Classical Economic Thought and The Wealth of Nations

Microeconomics I: Classical Economic Thought

Overview of Classical Economic Thought

  • Key Figures in Classical Economics:

    • Adam Smith (1723-1790)

    • Thomas Malthus (1766-1834)

    • David Ricardo (1772-1823)

    • Karl Marx (1818-1883)

  • Transition to Neoclassical Economics during the Marginal Revolution:

    • Stanley Jevons (1835-1882)

    • Leon Walras (1834-1910)

    • Carl Menger (1840-1921)

Adam Smith: The Father of Modern Economics

  • Known for the seminal work "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776).

The Wealth of Nations: Key Themes

  • Questions Addressed:

    • What is wealth? What is its nature, and what does it consist of?

    • What causes wealth? Why are some countries rich while others are poor?

  • Critique of Prevailing Doctrines:

    • Mercantilism: Wealth and national progress measured by gold reserves.

    • Physiocracy: Argues that only agriculture produces a surplus (output > input).

Understanding Wealth

  • Definition of Wealth: Wealth does not equate to agriculture or gold.

    • It is determined by the usefulness of whatever is produced.

    • Wealth is defined as the utility derived from goods, which are products of:

    • Labour

    • Land

    • Capital (materials, energy)

  • Manufactured Goods: Considered a form of wealth.

Theory of Value in Classical Economics

  • Labour Theory of Value:

    • Only labour can add value to commodities.

    • The value of a good correlates with the amount of labour invested in its production.

  • Key Quote from Smith:
    “Labour alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. It is their real price; money is their nominal price only.” (Wealth of Nations, Book 1, Chapter 5)

  • Contrast with Neoclassical Economics:

    • Current mainstream economics centers on Subjective Utility Theory of Value: Value is viewed as independent of the labour quantity required for production and associated with personal wealth and desires.

    • Classical economists largely rejected this theory, except for special goods, such as fine art.

Prices and Distribution of Wealth

  • Concerns in Distribution of Wealth Between Three Classes:

    • Workers: Provide Labour (L); receive Wages (w).

    • Landlords: Provide Land (N); receive Rents (r).

    • Firms/Capitalists: Provide Capital (K); receive Profits (s).

  • Market Prices vs. Natural Prices:

    • Prices for goods arise from the costs associated with land, labour, and capital.

    • Natural rewards are the prices that maintain individuals in their activities without surplus.

    • Market prices may fluctuate, but there exists a natural price that is targeted.

Growth and Distribution Considerations

  • Trajectory of Wages (w), Rents (r), and Profits (s):

    • Profits (s): Limited by competition.

    • Wages (w): Follow the subsistence level (following Malthus).

    • Rent (r): Pure surplus mechanics.

The ‘Invisible Hand’ Theory

  • The term suggests that individual self-interested decisions collectively lead to optimal societal outcomes.

  • Smith used the concept twice in his works, in different contexts:

    • One reference discusses the rich sharing their improvements with the poor, indicating that their self-interest inadvertently benefits society.

    • Quote from The Theory of Moral Sentiments:
      “[The rich] consume little more than the poor, and in spite of their natural selfishness and rapacity… they divide with the poor the produce of all their improvements…” (The Theory Of Moral Sentiments, Part IV, Chapter I)

    • Another reference highlights individual actions leading to benefits for the public interest, despite that not being the intention.

    • Quote from The Wealth Of Nations:
      “Every individual… neither intends to promote the public interest, nor knows how much he is promoting it…” (Book IV, Chapter II)

Specialisation, Absolute Advantage, and Gains from Exchange

  • Division of Labour: The increase in productivity and skills is attributed to the division of labour.

  • Gains from Specialisation:

    • Specialisation leads to 'universal opulence' where even the lowest ranks benefit from increased productivity.

    • Exchanges among workers enhance their ability to trade goods they produce for the goods they need.

  • Alienation: Workers performing monotonous tasks may lose their inventive abilities and become less intellectually engaged.

Distribution of Income and Wealth

  • Importance of Equity in Distribution:

    • Quote: “No society can surely be flourishing and happy, of which the greater part of the members are poor and miserable.” (The Wealth Of Nations, Book I Chapter VIII)

  • Gains from Exchange: An individual can exchange goods efficiently, benefiting both parties.

Concept of Absolute Advantage

  • Defined by David Ricardo:

    • Countries should produce goods where they hold an absolute advantage in terms of production efficiency.

Practical Example: Absolute Advantage

  • Comparative production times:

    • France:

    • Silk cloth: 6 metres/hour

    • Cotton cloth: 4 metres/hour

    • UK:

    • Silk cloth: 1 metre/hour

    • Cotton cloth: 5 metres/hour

  • Allocation of production advantages allows for mutually beneficial trade.

Additional Example Scenarios

  • Different allocation of production times to illustrate shifts in absolute advantage, including whether mutually beneficial trade can take place, focusing on comparative production costs and potential for beneficial exchange.