The three snippets that follow, gathered from the worlds of literature and entertainment, can help us understand an important development in neoclassical economics:
In Evelyn Waugh’s novel Scoop, a British newspaper owner confronts an editor whose vocabulary consists of two responses: if the owner says something true, the editor replies “definitely”; if the owner says something untrue, the editor replies “up to a point.”
“Let me see, what’s the name of the place I mean? Capital of Japan? Yokohama, isn’t it?”
“Up to a point, Lord Copper.”
“And Hong Kong belongs to us, doesn’t it?”
“Definitely, Lord Copper.”
The old vaudeville comedian Henny Youngman, whose jokes have elicited more moans than ptomaine poisoning, framed many a classic line worthy of philosophical discourse, including
“How’s your wife?”
“Compared to what?”
In the peculiar cult film The Adventures of Buckaroo Banzai, the hero reminds his friends of a metaphysical tautology:
“No matter where you go, there you are.”
“Up to a point,” “Compared to what?” and “No matter where . . .” can be said to symbolize the powerful change in economic thought at the end of the nineteenth century called marginalism. Before we examine the impact of Alfred Marshall, the preeminent marginalist, let us see how these snippets can explain this new approach.
Imagine you are traveling through Europe. You begin in Greece and have a splendid time. On the way to Italy, you stop in Corfu, where you rent a moped and circle the charming island. In Italy you enjoy Florence more than any place you have ever seen. Your visit in Italy cost $800 but gave you thousands of dollars’ worth of pleasure. You reach Venice and then consider crossing the border into Austria. Austria, you fear, will be disappointing compared to Italy. You prefer calamari to Wiener schnitzel. How to decide whether to go forward or go home?
First, consider Buckaroo Banzai’s advice: “No matter where you go, there you are.” You are now on the border of Austria. Forget where you have been—the pleasure you had in Italy is irrelevant! Marginalism declares that the past is behind you. The issue is whether to step forward, and the starting point is where you are now.
Second, think of Henny Youngman’s joke. What do you compare when choosing whether to go to Austria? You ignore the past pleasure in Italy and ask, Will the benefits of going to Austria exceed the costs of going to Austria? If a day in Austria will cost $50 and give you $75 worth of pleasure, go. So what if in Italy the benefits outweighed the costs by tenfold? The issue at hand is whether to go forward. And you should go forward if the benefits outstrip the costs, even if they exceed by a lesser margin than those before.1
Third, remember the editor in Scoop. Up to what point do you continue moving forward? You continue as long as the benefit of one step outweighs the cost of one step, until the marginal benefit equals the marginal cost. When a $50 day in Austria gives $50 of pleasure, you rest. To keep going would be like the proverbial boy who says he knows how to spell “banana,” but just doesn’t know when to stop. One shouldn’t get carried away with forward movement. Many businesses fail because they do not know when to stop expanding. When People Express airlines saw success in the early 1980s, it rapidly expanded the number of routes and aircraft it owned and ignored the warnings of many consultants. Within a few years the overambitious airline folded. In more recent times, Boston Market and Krispy Kreme doughnuts walked into a similar mess. And in 2019, Forever 21, known for jumping onto changing “fast fashion” trends, declared bankruptcy, admitting that many of its eight hundred stores couldn’t last another week, much less forever.
The essence of marginalism is the insistence on incremental, gradual moves as the focus of inquiry. How do firms decide how many cars to produce? They continue producing until the revenue they receive from producing one more car equals the cost of producing that extra car. The marginal revenue/marginal cost rule has numerous applications in and out of economics. Some students study all night for exams. But if at midnight the cost of staying up an extra hour (in terms of fatigue the next day) exceeds the benefit of cramming a bit more, it’s better to be between the covers of a bed than the covers of a book.
Alfred Marshall did not invent or discover marginalism. It was in the European air, hovering in the cigar smoke of faculty clubs and intellectual kaffeeklatches. Just as Newton and Leibniz stumbled on or invented calculus in the seventeenth century, the Frenchman Augustin Cournot and the Germans J. H. von Thünen and H. H. Gossen began exploring marginal analysis a decade or two before Marshall did. William Stanley Jevons, an Englishman, contributed many important ideas that Marshall developed further, as did Carl Menger, founder of the Austrian school of economics. Questions of originality can spawn grudges. One summer while vacationing in the Alps, Marshall found himself in a shouting match over interest rates with Menger’s successor, Eugen Böhm-Bawerk. Mary and Frau Böhm-Bawerk managed to tug their husbands away from each other before noses could get bloodied.2 Marshall will get prime attention here for four related reasons: First, he most clearly and comprehensively applied marginal analysis; second, he established the marginal tradition that dominates microeconomics today; third, he taught some of the most prominent twentieth-century economists, including John Maynard Keynes (and Keynes’s father), A. C. Pigou, and Joan Robinson; and fourth, his life neatly contrasted with Mill’s and reflected the intellectual movements of his day, as well as the spirit of marginalism.
Alfred Marshall was born in the London slum of Bermondsey in 1842. It was on the wrong side of the Thames, and often on the wrong side of the law. In Dickens’s Oliver Twist, the vicious thug Bill Sikes dies there, amid cramped homes with “rooms so small, so filthy, so confined, that the air would seem to be too tainted even for the dirt and squalor which they shelter.”3 Marshall’s father, a Bank of England cashier, was a weak figure only if compared with James Mill or Caligula. William Marshall was a stern, nasty tyrant with a jutting jaw and an austere, evangelical creed to match. Alfred’s great-great grandfather was a minister known for his strength and intimidating physique, traits not passed on to the boy, who was more inclined to hypochondria and agnosticism.4 William Marshall drilled Alfred on his schoolwork, often Hebrew lessons, until eleven at night. A kind aunt saved Alfred’s sanity, for he spent long summer holidays with her. She did not care so much for Hebrew, but did buy him a boat, a gun, and a pony.
Alfred soon put down the gun and got off the pony, trading Cowboy Alfred for Cambridge Alfred. This was an act of defiance. William wanted Alfred to accept a scholarship to Oxford, where he could study Latin and prepare for the ministry. But Alfred had a touch of the devil in him. While the father thought he was studying religion in his room, the rebellious son was often reading mathematics, which his father did not understand and therefore despised. For Alfred, mathematics was a symbol of liberation (perhaps, subconscious guilt led him later in life to hide his mathematical economics in footnotes and margins). As Keynes’s majestic essay on Marshall put it: “No! he would not take the scholarship and be buried at Oxford under dead languages; he would run away—to be a cabin-boy at Cambridge and climb the rigging of geometry and spy out the heavens.”5
At St. John’s College, Cambridge, Marshall earned academic honors in mathematics and then pocketed money for coaching other mathematics students. In his final exams he scored second highest at the university. (Marshall was sandwiched between the top scorer, J. W. Strutt, who later won the Nobel Prize in Physics, and the third scorer, H. M. Taylor, who invented the Braille system for mathematics and chemistry.) Marshall gravitated toward science, too, and graduated in 1865, the year that the first stick-and-ball model of the molecule was displayed. Excited by such developments, Marshall intended to study molecular physics, but metaphysics got in the way. In 1868 he trekked to Germany to read Kant in the original. Soon he followed his Cambridge colleague Henry Sidgwick into agnosticism. Sidgwick, who sometimes wrote on political economy, approved of Christian ethics and ideals, showing every Christian virtue except faith. An admirer once said that of all forms of wickedness, “Sidgwickedness” was the least wicked. According to Keynes, Sidgwick spent half his life proving that God did not exist and the rest of his life hoping he was wrong. While Marshall did not share Sidgwick’s tortured internal struggle, he did strive for a similar noble character.
To his father’s disappointment, Marshall did not hear God’s voice calling him to the pulpit, but he did hear cries of the poor urging him to study economics:
From metaphysics I went to Ethics, and thought that the justification of the existing condition of society was not easy. A friend, who had read a great deal of what are now called the Moral Sciences, constantly said: “Ah! if you understood Political Economy you would not say that.” So I read Mill’s Political Economy and got much excited about it. I had doubts as to the propriety of inequalities of opportunities, rather than of material comfort. Then, in my vacations I visited the poorest quarters of several cities and walked through one street after another, looking at the faces of the poorest people. Next, I resolved to make as thorough a study as I could of Political Economy.6
Once Marshall had chosen economics as his calling, he showed priestly devotion to it. In the Middle Ages, three great disciplines reigned: theology, aimed at spiritual perfection; law, aimed at justice; and medicine, aimed at physical soundness. Marshall offered a fourth great vocation: economics, aimed at the material welfare of all. Though many economists fought among one another, Marshall never faltered in his respect for his profession and his dedication to improving the human condition.
Throughout his life Marshall fought for economics as a separate field apart from history and the “moral sciences.” In 1890 he called a meeting in London and led the charge to create one of the first professional journals, the Economic Journal. The hall was packed with prominent economists, philanthropists, journalists, and businessmen. Even George Bernard Shaw attended.7 While trying to carve a space in the curriculum for economics, he also tried to unify the practitioners. To Marshall, economics was a cooperative calling. He had little patience for internecine rivalries (he was especially touchy when others criticized his work). He said that nearly everything the classical economists taught, when properly interpreted, was right—except when they were criticizing one another. Economists must be guardians of reason and truth, above politically expedient allegiances:
Students of social science must fear popular approval. . . . If there is any set of opinions by the advocacy of which a newspaper can increase its sale, then the student, who wishes to leave the world in general and his country in particular better than it would be if he had not been born, is bound to dwell on the limitations and defects and errors, if any, in that set of opinions, and never to advocate them unconditionally.8
Cambridge inertia proved potent. Not until 1903 did Marshall persuade the university to establish a separate economics course.
But from Marshall’s first contact with economics in the 1860s, he began developing a system of it. He saved metaphysics for light vacation reading and spent his vacations in the Alps. Each summer he took
a knapsack, and spent most of the time walking in the high Alps. . . . He left Cambridge early in June jaded and overworked and returned in October brown and strong and upright. . . . When walking in the Alps his practice was to get up at six. . . . He would walk with knapsack on his back for two or three hours. He would sit down, sometimes on a glacier, and have a long pull on some book—Goethe or Hegel or Kant or Herbert Spencer. . . . This was his philosophic stage. Later on he worked out his theories of Domestic and Foreign Trade in these walks. A large box of books, etc., was sent on from one stage to another, but he would go for a week or more just with a knapsack. He would wash his shirt by holding it in a fast-running stream and dry it by carrying it in his alpen-stock over his shoulder. He did most of his hardest thinking in these solitary Alpine walks.9
With a small gift from his uncle, Marshall sailed across the Atlantic in 1875 to spend a summer in the United States. He did more than hike, for within just a few months he stamped letters from New York, Boston, Cincinnati, San Francisco, and points in between. During his travels, he met with factory managers and union workers at stove foundries, horseshoe works, carpentry shops, and elsewhere, trying to discern New World hype from New World fact. Like a man visiting a zoo, he wrote his mother some charming letters about his encounters with the exotic Americans, who did not feel obliged to abide by English manners. Shortly after arriving in New York, he walked into a hat shop where his Victorian sensibilities were shocked when the proprietor asked his hat size and, before waiting for an answer, swiped Alfred’s hat off his head, placed it on his own head, and quickly calculated Alfred’s cranial measurements. “My friend was the perfect democrat,” Alfred wrote, and then suggested to his mother that some “go-ahead Yankee will find space in his advertisements for a line: ‘Our shopmens [sic] heads warranted perfectly clean.’”10
Marshall spent nine years at St. John’s College teaching economics to young men while also instructing women at Cambridge’s Newnham College, which had recently been launched as a residential house that hosted “Lectures for Ladies.” Marshall may have been the first—and certainly the most important—academic economist to tutor women at the most sophisticated level. In that era, well-to-do women were directed to “home economics,” which involved planning for a Sunday roast and budgeting for maids and gardeners (the word “economics” comes from the Greek oikos, meaning “management of the household”). In the process of his lecturing, Marshall gained a wife and thereby, like Malthus, violated his bachelor vows and lost his fellowship. Mary Paley, great-granddaughter of Malthus’s intellectual archenemy, Archdeacon William Paley, was one of the five students who made up the Newnham College inaugural class that Marshall tutored. With his fellowship withdrawn, Alfred and Mary, who had been named the first woman lecturer in the history of Cambridge, moved to University College at Bristol and then Oxford before returning to Cambridge in 1885, when Marshall accepted the chair in political economy. Alfred and Mary worked closely together, and in 1879 jointly authored Economics of Industry. Though Alfred’s name appears above Mary’s on the title page, the sizes of the fonts are equivalent, a generous nod by a much higher-ranking scholar. Unfortunately, as Marshall aged, he would grow grumpier and more dyspeptic about such matters and not fully support the elevation of female researchers.
In his prime, though, Marshall was an engaging if quirky man with cheery blue eyes. His students tell of innumerable conversations over tea at his home. As a teacher, he stressed illustration and current events over an orderly textbook approach. Marshall could find economic examples almost anywhere, sometimes in ancient history, other times in contemporary plays being performed in Cambridge. He spoke with a chuckle and often concluded sentences with a gleeful falsetto. Sometimes he seemed a bit silly. One famous story recalls a graduate student visiting Marshall’s home in search of a dissertation topic:
“Come in—come in,” he said, running in from a little passage, and I went with him upstairs. “Have you any idea what to do?” he asked me. I said, “No.” “Well, then, listen,” he said, producing a small black book. He proceeded to read out a list of subjects, having previously ordered me to hold up my hand when he came to one that I liked. In my nervousness I tried to close with the first subject, but Marshall took no notice and read on.
Marshall rejected the student’s second and third signals.
He kept reading out topics for another five minutes. Finally, Marshall stopped and asked, “Have you found a subject you like?” “I don’t know,” I began. “No one ever does,” he said, “but that’s my method.”11
Despite such silliness, Marshall could be stunningly clever. According to Cambridge mythology, whenever a difficult mathematical treatise came out, Marshall would read just the first chapter and the last chapter. He would then stand in front of the fireplace and figure out the rest. He also had a touch of vanity and did not think that photos did justice to his noble gaze. While a graduate student at St. John’s, Cambridge, I would eat dinners most evenings under the gaze of his portrait, painted in 1908 by the acclaimed artist William Rothenstein, who reported that Marshall “took sitting seriously,” adding that “vain men make the best sitters.”12 Marshall preferred a portrait of another man. In the 1870s, before he had achieved much fame, he spotted in a shop window a small oil painting of a dark-complexioned, anonymous laborer, with a “strikingly gaunt and wistful expression,” staring downward. Marshall bought the portrait for a few shillings. “I set it up above the chimney-piece in my room . . . called it my patron saint, and devoted myself” to trying to help such men, he said.13
Perhaps no one among the “hall of fame” economists contrasts more with the tempest-tossed mind of John Stuart Mill and the incendiary visions of Karl Marx than Marshall, whose life and thought were about as frenzied as an old basset hound on a Sunday afternoon. Interestingly, his inner and outer calm reflected his view of economics and, indeed, his view of the world. He had read enough German philosophy to know that he had a Weltanschauung. Never one for legerdemain, Marshall immediately tells us his creed when we open Principles of Economics, first published in 1890: “Natura non facit saltum”—nature makes no leaps.
Whereas Apollonian and Dionysian forces battled in Mill’s mind and revolutions exploded in Marx’s, Marshall appeared as steady as the Alps. Like his predecessors, he hosted idealistic visions of a better world. But he was never fooled into abandoning careful analysis:
In every stage of civilization . . . poets in verse and prose have delighted to depict a past truly “Golden Age,” before the pressures of mere material gold have been felt. Their idyllic pictures have been beautiful, and have stimulated noble imaginations and resolves; but they have had very little historical truth. . . . But in the responsible conduct of affairs, it is worse than folly to ignore the imperfections which still cling to human nature.14
Still, Marshall thought the world could improve—gradually. Whereas classical economists followed a Newtonian scientific approach searching for laws of nature, Marshall turned to a more evolutionary approach. Charles Darwin and biology replaced Isaac Newton and physics. The “mathematico-physical” sciences ruled in the eighteenth century—studying unvarying natural phenomena—and economists followed. As the nineteenth century wore on, however, biological studies—concentrating on organic, evolving phenomena—ascended into prominence. Economists, first led by John Stuart Mill, followed. Marshall took them even further.
Alfred Marshall’s marginalism is evolution applied to economics. The businessman and the consumer make no great leaps, but step by step they try to improve their situations. Individuals, companies, and governments all adapt to changing prices. The fittest firms survive. Low profits drive out the weakest. Competitive pressures force firms to cut costs. Although the final results do resemble Adam Smith’s Newtonian economics, Marshall teaches us how to closely inspect individual decisions along the way. Marginalism paves the way for the development of microeconomics. And microeconomics persuades us that actors will reconsider their positions and decide to take new steps if the benefits exceed the cost. Only if benefits and costs stagnate can we assume constant, Newtonian behavior:
The main concern of economics is thus with human beings who are impelled, for good and evil, to change and progress. Fragmentary statical hypotheses are used as temporary auxiliaries to dynamical—or rather biological—conceptions: but the central idea of economics, even when its Foundations alone are under discussion, must be that of living force and movement.15
Marshall lived his life by a gradualist creed: he dared to be cautious. Sometimes he may have been too slow. While Marshall developed many of his ideas in the early 1870s, Principles was published so many years later that critics disparaged his claims of originality, although more recent scholarship shows that many of his principles did appear in lectures decades before they appeared in print.
Fortunately, Principles stayed fresh for a long time. Originally appearing in 1890, the text sold more and more copies every year, finally peaking in the 1920s. Marshall saw eight editions in his lifetime, and modern microeconomics textbooks still rest on this text. Principles differs from contemporary works in several ways, though. First, Marshall can’t resist moral platitudes. Every so often Marshall slips in advice that might be better suited for “Dear Abby”; sometimes he sounds like the right man to resolve a feud between Abby and her sister, Ann Landers, but the wrong man to resolve a tough business dispute. Happily, Marshall does not always sound as if he’s addressing a convention of Victorian schoolmarms.
Second, in contrast with modern textbooks, which aim at students and specialists, Principles often speaks directly to laypeople. Economists cannot hide in pure theory but must look at the world and try to improve it with the tools they develop. Marshall develops complex models, but he saves the complexity for footnotes and appendices. In the main text he uses simple, accessible English. Marshall warned that elegant models with “long-drawn-out and subtle reasonings” may become “scientific toys rather than engines for practical work.”16 If Marshall wanted toys, he could have stayed with his aunt and played cowboys and Indians. Instead he sought a noble profession and urged others to follow. And they did, although he sometimes complained about his early students. By the first publication of Principles, more than half the chairs in economics in the United Kingdom were filled by his pupils. And as the number of chairs increased, more Marshallians settled into them.
Although trained as a mathematician, Marshall feared that economists would calculate themselves into irrelevancy. Ricardo forever remained a hero to Marshall, because Ricardo thought like a mathematician without resorting to obscure symbols and secret formulae. Marshall translated Ricardo and Mill into calculus but never let his economic arguments rest on solely mathematical proofs. In a charming letter, Marshall put forth his system:
(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 did often.17
No wonder Pigou reported that Marshall read mathematical treatises in front of the fireplace. Perhaps Marshall’s maneuvers assuaged his guilt for stashing mathematical curves under his childhood bed the way other boys conceal sketches of other kinds of sinuous shapes.
Marshall was a little less pert about economic method than the preceding letter suggests. Like Mill, Marshall avoided the classical trap of declaring rigid economic laws. History had a place in economics along with deductive theory: “The chief fault in English economists at the beginning of the century was not that they ignored history and statistics, but that they regarded man as so to speak a constant quantity. . . . I do not assign any universality to economic dogmas. It is not a body of concrete truth, but an engine for the discovery of concrete truth.”18 Marshall also realized that facts teach nothing by themselves. According to John Neville Keynes, Marshall employed “deductive political economy guided by observation.”19 By finding a golden mean between the ivory tower and the public house, between pure theory and earthly fact, Marshall defended economics from the biting attacks of sociologists and moralists.
Rather than becoming the Newton of economics, Marshall sought to be the Darwin. He would look at firms to see how they reacted to environmental changes. “The mecca of the economist lies in economic biology,” he declared.20
Rome was not built in a day, and man did not evolve from monkeys in a week. Paradoxically, Darwin taught that whereas a thousand years may be biologically insignificant, the brief lifetime of a mutant could determine the future of a species. Marshall realized that like biological time, “economic time” was not synchronized with Big Ben in London. Ten years does not simply permit a firm to do ten times what it could do in just one year. For some transactions, one year is a long time. For other moves, one year barely allows preparation.
During every step of economic analysis, clocks are ticking. During the first OPEC embargo in 1973, politicians grabbed economists by the necks, shaking them to and fro until they answered crucial questions: When will consumers respond to higher prices by conserving? When will General Motors, Ford, and Chrysler respond by producing smaller cars? When will oil companies respond by drilling elsewhere? Each of these eventually took place—but not at the same time.
Marshall tried to isolate particular tendencies and the time periods in which they operate. Time is “a chief cause of those difficulties . . . which make it necessary for man with his limited powers to go step by step; breaking up a complex question, studying one bit at a time, and at least combining his partial solutions into a more or less complete solution of the whole riddle.” Marshall created an ingenious system of analysis. While looking at one factor, he threw all others into a “pound.” There they waited while he vetted the solitary factor. He called the pound ceteris paribus, meaning “other things being equal: the existence of other tendencies is not denied, but their disturbing effect is neglected for a time. The more the issue is narrowed, the more exactly can it be handled.”21
Prior economists had already advised a ceteris paribus assumption. But Marshall derived an explicit method and constructed rigorous theories according to it. Today’s textbooks rest on Marshall’s method.
Marshall’s method contrasted sharply with the highly theoretical and mathematical “general equilibrium” analysis of the nineteenth-century Frenchman Léon Walras. While Walras’s abstract apparatus receives little attention in undergraduate textbooks, his work was extended in modern times by some very intelligent theoreticians, including Nobel laureates Kenneth Arrow, Gérard Debreu, and Cambridge’s Frank Hahn. (An interesting aside: despite the dazzling mathematics behind Walrasian analysis, Walras twice failed the mathematics portion of his college entrance exam.)
An example may help our understanding of Marshall’s system. Assume the development of a new product called Yuppie Yogurt, which appeals to an obvious market, partly because it’s actually produced on Wall Street. Even better, assembly workers drop pieces of Godiva chocolate into the yogurt cultures as they grow. The slogan “Eat Your Way to the Top Without Getting a Fat Bottom!” drives yuppies wild for yogurt. On any particular day, the supply of Yuppie Yogurt is fixed. If computers crash and more than the usual number of yuppies take snack breaks, some will go hungry. By the time the producer hears about an excess demand, packages more yogurt, and sends it out of the factory, the working day is over. In the time frame of one day, therefore, only demand fluctuates.
With more notice, producers can boost supply. The second time frame, which Marshall called the “short run,” lasts long enough for producers to change the amount supplied. To supply more, they can hire more labor and buy more raw materials. But they cannot expand too much. Marshall’s short run does not last long enough to build new manufacturing plants. What if Yuppie Yogurt manufacturers advertise on television, which sends demand flying? In the short run, they can buy more milk for the yogurt and hire more workers to add the chocolate. If demand falls, they can fire the workers and reduce their milk purchases.
Because plant capacity is fixed in the short run, producers do face the law of diminishing returns—that is, stuffing too many workers in a room reduces their productivity. Of course, producers will still employ the marginal rule and produce yogurt until the price they receive equals the cost of the last pint.
In the third time frame, the “long run,” producers have enough time to build new plants, as well as vary labor and materials. If demand for Yuppie Yogurt persists, they can even extend Wall Street into New York Harbor—or erect a plant across the harbor. They may even replace the workers with pin-striped robots.
In the long run, new producers could enter the industry, and old producers who lost money could leave. Survivors would earn normal profits. Thus, supply becomes prominent in the long run.
How long are the short and long runs? It depends on the particular industry; the periods are defined by how long it takes to alter capital and capacity. Obviously, Marshall did not discuss Yuppie Yogurt. Instead he discussed fish; in the fishing industry, Marshall supposed that it would take a year or two to employ new ships. As technology improves, however, the long run (reaction time) may shrink.
Marshall had more to say about the size of firms. The classicalists often decreed that as a firm increased in size, its average costs remained the same: growth tended to neither help nor hurt a firm. By Marshall’s time, most economists spoke of decreasing returns: at some point bigness led to inefficient operations. In his fish examples, Marshall noted that too much fishing may deplete resources and eventually force fishermen to sail farther from shore for their catch. Nonetheless, Marshall asked, what if bigness made certain industries more efficient? Larger companies often have access to cheaper credit and more efficient machinery. Today, Whirlpool can get a loan cheaper than you can; moreover, it can afford to buy a better assembly line than you.
Marshall identified two different sources for increasing returns to scale. Internal economies arise from division of labor, buying supplies in bulk, and using specialized, large machinery that smaller producers cannot afford to operate. Imagine a small company called Chuck’s Crossings that transports aristocrats across the Atlantic on luxurious dinghies. The cost to the company is $3,000 per passenger. If Chuck can attract one thousand passengers, he can use the Queen Mary 2 instead of dinghies. With a thousand on board, the cost per passenger is only $2,000. Thus, if Chuck can billow his sales, he can scrap the dinghies and sail more cheaply. (Eventually, if Chuck keeps expanding, costs will likely rise because of management inefficiencies and marketing problems.)
The seemingly dull business of freight shipping has changed in radical and exciting ways over the past fifty years. In the 1950s, when a ship steamed into port, one hundred stevedores would toil for a week unloading it. Now, with freight packed into containers, seven dockworkers can unload a major vessel in just a day. Those containers go directly from ships to trains to trucks with almost magical efficiency. This transportation revolution has stomped on distribution costs, making it economical for Americans to import bottled water from Fiji.
External economies follow from events outside the particular firm. If an industry tends to locate in a particular area, the communities may provide an orderly, constant market for skilled labor. The firms get an extra push because subsidiary trades emerge, offering the industry low-cost supplies:
Good work is rightly appreciated, inventions and improvements in machinery, in processes and the general organization of the business have their merits promptly discussed: if one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas. And presently subsidiary trades grow up in the neighborhood, supplying it with implements and materials, organizing its traffic, and in many ways conducing to the economy of its material.22
One need consider only the rather incestuous relationship between Stanford University and Silicon Valley or Cambridge University and the collection of high-tech firms located in “Silicon Fen” to see important linkages between an industry and its suppliers. Cities like Wichita, Kansas, and Querétaro, Mexico, have become hubs for airplane and helicopter manufacturers. In an older example, Pennsylvania miners extracted coal, which was turned into coke and fed into nearby furnaces used in the steel industry. Sometimes the linkages are not so obvious. Consider: Broadway is a boulevard running north to south in Manhattan, and of course the moniker “Broadway” refers to the theater district, a square-mile neighborhood near Times Square where the theaters are located. But the district is not made up of just theaters. Within blocks of Broadway are rehearsal halls that can be rented by the hour and the offices of theatrical producers, casting directors, publicity firms, and vocal and dance coaches. The union of stagehand, lighting, and sound workers is right in the heart of it, too, a few yards from Joe Allen, a legendary tavern catering to the Broadway crowd. It would be hard for, say, Albuquerque to grow a similar complex of talent within a small neighborhood.
Marshall’s observations apply beyond cities, however. Fargo, North Dakota, the butt of jokes and a sardonic movie, has become a fast-growing software powerhouse that boasts one of the lowest unemployment rates in the country. In the early 1990s, Fargo looked like just another Great Plains town fading away, as frigid winter winds blew through a dilapidated downtown. But some entrepreneurial souls figured out that modern telecommunications could permit them to design and sell software from anywhere, including a remote place in North Dakota. Microsoft bought Great Plains Software in 2001 and expanded the facilities, and today Fargo is a bustling hub of technological know-how. Belying its dusty, backward reputation, North Dakota spends more on research and development as a proportion of income than almost any other state.
If Marshall is right about increasing returns, then big is beautiful. If big is beautiful, competition could not long continue, for large firms would always defeat small firms. Chuck’s Crossings would always be swamped by Cunard. And a monopoly would dominate each industry. How could Marshall, a prime proponent of competition, live with this theoretical implication?
He could because he thought that firms could not live forever. He resorted again to biology and borrowed an organic metaphor. Entrepreneurs can fertilize and deliver a bouncing baby firm. They can nourish and raise it to adulthood. But soon the entrepreneurs die. Succeeding managers will frequently be less talented. New firms, sired by other entrepreneurs, will flourish:
Nature still presses on the private business by limiting the length of the life of the original founders, and by limiting even more narrowly that part of their lives in which their faculties retain full vigour. And so, after a while, the guidance of business falls into the hands of people with less energy and less creative genius, if not with less active interest in its prosperity. If it is turned into a joint-stock company, it may retain the advantages of division of labor, of specialized skill and machinery: it may even increase them by a further increase of its capital, and under favorable conditions it may secure a permanent and prominent place in the work of production. But it is likely to have lost so much of its elasticity and progressive force, that the advantages are no longer exclusively on its side in its competition with younger and smaller rivals.23
According to Marshall, the lean and hungry will eat into the profits of the fat and lazy. While Marshall’s theory seemed dated in post–World War II America with the rise of international conglomerates, it now appears rather contemporary. Stable, giant conglomerates of the 1970s, like Gulf and Western, ITT, AT&T, and IBM, all got thrashed in hotly competitive markets of the subsequent decades. RCA, which dominated media and electronics under longtime chief David Sarnoff, quickly unwound after his retirement.24 Later, even the famous red-neon RCA sign on its Rockefeller Center headquarters was dismantled, though millions of New Yorkers had lived their lives under its glow.
New entrepreneurial efforts may be willing to take more risks than established companies that must answer to stockholders. Even if the start-up ventures usually fail (perhaps for taking foolish risks), just one success story from a garage can spoil the careers of dozens of vice presidents for long-range strategic planning who work in shiny, glass skyscrapers. During the last thirty years, a clear majority of the new jobs in the United States were created by companies with fewer than five hundred employees.
After waves of corporate mergers from the 1950s through the 1980s, many firms reversed gears and aimed to create “meaner, leaner” businesses by streamlining and selling off divisions. National Distillers Corporation no longer produces liquor and changed its name to Quantum Chemical Corporation, after spinning off its spirits division to Jim Beam. In March 1989, BusinessWeek devoted its cover story to the question “Is Your Company Too Big?”25 AT&T’s biggest success in the 1990s was spinning off Lucent Technologies, which made sophisticated telephone equipment. While AT&T languished, Lucent share prices soared into the stratosphere, until crashing in the “tech wreck” of 2000. At the same time, many corporations such as Time Inc. and Warner Communications merged in hopes of efficiently sharing knowledge and assets. The subsequent Time Warner merger with AOLin 2000 was miserably timed and miserably executed. Since the publication of Marshall’s Principles more than a hundred years ago, businessmen have continually struggled to balance flexibility and economies of scale in order to discover the optimal size of their enterprises.
So far we have discussed the firm without examining the consumer. Marshall would not be happy with such one-sidedness, for he rebelled against the classical claim echoed by Ricardo and Mill that the value of a product reflects the hours it took to produce it. In a famous metaphor, Marshall proclaimed that supply and demand are equally powerful: “We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production.”26 With Marshall’s encouragement, then, let us combine supply and demand, using the marginalist tools.
The last time we left our Wall Street friends they were lusting for yogurt. Yuppie Debbie’s demand for yogurt is based on the additional satisfaction each half pint of yogurt gives her. Marshall called this “marginal utility.” Jevons insisted on calling it “final utility.” Fortunately, they never lectured together, or a very boring debate might have followed.
Marshall and Jevons each asserted that Debbie’s marginal utility would diminish with each portion of yogurt. That is, the first portion might give her $1 worth of pleasure; the second, only 90 cents; the third, perhaps 70 cents; the fourth, 64 cents; and so on. Finally, the idea of eating one more spoonful would repulse her. In deciding whether to buy yogurt, Debbie would compare the selling price with her marginal utility. If the selling price for each portion were $1, Debbie would buy only one (because a second portion costing $1 would give her only 90 cents of pleasure). If the price were 65 cents, Debbie would buy three. The third portion, costing 65 cents, would give her 70 cents of utility. But if she kept going and bought a fourth, it would give her only 64 cents of pleasure. Economists draw downward-sloping demand curves that trace the diminishing marginal utility. In each case, Debbie compares the marginal utility (benefit) of yogurt with the marginal cost (price).
Marshall then enunciated the “law of demand:—The greater the amount to be sold, the smaller must be the price. . . . The amount demanded increases with a fall in price, and diminishes with a rise in price.”27
Of course, Marshall knew that price alone did not determine demand. He listed several other factors and placed them in the ceteris paribus pound. Most important of those he discussed are as follows: (1) the consumer’s tastes, customs, and preferences; (2) the consumer’s income; and (3) the price of rival goods. If Debbie read in the Wall Street Journal that eating Yuppie Yogurt helped one’s racquetball game, she would immediately begin salivating, and her tastes would change. Even if the price stayed the same, she would buy more. But in explaining the law of demand, Marshall asked us to assume that tastes, income, and other prices remained steady. If so, the law of demand usually holds (a change in one of the impounded factors shifts the demand curve).
Marshall then deployed the marginalist principle again and asked the marginalist/Henny Youngman question: Where does Debbie step next? The rational consumer continually looks forward and compares the additional satisfaction available from one good with that of other goods. If $1 spent on yogurt yields $1 worth of pleasure, but that dollar spent on sushi would bring $1.20 of pleasure, Debbie should buy sushi. How long should she continue buying sushi? Remember that according to the law of diminishing marginal utility, as she buys more, the sushi becomes worth less to her. Therefore, she should continue buying until the pleasure from sushi equals the pleasure from yogurt. In equilibrium, a dollar spent on all goods begets the same amount of pleasure. If a dollar spent on product A gives more pleasure than a dollar spent on product B, the consumer should consume more of A and less of B until the marginal utilities are equal. In Marshall’s words, the consumer is “constantly watching to see whether there is anything on which he is spending so much that he would gain by taking a little away from that line of expenditure and putting it on some other line.”28
When Marshall visited American shops as a young man, he noticed many bargains. But what really is a “bargain”? Marshall said that when a shopper buys something for a lower price than she would be willing to pay, it is a “consumer surplus.” Take this example: In 2018, Bruce Springsteen performed on Broadway in a one-man show that sold out every night and was filmed for a Netflix special. The average price of an official ticket bought at the box office was $500. But many of his fans would have paid much more. We know this because scalpers charged about $2,000 per seat.29 Many of those fans lucky enough to purchase official box office seats for $500 enjoyed a $1,500 “consumer surplus,” in Marshall’s parlance. Marshall used his ingenious mathematical and graphical framework to illustrate this surplus, a technique that still shows up on economics exams.
Marshall developed a similar framework for suppliers. As a producer supplies more, her costs tend to rise. The law of supply is opposite to the law of demand: supply will rise only if the price received from consumers rises. The producer compares the marginal cost of producing one more unit to the marginal benefit, the price. (A supply curve slopes upward, whereas a demand curve slopes downward.)
In the same way that the consumer constantly compares the marginal utility of spending a dollar on various products, the producer constantly compares the marginal utility of spending a dollar on capital (machinery) with the marginal utility of spending that dollar on labor. If a dollar spent on a new machine yields more than a dollar spent on a new employee, the manager will invest in machinery and reduce her labor force. In equilibrium, the marginal return from capital equals the marginal return from labor.
Assume that the firm is in equilibrium. The assembly union gets a raise. What happens? The marginal return from labor (the marginal output divided by the wage) falls in comparison with the marginal return from capital. The manager would substitute a robot for a human assembler until the marginal returns equalize again. For this reason, Marshall blasted unions that supported make-work projects and featherbedding, for they only hurt their members.
Sometimes prices would lead the manager to fire robots and hire human assemblers if, for example, the cost of electricity rose or wages fell. Sometimes governments seem to inadvertently tip the scale against human beings. Let’s ask a simple question: If you were a manager, why would you hire a human? Yes, they can be wondrously creative and caring, but they get sick. They daydream. And they take coffee breaks. The cost of capital equipment, meanwhile, from laptops to lathes, has plummeted for the past twenty-five years. Moreover, because interest rates have been remarkably low, the cost of leasing and financing new tools has fallen to the lowest levels since, well, before there were laptops and lathes. At the same time, federal tax policy has been tilted toward capital spending, with businesses able to immediately deduct the cost of new equipment. People, however, remain relatively expensive. Let’s say that an applicant can deliver $50,000 of value to a firm—and she is willing to work for $50,000 a year. Great match, right? Not exactly. In addition to her salary, in the United States the employer also has to pay a 7.56 percent Social Security and Medicare tax and contribute to workers’ compensation and unemployment insurance. And then there are health insurance costs. Suddenly, that hunk of metal robot is looking shinier.
The constant balancing act is not just between capital and labor, but among land, new machinery, used machinery, skilled labor, unskilled labor, and such. If land prices rise, a manager may build another story onto the plant rather than expand horizontally.
Marshall’s Principles do not argue that all producers act marginally or rationally. But if a producer does not, her competitors will be more successful, and economic evolution will favor them. Eventually, the irrational firm will fail.
Whether consumers or producers, most economic agents live by the words of Evelyn Waugh, Henny Youngman, and Buckaroo Banzai, engaged in a never-ending comparison of marginal steps.
Is it the consumer or the producer who determines the price? Both. Like blades of scissors, the intersection of supply and demand gives us prices. While the classicalists overemphasized supply, Jevons overstressed demand. But Marshall’s persuasive idea, that of an “equilibrium point of demand and supply, was extended so as to discover a whole Copernican system, by which all the elements of the economic universe are kept in their place by mutual counterpose and interaction.”30
Marshall also took time to rebut the Marxian labor theory of value. He starts by stating that man cannot create material things—man can only rearrange matter to make it more satisfying to others. Capitalists contribute to satisfying others by contributing their money. Their return rewards them for waiting, for not spending it today on consumer goods. Marshall speaks so forcefully here that direct quotation is warranted. Marx and others
argued that labour always produces a “surplus” above its wages and the wear-and-tear of capital used in aiding it: and that the wrong done to labour lies in the exploitation of this surplus by others. But this assumption that the whole of this Surplus is the produce of labour, already takes for granted what they ultimately profess to prove by it; they make no attempt to prove it; and it is not true. It is not true that the spinning of yarn in a factory, after allowance has been made for the wear-and-tear of the machinery, is the product of the labour of the operatives. It is the product of their labour, together with that of the employer and subordinate managers, and of the capital employed; and that capital itself is the product of labour and waiting: and therefore the spinning is the product of labour of many kinds, and of waiting. If we admit that it is the product of labour alone, and not of labour and waiting, we can no doubt be compelled by inexorable logic to admit that there is no justification for interest, the reward for waiting; for the conclusion is implied in the premiss. . . .
. . . If it be true that the postponement of gratifications involves in general a sacrifice on the part of him who postpones, just as additional effort does on the part of him who labours; and if it be true that this postponement enables man to use methods of production of which the first cost is great; but by which the aggregate of enjoyment is increased, as certainly as it would be by an increase of labour; then it cannot be true that the value of a thing depends simply on the amount of labour spent on it. Every attempt to establish this premiss has necessarily assumed implicitly that the service performed by capital is a “free” good, rendered without sacrifice, and therefore needing no interest as a reward to induce its continuance; and this is the very conclusion which the premiss is wanted to prove. The strength of Rodbertus’ and Marx’s sympathies with suffering must always claim our respect: but what they regarded as the scientific foundation of their practical proposals appears to be little more than a series of arguments in a circle to the effect that there is no economic justification for interest, while that result has been all along latent in their premisses; though, in the case of Marx, it was shrouded by mysterious Hegelian phrases, with which he “coquetted,” as he tells us in his Preface.31
While developing his demand apparatus, Marshall refined one of the most important tools in all economics, elasticity. Almost every economic debate today, whether “macro” or “micro,” confronts the elasticity issue. Every government policy must implicitly or explicitly deal with elasticity. What is this unavoidable, haunting specter? Elasticity is another name for responsiveness. How responsive are people to changes in prices? Do people adjust their purchases when prices rise or fall? Or do they continue buying the same amount? The answer, of course, depends on the product.
If the price of a product rises and people cut back their purchases, we say that demand is elastic. If they continue buying the same amount, demand is inelastic. More precisely, elasticity is the percentage change in demand divided by the percentage change in price. If a 10 percent change in price leads to an 11 percent change in purchases, demand is elastic. If it leads to a less than 10 percent change in purchases, demand is inelastic. If it leads to a 10 percent change, demand is “unit inelastic.” (If demand is highly elastic, we should see a nearly horizontal demand curve, indicating that people will easily adjust their purchases. If demand is highly inelastic, we should see a nearly vertical demand curve, indicating that people will purchase the same amount regardless of price.)
Why is this important? Let’s look at some simple examples. In nearly every James Bond movie, the following line appears: “Vodka martini, shaken not stirred.” If Bond drinks one and only one vodka martini and does not substitute a gin martini or a glass of milk, his demand is inelastic. Regardless of price, he will drink one vodka martini. This puts bartenders in a good position. They can charge a million dollars for a drink. Lucky for Bond, other bars will compete for his business.
Trouble arises, however, when a monopoly meets inelastic consumers. If only one company supplied insulin, for example, it could charge an outrageous price. When monopolies face inelastic consumers, government regulators often step in. Thus, for example, the relationship between pharmaceutical companies and the government is precarious. On the one hand, the government wants companies to perform research to cure diseases. But companies need assurances that the government will not just seize their miraculous discoveries and leave them bankrupt. On the other hand, the government must ensure that needy, desperate patients are not gouged. In August 2016, just before the school year began, the pharmaceutical company Mylan announced a dramatic price hike for its popular EpiPen, which counteracts life-threatening food and insect-sting allergies. Parents were outraged. While Mylan had a monopoly on the injector mechanism, it did not have a patent on the drug inside (epinephrine). It turned out that the Food and Drug Administration had been slow to approve alternatives in a convoluted process that can cost applicants hundreds of millions of dollars and takes years to get a verdict. In 2018, new FDA commissioner Scott Gottlieb clarified and sped up the process, leading to a rash of competitors, including a generic version of the EpiPen released by the Israeli company Teva, which undercut the Mylan product price by about 50 percent.
The fear of price-gouging and of limiting supply leads economists to follow Marshall’s advice that many monopolies—for instance, water and electrical utilities—be regulated. Since they are “natural monopolies” (it would be inefficient to have several water companies lay pipes on one street), Marshall suggests that the government encourage them to expand output through subsidies or at least guarantees that they will remain profitable.
Often demand for goods is highly elastic. If the price of iceberg lettuce rises, people will turn to Boston lettuce, romaine lettuce, or maybe the crabgrass on their front lawns.
What determines the degree of elasticity? First and most obvious, the number of substitutes available. The more alternatives, the easier consumers can switch. The demand for Robert De Niro may be inelastic. The only alternative seems to be Al Pacino, although some would say that he is an almost perfect substitute. Hollywood first offered the part of Rick in Casablanca to Ronald Reagan, not Humphrey Bogart. Not exactly substitutes, but Marshall never claimed that everyone was rational.
Second, the more time we have to find substitutes, the more elastic demand can be. From fall 1973 to summer 1974, gasoline prices rose by 45 percent. In that year demand fell by only 8 percent. After a few years, though, consumers showed much more elasticity. They bought smaller cars, rode mass transportation, and insulated homes. Airlines reduced their flight weight by cutting the number of pillows, blankets, and magazines. They also reduced the amount of food and fuel carried, and even thinned the exterior paint.
Third, Marshall argued that products unimportant in the household budget may be inelastic. If the price of toothpicks rose sharply, few would cut back. Toothpicks compose too small a percentage of the budget to worry about.
Consumer companies must constantly gauge the elasticity of demand, and sometimes they get it wrong. In 2020, the Clorox company sheepishly admitted that it had sold fewer Glad trash bags and freezer wraps than expected. When the company raised prices, shoppers shied away and stores cut back the amount of shelf space, shaving sales by 8 percent. The CEO reported, “Pushback was more than we anticipated,” meaning that the company underestimated the elasticity of demand.32
Marshall’s elasticity toolkit led to another insight: the income elasticity of demand. This measures whether people will buy more or less of something if their income changes. For example, during a recession, when people lose jobs, they may be less likely to buy “name brands” like Clorox and Kleenex and more likely to buy cheaper store brands or so-called plain wrap. Comedian Chris Rock jokes about his parents being so cheap that they would buy only unbranded food in a plain white box, rather than famous brands featuring flashy labels and iconic spokespeople: “The label just said one thing: ‘rice.’ No Uncle, no riverboat, just ‘rice.’” And for breakfast? “White box, black letters: ‘cereal.’ There ain’t no captain on this ship. Ain’t nothing lucky about these charms.” But what if Rock’s father got a raise? Maybe he would spring for Uncle Ben’s rice and Cap’n Crunch or Lucky Charms cereal. If so, his income elasticity of demand would be positive, and his family breakfast might be sweeter.
Following Marshall’s lessons, economists call less-desirable, no-brand items “inferior goods.” The coronavirus crisis delivered a quick example. Between February and March 2020, as consumers lost jobs and investors watched their stock portfolios crater, Walmart’s sales of ramen noodles jumped by 578 percent.33 Suddenly, Americans across the country were adopting the culinary proclivities of poor college students armed with only a teapot.
How does the elasticity issue sneak into every government policy? A few more examples will suffice:
1. Every few years, New York City’s MTA raises the subway fare, arguing that higher fares mean more revenue to balance the budget. The argument assumes that demand is relatively inelastic. If too many people respond by taking buses, an Uber or Lyft, or a horse-drawn carriage, total revenue falls.
2. In 1998, the Clinton-Gore White House proposed jacking up cigarette taxes in order to cut teenage smoking. Vice President Gore asserted that for every 10 percent increase in cigarette prices, teenagers smoke 7 percent fewer cigarettes. Using these elasticity estimates, the White House proposed a $1.50 per pack increase, which it claimed would reduce smoking by 42 percent over a five-year period. Opponents argued that since lower-class Americans are disproportionately smokers, the burden of the tax would fall on their shoulders. At the same time that U.S. politicians debated the issue, Sweden actually cut its tobacco tax to make black market smuggling from neighboring countries less attractive.
3. Marshall’s elasticity also applies to international trade, and was enhanced by a posthumous partner named Abba Lerner. Lerner was a pioneering Moldovan-born, British economist who hopscotched from university to university from the 1930s to the 1970s, poking holes in neoclassical economics and trying to patch the craters in socialist economic theory. Lerner used Marshall’s elasticity formula to show that under certain conditions, if a country’s currency dropped in value, its trade balance would improve. The “Marshall-Lerner condition” now appears in every international economics textbook and informs many foreign-policy shouting matches. From the early 1980s until the present, the United States has run large foreign trade deficits. In 1985, many economists blamed a “high” dollar—that is, American goods seemed expensive to foreigners, whereas other countries’ goods seemed cheap to Americans. These economists suggested driving the dollar downward by buying up foreign currencies, thus making American goods appear cheaper and thereby spurring foreigners to buy more (and making foreign goods appear more expensive to Americans). The argument assumes that domestic demand for foreign goods is elastic. From spring 1985 until fall 1987, the value of the dollar fell by 40 percent against the currencies of other industrialized nations. But it was not until the very end of 1987 that the trade deficit began falling. The long delay in reducing this deficit indicated less elasticity than expected. Economists also underestimated the willingness of foreign companies to maintain their market shares by allowing profits to fall, for prices of goods imported into the United States did not rise enough to fully reflect the dollar’s fall.34 From 1995 to 2002, the United States took a reverse trip as the U.S. dollar jumped by more than 25 percent. As a result, the trade deficit worsened significantly. In 2019, when President Trump officially named China a “currency manipulator” and said that China’s cheap-currency strategy was one of “the greatest thefts in the history of the world,” he was inadvertently opining on the Marshall-Lerner condition, a mathematical formula put together by the sons of a poor English cashier and a Moldovan peasant.
Elasticity underlies nearly every practical economic dispute. Marshall always warned that economists must confront the real world. A neat, theoretical model may be persuasive on paper but prove useless when actual elasticities are included. By clarifying the concept, Marshall showed economists that they must unite theory and practice.
On macroeconomic issues, Marshall did not venture far. He held to Say’s Law and the “quantity theory” of money (see chapter 10), and he taught them both to Keynes. Keynes held to them for years before turning on Marshall and tossing them away, as we will later discuss.
Although Marshall thought the economy operated rather smoothly on its own, he admitted that business cycles bring ups and downs. Business optimism and pessimism accelerate and amplify the blips and dips. In the ascending phase, banks lend too boldly, even to novice businessmen. But when the economy finally slows, investors withdraw their funds, sending the economy down faster. “The fall of a lighted match . . . has often started a disastrous panic in a crowded theatre,” Marshall analogized.35 Happily, Marshall’s old friend, time, heals all wounds, and the economy rises again. Though Keynes would agree that moods help swing the economy, he would later point out that after the fire goes out, the theater remains ruined for a long time. Depression can be a long-running act.
One macroeconomic distinction that Marshall and Yale professor Irving Fisher drew has still not been accepted by politicians today. Economists distinguish between real interest rates and nominal interest rates. Nominal interest rates are the lending and borrowing rates as usually posted in the windows of banks. Real interest rates subtract the rate of inflation from nominal rates: if bonds pay 8 percent, but inflation is 5 percent, the real rate is 3 percent. Politicians have been known to define the real interest rate as the rate you “really” have to pay when you go to the bank for a loan.
Despite the grand theoretical scope of the Principles, Marshall insisted that economics must be practical. He frequently served on royal commissions and testified before Parliament. He studied economics to help the poor. Years later, he said to the Royal Commission on the Aged Poor: “I have devoted myself for the last twenty-five years to the problem of poverty; and very little of my work has been devoted to any enquiry which does not bear upon that.”36 He supported public education and argued that “the best investment of the present capital of the country is to educate the next generation.”37
Although Marshall supported a moderate redistribution of wealth, because it would heighten productivity and social happiness, he stopped far short of socialism, at one point calling it the “greatest present danger.” Like philosophers and economists as far back as Aristotle, Marshall feared that collective ownership would “deaden the energies of mankind, and arrest economic progress; unless before its introduction the whole people had acquired an unselfish devotion to the public good.” Revealing again his gradualist, evolutionary Weltanschauung, Marshall observed that “patient students of economics generally anticipate little good and much evil from schemes for sudden and violent reorganization of the economic, social and political conditions of life.”38
To Marshall, “impatient” was nearly as devastating an insult as “dishonest.”
Marshall thought that both the classical pessimists and the hopeful Marxists were wrong. The stationary state had not arrived yet. Population did not outstrip food. Landlords did not reign. Although poverty still degraded a portion of the citizenry, the
hope that poverty and ignorance may gradually be extinguished, derives indeed much support from the steady progress of the working classes during the nineteenth century. The steam-engine has relieved them of much exhausting and degrading toil; wages have risen; education has been improved and become more general; the railway and the printing press have enabled members of the same trade in different parts of the country to communicate easily with one another, and to undertake and carry out broad and far-seeing lines of policy; while the growing demand for intelligent work has caused the artisan classes to increase so rapidly that they now outnumber those whose labor is entirely unskilled. A great part of the artisans have ceased to belong to the “lower classes” in the sense in which the term was originally used; and some of them already lead a more refined and noble life than did the majority of the upper classes even a century ago.39
Only Marx wrote a more glowing paean to capitalism.
But Marshall was no knave. He knew work had to be done. He begged his students to help make economics a tool for enhancing man’s well-being. He was disgusted by the remaining poverty he saw, but he refused to let disgust guide his economic logic. Nature would make no quick leaps in wiping out destitution.
Marshall retired in 1908 but continued to refine and update his works. He retreated to his house on Madingley Road in Cambridge, where he endured an assortment of ailments, digestive and respiratory. He lived until 1924, a few weeks shy of his eighty-second birthday, remaining the grand old professor of Cambridge. He left his estate to Mary (who would live until 1944) and asked that she provide an annual lifelong gift to their gardener and maid, along with a generous grant to Newnham College, where he had established himself as one of the first Cambridge dons to educate women. He provided scholarships for economics students, specifying that one-quarter should go to Newnham women, and established the Marshall Library to support the economics faculty. Mary spent the next twenty years painting watercolor landscapes and pedaling her bicycle to the library to work as a volunteer librarian, until she retired at age eighty-seven. Visitors to the library today can see Alfred’s patron saint, the portrait of the workingman that he bought at the little shop for a few shillings 150 years before.
While researching the first edition of this book, I decided to pedal my bicycle to the old Marshall house on Madingley Road. I wasn’t sure what I would find roughly a half century after Mary’s death. I knocked at the door, and a stern-looking older woman answered. If I hadn’t known that the Marshalls were childless, I would have guessed that she was Mary’s now-elderly daughter. I explained my mission, that I was writing a book on Marshall. The old lady paused, suddenly grinned, and then invited me into the parlor. It was in this room that Marshall would give students a copy of his Principles and inscribe it, “To ____, in the hopes that in due course he will render this treatise obsolete.” Then we strolled out to the backyard, and the lady said, “The professor loved living along the fen. He thought the marshes would help his breathing. Alfred and Mary loved the garden and the students. They tended the garden and they tended the students together.”
Keynes praises Marshall for a rare combination of gifts. The master economist must, like Marshall, be a mathematician, historian, statesman, and philosopher to some degree. “He must study the present in the light of the past for the purposes of the future.”40
A man who shared Karl Marx’s surname but had a better sense of humor was once scolded: “Sir, you try my patience.” Groucho responded: “I don’t mind if I do. You must come over and try mine sometime.”
All economists would do well to “try” Marshall’s brand of patience. He did not wait for answers, he searched for them. He did not wait for their adoption, he campaigned for them. But he never embraced his own ideas without cautious thought. And he never rejected the ideas of others without careful reflection. He wanted to unite classical and marginalist economics. He wanted to understand slopes and plateaus, change and equilibrium, evolution and stability. In the end, he did much of this, while reconciling a heart of soft gold and a mind as sharp and clear as a diamond.