Economic challenge

Economic Challenge1 Challenge to classical theory came not from ‘outside’, but from ‘within’—not from the Historical School nor from the Socialists, but from the Marginalists. The socialists, including Karl Marx, built on classical theory, while the Historical School repudiated theory altogether. It is the Marginalists who diverted economic theory away from the main stream, concentrating chiefly on value and resource allocation.

And even here it was no longer a problem of variations in absolute values over time and their impact upon society but a problem of ‘relative prices’ seen as functioning within the framework of an impersonal, self-adjusting economic system. So pronounced was this deviation that with the emergence of marginalism the problems that evoked classical economics came very nearly to be forgotten. Economic challenge is only in recent years, partly under the impact of post-Keynesian ‘growth’ economics and partly due to the urgency created by a more intimate appreciation of the problem of what Myrdal calls ‘international economic integration’ that the older sights are reappearing.

The advent of marginalism did indeed mark a revolution in economic theory. The old terms no doubt continue to be used, but they have lost their old connotation. Not only is a new technique introduced into economic analysis, but the structure and content of economic theory have also received a new orientation. Value has ceased to be an absolute, measurable entity; it has become a ratio of exchange, without a dimension.2 Distribution appears as an extension of the theory of value—being just a problem of pricing of factors of production.

The two aspects of the economic problem are then integrated into a unified and logically self-consistent system. The old tripartite division of ‘factors’ into land, labour and capital is retained, but their old association with social ‘classes’ (or ‘orders of society’, as Adam Smith would put it) is lost. Factors are conceived just as productive agents independently of the institutional framework within which they operate. The concepts of Cost and Surplus thus cease to have the significance that they acquired in classical political economy. Cost stands for ‘opportunity surrendered’, and Surplus turns out to be an excess of the actual income of a factor over its transfer price. Whereas in the classical system these concepts were used as criteria for the evaluation of the economic progress of a society   indeed the labour theory of value derives whatever significance it has from just this consideration, in the new system they are used as criteria for judging allocative efficiency, their application being confined primarily to the sphere of taxation.

The marginal technique was designed to bring out the principle of maximization that is supposed to characterize rational conduct. In the equation of the price ratio of goods with their marginal utility ratio there is the fulfillment of maximum principle in respect of consumer’s expenditure. And in the equation of the price ratio of factors with the marginal productivity ratio we have a similar fulfillment of maximum principle in respect of the firm’s choice of technique of production. Precisely the same principle is postulated in respect of the allocation of resources where it expresses itself in an equation between the price ratio and marginal cost ratio of products.

The entire analysis proceeds on the basis of the principle of substitution. Economic phenomena are manifestations of choice exercised by consumers and producers in respect of the disposal of scarce resources, and the phenomenon of choice in human behaviour is inseparably associated with the phenomenon of substitution. The principle of choice and substitution is thus fundamental hi the marginalist system of economic theory. The system is worked out within the framework of a static economy population, tastes, technology and resources being all held as data. This surely is in sharp contrast with the classical approach which is set out against the background of a growing economy, where the dynamic determinants such as accumulation of capital, technical progress and growth of population are shown as integral parts of the analytical model. How pronounced the cleavage is between the two systems is seen from the fact that whereas Adam Smith’s enquiry was into the nature and causes of the Wealth of Nations, one of the modern exponents of the marginalist system goes to the length of urging that ‘in strict delimitation of economic science’ the term Wealth should be discarded.1
It must be a puzzle to the historian of economic thought how economic theory should have taken such a sharp turn away from the Planning and Economic Growth
classical direction and why the initiative should have come at the same time from three different centres, as it did.

The sociology of scientific discovery is a complicated subject, and no single explanation of the phenomenon would perhaps be deemed adequate. Shift of events could hardly explain it. It is not the Ricardian ‘stationary state’ into which the new technique was projected, although it is there that it legitimately belongs. In fact, if economic challenge events were the determining factor, we might have in the post-classical period a theory of crisis rather than a theory of static equilibrium. For as sequel to the industrial revolution, the countries of the West had already started experiencing the ‘paradox of poverty in plenty’ and the period 1873-98 during which the marginalist school established itself was marked by a slump so conspicuous as to have earned the title Great Depression.

One would perhaps be inclined to put the emergence of the marginal principle as an instance of ‘pure reason’; indeed there is something in the analytic vision displayed in the system of at least one of the leaders of the school—Walras—which lends strong support to this view. Here too one would find it difficult to explain why different centres could have seen the same light at the same time. Nor is it easy to see what made it possible for the new doctrine to get so readily absorbed in the corpus of economic theory. Others had seen the light before—Lloyd and Dupuit and Gossen, for example— and they went into wilderness. Jevons, Monger and Walras, on the other hand, just ‘came and conquered’.

The discovery (or, as one would prefer to say, rediscovery) of the marginal utility principle and the associated development of economic theory could not surely be an isolated scientific phenomenon. There must have been some sort of provocation somewhere. And one cannot help suspecting that the provocation was largely political; the connation between the emergence of the marginal utility school and the political side of the teachings of Karl Marx seems to be too close to be ignored. Marginalism came up, so to say, to ‘save’ economic theory from being turned into an engine of class-war. In breaking away from Classical Political Economy it bid fair to destroy the theoretical foundation of the Communist Manifesto.

In the theory of Exchange and Distribution, the Marginalist School offered an alternative explanation of social relations which cut across ‘classes’ and was designed as a counter to Marxist political propaganda. The switchover from ‘accumulation’ to ‘consumption’ as the mainspring of economic activity, the principle of maximization in the analysis of consumer’s behaviour, the consistency theorem relating to individual maxima in the analysis of equilibrium of exchange, the marginal productivity principle of distribution, the application of Euler’s theorem to the solution of the so-called ‘adding up’ problem Tendencies in Economic Theory.
—implicit in all these is one long refutation of the Marxist theory of class-war and a plea for economic liberalism. If the marginalists were anti-classical1 in their economic theorizing, they were overwhelmingly classical in their political predilections.

2. Now, whatever may be the impulse that stimulated the discovery of the marginal utility principle, there can be little doubt about its significance for the development of economic theory. For over sixty years since the marginalist revolution, economists have kept busy refining and sharpening the technique of analysis which it opened up, and within its limited frame of reference, the technique has yielded significant results. Our knowledge of the nature of equilibrium of exchange is much more precise now than it was even thirty years ago. We now know better what elements constitute the theory of demand; one may refer to the separation of the income effect from the substitution effect of price variation, which is not merely a contribution of utmost importance to economic theory, but is also a valuable aid to econometric studies.

The conditions of stability of interrelated markets are now capable of being more precisely shown, and we have a better analysis of the working offerees needed to bring back the equilibrium of an economic system once it is disturbed— the system consisting not only of commodities and factors but also of securities. The technique of deriving welfare propositions is also more scientific today, and we know better their significance as well as limitations for economic policy. It is said that the more advanced a theory is, the less is the use of ‘data’ and more the use of ‘inference’ that it involves. Judged by this test, the advance in economic theory that marginalism has led to is considerable.
True—but all this advance is within the framework of an economy with given ‘tastes and obstacles’. Once we get into the dynamic field—where ‘tastes and obstacles’ are themselves a function of the rate of exchange, the analysis goes awry.

Let us see what it all means. Let us take the simple case of exchange between two persons in respect of two goods—the famous barter case of Alfred Marshall.3 We know that in this case the rate of exchange (‘terms of trade’, as some of you might prefer to call it) would lie between the limits set by the zero-indifference curves of the trading parties or, in case the goods are ‘produced’, by their comparative costs. Now, if these outer limits are given—if, that is to say, the ‘tastes and obstacles’ are constant, you can chalk out a path from any point on the so-called contract curve which would lead the trading parties to a determinate rate of exchange, on the simple  Planning and Economic Growth
assumption that successive transactions enable the parties gradually to acquire knowledge of their respective preference systems.1 However, suppose that the tastes and obstacles are themselves a function of the rate of exchange; the outer limits may then recede in a direction unfavorable to the weaker party, and this recession may proceed cumulatively until the limit of tolerance is reached.

Now this has awkward consequences for equilibrium theory. For, the simple case just considered typifies the entire universe with which equilibrium theory is concerned. Indeterminateness pervades the whole field of exchange—between persons, between groups, between sectors and between nations. ‘The whole creation groans’ exclaims Edgeworth, as he perceives this ubiquity of indeterminate-ness, and he seeks relief in arbitration.2 Static analysis glosses over the awkward edges of economic theory by invoking such devices as the law of indifference, crying of prices, recontract etc. And in terms of these devices a possible equilibrium is constructed. But paradoxically the construction that is drawn turns out to be not so much an aid to the interpretation of reality as a model for short term planning of resource allocation. The dynamics of exchange—which is what reality is—reveals, on the other hand, disharmony, if not conflict. In a situation where the so-called data of static theory are themselves determinates of the system, the weaker party (be it a ‘class’, a ‘sector’ or a ‘nation’) is apt to find its position cumulatively deteriorating in the process of exchange.

So we are brought back to just where we left off Karl Marx. A certain disharmony is inherent in exchange relations as they operate through the market. Whether, however, the disharmony is inevitably resolved by ‘war’, as Marx would have it, or it lends itself to treatment by ‘countervailing power’, ‘arbitration’ or ‘pact’ is another matter. For that depends, one might say, upon the degree of sanity and resourcefulness that the world concerned is endowed with at a given stage of its civilization. So economic challenge also valid for us.

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