Economics (McConnell) AP Edition, 19th Edition

Chapter 3: Demand, Supply, and Market Equilibrium (+ Appendix)

Origin of the Idea

	3.1 Demand and Supply
	3.2 Law of Demand
	3.3 Diminishing Marginal Utility
	3.4 Income and Substitution Effects

3.1 Demand and Supply

Alfred Marshall's best-known contribution to economics is the familiar model of supply and demand, sometimes referred to as the "Marshallian Cross." The demand and supply model represents a synthesis of the work that many earlier economists had done. Classical economists, such as Adam Smith and David Ricardo, articulated many of the concepts related to supply. A later group of economists, the Marginalists, developed and articulated fundamental principles of demand. Marshall was the first to combine them formally and truly unleash their analytical power.

Alfred Marshall (1824-1924) was born in Clapham, England, the son of a cashier of the Bank of England. Despite his father's wishes that he study for the ministry at Oxford, Marshall attended Cambridge University, where he studied mathematics, physics and economics. In 1877 he married one of his students, Mary Paley. They collaborated on his first book, The Economics of Industry, published in 1879.

The leading economist of his time, Marshall belonged to what economists refer to as the Neoclassical school of economic thought. Much of what appears in your textbook comes from

Neoclassical economics, and Marshall's contributions have stood the test of time. Although Marshall used mathematics extensively in his economic models, he emphasized that the math was merely a shorthand language, and not the foundation for economic inquiry and analysis. Marshall established his own set of rules for the use of mathematics in economic theorizing:

"(1) Use mathematics as a shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life.(5) Burn the mathematics.(6) If you can't succeed in (4), burn (3). This last I [Marshall] did often."⁽¹⁾

Jeremy Bentham, An Introduction to the Principles of Morals and Legislation, (New York: Hafner, 1948), p. 1. [Originally published in 1780].

Photograph courtesy of: Used from the website of Thoemmes Press.

3.2 Law of Demand

Besides creating the now familiar diagram of supply and demand, Alfred Marshall articulated the law of demand, and justified the law of demand with the concept of diminishing marginal utility and development of the income and substitution effects. As for the law of demand, Marshall stated: "There is then one general law of demand: The greater the amount to be sold, the smaller must be the price at which it is offered in order that it may find purchasers; or, in other words, the amount demanded increases with a fall in price, and diminishes with a rise in price."⁽¹⁾

Theoretical justifications for the law of demand include diminishing marginal utility, and the income and substitution effects. The notion of diminishing marginal utility was not a creation of Marshall's, but Marshall applied it to his law of demand. "The larger the amount of a thing that a person has the less, other things equal (i.e., the purchasing power of money and the amount of money at his command being equal), will be the price which he will pay for a little more of it: or in other words his marginal demand price for it diminishes."⁽²⁾

Alfred Marshall (1842-1924) was born in Clapham, England, the son of a cashier of the Bank of England. Despite his father's wishes that he study for the ministry at Oxford, Marshall attended Cambridge University, where he studied mathematics, physics and economics. In 1877 he married one of his students, Mary Paley. They collaborated on his first book, The Economics of Industry, published in 1879.⁽³⁾

The leading economist of his time, Marshall belonged to what economists refer to as the Neoclassical school of economic thought. Much of what appears in your textbook comes from Neoclassical economics, and Marshall's contributions have stood the test of time. Although Marshall used mathematics extensively in his economic models, he emphasized that the math was merely a shorthand language, and not the foundation for economic inquiry and analysis. Marshall established his own set of rules for the use of mathematics in economic theorizing:

"(1) Use mathematics as a shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can't succeed in (4), burn (3). This last I [Marshall] did often."⁽⁴⁾

Alfred Marshall, Principles of Economics, 8th edition (London: Macmillan, 1920), 99 [originally published in 1890].
Ibid. 95.
William Breit and Roger Ransom, The Academic Scribblers, (New York: Holt, Rinehart and Winston, Inc., 1971), 21.
Alfred Marshall, Memorials of Alfred Marshall, ed. A.C. Pigou (London: Macmillan, 1925), 427.

3.3 Diminishing Marginal Utility

Many prominent economists have contributed to the development and use of the concept of diminishing marginal utility. The first was Jeremy Bentham (1748-1832). Bentham, an Englishman, studied history and Latin at the age of four, entered Queen's College in Oxford when he was 12, and graduated at 15. He then went on to study law, at the behest of his father, but quickly moved on to a more scholarly life. Bentham saw people as machines designed to maximize pleasure and minimize pain. To that end, and in support for scientific advancement in general, he advocated anatomical research on cadavers at a time when such practices were viewed, at the very least, as distasteful and immoral. Bentham donated his own body for dissection, largely to promote acceptance of the practice. This, however, was not the end of Jeremy Bentham. He also left his estate to University College, London, but under the condition that his remains be present at all board meetings. His padded and dressed skeleton still sits (in a glass case) at the college. A wax head sits atop the body, and his actual head was preserved using South American headhunting techniques. Bentham's real head used to sit on a plate between his feet, but in recent years has been relocated to a safe at the college, presumably to protect it from would-be pranksters using it on the soccer pitch or in other unspeakable ways. Bentham applied the notion of diminishing marginal utility to happiness derived from wealth. Bentham wrote:

Of two people having unequal fortunes, he who has most wealth must by a legislator be regarded as having most happiness. But the quantity of happiness will not go on increasing in anything near the same proportion as the quantity of wealth:– ten thousand times the quantity of wealth will not bring with it ten thousand times the quantity of happiness.

It will even be matter of doubt, whether ten thousand times the wealth will in general bring with it twice the happiness. The effect of wealth in the production of happiness goes on diminishing, as the quantity by which the wealth of one man exceeds that of another goes on increasing: In other words, the quantity of happiness produced by a particle of wealth (each particle being of the same magnitude) will be less at every particle; the second will produce less than the first, the third than the second, and so on.⁽¹⁾

Jules Dupuit (1804-1866), a French engineer, applied the concept of diminishing marginal utility to the consumption of water. He argued that people use water for highest value uses first, such as drinking, and then use it for less valuable uses (agriculture, bathing, fountains) as water becomes more plentiful. Dupuit used this idea to create "curves of consumption," where, because of diminishing marginal utility, people would be willing to purchase more if the price were lowered. This, of course, describes what we now call a demand curve. Born in Fossano, Piedmont, Italy (then part of the French empire), Dupuit moved to Paris with his parents in 1814. He studied in Versailles, Louis-le-Grand and Saint Louis, eventually earning his degree in engineering from Ecole des Ponts et Chaussees. Dupuit became a prominent engineer in France, receiving the French Legion of Honor in 1843, becoming the chief engineer in Paris in 1850, and earning the position of inspector-general of the French Corps of Civil Engineers in 1855. From 1844 to 1853, Dupuit published numerous works in economics, his "hobby," contributing to the theories of utility, consumer surplus and price discrimination.

While Dupuit was in France formulating his ideas on utility, Herman Heindrich Gossen (1810-1858) spent four years in seclusion in Germany developing his own. Gossen developed two laws of utility, the first being the law of diminishing returns. Gossen's law of diminishing returns applied to consumption, unlike the modern definition which applied to production. Gossen was clearly referring to what we call diminishing marginal utility, and he used his theory to demonstrate how exchange can increase satisfaction for both parties.

Gossen was the only son of three children, born to the devoutly Catholic Joseph and Mechtildes Gossen. He excelled in mathematics, studied law and public administration, and followed in his father's footsteps to become a civil servant. Following his father's death, Gossen took his inheritance, left public life, and wrote The Laws of Human Relations and the Rules of Human Action Derived Therefrom. Disheartened by the lack of public interest in his book, Gossen requested that it be withdrawn from circulation.

In 1871, English economist William Stanley Jevons applied the idea of diminishing marginal utility to the work decision, arguing that the marginal utility of the money earned for each hour of work decreases as the day progresses, and the disutility (pain) from working increases as each additional hour is worked. According to Jevons, a person will choose to work up to the point where the marginal utility of earnings (or the marginal benefit) equals the marginal disutility (or marginal cost) of work. In formulating this theory, Jevons did recognize that workers cannot always choose how many hours they can work at a particular job.

The concept of diminishing marginal utility has a long intellectual history, and is an integral part of modern economic theory.

W. Stark, Jeremy Bentham's Economic Writings, 3 vols. (New York: Franklin, 1952), 1: 113.

Photograph courtesy of: (c)Nance Trueworthy.

3.4 Income and Substitution Effects

The substitution effect was first articulated by Alfred Marshall (1842-1924), the leading figure in neoclassical economics, as part of his explanation for the law of demand. Marshall recognized that changes in relative prices would lead consumers to substitute in consumption, but he failed to recognize that prices changes would affect overall purchasing power (what we call the income effect).

Articulation of the income effect would come years later from Sir John R. Hicks (1904-1989). Hicks studied politics, philosophy, and economics at Oxford, and went on to teach at the London School of Economics, Manchester University, and Oxford.

Hicks made numerous contributions to the field of economics, including the application of indifference curves and budget lines to demand theory. He also furthered the development of wage and production theory, and, in the area of macroeconomics, expanded upon the works of Leon Walras and John Maynard Keynes. For his contributions to economics, Hicks was knighted in 1964 and received the Nobel Prize in economics in 1972.