, labor, etc. can be pushed up or down to “abnormal” levels by technology, time, changes in season or tastes.

§2. Economists gain insights by via “ceteris paribus” (holding all other things equal) analysis that allows them to ignore complexities while focussing on the most important causal factors. Results are “cleaner” with more controls but less realistic. Marshall cautions against abuse (p 306):

But nothing of this [the world standing still] is true in the world in which we live. Here every economic force is constantly changing its action, under the influence of other forces which are acting around it. Here changes in the volume of production, in its methods, and in its cost are ever mutually modifying one another; they are always affecting and being affected by the character and the extent of demand. Further all these mutual influences take time to work themselves out, and, as a rule, no two influences move at equal pace. In this world therefore every plain and simple doctrine as to the relations between cost of production, demand and value is necessarily false: and the greater the appearance of lucidity which is given to it by skilful exposition, the more mischievous it is. A man is likely to be a better economist if he trusts to his common sense, and practical instincts, than if he professes to study the theory of value and is resolved to find it easy.

§3. Marshall recommends starting with a stationary state before introducing “partial perturbations,” which is now known as partial equilibrium analysis.

§4. He then explores how the prices of fish might vary in the short, medium and long terms. In the short term (day-to-day), prices rise and fall with weather, “meatless Fridays,” etc. When looking at the medium term (~2 years), these fluctuations might cancel out and they can be should be ignored while examining the impact of, e.g., a fall in demand for beef due to a multi-year plague that increases demand for fish. In such a case, prices will rise and stay there (should people permanently change their taste for beef) until long-term adjustments (e.g., more boats and fishermen) increase supply.

§5. Producers will consider time when responding to abnormal prices. In the short run, marginal producers will work harder to add more quantity to the market while incumbents enjoy excess profits from above-average prices. If abnormal prices look set to endure, then producers will alter their capital mix to fit the “new normal.”

§6. Producers will sell at a loss in the short run (e.g., when higher production costs cannot be recovered in prices), but not without considering impacts on the market, competition and their long-run (capital) costs. Marshall cautions: “he [the producer] regards an increase in his processes of production [VC and FC], rather than an individual parcel of his products [VC], as a unit in most of his transactions. And the analytical economist must follow suit, if he would keep in close touch with actual conditions” [p 312]. Economists should not let their theory stray too far from reality. In modern industrial organization, it’s “continue to produce while pq>c(q) — even if pq-c(q) < fc — but shut down if pq<c(q).”

§7. In the long run, investments in production capacity depend on the expectation of profits. Changes in those perceptions thus impact changes in long run supply, in terms of prices and quantities.

§8. Thus, Marshall concludes, short-run supply depends on current capacity whereas long-run supply allows for changes in capital and thus capacity. In both cases, prices also depend on changes in demand (tastes) as well as technology, which affects both supply (more efficient production) and demand (via the appearance of competing substitutes).

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This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Book 5, Chapter 4

§1.Marshal begins with a simple example of a man building his own house, which he uses to explain how present costs must be less than (expected) future benefits, which are “normalized” (discounted to net present value) via a “sort of compound interest.” I find this beginning quite interesting, since I am now teaching students about cost-benefit analysis and discount rates!

§2. Expanding to the example of a businessman incurring costs now for potential (risk-adjusted) future benefits, Marshall explains how present values are “aggregated” to future values, whereas future values are “discounted” to present values, with the net benefit being calculated at the same point in time.

§3. Competing businessmen will change their mix of inputs in an attempt to find a cheaper means to the same end. Their profit-seeking searches increase efficiency and thus deliver “progress.”

§4. Marshall gives examples of a housewife or house builder changing their mixes of products and inputs, to maximize net benefits. These substitutions are mathematically equalized via “marginal products” that both implicitly understand as if solving equations.

§5. A businessman must recover both “prime” (variable) and “supplementary” (fixed) costs when pricing products for sale.

§6. In the short run, a product’s price need only cover variable costs, but revenues total sales must cover fixed costs in the longer run, if the business is to continue.

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This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.