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Summary History of Economics, part 1 () (Grade; 8.6)
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History of Economics2021 – 2022
Mercantilism (1500 – 1800)
The school started among merchant businessmen, who were merely trying to promote their self-interest by writing
and theorizing about those topics
What characterizes the school?
Bullion was the most important source of wealth (thus basically, money = wealth)
- Bullion; gold and raw silver
- Mercantilist valued bullions as the way to achieve power and riches
- The amount of wealth was considered fixed and countries tried to acquire the largest share of that. A surplus of
exports from a country was therefore necessary to generate payments in hard money
- Most countries would pursue a situation with export > import. Even at war, nations would export goods to the
enemy as long as the products were paid for in gold
Nationalism; all countries could not simultaneously export more than they imported. Therefore, one’s own
country should promote exports and accumulate wealth at the expense of its neighbors
- Because they believed that there was a fixed quantity of economic resources in the world; one country could
increase its resources only at the expense of another
- Nationalism promoted this ‘war’ against other countries to have more economic growth
- This often led to militarism
The emphasis on exports and a restriction on imports = ‘the fear of goods’
- Many restrictions were based on the export of raw materials. Countries wanted to export finished products, since
these have a higher profit margin
- Duty free importation of raw materials that could not be produced domestically, protection for manufactured
foods and raw materials that could be produced domestically, and export restrictions on raw materials
- Merchants received inflows of gold in return for their exports, while the restrictions on imports reduced the
availability of goods for consumption at home. Consequently, gold and silver accumulated, supposedly enhancing
the country’s wealth of power
Opposition to internal tolls, taxes and other restrictions on the movement of goods
- Mercantilists realized that these forms of tolls and taxes in the home country could have a negative impact on the
cost of production, it could drive up the price of a country’s exports, thus a negative impact on the profit being
made on exports
- It is important to point out, however, the mercantilists did not favor free internal trade in the sense of allowing
people to engage in any trade that they wished. On the contrary, mercantilists preferred monopoly grants and
exclusive trading privileges whenever they could acquire them
Strong central government; a strong central government was necessary to promote the mercantilist goals
- The government granted monopoly privileges to companies engaged in foreign trade
- It restricted free entry into business at home to limit competition
- Agriculture, mining and industry were promoted with subsidies from the government and protected from imports
via tariffs
- The government closely regulated the method of production and the quality of goods so that a country would not
gain a bad reputation for its products in foreign markets, thereby hampering exports
- In other words; mercantilists placed little trust in their own judgement and honesty
- The government would protect the country and the quality of the products it exported. This was the case because
of the good reputation a country needed to ensure more export
- Mercantilism benefited those who were most powerful and had monopolies or other privileges. In contribution to
this situation, laws arose that protected the settled merchants and producers, making it difficult to enter new
markets
, Importance of a large, hard-working population
- It keeps the labor supply high and wages therefore low
Advantages;
i. Low wages enable lower prices on export (thereby increasing the inflow of gold)
ii. Low wages reduce idleness and promote greater participation in the labor force
- Some mercantilists contented that low wages were necessary to reduce idleness and promote participation in the
labor force. They believed that increases in the wage rate, would allow them to reduce their hours of work
- Some secondary workers, including child workers, might even exit the labor force if their parents could earn
more income per hour
- Low wages also discourage consumption, leaving more production to be exported
- Laborers were just a resource and were looked down upon. Mercantilists ‘liked’ the sight of poor laborers, as
laborers getting underpaid lead to more productive laborers and less costs for the company, resulting in bigger
profits for themselves
Whom did the mercantilist school benefit?
The mercantilist school obviously benefited the merchant capitalists, the kings and the government officials
- It especially benefited those who were most powerful and entrenched and had the most favored monopolies and
privileges
- Such laws took the form of grants of monopoly status, prohibitions against imports and regulations that made it
difficult for new producers and merchants to compete successfully against the established ones
- The government officials in power were willing to make these laws and regulations, as a way to secure benefits
for themselves and for the royalty at whose pleasure they served
What are the school’s lasting contributions?
An important insight of this school was the importance of money in an economy
- It showed the relationship between money and price levels and how an ever-increasing balance of trade is not
possible and should not be strived for
Zero-sum game
- It showed how trade would result in winners and losers and it would only be the classical school to show how both
parties could profit from trade
Emphasizing the importance of international trade
Economics became part of a political project
- The mercantilists started to advise the government what to do. Mercantilism shows itself as being very
conservative. This makes sense considering mercantilist wrote in their own interest; they wanted to keep their
own position secure
Reconsidering the social status of merchants
Beyond these contributions, the mercantilists contributed little to economic theory as we know today. Most of
them failed to grasp that a country could become richer not only by impoverishing its neighbors but also by
discovering a greater quantity of natural resources, producing more capital goods and using labor more efficiently
Still alive and well in many protectionist policies
What (modern) criticism can be expressed?
Mercantilists only focus on generating as much nominal wealth as possible. They do not look at real numbers
The intellectual achievement back then wasn’t as high as it is today. If you were to compare it to today’s
knowledge, you wouldn’t be very impressed
A disadvantage of the mercantilist school of thought is their idea about money leading to the main source of
wealth. Because they wanted as much as they could in export, they lowered wages to the very minimum. This
avoided consumption and allowed export. Lower wages also caused higher productivity and more labor hours,
also increasing productions. Their vision about export as high as possible affected the lives of thousands of factory
laborers and let them live a life of poverty
Since almost all major mercantilist writers are business owners and factory bosses themselves, their theories will
not be very objective
- A mercantilist working in the steel industry would write about how important steel is in the economy, for example
Mercantilist theory failed to see the advantage of trade for both parties
- Mercantilist only showed the existence of absolute advantages. This led to import being seen as something bad,
while it actually isn’t.
,David Hume and his critique of mercantilism
Hume criticized mercantilist, he believed that trade was mutually beneficial. Hume’s greatest contribution to economic
studies is the Prices Species-Flow Mechanism. The mercantilist strived for a positive BoT. Hume criticized
Mercantilism’s urge to accumulate bullion. Mercantilist did not account for inflation
Prices Species-Flow Mechanism; inflation and exchange rate work as mechanism which restore the equilibrium
of trade balance
EX > IM ---> you sell more than you buy ---> more money in the economy ---> inflation --> price level increases -->
countries are less competitive (because it now costs more) ---> IM increases (or EX decreases) (the BoP is restored)
- Increasing export means increasing the quantity of money in the country. This creates inflationary pressure,
making it more difficult to export and cheaper to import. It is now more difficult to maintain an export-surplus
- When prices are high (high price level), it means our goods cost relatively more than goods from abroad. Our
goods are not competitive on the international market anymore, which means import increases. The
disequilibrium equals again
- Thus, the price specie-flow mechanism causes international equilibrium without government interventions
In other words; focusing on exports make it difficult to export
Conclusion; promotion of exports to accumulation gold and silver (specie) is a self-defeating tactic
Direct criticism of mercantilism
There is no gain in mercantilist policy; the economy is regulating itself. Even if you follow this policy, all the
additional money you get is useless
Changes in the amount of money only causes temporary changes in the economy
- Hume believed that economies always tries to find equilibrium
- Hume also noted that if a country has more import than export, its currency will lose value in comparison to other
nations.
Hume is saying that international trade is a positive sum game, one in which the payoffs sum to a positive number.
This is to be contracted to the zero-sum game of the mercantilists, where the gain to one party is exactly offset by
a loss to the other
,Physiocrats (1756 – 1776)
It originated in France in the 18th century, which was an overregulated economy. There were lots of regulations/rules,
very chaotic/complex system of taxes. There were limits to free exchange of goods, to the output and pricing of goods.
They were all regulated by the state. If merchants traded, they needed to pay large amount of fees to authorities. This
was an obstacle for economic development. The physiocrats were a reaction of this mercantilist epoch; they said that
the value of wealth comes from nature and that there should be no intervention of the state, society should follow
the nature laws
- Physiocracy was a reaction to mercantilism (reaction of the overregulated economy)
- Physiocrats only lived in France and has Quesnay as its official intellectual leader whose ideas were generally
accepted by every Physiocrat
Physiocracy; rule by nature
- Physio ; nature
- Cracy ; power/rule
What characterizes the school?
Agriculture is the source of wealth
- They thought that industry and trade were a sterile market. They believed that only agriculture and mining were
productive since these two activities created surpluses (because it produces additional value). All the other sectors
reproduce the cost, the input and output are exactly the same in terms of value. With agriculture you’re really
producing a surplus.
- Physiocrats said that the value comes from nature and its raw materials. You produce something out of nothing
(nature gives surplus out of itself)
- In an industry you reproduce, you don’t produce something new and thus you don’t produce any additional
value
- There was also an emphasize on agriculture because food was very important at that time
No government intervention
- Nature/society has its own laws
- Let the society follow the natural laws, not something from outside (the government)
- Maximizing personal gain is the main goal, because it leads to as much wealth as possible (this vision is shared
with the Mercantilist)
- However, Physiocrats think that, in order for this to happen, government shouldn’t intervene. The only
allowed government intervention is taxation on landowners. If you were to tax the owners of any of the other
production factors, it would end up being paid by the landowners as well.
- The non-interference of the government could also be explained by saying the economy was already governed by
natural laws, who did a far better job than the government could ever do
Natural order
- The physiocrats introduced the idea of natural order to economic thinking
- The term physiocrats itself means ‘rule by nature’. According to this idea, laws of nature govern human societies
- Laws govern society just as physical laws govern the natural world (Newton)
- They believed that nature balances everything. The way that the economy would develop without any external
regulations, because external regulations are not natural
- They follow the nature. Laws of nature govern human societies, and so all human activities, should therefore be
brought into harmony with these natural laws
Laissez-faire; ‘let people do as they please without government interference’
- Governments should never extend their interference in economic affairs beyond the minimum absolutely essential
to protect life and property and to maintain freedom of contract
- Physiocrats were opposed to almost all feudal influence
Taxation of the landowner
- Physiocrats thought that because only agriculture produced a surplus, which the landowner received in the form
of rent, only the landowner should be taxed. All taxes imposed on others would be passed on to the landowner
anyway
- Only landowners have to be taxed, because only agriculture produces a surplus
, Interrelatedness of economies
- Physiocrats were the first to look at the economy as a whole. All elements in the economy are connected with
each other and dependent of each other. The natural flow of goods and money has to proceed by itself, in the
natural way
- They saw it as human body, like organs that are connected to each other
- Physiocrats pioneered modern economic logic by creating a basic system that looks at the inter-relationship of an
economy
Money (gold) does not have value
- Only nature has value
- Wealth accumulates and is created by nature
- Money is only a sign of wealth, helping to transfer wealth, but is not wealth itself
How does the school serve the needs of its proponents?
Physiocrats had a laissez-faire-like policy and a general equilibrium framework
They focused on real forces and not on the quantity of money
- This focus shift from quantity of money caused because of past experiences; bullion flowing in from the new world
caused a significant increase in prices ‘for some reason’. Later mercantilists discovered that a positive BoT was not
possible, and physiocrats took it a step further to say that money wasn’t the main source of wealth at all
Physiocrats were not shy of taxing. Mercantilism showed that taxing on capitalists would not be a good thing,
while Physiocrats did think taxing was good
- However, you should only tax landlords since taxing any other group would simply lead to the same but indirectly
through prices
Whom did the physiocrat school benefit?
The peasants ultimately would gain from the ideas of the physiocrats because onerous obligations to the
landowners would end
The Physiocrats especially favored capitalistic farms employing wage labor and advanced techniques. Big
producers having surpluses for sale would be helped by the Physiocratic emphasis on agriculture and free internal
trade in grain
By advocating the doctrine of laissez-faire, the physiocrats were promoting industry, even though this was not
their intention; they were interest in encouraging freer internal grain trade and in stimulating the export of farm
products and the import of manufactured goods
What are the school’s lasting contributions?
Several ideas of the physiocrats clearly were incorrect;
- The school was wrong to consider industry and trade as sterile; the more industry and trade developed in
France, the more conspicuously the physiocrats analysis became
- The belief than only landowners should be taxed because only land could yield a surplus
- Wealthy industrialists could smile as they endorsed the doctrine that they should not be made to pay taxes
because they added nothing to wealth
By examining the society as a whole and analyzing the laws that governed the circulation of wealth and goods,
they founded economics as a social science
By advocating laissez-faire, the physiocrats turned the attention of economists to the question of the proper role
of government in the economy
Smith based a lot of his work on the ideas of physiocrats
- He would go on to implement the natural laws as the invisible hand and the passive role of the government as
laissez-faire
The law of diminishing returns was stated by a physiocrat
The physiocrats originated the analysis of tax shifting and incidence that today is an important part of
microeconomics
Another important contribution from the physiocrats was the general equilibrium framework Quesnay presented
The rejection of money as the main source of wealth
- Physiocrats accepted Hume’s vision about the price specie-flow mechanism and rejected the idea to strive for as
much bullion as possible
- Instead, they looked at real forces of the economy
,What (modern) criticism can be expressed?
All physiocrats shared the same vision
- They tended to lack detail
- They saw the economy as a system superior to human will, and so they rejected government intervention posted
by mercantilists
Physiocrats would be the only school advocating agriculture as the main source of wealth
- Their idea that multiple production factors earned several rewards was correct, but the idea that only one of those
would actually generate a net benefit, was not correct
- Later schools like the classical school would show how production is the main source of wealth and the idea of
agriculture as the main source of wealth would soon be rejected, even going as far as saying landowners are the
parasites of the economy
,Classical School (1776 – 1871)
Classical school came about when Mercantilist and Physiocrats views are no longer satisfying. Because of the industrial
revolution, feudalism slowly but surely got replaced by capitalism. Economic theory had to deal with the dynamics of
capitalism; things like capital accumulation, technical progress, population growth, fighting poverty, the idea of free
trade and differences in income distribution across multiple social classes.
The rise of capitalism was especially big in England. There the change in preference for theory occurred. Classical
economics followed the Physiocrats, but quickly got rid of the part that said land was the only source of income. It also
was against the mercantilist attitude of businessmen to strive for their personal maximized wealth. Classical economics
was against monopolies and the restriction of import.
What characterizes the school?
Total annual product (GDP) is the main source of wealth
- This is a macroeconomic perspective
- Did not care about economic agency at micro level. Not interested in how actors make decisions
Power of self-interest
- Leave people to their own, and they will follow their self-interest
- People are driven by self-interest in the same way objects are driven by gravity (newton)
- This is a universal law, applying to anyone (same like Newton’s gravity law)
There is harmony of market forces, explained by the invisible hand
- The link between micro and macro
- There is social cohesion (story about links with others)
The role of specialization in fostering economic growth
- Division of labor and endogenous technological progress (Smith)
- Comparative advantage (Ricardo)
Dynamic view of capitalism
- Tendency of the profit rate to fall (in the long-run)
- Divergent views on the dynamics of productivity efficiency (increasing or decreasing returns)
- Smith; through competition, the profit rate will fall
- The more people work on the market, the lower the profit because of w, r
- Ricardo; the diminishing returns in agriculture caused lower marginal output, decreasing the profit and
increasing the rent
Long-term perspective
- Value theory instead of price theory
- Long-term stable exchange value of commodities
- Prices are short-term and say nothing about value. They come and go.
- Emphasis on natural prices (what it is worth) rather than market prices (what it costs)
- In the long-run, the market prices will converge to the natural prices
Focus on supply, not demand
- ‘Objectivity’ (diamond-water paradox to show objectivity)
- Supply side is a horizontal curve. Drawing a demand curve through that, no matter how large/small that is, it
results in the same 𝑝 only a different 𝑞
- Say’s law (aggregate supply will always be met by aggregate demand)
How does the school serve the needs of its opponents?
Focusses on supply side
Introduces comparative advantages, specialization and competitive markets
Overall more focused to help industries with their decision making
Consumption became the superior goal over production. This change of goal also causes change of policies
The importance of labor
Unlike mercantilism; they advocated a limited role of the state (the autonomy of
market forces)
Unlike mercantilism; money is a ‘veil’, it does not influence ‘real’ parameters of the
economy (neutrality of money)
Unlike physiocrats; the focus on industrial economy, rather than agriculture
,What are the school’s lasting contributions?
Smith’s analysis of the workings of competitive markets
- Price resulting from competition would equal cost of production (long-run)
- Difference between short-run and long-run prices; market vs. natural
Labor theory of value
- Explaining the relative prices of reproducible commodities
- Simple, straightforward and universal explanation of prices
- Money (gold) as one of commodities
- Wealth of a nation and economic growth depends on capital accumulation (which causes labor division)
- Decreasing returns to scale; extra input is less than the extra output that is generated
Ricardo’s labor theory of value
- More focused on the how rather than the why
- Against the corn laws; disagreed with protectionists and their vision about tariffs on profit and rent
Wage rate = wage fund / labor force
Laissez-faire policy and the role of the government
What (modern) criticism can be expressed?
Assumption that the economy would always have full employment of its production resources
- Why forces determine the levels of income/employment, given a production capacity?
No clear distinction between relative prices, general price level and change in welfare
To Ricardo; does not look at real values
- Also, his theories became less relevant when Malthusian population theory got debunked. This was paired with
Ricardian doctrine not matching the empirical evidence collected about English economy
Which economists belong to this school?
Adam Smith (1723 – 1790)
Thomas Robert Malthus (1766 – 1834)
Jean-Baptiste Say (1767 – 1832)
David Hume (1711 – 1776)
David Ricardo (1772 – 1823)
John Stuart Mill (1806 – 1873)
Karl Marx (1818 – 1883)
,Adam Smith
Smith was the founder of classical political economy. Smith was influenced by the thinkers of the Enlightenment. This
was an intellectual movement that was built upon two pillars; people’s reasoning ability and the concept of the natural
order. Smith based a lot of his work on the ideas of Physiocrat, particularly Quesnay and Turgot. From these thinkers
he drew the theme of wealth as the consumable goods annually produced by the labor of society, the desirability of
minimal government interference in the economy, and the concept of the circular process of production and
distribution. Smith was also influenced by David Hume.
Smith has 4 central ideas;
1) Specialization
- Processes would be more efficient if it were split up, multiple careers with specialization would arise.
- Bosses from the specialized workers have another responsibility; remind them of their purpose, role and dignity
of their labor
2) Consumer capitalism
- The surplus of wealth allowed societies to look after the weakest members
- Smith defended this on the basis that it did more good to the poor than societies devoted to high ideals
- Smith also recognized that people have higher needs that lie outside of capitalist enterprise like education, self-
understanding, etc.
- Capitalism shouldn’t just service our basic material needs, it should make money from goods/services that
deliver true fulfillment
3) How to treat the rich? How to let them behave well?
- Instead of raising taxes (which would only chase away the rich), Smith proposed something else; the rich should
get honor and respect
- Governments should understand the vanity at the heart of the rich and their motivations
- Give them honor and status in return for funding schools and hospitals, and paying their workers well
4) Educate consumers
- Consumers need to be taught to want better quality and pay a proper price for it
- Good capitalist society should exercise its consumers to choose in judicious ways
- Capitalism can be saved by elevating the quality of consumers demand
Smith’s work is about how human values can be reconciled with the needs of businesses. He was interested in the
issues; how to create an economy that is at once profitable and civilized?
Smith published 2 major works;
1) The Theory of Moral Sentiments
- It discussed the moral forces that restrain selfishness and bind people together in a workable society
- Shows how emotions relate to each other and to how people form a moral judgement
- Main part is about the self-interest of man, and how they handle out of own self-interest. All economic behavior
is a result from this self-interest. On the other hand, people have sympathy and have emotions, which keeps
them from stealing stuff
- Sympathy is the feeling we create when we place ourselves in another person’s position. We can be aware of
their situation
2) The Wealth of Nations
- In this book he argues against the Mercantilists and supports free trade and markets.
- The first chapter of this important book is titled; “The Division of Labor”. This chapter talks about fragmenting
the supply chain to improve efficiency. Smith stated that the division of labor increases the quantity of output
produced for 3 reasons;
i. Each worker develops increased dexterity in performing one single task repeatedly
ii. Time is saved if the worker need not go from one kind of work to another
iii. Machinery can be invented to increase productivity once tasks have been simplified and made routine
through the division of labor
Important part of the ‘Development Theory’ (which explains how economies become wealthier)
People will get numb from doing the same activity over and over again. This is the disadvantage of the labor division.
To compensate this, you should educate the public
- Division of labor could lead to a dissatisfied workforce and the answer for this problem is education
, Notice the emphasis on manufacturing production and the productivity of labor here. Recall that mercantilists were
concerned mainly with how the exchange of goods, once produced, could add to the nation’s well-being. The
physiocrats, on the other hand, focused on agricultural output.
Smith pointed out that participants in the economy tend to pursue their own personal interests. But hidden within the
apparent chaos of economic activity is natural order. There is an invisible hand that channels self-interested behavior
in such a way that the social good emerges.
- Invisible hand; a mechanism Smith invented that showed the economy will balance itself towards an efficient
outcome
- Any government intervention would only prevent this system from happening and would just delay the
process
The key to understanding Smith’s invisible hand is the concept of competition. The action of each producer or
merchant who is attempting to garner profit is restrained by the other producers or merchants who are likewise
attempting to make money. Competition drives down the prices of goods and in so doing reduces the profit received
by each seller. When there is only one seller who gains extraordinary profit, new competitors will join the market. This
increases supply and therefore decreases profit
Limited government;
In a direct attack on mercantilism, Smith argued that government should not interfere in international trade. Nations,
like individuals and private families, should specialize in producing goods for which they have an advantage and trade
for goods for which other nations have an advantage (absolute advantage)
- Division of labor ---> efficiency!
Where can the government still intervene?
Smith though, did see a limited role for the state;
i. National defense (also pertaining to international trade)
- Protect society from foreign attacks (good military order)
ii. Establish the administration of justice
- Provide a system of law, order and justice
iii. Erect and maintain public works/goods (education, infrastructure)
In order to provide for all these tasks, the government should collect taxes from the public (it should avoid collecting
from capitalists though, as they provide capital accumulation)
To finance government activities, Smith recommended taxation. His 4 maxims for good taxes are as follows;
1) Taxes should be proportional to the revenue enjoyed under the protection of the state
2) Taxes should be predictable from the regressive taxes prevalent at the time, the manner of payment and the
amount to be paid
3) Taxes should be levied at the time and in the manner most convenient to the contributor
4) Taxes should be collected at minimum cost to the government
Two kinds of value;
Smith stated that there are two kinds of value;
1) Sometimes expresses the utility of some particular object (value in use)
- Value in use explains why we find water more useful, but pay less for it than for diamonds
2) Sometimes expresses the power of purchasing other goods with the possession of that objects conveys (value in
exchange)
- Value in exchange is Smith’s Labor Theory of Value (LTV)
The things which have the greatest value in use have frequently little or no value in exchange; those which have the
greatest value in exchange have frequently little or no use in value.
- This is called the water-diamond paradox
The costs of production determine a good’s exchange value or relative price
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