Utilitarianism and the marginal revolution

Utilitarianism and the marginal revolution

Utilitarianism in some form or other goes back a long way, but it took its definitive form in the writings of JEREMY BENTHAM at the beginning of the nineteenth century. Utility is a measure of the happiness or well-being of an individual, pleasure minus pain. The principle of utility says that policies should be judged by their effect on the sum total of utility in the community, the ‘greatest good of the greatest number’. This embodies a number of tenets: that policies should be judged by their effect on individuals, that all individuals should count equally, and so on. Bentham was closely associated with the classical economists in a wider grouping known as the philosophical radicals. James Mill, in particular, was a substantial economist in his own right and a close friend both of Bentham and of Ricardo. At that stage, utilitarianism was not seen as part of political economy but as complementary to it—political economy would establish what was possible, while the principle of utility would guide policy choices.

Despite their utilitarian connections, the classical economists denied any direct connection between prices and utility. Earlier writers had commonly, if vaguely, explained the value of goods in terms of their utility and scarcity. Classical writers rejected this connection, citing what is called the water-diamonds paradox: water is essential but often free, while diamonds are of trivial use but have a high price. Utility, it was said, could not determine price. The resolution of this paradox depends on the distinction between total and marginal utility. It makes little sense to talk of the overall contribution of water to my utility because I could not live without it, but it makes perfect sense to talk about the marginal contribution of an extra litre of water. If water is available without charge I will use as much as I want, to the point where an extra litre has no value to me. The marginal utility of water, like its price, will be zero. Note that this is not a statement about the value of water, but about the amount I choose to use. Diamonds, however, are expensive so I will only buy a diamond if its (marginal) contribution to my utility at least matches that of other things I could buy with the money. If I maximize my utility, it follows that the marginal utilities of things I buy are proportional to their prices. The elements of this line of argument had been available for a long time, but it did not fully penetrate the mainstream of economics until the later years of the nineteenth century, in what has been called the ‘marginal revolution’.

By the 1860s there was growing dissatisfaction with the state of economic theory. Ricardo offered clear-cut answers to a limited range of questions but only on implausible assumptions, while dropping his strong assumptions left the results inconclusive.

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Malthusian wage theory seemed largely irrelevant, and there was no adequate theory of demand or of substitution between different methods of production.

In the final decades of the century, a new ‘neo-classical’ economics took over, based on demand and supply analysis with both demand and supply explained in terms of rational maximizing behaviour. Demand for consumer goods from utility-maximizing consumers depends on marginal utility. Profit-maximizing competitive firms set supply so that marginal cost, that is, the cost of an extra unit of output, equals the net selling price. If price exceeds marginal cost it pays to expand, and if marginal cost exceeds price it pays to cut back. Similarly, firms’ demand for labour and other inputs depends on their marginal contribution to output and hence to revenue. With hindsight, we can pick out a number of elements of the new direction earlier in the century, but they did not come together into a successful and widely accepted alternative to classical economics until the 1870s.

The pioneers of the new economics, Jevons in England, Walras in Switzerland and Menger in Austria, arrived at their conclusions independently and developed their conclusions in different ways. Jevons saw the marginal approach as directly opposed to that of the classics, though ALFRED MARSHALL was later to synthesize the two, arguing that long-run equilibrium prices will satisfy both Jevons’s marginal conditions and the classical condition of equalization of returns. Walras aimed to describe the general equilibrium of a system of interdependent markets through a system of simultaneous equations. Menger rejected the mathematical approach and emphasized the subjective element in valuation. He and his Austrian successors emphasized that input demands, and hence prices, are derived from the (subjective) value of the goods they are used to produce, reversing the classical idea that the prices of final goods derive from input costs.