CLASSICAL ECONOMIC THOUGHT

PHYSIOCRACY MERCANTILISM 1750-1780 1500-1750

MERCHANT INTERN. TRADE PROCTECT. POLICY

INTERRELATEDNESS AGRICULTURE SECTOR NATURAL LAWS

CAPITALIST INTERRELATEDNESS L PRODUCTIVITY NATURAL WORKING ECONOMIC FORCES

CLASSICAL 1776-1890s

Important Writersp:
Adam Smith (1723-1790) - Wealth of Nations, 1776. Thomas Robert Malthus (1766-1834) an Essay on the Principle of Population, 1978. David Ricardo (1772-1823) On the Principle of Political economy and Taxation, 1817. 1817 Nassau Senior An outline of the Science of Political Economy, 1836. John Stuart Mill (1806-1873) Principle of Political Economy, 1848. Karl Marx Capital, Volume I, 1867.

 Smith, Ricardo and Mill ruled economic thought from 1776 until the final part of the nineteenth century (1890s). Smith (1776-1820), Ricardo (18201850s) & Mill (1850s-1890s). Malthus and Marx - thought in some ways classical, are more significant as critics than as advocates of classical economics. Deviated significantly from the orthodox classical tradition in their analysis.

 Prior to 1776, no writer had been able to synthesize the important contributions of mercantilism & physiocracy into a single coherent system - which later became the interest of Adam Smith. The view that markets automatically provide harmonious solutions to the conflicts flowing from relative scarcity was first significantly advanced by the physiocrats of France. Assuming such harmony, the government should adopt a general policy of noninterference in the economy a policy of laissez faire. Scolastics considered it appropriate for the church to adjudicate the morality of the economic activity.

 Mercantilists advocated government intervention. Classical, favored free, unregulated markets and maximum individual freedom.
Economic freedom provided a means by which the economy could function most efficiently. Individuals and businesses should be free to trade without government interference. Political and economic freedom to be inseparably bound.

ADAM SMITH (1723-1790) An academic (SCOTTISH), a professor in Glasgow, in social sciences and humanities. Interrelatedness of the economy* - the important connections between economic and political freedom, between private property rights and just a state, and between individuals motivated partly by self-interest and partly by concern for the consequences of their actions on others. Influenced by Francis Hutcheson (1694-1746) & David Hume (1711- 1776). Smith shared Hutchesons strong disapproval of the idea of Bernard Mandeville (c. 16701733). Mandeville: individuals self-interest would generate many undesirable social and economic consequences, and therefore need for government intervention in the economy.

 Many of the attitudes toward knowledge and learning during Smiths time differed sharply from those of today. No clear explanation between various areas of inquiry existed (interdisciplinary approach). Philosophy, science, social science and ethics were all treated as a single body of truth, not separate discipline. This is certainly not opposites. The natural laws governing society. The economy was not chaos but individual selfinterest interacting in competitive markets to produce harmony, a profoundly significant insight.

Father of Economics - none had been able to integrate into a single vision of the forces determining the wealth of nations, the appropriate policies to foster economic growth and development - millions of economic decision are effectively coordinated by market forces.
Smiths major book is An inquiry into the Nature and Causes of the Wealth of Nations (1776). Interested in explaining the nature and cause of the wealth of nations. Modern economists would describe Smith as a macro theorist interested in the forces determining economic growth.

Analysis of Markets and Policy Conclusions A. Smith argument for laissez faire is based in part upon a theoretical model. But, his arguments are more than just theoretical, they are contextual that is, they are based on his observations of the existing historical and institutional circumstances. Smith advocated laissez faire not because he believed markets to be perfect but because, in the context of history and the institutional structure of the England of his time, markets usually produced better results than did government intervention. He was a policy formulator par excellence. Had broad knowledge of history and how people behave in practice contextual economic policy.

Assumption: For the most part, competitive market exists (mercantilists), and within these markets the factors of production move freely to advanced their economic advantage. A natural process @ work in the economy can resolve conflicts more effectively than any arrangements devised by human beings. Human beings are rational, calculating & driven by self-interest (mercantilists). If left alone, each individual will follow his/her self-interest, and in promoting self-interest promote the interest of society. Government should not interfere & follow a policy of laissez faire.

 Market harmony lies in the activities of the capitalist. The capitalist increases revenues by producing the commodities that people desire. Competition among capitalists will result in goods being produced at a cost of production that will return to the producer an amount just sufficient to pay the opportunity costs of various factors. If profits above a normal rate of return, other firms will enter these industries, force down prices to a cost of production at no excess profit. Capitalists will bid for various factors of production, offering higher prices for the more productive factors and thereby channeling L & land into those areas of the economy in which their efficiency is greatest.

 By emphasizing the agriculture productivity, they moved away from the older concept that only commerce produces and augments wealth. Physiocrats emphasized production rather than exchange as a source of wealth Capital accumulation through reduced consumption by the wealthy

The rate of profit falls over time

WHY???

Changes in their desires are shown in rising & falling prices and consequently rising & falling profits. Without planning / government direction, it leads to the satisfaction of consumer desires at the lowest possible social cost. An optimum allocation of resources occurs in competitive markets without government intervention.

 Smiths most significant contributionp - analysis of the workings of competitive markets. He was able to specify with greater accuracy than previous writers (the mechanism) - price resulting from competitive would, in the long run, equal the cost of production. He called short-run prices market prices & long-run prices natural prices. His primary concern was with the formation of long-run natural prices. Competition involved a large number of sellers, a group of resource owners who were knowledgeable about profit, wages, and rents & freedom of movement for resources among industries. Given these conditions, the self-interest of resource owners would lead to long-run natural prices that would equalize the rates of profits, wages and rents among various sectors of the economy. If the price of a final good is higher its long-run natural price, adjustment will take place via the movement of resources until the natural price prevails.

 Superiority of competitive markets, against monopoly & government intervention. Smith recognized the desire of businessmen to monopolize trade by joining forces. Monopolists would extract a higher price by restricting output. In general, any government interference is undesirable, because it infringes upon the natural rights and liberties of individuals. From economic arguments (more extensive): mercantilists regulations of domestic & foreign trade resulted in an allocation of resources that was less desirable than that produced by competitive market forces. The regulation benefited not the nation but the merchant. This was not purely theoretical argument, it came from Smiths personal observation. They inevitably do more harm than good.

Government intervention was necessary : for tariffs that protected infant industries. Trade regulation was also necessary when national defense might be weakened by a policy of perfectly free international trade. The government was to provide for the national defense, build and maintain roads and schools, administer justice and keep vital records Advocating government provision of goods that have greater social benefits but not supplied by the private because supplying them would not be sufficiently profitable. e.g. education, If the market is left alone, less education will be supplied than is socially desirable.

CAPITAL AND CAPITALISTS:

The wealth of the nation & econ dev depends upon CAPITAL accumulation. It determines the division of L & the proportion of the population engaged in productive labor. Productivity of L????? Individual self-interest + cap acc leads to optimum allocation of K among various industries. The source of capital in a private property economy is individuals.

savings by

Labor could not accumulate capital because the level of wages permitted only the satisfaction of immediate consumption desires. Landowners have incomes sufficient to accumulate capital but spend them on unproductive labor to satisfy their immense desires for high living. It is the members of the rising industrial class, striving for profits, striving to accumulate capital to increase their wealth through saving and investment, who are the benefactors of society.

Without an unequal distribution of income, economic growth is not possible, for the whole of the yearly output it will be consumed

An equal distribution of income in favor of the capitalists is therefore of tremendous social importance The larger the share of the L force producing tangible goods, the greater the wealth of the nation.

The Nature and Causes of the Wealth of Nations Wealth was an annual flow of goods & services, not an accumulated fund of precious metal (accumulation of bullion with the wealth of nation mercantilists). Fundamental of role of exports is to pay for imports. The end purpose of economic activity is consumption (production as an end mercantilists) & emphasizing labor as the source of the wealth in a nation (physiocrats land). Wealth of nations measured in per capita terms (not on the total output/income).

 The greater the K acc - the larger the proportion of the total L force involve in productive L. K - determines the ratio bet the numbers of L who are productively employed & those who are not so employed.

Causes of the Wealth of Nations: i. the productivity of labor ii. the proportion of labor productively employed The key determinant of wealth of the nation is K acc. assumed the economy will automatically achieve full employment of its resources. examined only those forces that determine the capacity of nation to produce goods and services.

 Adam Smiths fundamental contribution to economic theory: Not a detailed theoretical analysis but a broad overview of the way in which a market economy allocates scarce resources among alternatives uses. Major policy conclusion: The government should follow a policy of laissez faire.

International Trade Value Theory (Price) Distribution Theory Welfare and the General Level of Price

International Trade
Free international trade. Foreign trade is beneficial - a country trading the good it produces at lowest costs for the good it produces at higher costs (absolute advantage). Markets develop dynamically over time. L becomes more divided & specialized, productivity increases dramatically increasing returns. Over time any nation might achieve absolute cost advantage in the production of certain goods through specialization and division of L & that all nation could gain from intern. trade. Nations become more proficient by L specialization. Total amount of goods in the world is greater after the trading (exchange) than before.

All countries can benefit from foreign trade & there are more goods in the world after the exchange. Mercantilism: Trade increased the

wealth of one nation at the expense of other nations

Value Theory
What determines relative prices? What determines the general level of prices? Relative Prices are determined by costs of production or SS Short-run prices are determined by SS & DD. Natural, long-run equilibrium, prices - depend upon costs of production (or sometimes depend on SS & DD). Agricultural sector natural price depends SS & DD, lr SS curve upward-sloping, increasing costs. Manufacturing sector lr SS curve perfectly elastic, constant costs, therefore P depends entirely on cost of production.

THE END