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History of EconomicsWORKING GROUP 1 (chapter / )
Pre-classical economics;
- Mercantilism
- Physiocratics
MERCANTILISM (1500 – 1800)
- There was a growth of trade
- Nation states emerged
These two facts became crucial for the rise of mercantilism -----> 2 questions arose;
1. What is the source of wealth? (‘theory”)
2. What should the state do to become wealthier, and thus stronger? (political)
This contains:
- Imposing taxes on import
- Supporting export
- Preference for exporting manufactured goods over raw materials
- Promoting the existence of large and hard-working population ----> increasing domestic
competitiveness of domestic goods.
Mercantilism contributes to the following factors:
- The importance of money for the growing economies.
- Importance of trade.
- Reconsidering the social status of merchants (new ideology)
- Economics became part of political projects.
- Though, it is an economic theory.
Mercantilism has a couple main principles:
- Gold and silver (and other precious metals) are the most desirable form of wealth. This
meant that most countries would pursue a situation with export > import. Thus obtaining
more and more gold and silver.
- Nationalism; There was a believe that the world had a fixed quantity of economic
resources, thus a county could only have economic benefit at the expense of another.
Nationalism promoted this ‘war’ against other countries to have more economic growth.
This often led to militarism.
- There came an emphasis on export and a restriction on imports ----> this is called 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.
1
,- Colonization and monopolization of colonial trade. Merchants benefited a lot from
colonies, since they provided raw materials and extra consumers.
- Opposition to internal tolls and taxes. Mercantilist realized that these forms of tax in the
home country could have a negative impact on the cost of production, thus receiving the
profit being made on export. They did however preferred monopolies and didn’t prefer
free trade and competition.
- Strong central government. This was necessary to promote the mercantilist goals.
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. Since commerce was on a rise, it’s
logical that countries needed more and more money.
Mercantilism did not contribute directly to modern economic theories, but they did indirectly.
They changed the view on merchants and it promoted nationalism. Last it enabled trading
companies to start business.
Thomas Mun (1571 – 1641)
Mun thought that the British kingdom could be enriched due to surplus of export. This was a
classical mercantilist view on economic growth. Even though England was rich, it could
become even richer if it started to use wasteland to grow certain products. Emphasis on
importing treasure led him to a strange conclusion; trade at home cannot enrich a country.
This meant that trade should always happen with foreigners.
Gerard Malyens (1586 – 1641)
Malyens believed that governments needed to regulate goods to ensure high-quality goods.
He also stated that more money inside a country would raise prices, and therefore would
stimulate business.
Charles Davenant (1656 – 1714)
He was more a laissez-faire thinker: this way of thinking encouraged the free movement of
the market, and free markets. He also said that a countries wealth was what it produced, and
not the amount of gold/silver it had available.
Jean Baptiste Colbert (1619 – 1683)
Colonies were desirable as markets for French goods. One country could only become richer
at the expense of another. He favoured a hard-working population, and believed that no child
was too young to start working.
Sir William Petty (1623 – 1687)
Petty favoured free foreign trade other than many other mercantilists, partly because it
would stop some of the smuggling that took place. Imports should only be lightly taxed and
he opposed laws against the export of money. As many others he did favour a large
population. If people lose their job, they should be employed by the state until they find
new work. Petty argued that these state projects should be financed by taxes.
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,PHYSIOCRATS (1756 – 1776)
Physiocracy was a reaction to mercantilism.
Physiocracy ----> physio means nature, and cracy means power (rule by nature)
It originated in France, which was a retarded land. If merchants traded, they needed to pay
large amount of fees to nobles and other local authorities.
Physiocrats has a couple main principles:
- No government intervention, nature/society has its own laws. Let the society follow the
natural laws, not something from outside (the government)
- Physiocrats say the value comes from the nature (abandoness and richness of nature). In
an industry you reproduce, you don’t produce something new and thus you don’t produce
any additional value. Physiocrats said that the value comes from nature and its raw
materials. You produce something out of nothing (nature gives surplus out of itself)
- Natural order; they introduced a natural order in economic thought. 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’.
Physiocrats were opposed to almost all feudal influence.
- Emphasis on agriculture. 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.
- Interrelatedness of economies
- Money (gold) doesn’t have value, only nature has value. Money is only a sign of wealth,
helping to transfer wealth, but it is not wealth of itself.
Adam Smith (1723 – 1790)
Adam Smith was influenced by the physiocrats.
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 worker 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/elf-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.
3
,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 consumer 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 issue: how to create an economy that is at once profitable and
civilized?
Smith published the book ‘Wealth of nations’.
Adam Smith argues in his Wealth of Nations against the mercantilists and supports free trade
and markets. The first chapter in this important book is titled, the Division of Labour. This
chapter argues the benefit of specialization in economics. This increased production via 3
reasons:
1. Each worker develops increased dexterity.
2. Time is saved since workers don’t need to go from one place to another.
3. Specific machinery could be invented to increase production.
Smith was quick to point out that participants in an economy tend to pursue their personal
goals and interest. One could argue that there is such a thing as an invisible hand that channels
people towards their self-interest. The concept of competition is the key to understanding
Smith’s invisible hand. Competition drives down the profit which is being made by sellers.
Smith thus believed that everything should let the economy do its job, and therefore
governments were wasteful. In this case he put himself in the same line as the laissez-faire.
He also directly attacks mercantilism in saying that governments shouldn’t intervene with
international trade. Smith though, did see a limited role for the state. He saw 3 major functions
for the government:
1. Protect society from foreign attacks.
2. Establish the administration of justice.
3. Erect and maintain public works and institutions.
Smith also believed that legal control over interest rates were acceptable.
In terms of value, Smith focussed on the exchange value of certain goods. In short this means
the terms of trade between 2 goods. How much is a good worth in comparison with another
good.
The natural price is the price which below entrepreneurs wouldn’t want to produce a certain
product anymore. Demand doesn’t influence the value of commodities.
The natural price reflects the relative amount of labor that goes into producing a good, also
called the labor time.
- The more labor employed in production, the greater the value of that item in exchange
with other items on a relative basis.
4
,Knowledge clip; The invisible hand
The invisible hand is the single most important image in economics, attributed to Adam Smith
(1723-1790).
What is the problem?
The initial problem that it is trying to solve is to explain the social order (society as a whole) -
the stability and optimality of the common life.
The starting point of the argument is; Self-interested individuals who intend only their own
game, look only for their own interests. These individuals interact with each other on the free
market, and led by the invisible hand, somehow promote the interest of others as well, and
thus increase the well-being of the whole society.
There are unintended consequences of self-interested actions.
Interestingly, this happens spontaneously in the market, without external governmental
intervention.
Famous quote of Smith; ‘’It’s not from the benevolence of the butcher, the brewer, or the baker
that we expect our dinner, but from their regard to their own self-interest. We address
ourselves not to their humanity but to their self-love, and never talk to them of our own
necessities, but of their advantages.’’
Why is this idea so important?
It demonstrates one of the key economic ideas, that the interaction of these self-interested
individuals can be social optimal (optimal for all). This social order emerges without
governmental intervention, and reproduces itself spontaneously. Still this society is stable,
people don’t kill each other, they instead interact to each other’s’ benefits.
Any doubts?
The concept is not without problems. If you leave the market to itself, it would produce
monopolies, this happens very often. The market may undermine itself. The market forces
being unstraight can create huge inequalities, which is also far from the idea of social
harmony. Often, people arguing for the invisible hand, in fact argue for their own interests,
which can take over and hide themselves behind the market rhetoric. Finally, the mechanism
of the self-interest is still unclear. The invisible hand of God: the invisible hand is interpreted
theologically.
So, invisible hand is an important concept in understanding market societies. But it is also
somewhat limited. We have to refer critically its potentials and limits.
5
, Working Group Questions 1
1. Compare the value theories and policy prescriptions of mercantilists and physiocrats
What are the differences and similarities both in theory and in policy?
THEORY question: What is the source of the wealth for the state?
Mercantilist Money and gold, trade
Physiocrats Real physical production (agriculture)
Mercantilists believed that the source of value was to exchange products for more money
than the products had previously been worth.
Physiocracy (‘rule by nature’) is about physics, democracy is about power. Physiocrats say
the value comes from the nature (abandoness and richness of nature), and you profit from
that. Whereas, in the industry you reproduce, and you don’t produce something new as in
the nature. You get some value, you process this, and reproduce.
- Argiculture is the only sector which convincingly showed that a net product could be
generated, as all the other sectors would produce enough to just cover the costs.
POLICY question: What is the source of the wealth for the state?
Mercantilist The government should always intervene (win the trade war)
Physiocrats The government should not intervene, economy works best if let by itself
Mercantilist
The mercantilist policy prescription was to have a positive trade balance, which for example
could be achieved by maximizing production. The government should intervene so as to
minimize imports, through for example taxes or import quotas, and maximize exports,
through for example subsidies.
Physiocrats
You’re paying taxes on your income, something on your own wealth. The same happens in
micro economics. This was direct consequence of physiocratic thought. Money (gold) doesn’t
have value, only nature has value. Money is only a sign of wealth, helping to transfer wealth,
but not of itself. But there is another reason why money matters; one sector with more money
than another, becomes more wealthier. It attracts more money, and then money becomes
cheaper. But, in the long run, there comes inflation, which means no real wealth is available.
Everyone is richer, but no one is getting really richer. Mercantilists believe money matters,
because it gives you more dynamics. This is true, but only in the short run.
- The difference between nature and men produced is the scarcity of nature, therefore it
has a higher value.
6
,2. Explain the idea of laissez-faire and why physiocrats supported this idea
Laissez-faire; “let people do as they please without government interference”. Laissez faire is
a concept behind the neoclassical economics. It means that there is no intervention from the
government, as regulation, privileges and subsidies. It argues for a separation of government
and economics.
- Physiocrats supported this idea as they thought that there was a natural law which would
direct the economy to the best possible outcome as the economy is self-regulating. Under
this natural law individuals would follow their self-interest and by doing so they will
maximize welfare in society.
3. Describe the major contributions and shortcomings of the physiocratic doctrine.
Shortcoming;
- They only considered the agricultural side: ‘why only the nature?’.
- The industrial sector became one of the most important sectors in an economy
Contributions:
- They founded economics as a social science by studying the society as a whole and the
laws that governed the circulation of wealth and goods
- They introduced the law of diminishing returns
- They analyzed the tax shifting and incidence
- They were the first to question the proper role of the government in society and economy
and came up with the idea of laissez-faire
- It has become part of all economic thinking. They clarified the conditions under which
laissez faire works or not.
- What can we say today about the value of nature? The value of nature is higher today,
because it is scarce. Nature is limited, and we can’t produce more. Now economists are
going to think about that.
4. What were the main elements and intuitions of the classical approach to political
economy?
The classical approach to political economy consisted of a couple of main elements;
- First, they believed that the total annual product was the source of wealth for a nation,
which is a macroeconomic view.
- Secondly, people were driven by the power of self-interest. This will lead to the harmony
of market forces. An invisible hand will guide us towards collective wealth. The invisible
hand is an effect of a market, when everybody is driven by the power of self-interest, we
will obtain a social wealth.
- Third, classicals focused on the supply and not on the demand (diamond-water paradox).
- Fourthly, they were known for their long-term perspective . They emphasized the natural
prices of goods rather than their market prices and put more emphasis on value theory
instead of price theory.
7
,5. What were David Hume’s arguments against mercantilist theory and policy?
Another contemporarist is David Hume
Mercantilist They believed that trade is zero-sum-game (‘war’)
David Hume Trade is mutually beneficial
David Hume (1711 – 1776)
David Hume was against mercantilist, he believed that trade was usually beneficial. Hume’s
greatest contribution to economic studies is the prices species-flow mechanism; this meant
having an export surplus in order to accumulate specie.
- EX > IM ---> you sell more than you buy ---> more money in the economy ---> inflation
---> price level increases ---> IM increases (or EX decreases)
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-species-flow mechanism causes international equilibrium without
government interventions
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
- Thus, Hume was against government intervene
Changes in the amount of money only causes temporary changes in (mostly stimulations) in
the economy. Hume believed that economies always tried to find equilibrium. Secondly,
Humes noted that if a country has more import than export (import > export), its currency will
lose value in comparison to other nations.
6. What is the general theme of Adam Smith’s Theory of Moral Sentiments?
Self-interest and sympathy
Theory of Moral Sentiments;
It shows that our moral ideas/actions are a product of our very nature as social creatures. It
argues that this social psychology is a better guide to moral action than that reasons are. It
identifies the basic rules of prudence and justice that are needed for society to survive, and
explains the additional/beneficent actions that enable it to flourish.
Theory of Moral Sentiments is not a social theory but a moral theory.
Smith investigated the other side of the self-interest; the interest of the greater good
(sympathy). The theory of moral sentiments advances ideas about conscience, moral
judgment, and virtue. These concepts have taken on renewed importance in business and
politics.
- The Theory of Moral Sentiments; sympathy and benevolence restrain selfishness
- Empathy; image yourself being another person
8
,Smith explains, that we as social creatures are endowed with a natural sympathy. Smith has
that meaning what we now call empathy (feeling for others, image yourself being another
person).
- For Smith, this is a powerful moral sentiment. That is, a feeling that has moral significant,
and some kind of normative power in regulating the relations between people, and in
stabilizing the society.
- Sympathy is important for society. So is also justice and beneficence. We have to live
alongside others without harming them.
For Smith, morality is not something we have to calculate but which is natural, built into social
beings.
7. How does it relate to his Wealth of Nations?
The Wealth of Nations; competition channels economic self-interest towards the social good.
Smith became famous because of his Wealth of Nations, which was to critique and offer an
alternative to the mercantilists.
- Smith thought this policy of the mercantilists was foolish and limited the potential for ‘real
wealth’, which he defined as the ‘annual produce of the land and labor the society’.
- The remedy is education. Education gives you options. If you don’t see the whole process,
your perspective becomes very limited. Education gives you more insights, in what to do.
The division of labor is a powerful concept, something which works all the time
8. Explain the idea and the advantages of the division of labor. What is the role of this
concept in Smith's work? What could be the shortcoming of the division of labor,
according to Smith, and the possible remedy?
The division of labor means that workers in a production process specialize in some part of
the process. By specializing in some part of the production process, workers become more
productive in doing their task and as a result the production process improves.
- This leads to more exchange, not only due to having more parts in the production
process, but also due to the improvement in the production process which raises the
output.
The devision of labor is the principle on which all of Smith’s work is based.
Advantage of the division of labor;
- Time is saved by not moving from task to task
- More dexterity
- Specific machinery could be inventend (thus, leads to innovation)
Shortcoming of the division of labor;
- If the line breaks, it won’t work (it will stop)
- Division of labor is very limited in some countries (it will not always work)
- If you specialize, you do your whole life the same task (it will bore you)
- But the remedy is schooling, we need to be intellectually stimulated
- Distance ourselves from our jobs, because we don’t see the whole process anymore,
only the part that we are working on.
- If the technology changes in that sector, and you’re not more needed, What are you
going to do the rest of your life? How are you going to earn money?
9
, 9. In what respects might Smith rightly be called an advocate of laissez-faire? On what
basis might one challenge this label?
Laissez-faire; ‘let people do as they please without government interference’.
Smith does not want governmental regulations, because he wants free market trade. There
is no need for institutions to intervene. People know much better, than anyone who wants
to regulate them.
Individuals strive for their own self-interest, while in doing this contributing to the whole
society. That’s because they need things from each other, (they trade and compete with
each other). The free competition, when everyone peruses his own interest, leads to the
whole society to become greater.
Public goods (infrastructure/education/health) are provided by the state. For this, state
intervention can be justified according to Smith. The state should intervene in times of
struggle, laissez-faire also doesn’t work when your country is under attack by a foreign threat
(then a political framework is needed).
10. What is the source of value for Adam Smith?
Labour
Every product has 2 different values
- Value in use
- Value in exchange
Water has a high value in use (necessary for life) and the value in exchange is low (cannot
exchange water)
- Diamond is the other way around
Source of value;
Mercantilist Production
Physiocrats Exchange
In mercantilism production is the source of value, while in physiocrats it’s exchange. Adam
Smith is closer to phsyiocrats, but the real source of value is ‘labour’. It’s called the labor
theory of value (thus, according to Smith, value can be determined with the labor theory of
value).
The Labor Theory of Value (LTV);
States that the value of economic goods derived from the amount of labor necessary to
produce them.
- In LTV, relative prices between goods are explained by/expected to tend toward a ‘natural
price’, which reflects the relative amount of labor that goes into producing them.
- LTV suggested that 2 commodities will trade for the same price if they embody the same
amount of labor time, or else they will exchange at a ratio fixed by the relative differences
in the 2 labor times
10
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