History of Economic Thought Lecture 1

Pre- Adam Smith, main classical economists

Aristotle

• Exchange occurs when its mutually beneficial

• Principle of diminishing marginal returns

• Only reasoning, no clear system

Scholastics

• During feudal times

• Economics from an “ethical” POV by priests and teachers at medieval universities

• A “just price” is in the interest of society 

What is the “natural price”? Which school of thought coined the term? What influenced this price?

1. price emerging under free and effective competition, without monopoly, resource waste or deceitful behaviour 

2. Theorized by Scholastics

3. Influenced by (1) Cost of production and (2) Consumers’ perception of utility of good

What are the main objectives of Mercantilism?

• Positive balance of trade (source of economic growth): limit imports to only raw materials and promote exports through subsidies. BUT minimal internal tolls/taxes

• Accumulation of gold and silver through trade

• Zero-sum game: promote their country’s prosperity at the expense of other countries

• A strong national government for uniform regulation

• Nationalism, protectionism, colonialism and a strong military

David Hume monetary theory. Who agreed and who disagreed with him?

• Money has no effect on the real economy in the long run

• Contours for later developed quantity theory of money

• International adjustment: An increase in domestic money supply has an impact on a countries international position. He argued that it would experience an initial increase in prices, leading to higher costs of production relative to other countries. More expensive exports and cheaper imports.

Quesnay and Physiocrats. What were their main tenants?

• Tableau Economique : Quesnay was the first to create a model that illustrated the circular flow of income and the interdependence of economic sectors/ National accounts model

• Was a pioneer in maroeconomic models

• Believed that agriculture is the key to economic growth

• Laissez fair, laissez passer: Opposed to government intervention, they should instead promote free competition and free trade (Against mercantilist views)

Which historical settings influenced the Classical School?

(1) Scientific revolution: The understanding of natural laws, established during the Scientific Revolution, influenced Enlightenment philosophers to support laissez-faire economics, as they believed in the efficacy of allowing natural economic forces to operate freely.

(2) Industrial revolution: During this time there was a huge growth in industry, competition and a large, low paid labour force

What is the core ideology of the classical school? What are the major tenants of the classical school?

• Classical school focused on economic liberalism

• Major tenants are:

1. Limited government intervention: enforcing property rights, public education, national defense 

2. Self-interested economic behaviour: profits, wages  

3. Harmony of interests: serve society’s interest best by pursuing private interest 

4. All economic resources and activities important

5. Economic laws: law of comparative advantage, law of diminishing returns, labour theory of value, etc 

Adam Smith’s Labour theory of value (Portion of price theory)

• relative prices are determined by relative production costs: Higher production costs = higher prices

• Division of labour: when individuals specialize in specific tasks, they become more skilled and efficient, leading to increased labor productivity. This heightened productivity enables economies to produce more goods and services with fewer resources.

Water-diamond paradox

• Tension between value in exchange and value in use, Smith did not figure out why water is cheaper than diamonds even though water has a higher value in use.

Smith’s rationale on natural price vs market price. What are they? What occurs in the long run?

• Similar to Scholastics Smith believed that wages/rents/profits all tend towards the “natural price”.

• Natural price: price that corresponds to normal levels of costs

• Market price: price that prevails in the market

• If N > M: excess supply

• If N< M: little supply

• In the LR: M>N if monopoly rights are granted, the alternative will cause firms to exit so then M=N.

What was Smith’s most famous work? What books/sections did it Include?

Wealth of nations (Adam Smith) 

1. Price theory: division of labour, price formation and determination  

2. Capital accumulation and financial system  

3. Historical (development agriculture in Europe) 

4. International trade: criticism on Mercantilism  

5. Role of public sector  

According to Smith, why do wages differ? Why was this important for economic thinking?

• Smith theorized that contracts gave at least subsistence wage.

• Wages differ due to:

  • Ease/hardship of employment

  • Level of trust and responsibility

  • Regularity of employment

  • Difficulty/expensiveness to learn employment

  • Probability of success in employment

• It is the foundation for the theory of compensating wage differentials! 

According to Smith, why do profits and rents exist?

• Profits arose due to differences in risk and it serves as compensation for the management and supervision of business 

• Smith theorized that rents are equivalent to: tenant’s income – natural costs (wages/profit) = residual pay  

• Increase in prices »» Increase in rents, not the other way around

• This is all under the assumptions that there are free and unregulated markets 

What is the invisible hand? What are its drawbacks?

Invisible hand: what is best for the individual is best for society because the invisible hand ensures competition which promotes efficient use of resources 

• May only have been meant to apply to international trade 

• Only works under very stylised conditions 

• Invisible hand is only actually mentioned once 

Characteristics of a Perfect competition

A perfect competition or a “ system of perfect liberty” :

• Absence of monopoly  

• Free entry and exit  

• Profit maximization by producers  

• Degree of competition increases with the number of sellers

Why did Smith like competitive markets? What were his views on International Trade

Competition is good for economic efficiency because it ensures that resources are devoted to most efficient uses, and hence output is maximized 

• However a just distribution of resources could not be achieved by the market alone, inequalities may arise

He supported free international trade unlike Mercantilists. Trade policies create inefficiencies.

According to Smith, what are the roles of the government?

1. Protect society against foreign invasion 

2. Protect individuals against injustice and oppression by other members  

3. Erect and maintain public works and institutions, which an individual would never find profitable to erect/maintain

   ⇒

   First mentioning of public goods 

Smith’s views on the role of money

Similar to Hume, he believed that an increase in money stock lead to an increase in prices. (Contrary to Mercantilists)

Smith’s views on economic growth? What does this have to do with his wage fund theory? How is the wealth of a nation achieved?

• Growth is driven by capital accumulation and the wage fund theory suggests that employers pay wages from their stock of capital

• The division of labor leads to increased productivity, which boosts output. This spurs further investment and job creation, driving up wages. Higher wages, in turn, motivate even greater productivity, resulting in the overall wealth and prosperity of a nation. (Formed the basis for the efficiency wage theory, a theory coined by Akerlof)

Which historical settings influenced Malthus?

• The industrial revolution lead to high levels of urbanization, unemployment and poverty

• He lived in a time wherein the Corn laws were being implemented: grain was scarce due to war between France and England, so prices were high and landowners were rich. When Napoleon was captured, landowners set a minimum price for food to maintain high income.

Malthus Population growth theory. What are Malthus’ solutions to overpopulation?

• Population grew geometrically whilst food production grew arithmetically, thus there are implicit diminishing marginal returns between the two.

• Mechanism: economic growth ⇒ population growth ⇒

  food shortage ⇒ more people living in poverty ⇒

  starvation and fewer births ⇒ balance population and food supply

• Solutions:

  • Preventive checks: Decrease birth rate through moral restraint and NOT vice (birth control)

  • Positive checks:  Increase death rate through war, famine, disease and war.

Malthus Theory of gluts

• Capitalists retain profit by paying workers subsistence wages. Hence, workers are unable to purchase total output.

• Capitalists are not concerned about buying products but rather accumulating more capital.

• Solution: Society should enrich landlords. This way they will be able to purchase excess goods on the market and hence prevent market stagnation and unemployment. Moreover, their spending creates demand without increasing production costs.

Malthus’ recommendations for Economic policy

• He was opposed to poverty relief: It would incentivize people to have more children » Poor law amendment of 1834. Their suffering was a “positive check”.

• Prevent the abolishment of Corn laws » to enrich landlords to avoid market stagnation

Critiques on Malthus’ theory

• Theory of gluts: showed awareness of problem that lack of demand could lead to unemployment: Keynes later built on that in 1930s  

• Population Theory:

  • Overstated population growth.

  • Underestimated agricultural possibilities: tech innovation and capital accumulation led to more food production with fewer workers

Ricardo’s relative price theory/extended labour theory of value

Ricardo believed that prices are determined by:

• Multiple production factors influence prices (not just labor like Smith) and thus, we can express capital costs in terms of labor costs.

• Time costs: prices are influenced by the time required for production. Goods requiring longer production times tend to have higher prices because they tie up capital for a longer period, thus incurring higher opportunity costs.

Hence Ricardo’s extended labour theory of value: by dissolving capital into labour units and using the 93% approximation, both labour and capital could be incorporated and this helped fix for complications raised by use of capital in the simple labour theory of value 

• Contrary to Smith: Level of wages DO MATTER for relative prices. In opposition to wage fund theory!!

Theory of rent. What are the intensive and extensive margin of cultivation?

Similar to Smith, Ricardo believed that prices determine rents. Or in other terms, rents arise from the intensive and extensive margin of cultivation.

The intensive margin of cultivation: the increasing the amount of inputs to improve the productivity of existing farmland (more crops per meter)

The extensive margin of cultivation: When prices increases we work on more but less fertile land »»» leading to diminishing returns and higher rents on the most fertile land.

Thus prices are determined by the marginal farmer. and rents ARE NOT production costs.

Ricardo’s Theory of International Trade. What were the drawbacks?

Unlike Smith, he believed that we should trade based on relative cost differences

• Smith believed that trade should be based on absolute cost differences

• Theory of comparative advantage: Each country specializes in production and uses part of production for exports – which in turn finances imports

Drawback 1: Tension between Ricardo’s labour theory of value and theory of comparative advantage but why?:

»»»» His labor theory of value implies that prices should be determined solely by the relative input of production factors, while the theory of comparative advantage suggests that prices are influenced by differences in productivity and opportunity costs among countries.

Drawback 2: He doesn’t tell us how gains of trade are split.

Ricardo theory on market gluts 

• They are only temporary but normally full production and employment prevail because effective demand is always sufficient: Say’s law of markets 

• Why?: Supply creates its own demand:

  • Resource allocation between production process of various commodities  

  • Capitalists’ savings imply investment expenditures which create demand for goods 

Ricardo on economic policy

Abolish corn laws

• With Corn laws population growth does come at the cost of lower economic growth

• There are gains from international trade that should not be restricted

Ricardo’s main contributions and critiques

• Theory of comparative advantage 

• Marginal analysis (price determined by marginal farmer)

• Law of diminishing returns

• *Overemphasize law of diminishing returns of land ⇒ technological innovations increased output

• *Land has multiple competing uses hence there are opportunity costs and thus rent is part of production cost

How did John Mill improve price theory? What is a fundamental principle of price formation?

Unlike Smith and Ricardo, Mill introduced the demand side to price formation:

(1) Price formation in international trade: prices adjust until EX = IM

(2) General situation: prices adjust until S=D of a commodity

(3) General equilibrium concept: AD = AS for all commodities (Reciprocal demand) ⇒ price elasticity 

Fundamental principle of price formation is tendency of market mechanism to equate supply and demand. Mill solves Ricardo’s issue!

Mill’s views on Smith’s wage fund theory.

• He eventually rejected it because it’s implications were not consistent with actual functioning of the economy: unions do have an impact on wages