HOW DOES MARGINAL UTILITY EXPLAIN WHAT ARE THE WEAKNESSES OF MARGINAL

WATER-DIAMOND PARADOX? ANALYSIS IN THE FIRST GENERATION?

Before marginal analysis, economists were The utility approach is based on a number of
puzzled by the fact that some essential goods restrictive assumptions. All of these
like water had lower prices than luxuries like assumptions are unrealistic. This is why there
diamonds. The paradox is resolved when we are certain limitations of the law of
look at the abundance of water relative to diminishing marginal utility. Consumer’s
diamonds. Theory tells us that consumers habits / tastes may change in the meanwhile.
should purchase any goods until the ratio of its We must assume a specific period of time
marginal utility to price is the same as that suitable for each occasion. It still remains true
ratio for all other goods. The marginal utility that at any given time, given the consumer’s
of an extra unit of water may be low its price, tastes and habits are fixed, the successive
but the total utility derived from water is very units will yield smaller satisfaction than
large. Total utility of all water consumed is before.
larger than the total utility of all diamonds
purchased. However, society prefers an We must take into account where the units
additional diamond to an additional drop of must be reasonable and adequate amounts. If
water, because of the abundant stock of water the earlier amount to be very small, marginal
available. utility may rise at first, instead of fall. There
are group of commodities that the marginal
Subjective value can show diamonds are more utility is not diminish with every increase in
expensive than water because people stock.
subjectively value them more highly. William
Stanley Jevons, Carl Menger and Leon Walras, EXPLAIN THE MARGINAL ANALYSIS SECOND
discovered that economic decisions are made GENERATION?
based on marginal benefits rather than total
benefit. Consumers are not choosing all of the In the Marginal analysis second generation,
diamonds in the world compared to all water theories were deficient in a number of ways.
in the world. Clearly, water is more valuable. Marginal analysis exclusively to demand
They are choosing between one additional theory and completely ignored supply theory.
diamond versus one additional unit of water. This is because the value is depended almost
This principle is known as marginal utility. exclusively on marginal utility. According to
Additional one unit of water give less marginal Walras, general equilibrium concentrated on
utility than additional unit of diamonds. The the interrelatedness of economic variables.
price we willing to pay for a commodity Supply was given.
depends on its marginal utility. Imagine you
are participating a marathon; you are willing Resources allocation problem was allocating a
to pay RM5 per bottle of mineral water; are fixed supply among alternatives uses. There is
you willing to pay RM5/mineral water when no explanation on the forces that determined
you are enjoying coffee at Starbucks? the prices of factors of production when
supply curve was not fixed. Forces that
Since Adam Smith only focus on total utility, determining the distribution of income. No
so he could not find a satisfactory solution to insight into the unique problems that must be
the diamond-water paradox nor see the solved in developing theories to explain
relationship between use value and exchange wages, rents, profits and interest. It is a new
value. As for Ricardo, use value is essential for tool where broad applicability to the theories
the existence of exchange value. The value/ of both demand and supply. It used exclusively
price of goods with inelastic supply curve such to analyze the demand side particularly the
as wines and paintings, are not depend on cost household theory. theory of supply or theory
of production. Given a fixed inelastic supply of firm rarely analyzed.
curve, demand curve will determine the price;
demand curve position is determined by
individuals’ preferences and income.
WHAT ARE MAJOR TENET OF POST POST-KEYNESIAN ECONOMISTS CONTEND
KEYNESIAN? THE CONTEMPORARY NEOCLASSICAL
SYNTHESIS IS NOT ONLY SERIOUSLY FLAWED
Markup pricing. Prices are set by oligopolistic BUT ALSO INCOMPATIBLE WITH KEYNES’S
corporations. These firms finance investment IDEAS. DISCUSS.
largely from retained profits. To achieve their
desired levels of profits and therefore realize
their investment plans, Oligopolists set prices • Post Keynesian economists stress that
above current costs. When costs rise, firms the Keynes's ideas were mistakenly
increase their prices to maintain their incorporated with the classical theory,
markups over their costs. this is known as the “Neoclassical
Synthesis"
Endogenous money. Contrary to the view • The fact that Keynes never fully
held by Fisher and Friedman, post-Keynesians abandoned some fundaments of
regard the stock of money as being essentially neoclassical theory allowed some
endogenous to the economy, changing in economists to develop the Neoclassical
response to changes in the level of wages. Synthesis.
Wage increases cause production costs to rise. • The Neoclassical Synthesis accepts
Business borrowing rises and the money stock Keynes’s idea that the capitalist
increases. economy will present persistent
unemployment from time to time, but
Pronounced cyclical instability. The fiscal and monetary policy can
economy is inherently unstable. Investment eliminate this problem.
must grow sufficiently to keep national • However, they are unable to explain
income and output growing at a steady rate. why fluctuations in the business cycle
When investment is less than required to take place.
maintain the steady rate of growth, the
economy recedes and unemployment rises. • Elements of Keynes, such as the pricing
of capital assets and the impact of the
Need for an incomes policy. An incomes capitalist financial institutions over the
policy limits the average annual wage increase economy, were overlooked, and thus
to the nation’s annual rate of productivity this economic theory is unable to
growth. A successful incomes policy holds incorporate the characteristics that
down inflation, minimizes the redistribution money and capital assets present in
of income from inflation and avoids the loss of capitalist economies, such as the
output associated with anti-inflationary fiscal process of creation of money by banks,
and monetary policies. when capital assets and production are
financed.
• In other words, the endogenous
character of money, caused by the
evolution of the financial system and
the consequent ability of banks to
create money, is not recognized by the
Neoclassical synthesis, which believes
that the money supply is exogenously
determined by the Central Bank.

• Due to overlooking many of Keynes’s

ideas, this theory is flawed and does
not incorporate the characteristics of a
capitalist economy.
• The neoclassical synthesis disregarded
the internal forces that disrupt matters
of money, and it became the economics
 of capitalism without the capitalists,
capital assets and financial markets.
• In the Neoclassical synthesis, the
market mechanism will ultimately lead
to full employment equilibrium,
through an internal feature called "the
real balance effect.”
• The Neoclassical synthesis reached the
conclusion that market economy has
internal mechanism that will allow the
demand curve for labour to intersect
the supply curve at full employment.
• This would make the labour market
dominant, which means that the labour
market determines employment and
employment.
• This is not the case in Keynes’s view,
his theory says that the output supplied
and employment demanded is by the
pursuit of profits (the expected level of
profits determines the amount of
labour hired and the amount of output
produced).

• The Neoclassical Synthesis does not

have the same “less than full
employment equilibrium” like Keynes
does.
• It leans towards a full employment
equilibrium – which is completely unlike
that of Keynes’s theory.
• There is a lack of explanation on how
the economy deviates from
equilibrium, or the view of fluctuations
and financial instability as a result of
shocks.
• This is due to not considering many
parts of Keynes’s theory, which makes
the Neoclassical Synthesis flawed.
• It is incompatible with Keynes’s ideas
due to the fact that its underlying
theories differ from that of Keynes (Full
employment equilibrium and less than
full employment equilibrium).
CRITICALLY EVALUATE THE ARGUMENT  capitalist system will automatically
BETWEEN RICARDO AND MALTHUS provide full employment of its
CONCERNING THE STABILITY OF A MARKET resources and high rates of economic
SYSTEM. growth.

Malthusian Model  Ricardo favoured Says law, but Malthus

 Malthus, Essay on the Principle of attacked it.
Population, 1798, 1803 - Maintain that overproduction (glut)
 Malthus’s population principle might occur in particular markets, but
(population thesis) - population tends it was impossible to have general
to increase faster than the food supply overproduction for the entire economy.
 Assumptions: – Food is necessary for the - Market would automatically return the
existence of humankind; – Passion system to a full utilization of its
between sexes is necessary and will resources.
remain unchanged.  Most famously, Malthus denied the
 Population growth it will grow in validity of Say's Law and argued that
geometric progression (i.e. 1, 2, 4, 8, there could be a "general glut" of goods
16… ), while food supply increases  The ‘law’ excludes the possibility that
arithmetically people hoard the money (hoarding =
 Population will develop in society to accumulating money without any
keep the rate of population growth in purpose instead of spending it on
line with the growth rate of food supply savings or consumption)
 Malthus’s view on the economic
 Economic implication of Malthus’s consequences of saving or capital
population principle: – accumulation.
 There is mass poverty in the society and
you can’t help it; MALTHUS’S ARGUMENTS AGAINST THE
 If the welfare of the poor is increased STABILITY OF CAPITALISM
above the subsistence level, they start
to reproduce at a higher rate than the  Labour does not receive the whole
rate of growth of their welfare product produced in the economy
 In the end the welfare of the poor o demand created by the labour class is
returns to the subsistence level. not sufficient to purchase all final
goods at market prices.
o Labour has the will to purchase the
RICARDO VS. MALTHUS ON THE goods, but lack of purchasing power.
STABILITY OF CAPITALISM - For full utilization of resources in a
capitalist system to be maintained, the
 Argument over the ability of a total level of output and consumption
capitalist system to maintain full must keep expanding.
employment of its resources - There was insufficient effectual
significantly influenced the demand from the labourers and
development of economic theory. capitalists, the gap must be filled by
 The debate is also known as controversy those in the society who consume but
over Say’s Law. do not produce. (role of landlords)
 Jean Baptiste Say (1767-1832),  Too much savings in capitalism can
formulated a ‘law’ that there could be produce troubles in the long-run
no underutilization of resources in  Today’s savings reduce the demand for
market economy (“supply creates its consumer’s goods, but the process of
own demand”) investment leads to production of more
 Says law: consumer’s goods in the future – but
 when an individual produces a product the demand for those goods is already
or service, he or she gets paid for that reduced.
work, and is then able to use that pay
to demand other goods and services
 So in the long-run consumer’s demand dangerous for Britain to rely on
will not be sufficient to purchase all imported corn
final goods produced.  Lower prices would reduce
 Malthus believed that economic crises laborers' wages, and
were characterized by a general excess manufacturers would lose out
supply caused by insufficient due to the fall in purchasing
consumption. His defense of the Corn power of landlords and farmers
Laws rested partly on the need for
landlord consumption to "make up" for Ricardo’s view-
shortfalls in demand and thus avert  Although he concluded that the LR
crisis trend I economy would bring about this
redistribution of income from the
Corn Laws (1815-1846) controversy: capitalists and towards the landlords,
 Tariffs were placed on imported he against Corns law
grain (basically a minimum price  It would accelerate the process
on grain)  The sources of economic growth was
 tariffs were fixed at such a high capital accumulation by the capitalists.
level that corn, the foreign  Had a undesirable consequences of
prices of which were much lower slowing down the rate of economic
than the internal ones, could not growth and hastening the arrival of
enter the country at all. stationary state.
 Growing population placed  Higher tariff resulted in
pressure on food supply, so it higher grain prices.
was necessary to import grain  Rents were price-
determined.
 Outside factors, like the
Napoleonic wars, caused import
levels to drop, and domestic
grain prices to increase
 When wars ended, English
landlords – who controlled
Parliament – worried domestic
grain prices would fall; they
pressured for Corn Laws
 Other business interests,
however, wanted Corn Laws
repealed: it prevented free
trade
 The protectionist barriers
allowed the maintenance of high
land rents to the detriment of
profits, given the rigidity of real
wages. The opposition of the
manufacturers was strong, not
only because of the
redistribution effects of the
protectionist barriers but also
because these prevented English
industry from taking advantage
of its higher level of productivity
with respect to its European
competitors
 Malthus believed Corn Laws were
good, and that it would be
CRITICALLY EVALUATE THE medium of exchange and that no one
ARGUMENT BETWEEN RICARDO AND withholds purchasing power.
MALTHUS CONCERNING THE Saving-investment process cannot go on
STABILITY OF A MARKET SYSTEM. indefinitely without leading to long-run
stagnation. Process of saving leads to a
Ricardo’s argument on the stability reduction in the demand for consumer
of market system goods and the process of investment
leads to the production of more
Stable market system. There is Corn’s consumer goods in the future. Full
Law Controversy in which higher tariff utilization of resources in a capitalist
is imposed on imported grains. Protect system to be maintained, the total
local producer from foreign level of output and consumption must
competition and landowner gains keep expanding.
profit. Rent was deduction of wealth as
it gains profit for landlords and losses Malthus concluded that because there
for labors. Ricardo believes that was insufficient effectual demand from
abolishment of tariff on Corn’s Law the laborers and capitalists, the gap
would prosper the nation. He develops must be filled by those in the society
a theory to explain profit, rent, wages who consume but do not produce.
and also interest. Macroeconomic These unproductive consumers are
stability. He believed in the forces of those who provide services and the
supply and demand in the market. Say’s landlords. Thus, one of the social
Law Controversy where supply creates functions of the landlords is to consume
its own demand. There is no without producing and therefore to
overproduction and under- help prevent depression and the
consumption. Economy is at full eventual stagnation of the economy.
employment. Ricardo believed that the
market would not always worked due to
excess supply and demand of particular
commodity and not because of gluts of
commodities as a whole.

Malthus’s argument on the stability

of market system.

Instable market system. There is

market glut in the economy. Malthusian
under-consumptions. The economic
consequences of saving or capital
accumulation. Malthus examined the
alleged causes of economic growth and
criticized each as being inadequate,
maintaining that it was necessary to
consider the demand side, or what he
called effectual demand. Difficulties in
maintaining full employment of
resources. Labor has the will to
purchase goods but lacks the
purchasing power, whereas the
capitalists have the purchasing power
but lack the will. Malthus accepted the
notion that saving does not mean
hoarding and that savings will flow back
to the market as investment is only a
 WHAT, ACCORDING TO SMITH, AS A MEASURE OF THE VALUE OF A
DETERMINES EXCHANGE VALUES? WHY GOOD?
SMITH USE ‘LABOR COMMANDED’
RATHER THAN ‘MONEY COMMANDED’  For Adam Smith wealth has to be
AS A MEASURE OF THE VALUE OF A measured by its purchasing power.
GOOD? AND HOW DOES THE NATURAL  However, money does not accurately
PRICES BEHAVE IN THE ECONOMY. measure that power, since money itself
has a variable purchasing power.
 Smith believed that the word value has  As a solution to this problem, Smith
two different meanings. formulates his idea that the purchasing
 Value in use - sometimes expresses the power of wealth is measured by the
utility of some particular object, and quantity of labour that wealth allows
 Value in exchange - sometimes the its owner to impose on others.
power of purchasing other goods which  In this context he develops the concept
the possession of that object conveys. of real price and the concept of value
 The things which have the greatest (whose magnitude depends on different
value in use have frequently little or no amounts of labour), but their birth is
value in exchange; and on the contrary, marked by the ambivalence around the
those which have the greatest value in role of labour as a measure and source
exchange have frequently little or no of wealth.
value in use.
 Nothing is more useful than water: but
it will purchase scarce anything; scarce  Smith’s analysis of the formation of
anything can be had in exchange for it. relative prices in the economy
A diamond, on the contrary, has scarce distinguishes two time periods, the
any value in use; but a very great short run and long run “natural prices”
quantity of other goods may frequently and two broad sector of the economy
be had in exchange for it. that is agriculture and manufacturing.
 During short run, Smith found
downward sloping DD curve and upward
 According to Smith, exchange value is sloping SS curve in agriculture and
the power of a commodity to purchase manufacturing. Therefore, market
other goods that is price. prices depend upon DD and SS.
 His concept of value in use is ambiguous  In natural price contains some
and it resulted in a good part of his contradiction
difficulties in explaining relative price  For agricultural sector, natural prices
 Relative prices are determined by cost depend upon supply and demand
of production or the supply because in the long run SS curve is
 The short run prices are determined by upward sloping, indicating increasing
the SS and DD costs.
 Natural price, long run equilibrium  But for manufacturing sector, the long
prices are depending upon costs of run SS curve is assumed to be perfectly
production elastic (horizontal), representing
 Natural prices in agricultural sector constant cost and in other parts of the
depends on SS and DD. If the long run analysis is downward sloping.
SS curve upward sloping it will increase  When the long run is SS curve is
costs. perfectly elastic, price depends
 In manufacturing sector, long run SS entirely on cost of production, but
curve perfectly elastic, constant costs, when it is downward sloping, natural
therefore price depends entirely on prices depends upon DD and SS.
costs of production.
 Adam Smith called short run prices as
WHY SMITH USE ‘LABOR COMMANDED’ market prices and long run prices as
RATHER THAN ‘MONEY COMMANDED’ natural prices.
 The competition involved in large
number of sellers, a group of resource
owners who were knowledgeable about
profit, wages and rents and freedom of
movement for resources among
industries.
 The self-interest of resources owners
would lead to long-run natural prices
that would equalize the rates of profits,
wages and rents among various sectors
of the economy.
 If the price of final good is higher its
long run natural prices, adjustment will
take place via the movement of
resources until the natural price
prevail.
 price. Market price may deviate from
COMPARE AND CONTRAST ADAM natural price because of temporary
SMITH AND DAVID RICARDO THEORY fluctuations of supply and demand. The
OF VALUE relative cost of production of two
commodities are proportional to the
Adam Smith relative amount of labor required to
According to Smith, in an undeveloped produce it.
economy, the exchange value (price) of
a product depends upon the quantity of
labor embodied in each based on Labor
Theory of Value. When Smith tried to
answer this question, he ended up with
wages as a measure of quantity. In a
more advanced society, the value
(price) of a product is determined by
the cost of production that include
wages, profit and rent.

Price depends entirely on cost of

production. In the long run, with
perfect competition, price will equal to
the cost. The major emphasis in the
determination of natural prices is on
cost of production. In addition, Smith
defined value in exchange is the power
of a commodity to purchase other
goods—its price. Value in use is the
want-satisfying power of a commodity,
the utility received by holding or
consuming a good. Smith’s focus was on
total utility. A commodity’s marginal
utility often decreases as more of it is
consumed, it is quite possible that
another unit of water would give less
marginal utility than another unit of
diamonds.

David Ricardo
Ricardo’s theory of value was
developed in response to the Corn Law
controversy. The price of commodities
is derived from scarcity & the quantity
of labor required to obtain them. The
value of these goods is independent of
the quantity of labor used to produce
them. Increased tariffs would push
down the margin and lowering the
profit as less fertile lands were utilized
thus reducing growth in economy. He
treats capital as stored up labour.

He formulates a measure of absolute

value that would be invariant over
time. Ricardo has made a distinction
between the natural price and market
SMITH, RICARDO AND MARX BELIEVED
PROFIT FALLS OVER TIME. DISCUSS.

Adam Smith
The rate of profit falls over time. There were
several reasons that make Smith to believe
profit falls over time. The first one is the
competition in the labor market. It will result
in rising of wages. Increased in wages would
bring about a fall in profits. Secondly,
competition in the commodity market. As
output increased and competition among
producers, commodity prices would fall and
profits decline. This implies the possibility of
overproduction. Lastly is competition in the
investment market. Limited number of
investment opportunities and that increased
capital accumulation would lead to falling of
profits.

David Ricardo
Ricardo believed that profit falls over time.
There are three classes in economy which are
landowners who spend their rental income on
luxuries, workers who spend their wage
income on necessities and capitalists who save
most of their income and reinvest. The size of
profits is determined residually by the extent
of cultivation on land and the historically-
given real wage. When economy is “young”
profits are high. Wages will increase and
population will grow. When population grows,
food production must increase. Less fertile
land is brought into production. Rents rise but
profits in agriculture will fall.

Karl Marx
Marx integrated his law of the falling rate of
profit into these two theories. Thus, his
theories that depressions result when
technology fails to develop smoothly, crises
will occur because overproduction in one
industry can adversely affect the rest of the
economy and that the rate of profit will
steadily decline. In the Marxian model, a
capitalist economy clearly depends on the
behavior of the capitalist. The capitalists
increase capital spending and causing the rate
of profit to fall. The capitalists will react to
this fall in profit rates by reducing investment
spending, causing fluctuations in economic
activity, which will engender crises.