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History of Political Economy 35.1 (2003) 49-75
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On the Methodological Foundations of Modern Microeconomics:
Frank Knight and the “Cost Controversy” in the 1920s
The criticism of Marshallian economics in the 1920s occupies a central position in the development of modern microeconomic theory. Crucial to that criticism, historians widely believe, was the so-called cost controversy—the critical debate that took place between 1926 and 1930 principally on the pages of the Economic Journal, in articles by Sraffa, Pigou, Robertson, Shove, Robbins, Young, and Schumpeter. The cost controversy is seen as a caesura in the discussion of Alfred Marshall's economics, and it is viewed as a prelude to the theory of imperfect competition.
This interpretation, however, unnecessarily narrows what is, in fact, a rich and broad debate. It overlooks a major theoretical event of those years, an event that the cost controversy was only a part of: the foundation of the concept of pure competition of modern microeconomics, which led to the separation between statics and dynamics, which in turn enabled economists to overcome the analytical difficulties of Marshall's microeconomics. It is within this broad perspective that we may [End Page 49] appreciate the absolute centrality of one contribution that the historical reconstruction has generally treated as marginal and has partially neglected: the work of Frank Knight on price theory in the period 1921–25.
This article reconstructs Knight's contribution to price theory in the 1920s. It places Knight's work in the context of the ongoing English side of the debate on Marshall's theory. In the first section we discuss the key theoretical problem of Marshall and the Marshallians up until A. C. Pigou's Wealth and Welfare (1912): the dilemma of “increasing returns and competition” and the devices introduced to solve it, especially external economies,1 the most debated-over device in the years immediately following Marshall. Then, in the core of the essay, we analyze Knight's work in the 1920s. Following that, we connect Knight's work to the Economic Journal controversy and, in particular, to the articles by Piero Sraffa (1926), Lionel Robbins (1928), and Allyn Young (1928). We conclude with some remarks on the theoretical consequences of Knight's contribution.
The “Cournot Dilemma,” or the Compatibility between Increasing Returns and Competition, from Marshall to Pigou
The most important and intriguing issue discussed in the controversy on costs in the 1920s was the compatibility—or not—of increasing returns and competition, a Smithian classical issue in the history of economic theory and one that Antoine Augustin Cournot (1838) had contributed to fundamentally. Cournot showed that nothing limits the production of a commodity under conditions of pure competition if a firm's marginal cost is falling. He concluded that, consequently, such firms cannot be in equilibrium and a monopoly would result. In Cournot's estimation, increasing returns and competition were incompatible.
Cournot's conclusion had been well known by marginalist economists like Vilfredo Pareto and Knut Wicksell. However, Marshall was certainly [End Page 50] the economist who devoted the most to “Cournot's dilemma,” as he called it. He challenged Cournot's conclusion and proposed a theory of competition that tried to solve the “dilemma” of increasing returns and competition and prove that the two were in fact compatible.
Marshall's theory in its mature form is presented in books 4 and 5 of the Principles (see Marchionatti 1992). In book 4 competition appears as a process that fundamentally relies on the “openness of markets.” Firms are no longer assumed to be price takers, and there are elements of partial and temporary monopoly. Marshall describes the growth of a typical firm that takes substantial advantage of internal economies through production on a large scale; it increases its efficiency by exploiting those economies and thus may become a monopoly. In effect, Marshall argues that a firm may grow rapidly as long as factors such as skill, inventiveness, and entrepreneurial energy exist. However, the firm does not inevitably monopolize the market, because its...