L. Walras Concept of Equilibrium - Assignment Example

L. Walras’ Concept of Equilibrium Answer 1 Being basically similar in their objectives, aims and results, L. Walras’ concept of equilibrium is different from that of Marshall. The first and main difference, of course, is that of scope. In Marshall’s partial equilibrium, the price of only one good is determined while assuming that the prices of all the other goods remain constant. Walras’ approach also discusses individual market and agents on the basis of ‘pure-exchange, two-commodity economy’ but it can be generalized to more complex markets. (Walras, 1874) The Walrus’ concept of equilibrium has three main assumptions: a. Prices are quoted in the market for each commodity at each instant of the trading process; b. The traders are price takers and they behave competitively i.e. the existence of perfect competition; and c. For any commodity, any transaction is not allowed to take place out of the equilibrium. According to Walras (1874), considering any particular market, if all other markets in an economy are in equilibrium, then that specific market must also be in equilibrium. Also, the sum of all excess demands and excess supplies (which have both positive and negative values) must be equal to zero. The equilibrium is attained through a process called “groping” in which each agent calculates its demand for a particular commodity and submits it to an auctioneer. This auctioneer matches the supply and demand of the commodities and tries to reach at an equilibrium price. “Trading stops” at the point where the demand and supply for all the commodities with positive prices equate and demand for goods with a price of zero does not exceed their supply (Walras, 1954). At this point, equilibrium is achieved by the process of Groping. Answer 2 The two actors i.e. households and firms both face the problem of scarcity and choice. In the case of households, they attempt to spend their scarce resources, i.e. income, on those goods and in such a way that gives them the maximum utility. They have to bear the opportunity cost when they forgo the benefit of one commodity to avail the benefit of another. According to the law of diminishing marginal utility, as a person consumes more and more units of a commodity, he obtains less and less amount of satisfaction from every additional unit that he consumes. A point comes when the additional utility even becomes negative. For instance, over-consumption of drinking water is harmful for health According to the equimarginal principle; the total utility is maximized when utilities obtained from each of the commodities consumed become equal. (Samuelson, 1939) The firms face the same problem and they want to utilize their scarce resources, i.e. factors of production, in such a way that maximizes their profits. Just like the households, they too have to bear the opportunity cost when they forgo the usage of one factor to avail the benefit of another factor. The law of diminishing returns is similar to the working of law of diminishing utility according to which as more and more units of a factor are employed with other factors remaining constant, the marginal product diminishes. Similarly, a point comes when marginal product becomes negative. For instance, a certain number of units of labor can produce effectively on a unit of land. More than enough units cause disturbance and disharmony in working environment. The equimarginal principle can also be applied to firms. The total product is maximized when marginal products of all the factors employed become equal. (Samuelson, 1939) Therefore, the two actors have to undergo the same processes to achieve their respective objectives. Answer 3 In Marshallian long-period equilibrium, the economies and diseconomies of scale determine whether an industry will be operating under increasing, decreasing or constant returns to scale. When the economies and diseconomies of scale are equal, they cancel each other and there is no net effect on the industry. The benefits availed by firms in the industry are set-off by the harms caused to them by diseconomies. In such a case, the industry operates under constant returns to scale. (Samuelson, 1939) When an industry operates under increasing returns to scale, it is benefiting from the economies of scale. The internal economies to scale are not similar for every firm in an industry unlike external economies. In this case, there is a possibility that few firms are able to benefit more than others. They develop lower cost structures and create monopolies. Monopolies and oligopolies are harmful in the way that they eliminate competition which results in exploitation of consumers. A monopolist charges higher than normal prices to earn supernormal profits and cartels are made in oligopoly which are also harmful for the economy. (Samuelson, 1939) According to Marshall, monopolies and oligopolies are not sustainable in very long-run because there is enough time for new firms to enter into the market and compete with them. They are able to take a substantial benefit from internal economies of scale. The low-cost structures become available to competing firms. This encourages more firms to enter into the market and the industry widens. Very long-run is a period that is long enough to convert a monopoly or an oligopoly into a perfectly competitive market. The monopolists and oligopolists are not able to hold the barriers to entry into the market for that much time. Therefore, they are unsustainable in such conditions. (Tucker & Irwin, 1997) Answers 4 According to Keynesian economics, the Business Cycles result from the fluctuation of aggregate demand from the full employment level. These fluctuations are caused by the interaction of multiplier and accelerator. When aggregate demand rises, it would make an economy grow but persistent rises in demand would lead to inflation and unemployment. The process of economic growth indicates recovery, reaching at the summit of growth indicates boom, leading to inflation indicates repression and reaching at the bottom indicates depression. The principles of multiplier and accelerators lie at the heart of Keynesian explanation of Business Cycles. A change in investment changes income multiple times which is determined by multiplier. The change in income accounts for a change in demand and in order to meet this demand, a change in investment is required which is determined by accelerator. Positive working of multiplier and accelerator leads to economic boom while their negative working leads to a depression. (Keynes, 1936) According to Credit Cycle theory, Business Cycles are caused by expansion and contraction of credit in the economy. The expansion of credit leads to a rise in aggregate demand which, if goes on increasing, leads to inflation and unemployment. Similarly, the contraction of credit leads the economy towards depression. The aggregate demand is determined by the availability of funds in the hands of the members of the economy. The two approaches differ in explaining the causes of changes in aggregate demand. However, the study of both approaches indicates that changes in aggregate demand are the major causes of Business Cycles. (Samuelson, 1939) Answer 5 Deflation is a situation where the prices of all the commodities in the market fall down. Less amount of money fetches greater amount of goods. A Capitalist economy works on the principle that Government should have no role in the economy and that the market mechanism adjusts itself. The unfettered forces of demand and supply achieve equilibrium by their-selves. (Samuelson, 1939) When prices start to fall down in an economy, the deflation spiral comes into operation. The consumers become sure that the prices would continue to fall. Therefore, they defer their consumption and wait for the prices to slip further. This retards the overall economic activity. For the fear of over-supply, the producers have to cut investments and multiplier and accelerator work in the opposite direction. Aggregate demand slumps further as a result. (Hummel & Jeffrey, 2007) According to Keynes, in order to cope with such situation, there is a need to increase aggregate demand by increasing investment in the economy. Income of consumers would be increased as a result and aggregate demand would increase hence increasing the prices. Deflation would be gotten rid of. (Keynes, 1936) Fisher argues that increasing money supply and expansion of credit in the economy is the answer. Rise in money supply would raise the aggregate demand in the economy which, as a consequence, would raise the price level. (Samuelson, 1936) Who can increase money supply and who can increase investment in the economy? The answer, of course, is the Government. The basic step in solving the problem of deflation is the interference of the Government. As Capitalist economies call for no Government intervention, Deflation is deeply problematic for these economies. (Keynes, 1936) Answer 6 Keynes suggested that savings could not be automatically translated into investments because the amounts saved are not necessarily reinvested. People hold money for reasons other than savings too. They hold funds for transactionary motives i.e. to have funds for transactions when required. They hold funds for precautionary motives i.e. to have funds in unforeseen circumstances. They also hold funds for speculation motives i.e. to have funds to invest in better opportunities that give higher return. Therefore, there is a time lag in reinvestment of savings. Savings are needed to be attracted towards investments. Changes in interest rates have a great influence on such decisions. (Keynes, 1936) The level of investment is determined by the interaction of interest rates and loanable funds in Keynes’ system. How much would be the rate of interest depends on what is the level of demand for money in the economy. The demand for money depends on a lot of facts which range from being quantitative to qualitative. The changes in demand for money are generally not quick. Therefore, levels of interest rates do not experience quick changes. When interest rates are high, loanable funds also rise and the level of investment goes up. Similarly, as the interest rates go down, people are discouraged to invest and supply of loanable funds decreases hence resulting in low level of investment. In the times of inflation, Government needs to bring a cut in rates of interest to bring the level of investment down. Multiplier works in the opposite direction bringing a fall in aggregate demand which lower the prices. In the same way, Government attempts to increase the rates of interest to attract investments in the times of depression. The resulting increase in loanable funds increases money supply in the economy which leads to an increase in price level eventually. (Keynes, 1936) Answer 7 The concept of neutrality in Quantity Theory of Money means that money is just like other commodities. It is neutral and it does not change its value. If there is a change in the value of money, it is for a little and a limited time. After that, the value of money is restored to its original value. Therefore, it is not able to influence the rates of interest in the economy. It has no ability to misdirect investments and create Business Cycles. The real interest rate is determined by non-monetary factors in Quantity Theory of Money. These factors include Productivity of Capital and Time Preference. The demand for money is not given any importance but supply of money is an important determinant. (Laidler, 1992) Keynes had criticized this notion. According to him, the demand for money is a really important factor which depends a lot on fluctuations in value of money. These changes have to be accounted for and money cannot be declared as neutral. The value of money plays a huge role in determining the demand for money. The fluctuations in its value cause inflation or deflation. The value of money has to be accounted for while searching for a cure for inflation or deflation. One of the basic economic objectives is the achievement of a stable price level. Fluctuations in the value of money have a direct impact on price levels. Keynes argues that the real economic growth can only be measured if value of money is taken into account. Keeping money neutral in Quantity Theory of Money limits the scope of the theory. Too many important aspects go unexplained. Therefore, money is not kept neutral in Keynes’ presentation. (Keynes, 1936) Answer 8 According to J.B Clark (1899), “…the distribution of the income of society is controlled by a natural law, and that this law, if it worked without friction, would give to every agent of production the amount of wealth which that agent creates.” The theory of distribution proposed by him runs on the principle of Marginal Product. It is also known as Marginal Productivity Theory. This theory explains that the factors of production are rewarded according to their marginal productivity. The factor that contributes more to the total product receives more reward than the factor that has contributed less. Supply of land is fixed and it is not needed to be paid. It has no other use and no opportunity cost is borne by land. Labor is a variable factor. At first, its marginal productivity increases and it is paid more. As more units of labor are employed, the marginal productivity starts to diminish and it is not profitable to employ more labor. Each unit of labor is paid according to its marginal productivity. This theory has some ethical implications. The first and the most important aspect is that it is not possible to measure the marginal productivity of each unit of labor separately. The end result is total product and it is impossible to measure each factor’s contribution. J.B Clark established that this theory of distribution grants “Moral Justice” to the labor. As marginal productivity is not separable, more productive unit of labor is paid exactly the same wage as less productive labor. This principle also results in labors getting paid less than their contribution in the total product. It often occurs that the marginal product of the labor is less than the average product. In this case, labor gets paid less than its average contribution. Therefore, “Moral Justice” seems to be violated. (Douglas, 1934) Answer 9 According to Piero Sraffa, there are some factors of production that are fixed in the production process or could only be used at more than proportional cost. When the production of the commodity in which the factor is used is increased, more of that factor is required. Demand for the factor rises which also increases the cost of the factor. If the factor is also used in other industries, the cost of the factor rises for those firms too. Therefore, the expansion of the scale of production not only raises the costs of one industry but also the cost of other industries in which the factor of production is required. Whereas, an industry that utilizes only a small part of a constant factor does not affect the demand for the factor and any increase in cost is negligible. Therefore, the structure of diminishing returns is left to explain only that rare class of products, in which whole of the factor of production is employed. (Sraffa, 1926) Sraffa further explained that in the structure of increasing returns, the reduction in costs due to the external economies should be ignored because they are incompatible with a particular equilibrium of a commodity. These reductions are obtained, according to Marshall, in relation to those incomes that are the indirect result of general progress of a society. According to Sraffa, the reductions in costs obtained by internal economies of scale must also be ignored as they are incompatible with competitive conditions. Sraffa asks for an intermediate position between the two extremes but there is nothing to be found in the middle of these extremes. Therefore, the concept of increasing returns to scale is also not compatible with notion of Perfect Competition by Marshall. (Sraffa, 1926) Answer 10 Michal Kalecki gave great importance to effective demand. According to him, investment is determined through expected profitability and availability of profits and depends greatly on expenditure decisions by Capitalists. If the expectations of profitability are higher, more investments would be made. More investments increase the income level in the economy but the increase in capital stock calls for a cut in investments. Kalecki attempted to explain the causes of Business Cycles through effective demand. According to Keynes, the level of effective demand is that level of demand at which it intersects available supply. The point of effective demand could be below or above the level of full employment. If it is at the level of full employment, the economy is in equilibrium. According to Kalecki, the point of effective demand is always below the level of full employment hence indicating that some productive capacity is always left unutilized. Kalecki perceived the economy as being competitive, oligopolistic or monopolistic. On the other hand, the General Theory of Keynes is free from any of such perceptions. (Korlira & Panayotis, 1975) Kalecki was brought up in a socialist environment but he never adopted it. His theory was directed at pointing out the factors and causes of Business Cycles that repeat themselves in a Capitalist economy. Keynes’ General Theory was basically a response to Say’s law and attempted to point out and remove the flaws of neo-classical principles. His principle of effective demand is largely influenced by Kalecki but the two differ in ultimate objective and also in identifying the determinants of investment. (Korlira & Panayotis, 1975) References 1. David Laidler (1992). Hayek on Neutral Money and the Cycle. UWO Department of Economics Working Papers #9206. 2. Hummel, Jeffrey Rogers. (2007). Death and Taxes, Including Inflation. The Public versus Economists. Na. 3. J.B. Clark (1899). The Distribution of Wealth: A theory of wages, interest and profits. 1927 edition, New York: Macmillan. Na. 4. Keynes, John Maynard. (1936). The General Theory of Employment, Interest and Money, London: Macmillan (reprinted 2007). Na. 5. Korliras, Panayotis. (1975). A disequilibrium macroeconomic model. Quarterly Journal of Economics, February 1975, 56-80. 6. P.H. Douglas. (1934). The Theory of Wages. New York: Macmillan. Na. 7. Samuelson, P. A. (1939). Interactions between the multiplier analysis and the principle of acceleration. Review of Economic Statistics, 21, 75–78 8. Samuelson, Paul A. (1939). Microeconomics: Supply, Demand and Product Markets. Economics, 111. 9. Samuelson, Paul A. (1941). The Stability of Equilibrium: Comparative Statics and Dynamics. Econometrica, 9(2), 97-120. 10. Sraffa, P (1926). The Laws of Returns under Competitive Conditions. The Economic Journal. 36(144), 535-550. 11. Tucker, Irvin B. (1997). Macroeconomics for Today. 553. 12. Walras. L. (1874). Principe d'une théorie mathématique de l'échange. Journal des économistes. Na. Read More