Marginal Revolution

What changed?

The classical economics of Adam Smith and David Ricardo, and Marx who carried it on critically, explained the value of commodities from the side of production: the labour socially necessary to make a commodity determines its value. One puzzle that troubled the classical economists was the "paradox of water and diamonds". People cannot live without water, yet it is cheap; diamonds are mere ornaments, yet they are dear.

Marginal utility theory solved the paradox from the side of consumption. What matters is not the usefulness of water as a whole but the usefulness of the "last unit" one gains or loses. Take some numbers as an illustrative assumption. For a thirsty person the first glass of water gives a satisfaction of 10, the second 6, the third 3 and the fourth 1. That the satisfaction from an additional unit falls as one has more of a good is the "law of diminishing marginal utility". Where water is plentiful people already have many glasses, so gaining or losing one changes their satisfaction very little; diamonds are scarce, so gaining or losing one makes a large difference. Price, on this view, follows usefulness at the margin, not usefulness as a whole.

With this turn the attention of economics moved from the class relations of production and distribution to the allocation of given resources according to individual preferences. The change of name from "political economy" to "economics" went together with this shift.

What did each of the three write?

William Stanley Jevons first proposed the theory in "A General Mathematical Theory of Political Economy", presented in 1862 and published in 1863, and completed it in The Theory of Political Economy (1871). He stood in the utilitarian tradition of Bentham and John Stuart Mill but parted from his classical predecessors in stressing that "value depends entirely upon utility". Carl Menger presented the theory in Principles of Economics in the same year, 1871. He explained that individuals rank possible uses and decide among them by marginal utility, and his followers became known as the Austrian or Vienna School. Léon Walras published the first part of his Elements of Pure Economics in 1874 in a relatively mathematical exposition. Few read it at the time, but twenty years later Pareto and Barone took it up and it became the starting point of general equilibrium theory, in which all markets clear at once.

The three became the mainstream through a second generation: Eugen von Böhm-Bawerk and Friedrich von Wieser in Austria, Philip Wicksteed and Alfred Marshall in England, Vilfredo Pareto in Switzerland and John Bates Clark in America, among others. Böhm-Bawerk explained interest and profit through diminishing marginal utility and time preference, and Marshall, in his Principles of Economics (1890), explained demand by marginal utility and supply by costs, setting up the supply and demand curves of today's textbooks. Clark and others applied the same marginal principle to distribution, producing the marginal productivity theory, in which each factor of production receives the contribution of its last unit. In the 1930s Hicks and Allen recast the theory as indifference-curve analysis, which does not require utility to be measured as a quantity.

How did it relate to Marx?

The first volume of Capital appeared in July 1867, by which time the work of Jevons, Menger and Walras had been written or was under way. Marx was then a relatively minor figure, and many doubt that they had him in view. Yet the interpretation of marginalism as a response to the rise of the workers' movement, Marxian economics and the earlier Ricardian socialist theories of exploitation is also widespread. Ernesto Screpanti and Stefano Zamagni hold that, in the face of the long depression after 1873 and the resurgence of class conflict, marginalism offered a theory of the free market as perfect, performing an optimal allocation of resources, which let economists blame any adverse effects on the interference of workers' coalitions.

The next generation did take aim at Marx. The first critique was Wicksteed's "The Marxian Theory of Value" (1884); the most famous was Böhm-Bawerk's Karl Marx and the Close of His System (1896). Böhm-Bawerk argued that the rate of profit and prices of production of the third volume of Capital contradicted the theory of value of the first, and his critique became the "classical" critique of Marxist economics. It is one of the starting points of what Marxists call the transformation problem debate.

How did Marxists reply?

Marx died before marginalism became the mainstream, but in the third volume of Capital he rejected explaining long-run market values by supply and demand:

If supply equals demand, they cease to act, and for this very reason commodities are sold at their market-values. Whenever two forces operate equally in opposite directions, they balance one another, exert no outside influence, and any phenomena taking place in these circumstances must be explained by causes other than the effect of these two forces. If supply and demand balance one another, they cease to explain anything, do not affect market-values, and therefore leave us so much more in the dark about the reasons why the market-value is expressed in just this sum of money and no other.

The Austrian Marxist Rudolf Hilferding answered Böhm-Bawerk in Böhm-Bawerk's Criticism of Marx (1904). The psychological school, he argued, fails to see the social nexus of economic phenomena. Marx's theory aims to disclose the social determination of economic phenomena, so that its "starting point therefore is society and not the individual", while Böhm-Bawerk, reading it with his own individualistic mentality, arrives at contradictions that belong to his interpretation, not to the theory. Marx, Hilferding wrote, disclosed personal relationships where material relationships had been seen before him, and social relationships where individual ones had been seen.

Nikolai Bukharin completed The Economic Theory of the Leisure Class in 1914. After escaping from Siberia he attended Böhm-Bawerk's lectures at the University of Vienna and read the Austrian theorists, and in Lausanne he studied Walras's Lausanne School. He had left the manuscript in Christiania (now Oslo); the Norwegian communist Arvid Hansen found it and brought it to Soviet Russia in February 1919, and it was published that year. Bukharin saw marginal utility theory as the ideology of the rentier. As credit developed and surplus flowed to people with no relation to production, the growing rentier stratum lived apart from production in the sphere of consumption, with an outspoken individualism and a fear of the future. Unlike the classical school and proletarian political economy, which took the point of view of production, the Austrian School's consistent point of view of consumption was the logical equivalent of that social psychology. As an internal criticism Bukharin pointed to a circle: the subjective evaluation from which price is to be derived really starts from that price. In his conclusion he wrote that Böhm-Bawerk's theory of value was a subterfuge to found his theory of profit, and that the theory of value serves as a theoretical starting point for justifying the modern order of society.

Later Marxists continued the criticism. Ernest Mandel argued that marginalism ignores the role of production and cannot explain how uniform prices that stay stable over long periods emerge from the clash of millions of different individual "needs", explaining at best ephemeral short-term variations. Maurice Dobb pointed out that consumers' ability to express their preferences depends on their spending power, that is, on the distribution of income, so marginalist price theory cannot explain how income distribution affects prices. Citing Jevons's statement that "so far as is consistent with the inequality of wealth in every community" exchange produces the maximum social benefit, he argued that marginalism sought to shield market economics from criticism by presenting prices as the natural result of a given distribution of income.

What came after?

In the twentieth century a large literature grew up on the conflict between marginalism and the labour theory of value, and the neo-Ricardian Piero Sraffa's critique became an important counter-argument. Meanwhile economists influenced by the Marxian tradition, such as Oskar Lange, Włodzimierz Brus and Michał Kalecki, tried to integrate the insights of classical political economy with marginalism and neoclassical economics, believing that Marx lacked a sophisticated theory of prices and neoclassical economics a theory of the social framework of economic activity. In the 1980s John Roemer and other analytical Marxists tried to rebuild Marxian theses on a marginalist foundation.