History of economics
Part 1
Readings of lecture 1
The major features of the Classical School are:
• Minimal government involvement, the forces of the free and competitive market will
guide production, exchange, and distribution by itself.
• Self-interested economic behavior, this is basic to human nature. You want to satisfy
your wants.
• Harmony of interests, (exception of Ricardo) by pursuing their own interest, people
served the best interests of society.
• Importance of all economic resources and activities, these all contribute to a nation’s
wealth.
• Economic laws, big focus on economic theories and laws.
Mercantilists: wealth is derived from commerce.
Physiocrats: wealth is derived from land and agriculture
Adam Smith: there are social and unsocial passions. Unsocial passions are hatred and
resentment, social passions are generosity, kindness, and compassion. Smith came up with
the division of labor and the increase in efficiency it brings. Smith also talked about the
invisible hand, competition drives down the prices of goods, and reduces the profit. Everyone
competes in the economy. Smith saw three major functions of government: to protect society
from foreign attack, to establish the administration of justice, and to erect and maintain the
public works and institutions that private entrepreneurs cannot undertake profitably. Smith
recommended taxation to finance these government activities.
The natural price is the power that the possession of a commodity provides to purchase other
goods. When a commodity is sold for the natural price, there will be exactly enough revenue
to pay the natural wages, rent and profit. This is the long-run price below which the
entrepreneurs no longer would continue to sell their goods. The actual price at which the
good is sold, is the market price. This depends on the aberrations of short-run supply and
demand, and it tends to fluctuate around the natural price. The real price is the command
over labour of the commodity.
Labor theory of value in a primitive society: when labor is the only resource, the relative
value of a good would be determined by the amount of labor necessary to produce it.
Value theory in an advanced economy: the real value of commodities is measured in the
quantity of labor that a commodity can buy.
The wages fund theory: there is a stock of circulating capital out of which present wages are
paid. Average annual wage = wages fund/ number of laborers.
Economies of high wages/efficiency wages: higher wages means better work.
The wage structure (actual wage rates for different jobs) varies according to five factors:
1. Agreeableness of the occupation (danger, harder, dirtier).
2. Cost of acquiring the necessary skills and knowledge. Theory of human capital.
3. Regularity of employment.
4. Level of trust and responsibility.
, 5. Probability or improbability of success (risk/failure).
Smith argued that the lowest rate of profit should be enough to cover the risk of losses, and
still leave a surplus (net/clear profit) for the entrepreneur = gross profit. The lowest rate of
interest should be a little bit higher than the losses that sometimes occur through lending.
Lecture 1
The classical school
Economic context of the classical school: the industrial revolution. The industrial revolution
is the most important event in the whole economic history because the changes were really
radical. The world has become many times richer after this. The second half of the 18 th
century and the first half of the 19th century the theory of the classical school emerged by
trying to understand the industrial revolution.
Classical political economists:
• Adam Smith: “the father of economic”
• David Hume: good friend of Smith
• David Ricardo: critic of Adam Smith
, • Jean-Baptiste Say: follower of Adam Smith
• Thomas Robert Malthus: friend of Ricardo
• John Stuart Mill: one of the first feminists
• Karl Marx: critic of classical political economy
Setting the scene: what were the problems?
The dynamics of capitalism:
• Capital accumulation.
• Technical progress.
• Population growth (ageing of the population holds
back the development of the economy).
• Fighting poverty.
• Distribution of income among social classes (see
picture to the right).
• Trade policy (shares, how do they evolve?).
How did it differ from the previous schools of economic thought?
Two major schools:
• Mercantilists (mainstream in 16-18 centuries) = they were not really scholars of
political economy, they were rather traders, administrators, and advisers.
• Physiocrats (influential in the 18th century) = laissez-faire.
The classical school unlike mercantilists: the limited role of the state! The autonomy of
market forces. The role of the state is not the major player in the economy.
The classical school unlike physiocrats: the focus on industrial economy, rather than
agriculture.
Although the classics inherited the physiocratic idea of laissez-faire (= let them do whatever
they please). You need to let the market naturally come to the best organization of the
economy.
Key intuitions of the classical school
• The basic point of departure – the total annual product as a source of wealth. This is
macroeconomics! This is a picture of society.
• This economy is governed by the power of self-interest – similar to the natural law of
gravity, because the power is so big! (Newton)
• Harmony of the market forces: the invisible hand (= Adam’s Smith theory that
everyone could care only for oneself, but then the invisible hand of the market makes
the outcome for the whole society the most beneficial)
Micro-macro link! – analytical significance
Social cohesion market exchange is a social phenomenon that allows us to relate
to each other. The economic exchange relates people together who have never even
met, by buying something someone else has made.
• The role of specialization in fostering economic growth
Division of labor and endogenous technical progress (= technical progress which is
conditioned by your wealth the higher income, the more investments you can
make, which will increase your income even further), the essence of specialization. In
the agriculture world, everyone was sustaining everything to survive, in the industrial
economy specialization begins, because is increases efficiency (Smith).
, Comparative advantage (formulated in the theory of trade. Countries trade in the
products which they can make the most efficient, Ricardo).
Why is invisible hand analytically and normatively important? Explained by the great 20th
century economists.
Whatever the source of the concept (Adam Smith), the notion that a social system moved by
independent actions in pursuit of different values is consistent with a final coherent state of
balance, and one in which the outcomes may be quite different from those intended by the
agents, is surely the most important intellectual contribution that economic thought has
made to the general understanding of social processes (Kenneth Arrow and Frank Hahn,
General Competitive Analysis, 1971).
The great advantage of the market is that it is able to use the strength of self-interest to
offset the weakness and partiality of benevolence, so that those who are unknown,
unattractive, or unimportant, will have their wants served (Ronald Coase). Market brings
independence.
Key intuitions of the classical school (continued)
• Dynamic view of capitalism
Tendency of the profit rate to fall. In the competitive economy there are not many
limits for moving capital to a more profitable sector. We assume that here there will
be an increasing return.
Divergent views on the dynamics of productive efficiency (increasing or decreasing
returns)
Ricardo there is always a limit to the growth of the economy.
• Long-term perspective
Value theory (= a long term price) instead of price theory
Emphasis on natural prices (= they come naturally, you don’t intervene in the
economy) rather than market prices.
• Focus on supply, not demand. Supply creates its own demand.
‘objectivity‘ (diamond-water paradox) = the water is something you really need,
essential, diamonds are not essential.
Say‘s law = what people want and are able to pay for is not really essential, it is
created by the supply. In an equilibrium the thing you produce will find a demand for
itself.
Conceptual core: labor theory of value
• Explaining the relative prices (= the price of one commodity in respect to the price of
another commodity) of reproducible commodities. The absolute price is the price in
real money.
• Simple, straightforward, and universal explanation of long-term prices involving a
special role of labor that would later become crucial for the economic doctrine of Karl
Marx.
