Leon Walras (1837-1910) developed a mathematical theory of general equilibrium that was a major contribution to today's economics.
Economists, for the most part, did not accept the extreme position of the philosophy of individualism. They were concerned with social problems, and the influence of Benthamite utilitarianism made them willing to support government intervention in economic affairs if clear social benefits could be demonstrated. Nevertheless, most economists remained within the framework of the individualist philosophy, accepting government action only in limited amounts for limited goals. The emphasis on laissez-faire remained, and economic theory reflected that point of view.
It reflected something else, too: the Marxist critique of capitalism. In part consciously and in part unconsciously, the economists of 1870 to 1900 developed new theoretical formulations that served to refute the Marxist propositions about capitalism.
In the early 1870s three economists, unaware of each other's ideas, developed a new theory of value to replace the old labor theory. An Englishman, a Frenchman, and an Austrian each wrote in a different language, yet their theories were remarkably similar—another example of that often-observed phenomenon in the development of science, the independent and simultaneous discovery of a new principle. Within ten years the new ideas had swept triumphantly through the economics profession and were hailed as a great breakthrough by all but a few diehards who clung obstinately to the old classical system. To compound the coincidence, the discovery came only a few years after Marx had published his attack on capitalism, using the labor theory of value as a base for his exploitation theory.
Later, it turned out that the new ideas were not so new after all. The basic principles had been stated by an Italian mathematician a century and a half before, and during the preceding fifty years had been published by a German engineer, a French public-utilities expert, and several rather obscure English economists. Even Aristotle had used the idea in his treatise on ethics, and related concepts had been discussed by Catholic theologians in the sixteenth and seventeenth centuries. All of these writings had been ignored until Marx attacked the private-enterprise system. When that happened the labor theory of value had to go, and economists had to give serious attention to problems of income distribution and business cycles. A new approach to economics was born.
The new principle was a simple one: the value of a product or service is due not to the labor embodied in it but to the usefulness of the last unit purchased. That, in essence, was the famous principle of marginal utility.
Karl Menger (1840-1921), the Austrian codiscoverer, best stated the basic principle. He pointed out that the rational consumer, faced with a large number of alternatives on which to spend income, will seek to maximize satisfaction. This will be achieved when the consumer has allocated spending so that the last (or marginal) amount spent on one commodity gives no more and no less satisfaction—or welfare, or utility—than the last amount spent on anything else. If it is possible to shift spending from one commodity to another and thereby raise the total satisfaction obtained, the rational consumer will do so, until utility "at the margin" is equalized. In this fashion the demand for any one commodity by any one consumer is determined. Menger pictured the consumer as a person who continually weighed the relative advantages of this or that course of action and always chose the one that gave the greatest increment in satisfaction.
William Stanley Jevons (1835-1882), the English codiscoverer, emphasized another aspect of the principle by showing that utility at the margin diminishes: The more one has of a commodity, the less satisfaction one gets from consuming another unit and the less one is willing to pay for it. This means that plentiful commodities will be cheap, because an additional unit is not worth much to the buyer, even though the commodity itself may be essential to sustain life—such as water or bread. Scarce commodities, on the other hand, will be expensive, because no one has much of them and one more unit will bring a great deal of satisfaction to the buyer—such as diamonds or mink coats.
Leon Walras (1837-1910), the Frenchman who published the same principle in the early 1870s, had a still different emphasis. He explained how the entire economic system, including production of capital equipment and raw materials, was keyed to the consumer's spending decisions. The economy was a seamless web of intricate relationships between prices and quantities purchased in which any change in the consumer's allocation of expenditures was felt throughout the entire system in tiny adjustments of production and prices. Especially in a competitive economy, the whole system automatically adjusted to match production to demand.
Thus, if consumers' preferences were to shift, so that people bought more beef and less lamb, the price of beef would rise and the price of lamb would fall. The rise in the price of beef would increase profits in beef production, stimulating increased output to match the rising demand for beef. Conversely, the lower price for lamb would bring reduced profits there, and output of lamb would fall. The resources released from raising sheep would shift to raising cattle.
The adjustment would not stop there. The increased supplies of beef coming onto the market would start to bring its price down again, and profits to producers would decrease. Meanwhile, the reduced supplies of lamb would bring its price up toward its former level, and profits would start recovering. Ultimately a new market equilibrium would be reached in which prices of beef and lamb generated equal profits at the margin for the producers of meat, while consumers were equating satisfactions at the margin from consuming beef and lamb.
Now generalize this two-commodity example to a multicommodity economy. One arrives at a general equilibrium involving all buyers and sellers, all consumers and producers, and all inputs and outputs. Walras developed this vision as a complex mathematical model in which he was able to specify the exact conditions under which it might be achieved: everyone acting on the basis of individual self-interest; perfectly competitive markets; and complete flexibility in shifting resources from one use to another.
These assumptions gave the theory a highly abstract and metaphysical air. Economic theory tended to focus increasingly on an imaginary exchange economy that was seen as a model of the basic forces operating in the real world, abstracting from the many real-world events that obscured the operation of those forces.
Nevertheless, three basic ideas were established as key elements of neoclassical economics. One was the equimarginal principle: consumers allocate their expenditures to equalize benefits per unit of expenditure at the margin, and producers use their resources to equalize profits per unit of capital at the margin. The second was the principle of diminishing marginal utility: satisfactions diminish at the margin as consumption of a good rises. This paralleled the older classical idea of diminishing returns in production: increases in output diminish in amount as a variable factor of production is added to a fixed factor, as, for example, adding labor to a given acreage of land. Finally, these ideas led to the concept of a general equilibrium in which production matched the preferences of consumers, and the highest possible level of consumer benefits would be achieved, given the existing resources and technology.
The new economics of marginal utility and general equilibrium found the source of economic values on the demand side of the market, in the preferences of consumers. The old labor theory of value had focused on the supply side of the market and had explained value and price in terms of costs of production, which were reduced ultimately to costs measured in labor time. It was an English economist, Alfred Marshall (1842-1924), who reconciled
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these two approaches. He insisted that market price—that is, economic value—was determined by both supply and demand, which interact with each other in much the same way as Adam Smith described the operation of competitive markets. Marshall demonstrated that in the long run prices in competitive markets would tend toward the lowest possible costs of production at which the amounts desired by consumers would be provided. But although Marshall brought costs of production back into the picture, he and most other economists accepted the broader approach of Menger and Walras: the basic pattern of production was determined by the myriad independent decisions of millions of individual consumers.
One of the most important conclusions drawn from this line of thinking was that a system of free markets tended to maximize individual benefits. Since it was assumed that consumers would try to maximize their satisfactions, and since production was patterned after consumer wants, it followed that the result would be benefit maximizing. The analysis also showed that costs of production were pushed to the lowest possible level by the forces of competition. The whole economy, in a sense, was a pleasure-maximizing machine in which the difference between consumer benefits and production costs was increased to the highest level possible—if the economy was allowed to operate without constraints.
These ideas shifted the whole focus of economics away from the great issue of social classes and their economic interests, which had been emphasized by Ricardo and Marx, and centered economic theory upon the individual. The principles of income distribution on which Ricardo had based his analysis of the progress of industrialism and on which Marx had rested his theory of the breakdown of capitalism were replaced by the individual consumer as the major determinant of economic activity and economic progress. The whole economic system was conceived as revolving around individual consumers and their needs.
Economics was transformed into a discipline consistent with the social philosophy developed by Herbert Spencer and William Graham Sumner. That philosophy, of course, reflected the freewheeling individualism that was remaking the face of the world. The economists and their highly abstract theories were part of the same social and intellectual development that brought forth the legal theories of Stephen Field and the folklore of the self-made individual.