History of Economic Thought2012 - 13

History of Economic Thought
Econ 461
Course objectives
 The main objective of this course is to provide students with a
general picture of the development of economics until the
emergence of socialist thinking.
 The course demonstrates the contributions of mainstream thinkers
and deviant thinkers from the orthodoxy of this era in shaping

contemporary economic thought.
The rationale for studying HET
 Enhancing ones understanding of contemporary economic thought
 It provides perspective and understanding of our past and anticipate
changes in the future as contributed by various schools with no monopoly of
the truth by a single source.
 Guarding from irresponsible generalizations.
1
Introduction
 Economics is a social science that examines the
problems of relative scarcity in material requisites of
life that societies face.
 Scarcity arises because individuals desire to consume
more goods and services than are available or
because of unlimited wants and limited resources.
 To mitigate the problem of scarcity, it may require
either restricting individual wants ( by inducing moral restraint on
demand ! Or by forcibly imposing austerity!) or increasing the supply
of resources ( increasing productivity and output) or both
2
Introduction cont‟d
 Whichever way scarcity is addressed there arises a

need for a social mechanism of allocating limited
resources among unlimited alternative wants.
 Resource allocation mechanisms determine
 Who gets and who does not get resources.
 Which want gets satisfied and which does not
 Historically four social resource allocating mechanisms
were used: Brute force, Tradition, Authority, Market
 Regardless of which mechanism is used to allocate
resources, the harsh reality of scarcity necessitates that
some wants among the alternatives remain unmet.
3
History of economic thought Versus economic
history
 History of economic thought charts the development
of economic thinking about the various economic
problems (problems of coping with scarcity) through
ages.
 Economic history tells about the various economic
activities that prevailed to create wealth in the past
and the various resource allocation mechanisms
employed to cope with the problem of scarcity across
ages.
4
 To understand the past economic thoughts we need
to have a good grasp of the central focus of modern
economic thought
 Modern economic theory examines the various ways in
which contemporary societies cope with the problems
that flow from relative scarcity (the problems of allocation ,
distribution, growth and stability)
 In modern economic thought the theories on the
problems associated with relative scarcity are
commonly divided into micro and macro economics.
 Micro economics considers questions of allocation and distribution ( what
to produce and how to produce, how real income and goods are divided
among the members of society).
 Macroeconomics considers questions of stability( issues of business
cycles inflation and unemployment) and growth 5
 Modern economic theory focuses largely on market processes

of allocating resources, which have replaced the others as
primary resource allocating mechanism.
 This economics is known as mainstream or orthodox economic
thinking.
 Although the mainstream modern economics ( orthodox
economic thinking), focuses on the use of markets to cope with
the problems associated with relative scarcity some economists
are interested in broader philosophical issues, straddling
disciplines within social sciences such as between economics
and political science, between economics and sociology etc.
 This economics is sometimes called heterodox economic
thinking.
6
 Differences between Orthodox and Heterodox economists
mainly lie in the questions they try to answer.
 Orthodox thinking
 Assumes specific social, political and economic institutions(
free and competitive market at its best, democratic politics ,

sovereign and rational individual consumers, respect for the
rule of law and private property etc) as given and studies
economic behavior in the context of these institutions
 focuses on the problems of market allocation, distribution,
Stability and growth in the context of the assumed specific

institutions.
7
 Heterodox thinking
 Focuses on forces leading to the development of
the institutions, in society.( Note that these institutions

are assumed as given in the orthodox economics, meaning
that it is not the interest of Orthodox economics to study
how they come and go)
 focuses on the forces that produce changes in
society and the economy, given the functioning of
markets and other forces.
 The differences are often differences of focus i.e. what
one tries to explain is taken as given by the other. 8
A theory of economic theory

 Can we formulate a theory to explain the development
of economic theory? The answers differ among
relativist and absolutists
 The relativist approach
 historical, economic, sociological and political forces bring people to
examine certain economic questions and these forces shape the
content of the theory.
 The absolutist approach
 internal forces such as the increasing professionalism in economics
account for the development of economic theory as intellectual
reactions to unsolved problems and paradoxes.
 Which one is right?
 Both convey part of the truth. 9
II Introduction to
the Methodology of economics
 The methodology of economics is about “what ever
economists know how do they know that they know
it?”
 Before introducing the Methodology of economics (
how economists know that they know) it would
be necessary to specify What economists know.
 The answer to What economists know has
remained as an important point of distinction in
methodological differences among economists .
 There are generally three distinctly defined areas of
economics about what economists know .
10
Methodological issues
 Positive economics ( The aim of economics is to know
about how the economy works)
 The methodology of positive economics is formal and abstract.
 It tries to separate economic forces from political and social forces
 It poses economics as a science rather than art
 Normative economics (its aim is to know how the
economy should work)
 The art of economics( if it knows that this is how the
economy works and knowing the given normative
goals , how best to achieve these goals)
 The methodology of the art of economics concerns policy, mixing
positive and normative economics.
 It addresses interrelationships among politics, social and economic
11
forces.
Methodology of economics
 Underlying the question “ how do we know
that we know” for Economics as a science (
positive economics ) lie more fundamental
questions:
 “ whether there is an ultimate truth that scientists
are in the process of revealing?”
 If there is ultimate truth how do we find it?
 With regard to these questions there are two
general positions.
12
 Subjectivism
 Reality is not independent of our individual or social thinking( reality is
individually or socially constructed) and it is not possible to assert the

underlying ultimate truth
 Realism
 Objective reality exists and Ultimate truth describes that reality(the
absolutist view )
 Objective reality may exist but truths describing it are relative to
circumstances ( the relativist view)

 In realism believing that truth exists leaves one with the problem of
deciding when one has discovered it.
 Scientific method is one means of discovering the truth.
 The method involves trained empirical observation integrated with
reason.
13
 The progress in methodology of science

 Prescience: Deductive method of gaining knowledge was followed. in
prescience deductive method was limited to general propositions ( positive
or normative) that led to specific logical implications. There was no felt
need for empirical verifications of the implications.
 The philosophical foundation of science lies in positivism.
 Positivism claims that :the only authentic knowledge is knowledge that is
based on actual sense experience. Such knowledge can only come from
affirmation of theories through strict scientific method. Science can rise above
superstition by specializing in the description and analysis of observable
phenomena leading to the discovery of natural laws.
 The importance of empirical verification was gradually acknowledged and reason
was integrated with empirical observation as exemplified in science. Science
used both the inductive method and deductive reasoning.
 Inductive method begins From specific observations, rooted in experience, and
goes to general conclusions. In the inductive view of science scientific
investigation begins with un prejudiced observation of facts and proceed via
inductive reasoning to the formulation of laws and theories ultimately to be
checked for their truth content by comparing their empirical consequences 14with
all the observed facts.
 Logical positivism provided the scientific method with stricter
philosophical foundations.
 Logical positivism combines empiricism, the idea that
observational evidence is indispensable for knowledge of the
world, with a version of rationalism incorporating mathematical
and logico-linguistic constructs and deductions.
 Scientists are supposed to develop a deductive structure ( a
logical theory) that leads to empirically testable propositions.
 A deductive theory is true , however, only after it has been
empirically tested and verified.
 It describes economics as a positive science whose goal is to
devise theories that can be empirically validated.
 It purges normative discussions from economics as
unscientific.
15
 Hypothetico-deductive model:- is the further
development out of logical positivism.
 This model claims that all truly scientific explanations
involve at least one universal law plus a statement of
relevant initial conditions that constitute the premises
from which a statement about some event whose
explanation or prediction we are seeking is deduced
with the aid of the rules of deductive logic.
 The universal laws are tested by using them to make
predictions about particular events.
16
 The departure from logical positivism resulted from
a concern about the logical validity “Verification” of
theories.
 Popper's Falsification and science
 The criterion of the scientific status of a theory
is its nature of falsifiability, or refutability

 There can be only a science of falsification not
verification.
 Kuhn‟s scientific paradigms
 Most scientific work is normal science in which
researchers try to solve puzzles posed within the

framework of the existing paradigm. 17
 This work often leads to the discovery of anomalies the
paradigm fails to account for, but the existence of such
anomalies is not sufficient to overthrow the reigning
paradigm: only an alternative paradigm better able to deal
with the anomalies can do so. Ones such a superior
paradigm develops a scientific revolution becomes possible.
 Imre Lakatos‟s Scientific Research Programs
 Scientists are engaged in the development of competing
research programs, each of which involves analyzing and
attempting to falsify a set of data but also involves
unquestionably accepting a set of hard core logical
postulates
18
 Theories have hard core which adherents do not attempt to
falsify .
 Hard core is surrounded by protective belt of hypothesis
which may be adjusted to defend the hard core.

 Only when sufficient peripheral implications are falsified will
the hard core assumptions be considered.

 Instrumentalism and Economics (Freidman‟s Essay)
 All theory is abstraction.
 Good theory abstracts from reality in a useful way

 Proper test of a theory is by its predictions.
 For this realism of assumptions is irrelevant.( F- twist)

19
 Paul Samuelson contradicts by saying that good theories are based on
reasonable assumptions.
 Austrian Methodology
 The task of the economist is deriving conclusions deductively from
the logic of human action
 Conclusions and theories thus derived need not be tested because
truth had already been logically established.
 Methodological anarchy
 “Any thing will do” approach: as long as there is internal consistency
 Sociological Approach to Method : Social and institutional constraints
influence the acceptability of theories
 Rhetorical approach to method : Emphasis on the persuasiveness of
the argument
20
3. Overview of schools of thought
 Classical economics is dated from the publication
of the Adam Smith‟s Wealth of Nations in 1776.
 The period of Pre classical economics ( the period
before 1776) is divided in to two parts:
 an early pre classical period before 1500AD
and
 A pre classical era between 1500 and 1776
 The first part of the period includes the economic ideas of the
Ancient Greeks, Romans, and the Medieval Economics of the
Scholastics
 The second part includes the Mercantilists and the Physiocrats
21
The general themes of Pre
classical economic thinkers
 Reflected on aspects of their Economic lives and

focused on non- market allocating mechanisms
 Focused on general philosophical questions of
fairness, justice and equity.
 Ancient Greek and Roman Economic ideas was dominated
with Economic ideas in connection to concerns for justice,
fairness, equality and non market methods of resource
allocation
 Medieval ( scholastic ) economic ideas were concerned with
reconciling the philosophy of the ancient classical
philosophers with medieval Christian theology and provide
religious guidelines to be applied to secular activities with a
general orientation to non market methods of resource
allocation 22
Merchantilism and Physiocracy
 Merchantilism is A body of economic doctrine reflecting the
interest of the mercantile capitalist, giving dignity and
importance to the merchant and trade, characterized by its
promotion of nationalism, a strong government and justification
of a policy of economic and military expansion, which is a
manifestation of the less importance attached to market
forces.
 Physiocracy was a reaction to Mercantilism and feudalism in
France characterized by its emphasis on agriculture and laissez
faire ,an advance in economic thinking towards the recognition
of the role of the markets
23
Classical school and
the Socialist school
 Classical thinking fully developed the role of markets
and Economic laws , the Importance of all economic
resources and activities and Self interested economic
behavior.
 Socialist thinking Opposed and repudiated the classical
concept of laissez-faire, the market mechanism of
capitalism as doomed to periodic crisis or general
stagnation and denied the concept of self interested
actors and advocated collective action and collective
property.
24
4. Pre classical Economic thought
4.1. Greek and Roman Economic Ideas
 Greeks
 Hesiod(800 BC)
 On scarcity- scarcity as emanating not from human
conditions
 Xenophon( 400BC)
 coined the word Oeconomicus- efficient management at
the level of the household
 discussed efficiency at the household, the producer, the
military and the public administrator level.
 Discussed efficiency and division of labor
25
Greeks
 Democritus
 Division of labor
 Private ownership of property – an incentive to greater economic

activity.
 Plato
 The ruling class should not possess private property
 The necessity of division of labor based on the best natural ability

for efficiency
 Sponsored one of the two fundamental theories of money. He
thought of money as a symbol devised for the purpose of facilitating
exchange, the value of which is on principle independent of the stuff
it is made of. ( Cartal theory)
 The canons of his monetary policy, i.e., his hostility to the use of
gold and silver and his idea of a domestic currency that would be
useless abroad were logical consequences of this principle.
26
Greeks
 Aristotle
 There should be no regulation to limit private property.
 But also condemned the pursuit of economic gains.
 Scarcity can be addressed by reducing consumption, by changing human
attitudes( the basis for utopians and socialists hopes of eliminating
conflicts that are inherent in scarcity and self interested behavior )
 The distinction between peoples needs and desires
 The developments that led to exchange of commodities and the
use of money
 Aristotle sponsored the second theory of money(Metallist theory)
 Money is a medium of exchange( catallactic theory of money)
 In order to serve as a medium of exchange in the market of
commodities money must be one of these commodities. Thus the money
commodity goes by weight and quality leading to metallism or the
Metallist theory of money as opposed to Cartal theory of Plato
 He recognized money as Measure of value and implicitly as a Store of value
 Money as a Standard of differed payments was not suggested by Aristotle
27
 Aristotle on value
 Recognized the distinction between Value in use and value

in exchange & the latter is derived from the former.
 Promoted the idea of Justice in price (Commutative justice)
as equivalence of what a man gives and receives.
 Defined monopoly as a single seller and condemned it as
unjust.
 Aristotle failed in formulating a theory of price.
 Aristotle on Interest
 Condemned interest, as usury, on the ground that money is
a medium of exchange the value of which does not change
as it crosses hands.
 He didn‟t asked why interest was being paid anyway.
28
The Romans
 The Roman period was characterized by the absence of
analytic work in spite of expanded economic activities,
markets and administrative concerns
 The probable cause could be the structure of
the roman society which might not allow
analytic works by a class of people who could see such
an engagement as their vocation rather than avocation
 What is recognized from this period is the importance
of Roman law that recognizes private property and
commerce
29
4.2 Scholasticism and
Medieval Economic ideas
 Scholastic writers were educated monks who tried to

provide religious guidelines to be applied to secular
activities
 Scholasticism originally began to reconcile the
philosophy of the ancient classical philosophers with
medieval Christian theology.
 Scholasticism is not a philosophy or theology in itself,
but a tool and method for learning.
 It puts emphasis on dialectical reasoning.
 The primary purpose of scholasticism was to find the
answer to a question or resolve a contradiction. 30
Scholasticism
 Historical context of the school
 Market was not playing a dominant role in everyday life
 Feudal, subsistence agriculture
 Society was bound together by tradition custom and authority ( not by market)
 Land, labor and capital were not market commodities as they are today.
Main themes of the school
 Scholastic writing represented a gradual acceptance of
certain aspects of economic activity as compatible with
religious doctrine,
 This acceptance was achieved by subtle modifications of
that doctrine to fit the economic conditions
 Fusion of religious teaching with writings of Aristotle
31
Value theory and the scholastics
 Albertus Magnus :planted in western thought the notion that value
in exchange must comply with cost of production (labor and
expenses)
 Thomas Aquinas( Albert‟s Pupil) introduced need, human wants, in to
value theory marking the earliest root of an analytical demand theory of
value. The notion roughly meant amount desired in relation to what is
available( demand in relation to scarcity)
 Henry of Friemar introduced aggregation and scarcity notion of value
where value is determined by the common need of something scarce
(roughly sketching market demand for scarce thing as the determinant of
value of the thing)
 Jean Buridan took the scholastic notion of human want to a concept much
closer to the modern concept of effective demand
 All through the middle ages value theory continued to pose the two
competing concepts of labor and demand theory as explanations of value.
 The school initiated the debate, which took more than half a millennium
period to solve, on cost of production theory of value and utility based
theory of value which ended with Alfred Marshall‟s Synthesis about the
beginning of the 20th century.
32
Value theory and
the scholastics cont‟d
 The concept of the Just price of scholastics taken

from Aristotle has left behind differences in
interpretation
 Just price equivalent to labor cost?
 Just price equivalent to utility?
 Just price equivalent to total cost of production?
 Just price equivalent to the prevailing market price?
 The harsh scholastic view on USURY gradually

moderated from fairly strict prohibition to its
acceptance, at least to business purposes.
33
Scholasticism
St. Thomas Aquinas and later Medieval thought.
 In an attempt to reconcile religious doctrine with the
institution of private property and with economic activity he
argued against those teachings and beliefs condemning
private property, wealth and the pursuit of economic gain.
 In his argument, although Communal property accorded
with natural law as exemplified by Jesus and his disciples,
he maintained that private property is an addition not a
contradiction to natural law..
 But advocated poverty and communal living for those
committed to religious living as ideal.
 Aquinas and others focused on the ethical aspect of prices
( equity and justice)

34
4.3. Mercantilism
 The body of economic doctrine known as mercantilism, appeared
between the Middle Ages and the period of the triumph of Laissez-
Faire. I came with the ascendance of the mercantile capitalist and
trade in western Europe.
 It was characterized by its promotion of nationalism, giving dignity
and importance to the merchant, justification of a policy of economic
and military expansion, belief in gold and silver as the most desirable
form of wealth, emphasis on export and restriction on import in the
interest of the mercantile capitalist.
 The historical background of the mercantilist school
 The self-sufficiency of the feudal community gave way slowly to
trade and higher interdependence,
 Merchants interceded between the small scale producers and
consumers, and merchant capitalists were becoming key figures in
the world of business
35
The historical background cont’d
 Cities became increasingly important.
 The use of money expanded.
 New sources of gold discovered, which facilitated the growing
volume of commerce and stimulated theorizing about precious
metals.
 The development in Navigation and great geographical discoveries
expanded the sphere of commerce.
 National states were rising and expanding their sphere of
influence and colonies, which intensified the rivalry between
Nations.
 Under these circumstances a body of mercantilist doctrine evolved
 superseding the feudal concepts, dignifying the merchant,
promoting Nationalism and justifying a policy of economic and
military expansion, aiming at the accumulation of bullion of
gold and silver as the most desired form of wealth.
36
Major tenets of Mercantilism
 Gold and silver as the most desirable form of wealth
 Emphasis on export, duty-free importation of raw
materials and protection of internal manufactures
 Opposition of internal tolls, taxes and restrictions on
internal movement of goods
 Nationalism and Beggar-thy- neighbor- policy
 Colonization and monopolization of colonial trade
 Strong Central government
 Emphasis on large, hardworking population
37
Major Tenets cont’d
 Gold and silver as the most desirable form of wealth
 Mercantilists tended to equate the wealth of a nation with the
amount of gold and silver bullion that it possessed. All of them
valued bullion as the ways to achieve power and riches.
 Mercantilism is known for its emphasis on exports and

restriction on imports( the fear of goods).
 Duty free importation of raw materials that could not be
produced domestically, protection for manufactured goods and
raw materials that could be produced domestically , and export
restriction on raw materials
38
Major Tenets of the school
 Opposed to internals tolls and taxes and other
restrictions on the internal movement of goods,
 They recognized that tolls and taxes could bottle neck
business activities and enterprise and drive up the prices of
the country‟s export and all these were in the interest of the
merchant.
 In mercantilism the interest of the merchant took
precedence over those of domestic consumers. Merchants
received inflows of gold in return for their exports that were
kept cheap by the above mechanisms, while the restrictions
on imports reduced the availability of goods for consumption
at home.
39
 Nationalism
 Mercantilists believed that there was a fixed quantity
of economic resources in the world; one country
could increase its resources only at the expense of
another.
 Therefore one’s own country should promote its
exports and accumulate wealth at the expense of its
neighbors.
 Only a powerful nation could compete successfully in
international trade, dominate trade routes, win wars
against rivals, capture and hold colonies.
40
 Colonization and monopolization of colonial
trade
 keeping colonies eternally dependant upon and
subservient to the colonizer to maintain cheap raw
material sources and importers of manufactured
goods.
 colonies were not allowed to import from places
other than the colonizer; colonies were not allowed,
curbed or outlawed to manufacture their
own;exports from colonies had to first visit
colonizers port before they move to the final
destination. 41
 Strong Central Government
 Mercantilists promoted a strong central government
as it was a means to achieve mercantilist goals of
 colonization,
 securing privileges of monopoly in foreign trade,
 restriction of new entry to businesses at home,
 regulation of methods of production and the quality of
export goods to maintain reputation,
 removal of excessive tolls and taxes in internal trade
goods,
 Restriction of imports and promotion of export etc.
42
Major Tenets of
the school
 Sizable industrious Population
 Mercantilism promoted a sizable industrious
population that
 provide an abundance of soldiers and sailors ready to
fight for the glory and wealth of the nation
 and also to keep labor supply high and wages low.(
Idleness , begging, theft were punishable by maim and
death)
43
Whom did Mercantilists
Benefit
 The doctrine benefited the merchant
capitalist, the Kings, and the government officials
 Some historians of economic thought suggest that
mercantilism can best be understood as an extreme
example of rent seeking behavior
 Here Rent seeking activities simply mean attempts by
private parties to increase their profits by securing favorable
laws and regulations from governments
 The laws took the form of
 grants of monopoly status
 Prohibition of imports
 Entry barriers for new producers

44
Whom did Mercantilists Benefit
 Examples
 In England and In France importing printed cotton called
Calicoes was prohibited to maintain the interest of wool
producers.
 In England the law required the dead to be buried in woolen
shrouds even though religious traditions required linens.
 Rules published in France in 1666 to 1730 on textiles alone
required seven huge volumes on quality specifications and
manuals on dyeing. These regulations prevented inferior
methods from being used, but they also seriously impeded
experimentation and the development of new techniques by
producers who could have competed with existing firms.45
How Valid , Useful and correct
in its time was the school?
 The arguments for bullion , although exaggerated,
made sense in that transition period from middle ages to money
and credit economy of modern times.
 Before the development of international finance and multilateral trade
bullion was of major significance in making international payments.
 Mercantilists were also aware that the influx of precious metals made tax
collection easier.
 They knew that prices would rise or at least would not fall if the
quantity of money increased as trade expanded.
 Not only was the volume of output expanding , but also the self
sufficient household was being drawn in to the market economy and
therefore more money was needed to buy and sell same volume of
output.
 Some Mercantilist were also aware that increase in the amount of
gold and silver in circulation reduced interest rates and promoted
business. 46
Which tenets of the school
become lasting contribution?
 Direct contribution
 Emphasis on international trade and laying the basis for the notion of the
balance of payments
 The macro economic concept that actual output could be lower than
Potential output as a result of imports and domestic demand deficiency
might have served as the intellectual root for Keynesian economics
 Indirect contribution to economics and economic
development
 They permanently influenced the attitude toward the merchant
 They promoted nationalism, which was necessary for regulations needed
for maintaining uniform weights, measures, coinage, etc; When financial
risks of trade were high providing monopoly privileges were necessary to
induce more risk.
 It helped European economy to transform by bringing in new products
and creating selling outlets for manufactured goods, by expanding the
internal market . 47
Thomas Mun
 Thomas Mun( British mercantilist) who Lived between 1571-
1641 was a merchant in Italian and near east trade and later
was elected as a director of the East India company.
 Because he was involved in the controversy over the
company‟s policy of exporting gold, he published a tract in its
defense.
 He argued that as long as the total export exceeded total
imports , the drain of species from a country in any one

trade area did not matter.
48
Thomas Mun
 A chapter in an exposition of the mercantilist doctrine by Mun
that was written around 1630 and published posthumously in
1664, entitled “ the means to enrich the Kingdom, and
increase our treasure” states
 that the means lay neither in production nor in the accumulation of
capital goods,but rather in a surplus of exports.
 Although England was rich, it could be still richer if it used waste land
to grow hemp, flax, lumber, tobacco and other things which now we
fetch from strangers to our great impoverishing.
 Exports should be carried in English ships to gain insurance and freight
charges.
 Argued for multilateral trade than bilateral trade and analyzed
England‟s overall balance of trade rather than its separate account with
each foreign country.
49
Thomas Mun
 His emphasis on importing treasure led to the strange conclusion that trade
at home could not enrich a country.
 “ we may exchange either amongst ourselves or with strangers; if amongst
ourselves the Commonwealth cannot be enriched thereby; for the gain of one
subject is a loss for another.And if we exchange with strangers, then our profits
is the gain of the Common wealth.”
 Mun listed the invisible items that should be included in an overall balance if
it were to show whether „ We prosper or decline in this great wealthy
business”.
 He included in the balance of payments;
 The freight charges for shipping goods
 Ships lost at sea
 Insurance
 Money paid up in supporting foreign wars
 International payment of bribes and funds for espionage
 Expense of travelers
 Gifts for foreigners and ambassadors
 Interest on money
 Smuggling to evade tariffs
 Contributions to religious orders that secretly sent the money abroad 50
Mercantilists
 Jean Baptiste Colbert( French mercantilist)
 Gerard Malynes ( Belgian born from English family )
 Charles Duvenant( British)
 Bernand Mandeville (British)
 Sir William Petty

 Favored freer trade
 Favored taxation of imported goods
 Favored gentle dealing with imported raw materials
 Opposed laws prohibiting the export of money but also deplored the
money paid to foreigners for shipping, the money paid to Hollanders
for their fishing trade, the money spent on importe4d commodities
that could be manufactured in England
 Favored large population
51
4.4 The Physiocratic school
 The term physiocrat means the rule of nature.

 The Physiocrats appeared in France toward the end of
the Mercantilist epoch around 1756 and ended in 1776
 The influence of the physiocrats lasted well beyond
the two decades during which they led the world in
economic thinking.
 Physiocracy was a reaction to Mercantilism and
feudalism in France.
52
4.4 Physiocracy
The historical background of the school
 The detailed government regulation of production became a fetter to
improvement in manufacturing and impedance to satisfaction of
changing consumer tastes.
 French industry was retarded by imposed local tolls taxes and tariffs that
impeded the movement of goods.
 French agriculture was burdened by taxes on land and profits of farming
that was enforced by landed nobility.Incentives for individuals to
accumulate wealth and expand investment were seriously impaired.
 For centuries the authorities subjected the grain trade to a severe
regulations.The freedom enjoyed by other trades were denied to grain
trade.
 Merchant and crafts guilds impeded the free entry of labor into certain
occupations, restricted and regulated output, fixed prices and opposed
competition
53
Major tenets of Physiocracy
 Natural Order
 Laissez faire
 Emphasis on agriculture
 Taxation on land owner
 Inter relatedness of the economy
 The physiocrats introduced the concept of natural order to

economic thinking, i.e.,the idea that the
laws of nature govern human societies just as those
discovered by Newton govern the physical world.( Natural
order)
 In the economic sphere the laws of nature conferred to the individual
the natural right to enjoy the fruits of their labor, provided that such
enjoyment was consistent with the rights of others.
54
Major tenets of the school
 Governments should never interfere in economic
affairs beyond the minimum required to maintain
freedom of contract and the protection of life and
property.( laissez faire – let the people do as they
please without government interference )
 Industry trade and the professions were useful but
sterile , simply reproducing the value consumed in
the form of raw materials and subsistence for the
workers, while agriculture was productive because it
produces a surplus, a net product above the value
of the resources use in production.( Emphasis on
agriculture) 55
Major tenets of the school
 Emphasis on taxation of the land owner
 Because only agriculture produced surplus, which the land owner
received in the form of rent, only the land owner should be taxed.
 Although all taxes imposed on others would be passed on to the
landowner anyway ( indirect taxes), directly taxing the land owner
(direct tax) was preferable to indirect taxes as they were increasing
when they were passed along to others.
 The economy was believed to be interdependent and the
circular flow of goods and money was analyzed. “Tableau
economique” of Quesnay was a table that traces spending,
revenue received, by farmers, landlords, manufacturers and
merchants.
56
Whom did the school benefit or seek
to benefit
 Peasants ultimately would gain from the ideas of the

physiocrats.
 Businesses would gain from the removal of the of all
restrictions on production and the movement of goods
 The doctrine of laissez faire promotes industry though
it was not the intensions of the physiocrats.
 Physiocrats favored capitalist farms.
 A single tax to all land in production would benefit the
landlords.
57
Usefulness , validity or correctness
of the school in its time
 Industry was an activity that was extremely low in productivity

and appeared to be sterile as compared to agriculture that has
sometimes bountiful harvest.
 By emphasizing agriculture they departed away from the
mercantilist thinking of only commerce creates and augments
wealth.
 The school emphasized production rather than exchange as a
source of wealth.
 The support for direct tax was a valid reaction to the cascaded
indirect taxes that corroded the society at the time.
58
Lasting contribution of the school
 Physiocrats laid a foundation for economics to be a social
science by examining society as a whole and analyzing the laws
that governed the circulation of goods and wealth, which were
the precursor of the flow and national accounts concepts of the
modern time.
 The law of diminishing returns actually originated from the
physiocrats( particularly Turgot)
 Physiocrats originated the idea of tax shifting and incidence
 Through the idea of laissez faire, they directed attention to the
analysis of the proper role of governments in the economy.
59
Physiocrats
 Francios Quesnay
 Hoped to transform the king to enlightened despot
 Expressed that small farms were incapable of the most productive
method, and favored large farms managed by entrepreneurs.
 Analogous to the natural organism and conforming to the natural order,
the circulation of wealth and goods in the economy was like the
circulation of blood in the body.
 Laws made by people should be in harmony with natural laws.
 Constructed Tableau Economique, which was the first systematic
analysis of the flow of wealth. A.Smith. K. Marxs and M. keynes, who
later on also described trhe economy in terms of large aggregates, paid
tributes to Quesnay.
 Quesnay‟s Tableau Economique foreshadowed national income analysis
and the modern circular flow of wealth and goods. It was also the
predecessor of the input- output analysis of Leontief.
60
Francios Quesnay cont‟d
 Regarding rent, he believed that nature, not the worker,

produced the surplus and hence the land lord has the right
to the surplus product.
 Quesnay defended the interest of the land lord but
landlords took his proposal of taxing only the lard lords as
an attack on their interests.
 Quesnay argued against excess luxury in the way of
decoration, and preferred spending on raw materials.
 Quesnay‟s thinking had medieval flavor in his glorification
of agriculture, in fixing of the interest rate by government,
in favoring the “Just price”. However, he believed the free
market rather than regulation by authority would best
achieve the “Just price”
 Anne Robert Jacques Turgot
61
The Classical school
 The school began in 1776, when Adam Smith published his Wealth of
Nations. It ended in 1871 when books on marginalist theories were
published by Stanley Javons, Carl Menger, and Leon Walras independently.
 The Historical back ground of the school
 The scientific revolution has discovered and advanced Natural laws, Planetary
motion, Universal Gravitation and laws of motion etc.
 The revolution in science relied heavily on experimental evidences.
 Scientists like Newton popularized the already existing idea that the universe is
governed by natural laws.
 The system of Newton was a static view of the universe that saw that nothing
changes over time. The motion and relationships in the universe continue in
endless repetition.
 This view served as a framework for the classicists that the natural laws would
guide the economic system and the actions of people.
 The Devine will had created a mechanism that works automatically without
interference . This applies to society and hence laissez faire was the highest form
of wisdom in social affaires.
62
Historical Back ground of the School cont‟d
 The industrial revolution was beginning and gaining momentum in England

 England was gaining supremacy in both commercial and industry and stood
to benefit greatly by free international trade.
 As English Entrepreneurs became stronger, they no longer were dependent
on government subsidies, monopoly privileges and tariff protection
 The entrepreneurs were increasing in number and hence monopoly
agreements could no more be easy to realize.
 Competition began to ensure moderate prices and good quality
 Wage and labor regulations by government had given way to market forces
and conditions of labor supply and demand were dictating low market
determined wages.
 The enclosure law brought land and strict private ownership regime and
encouraged larger scale and more capital intensive agriculture that turned
peasants into wage earners
 The factory system displaced handicrafts men, driving them to the labor
market as wage earners.
63
 Economic liberalism
 Classical doctrine is economic liberalism on the basis of personal liberty,
private property, individual initiative, private enterprise, minimal
government interference.
 Minimal government involvement
 The best government governs the least. The economy is self adjusting
and tending toward full employment with out government interference.
 Self interested economic behavior
 Self interested behavior is basic to human nature where actors produce
or sell to make profits, workers offer labor services to secure wages
consumers purchase to satisfy their wants.
 Harmony of interests
 By pursuing their individual interests people served the best interest of
society
64
Major Tenets cont‟d
 Importance of all economic resources and activities.
 Land, labor capital and entrepreneurship as resources and
agriculture, commerce, production and exchange as
economic activities contribute to a nation‟s wealth.
 Recognition of economic laws:
 Focused on explicit economic theories or “laws”.
Examples
 The law of diminishing returns
 The theory of population ( Malthusian)
 The law of markets
 Recardian theory of rent
 The quantity theory of money
 The labor theory of value
65
Classical school cont‟d
 Whom did the school benefit
 Classical ideas helped to promote the political , social and economic
climate that encouraged industry, trade and profit.
 How was the school valid, useful or correct in its time?

 It rationalized the practice of enterprising people.
 It justified the overthrow of mercantilism
 Reliance on competition was a timely view point
 Restricting the role of wasteful and corrupt government
was valid and well grounded.
 It helped to remove the remnants of feudalism and
enhanced investment in agriculture and industry
66
Classical School cont‟d
 Lasting Contributions Of the Classical School
 The several laws are now thought as the principles
of economics
 The law of diminishing returns
 The law of comparative advantage
 The notion of consumer sovereignty
 The importance of capital accumulation to growth
 The market mechanism for reconciling the interest of
individuals to that of society
67
4.5. Precursors of Classical Economic thought
• Sir William Petty as a precursor of the classical school

(He Was a pioneer statistician)
 Velocity of money
 velocity of money can be as important as the quantity of money
 Division of labor
 Recognized the economics associated with the specialization of labor
and division of tasks e.g. Cloth must be cheaper when one cards,
another spins, and another weaves
 Rent theory
 Arrived at a primitive theory of rent saying that a farmer planting a
corn taking out the seed out of the proceed of his harvest and also
what himself has eaten and given to others in exchange for clothing
and other natural necessities, the remainder of corn is the natural
and true rent of the land for that year.
68
Sir William Petty cont‟d
 What were the shortcomings of this analysis?

 the failure to separate the return to capital from the return to land
 The failure to show rent to be a differential return arising at the
intensive extensive margin of cultivation.
 Petty did realize that land nearer to the market yielded a higher rent
 Importance of capital
 Argued that the use of tools is much productive than simple labor
 Labor theory of value
 The value of a bushel of corn will be equal to that of an ounce of
silver if the labor necessary to produce each is the same.
 Refer books for more discussions

69
Sir Dudley North as a precursor of the classical
school
 Trade is not for one side benefit
 Trade‟s object is not to accumulate specie
 Wealth should not be measured by the stock of precious metals
 What matters is not money but bread
 Laissez faire in intra and inter national trade enables maximum gains
 Not complete harmony in interests( this makes him different
from most classical thinkers)
 Disagreed that war and conquest enrich a country( in
opposition to mercantilist) and undermined service and
emphasized on goods production( Not akin to a classical)
 Saw Industry as less important ( Not akin to a classical)
 Refer books for more discussions 70

Richard cantillon as a precursor of the
classical school
 Used the concept entrepreneurship for the first time.

 Predates Quesnay in recognizing the circular flow of resources
 Developed the theory of value and price ( Intrinsic value and market
price )
 He had a theory of population growth where population growth is
endogenous to the economic prosperity
 Analyzed interest as a reward for risk taking in lending
 Supported the export of surplus( Like the mercantilists)
 Believed that gold and silver mined at home would not bring wealth
rather raise domestic prices rather emphasized production of goods
and selling abroad.
 Stated that export surplus cannot be maintained for long
 Refer books for more discussions 71
David Hume as a precursor of the classical school
 Discussed the price-specie mechanism( like Cantillon)
 Price adjustment would not take place instantaneously, it
follows indirect routes)
 Imbalance of trade tends to correct itself
 Promoted a cooperative game in trade
 Stated that international trade will not perpetuate the
differences between advanced and less advanced nations
 Opposed the the physiocratic idea of tax on workers getting
passed to land lords
 Displayed insight to the Recardian Rent theory.
Refer books for more discussions

72
Adam Smith( 1723-1790)
The founder of the classical school
 The key influences on Adam Smith
 The general Intellectual Climate of the time known
as the enlightenment ( Enlightenment thinkers were
optimists of the human progress)
 His close friendship with Quesnay and Turgot
during his stay in France for more than two years
( For Adam Smith Physiocracy was the “nearest
approximation to the truth”
 Francis Hutchison‟s ( Adam Smith‟s
Instructor)moral philosophy and David hums
philosophy and economic ideas 73
Important works of Adam Smith
 The theory of moral sentiments ( published 17 years
before the “Wealth of Nations”
 The book discussed the moral forces that restrain
selfishness ( Sympathy and benevolence restrain selfishness)
 An Enquiry into the Nature and Cause of the Wealth of
Nations
 The book discussed various economic issues
 The division of labor:- that the division of labor increases the
quantity of output produced for three reasons.
 Develops increased dexterity in performing one single task
 Saves time through reduced movement
 Simplifies tasks for use of machinery and increases productivity.
74
Important works of Adam Smith
 The Harmony of interests
 “It is not from the benevolence of the butcher , the brewer, or the
baker that we expect our dinner but from their regard to their own
interest…. By pursuing his own interest each individual frequently
promotes that of society more effectually than when he really intends
it.‟
 The action of each producer or merchant who is attempting to gain
profit is restrained by the other producers or merchants who are
likewise attempting to make money. Competition drives down prices
and reduces profit. The pursuit of self interest restrained by
competition thus tends to produce Smiths social good- maximum
output and economic growth: Social good arising from the harmony
of interests
75
Important works of Adam Smith cont‟d
 Limited government and laissez faire
 As long as there exists harmony of interests government
intrusion is unneeded and undesirable.
 According to Smith governments are wasteful, corrupt inefficient and
the granters of monopoly privileges to the detriment of the society as
a whole. Laissez faire was promoted by Smith.
 However Smith saw a significant but limited role for government
involvement.
 To protect society
 To administer justice
 To erect and maintain public works that private entrepreneurs
can not undertake profitably
76
 To finance these government activities Smiths recommended

Taxation. Taxes should be
 Proportional to the revenue enjoyed under protection
 Predictable and uniform as to the time of payment, the manner of
payment and the amount of payment
 Collected at minimum cost to the government
 Extension of harmony of interests and laissez faire to

International trade
 “ If a foreign country can supply us with a commodity
cheaper than we can make it, better buy it of them with
some part of the produce of our own industry, employed in
a way which we have some advantage.”
 The law of absolute advantage in international trade 77
 The market laws of competitive economy
 Value (there are two kinds of value)
 Value in use ( the utility of some commodity)
 Value in exchange( the power of purchasing other goods)
 Smith didn‟t solve the paradox of value ( why objects
having high value in use may possess little value in
exchange(like water) and why objects having little value
in use may possess high value in exchange(like diamond)
 He focused on exchange value and the source or
determinant of exchange value for him was the cost of
production
78
 Smith examined exchange value under two circumstances
 “An early and rude state” where labor is the only scarce
resource(capital and land are either non existent of free goods)
 Advanced economy where capital had accumulated and land
commanded a positive price.
 Labor theory of value in primitive society:
 In a society where labor is the only resource the relative value of a
good ( exchange value) would be determined by the amount of labor
necessary to produce it. This is the labor cost theory of value (
remember William Petty)
 The value of any commodity to the person who possesses it , if he
wishes to exchange it for other commodities,is equal to the quantity
of labor which it enables him to purchase or command.This is is
referred as labor commanded theory of value
79
 Labor theory of value in advanced economy:

 The growth of capital invalidates the simple labor cost theory of
value
 The real value of commodities can no more be measured by the
labor contained in them
 In societies where capital investment and land resources become
important goods will normally be exchanged for other goods , for
money or for labor at a figure high enough to cover wages rents and
profits
 However the real value can still be measured by the quantity of labor
which they can purchase or command
 The quantity of labor that a commodity can buy exceeds the quantity
of labor embodied in the in its production by the total profits and
rents.
80
 For A. Smith Demand does not influence the value of

commodities
 The cost of production i.e., wages , rent and profits are the
only determinants of value in the long run
 The Implicit assumption of Smith is that production expands and
shrinks at constant cost per unit output
 Competition drives down prices to cost that include normal profits
 Any increase in demand will not increase value because the
cost of producing each unit of the good remains unchanged
 Note that if the assumption was that unit cost of production changes
as production increases and shrinks, then Smiths principle becomes
untenable.In that case changes in demand will affect changes in
production and hence changes in prices. 81
 Market price:- Smith like Cantillon makes a distinction between:
 Intrinsic or natural price-( realized in the long run )
 The long run price below which entrepreneurs will not sell their
goods. Such prices just( exactly) cover average rates of wages,
rents and profits.If they sale below these prices in a desperate
situation they would not continue in their business
 Market price(realized in the short run) –
 The actual price any commodity is sold. It tends to fluctuate around
the natural price depending on the short run supply and
demand.When it happens to be above the natural price more goods
come in to the market depressing prices and when lower some
productive factors will be withdrawn, the quantity supplied falling and
market price rising to the natural rate.
 Short run demand and supply are not fundamental determinants of
prices( exchange value) but are simple causes of fluctuations of the
market price around the natural or intrinsic price. 82
 Smith distinguishes between Real and Nominal price.
 Increases in the stock of money increases the money price of
commodities
 Real price of a commodity is its command over labor, not its command
over money.
 Wages : Smith addresses
 The aggregate level of wages
 The growth of wages overtime

 The structure of wages
 The aggregate level of wages

 Average annual wage =(Wage fund)/(number of laborers)
 The wage fund is a part of stock of circulating capital out of which present
wages are paid. The stock consists of the the savings of the capitalists from
previous production and sales. The wage fund is fixed in the short run but
can expand from year to year.
83
 The minimum wage rate must be that which enable a worker with a
family to survive and perpetuate labor supply
 The growth of wages overtime
 When demand for labor rises, wages will rise above the minimum.
The rate of increase of national wealth determines the demand for

labor and the wages by influencing the size of the wage fund.
 Smith also laid the basis for the modern concept of economies
of high wages or efficiency wage theory where high wages

increase the health and strength of workers and induce more
labor supply
 If the wealth is stationary population and labor supply will depress
wages. His emphasis is on Capital accumulation and economic growth in
opposition to the low wages doctrine o0f Mercantilists
 Bargaining play a role in determining wages
84
 The structure of wages
 With the underlying assumption of a society with perfect liberty to
choose and change occupations, advantages and disadvantages of

every type of employment would be equal or tend toward equality(
the theory of equalizing differences or compensating wage
differentials)
 According to the theory of equalizing differences or compensating
wage differential theory actual wage rates for different jobs, the
actual wage structure, would vary according to the five factors:
 Agreeableness of occupation
 Cost of acquiring the skill(Knowledge):embryonic human capital

theory
 Regularity of employment
 Level of trust and responsibility attached
 Probability or improbability of success

85
 Profit :
 is a compensation for the risk of losses and a return for
entrepreneurial effort ; hence, Smith argues, the lowest profit must
be high enough to compensate risk of loss plus some surplus( gross
profit). Net profit is the surplus alone.
 In countries that are advancing rapidly in wealth, competition among
businesses lowers the rate of profit.
 The low rate of profit in such countries offset the effect of high
wages and these countries sell goods as cheaply as those having
lower wage rates.
 Interest :was not treated as a separate distributive share. It was
handled simply as a deduction from profit. The lowest rate of interest
a little higher than the losses that sometimes occur through lending
and generally lower than the rate of profit. As profits rise borrowers
seek more money and interest rate rises. 86
 Rent:Smith presents several theories of rent
 Rent as a component of the cost of production and
constituent of price and determinant of price.
 Rent as a price paid for the use of land the amount of which
is determined by the price of the agricultural produce from
that land.Here rent is not the component of price of
agricultural produce.It is the highest price the tenant can
afford to pay after deducting wages , the wear and tear of
capital, average profit and other expenses of
production.Rent therefore is a surplus or a residual.High
prices high rents.
 Rent as a monopoly return
 Rent as an opportunity cost of using land for one purpose
rather than another. 87
 Smith‟s view on wages, profits and rents constitute an
attempt to formulate a theory of factor share (functional)
distribution of income.
 Money:
 is vital as a means of payment but does not add to the
output or to the wealth of a society
 Paper money would do equally well as gold and silver.
 Public debt and taxes required to pay the interest were
detrimental to the economy as they induce the merchants
and manufacturers to invest abroad and growing debt would
in the long run probably ruin great nations of Europe.
88
 Economic development
 The division of labor spurs capital accumulation
and increase labor productivity; capital
accumulation and high wages also increase labor
productivity
 High wages arise from high wage fund which in
turn increases with capital accumulation
 Increased productivity increases national output
and increased wealth of a nation.
89
Thomas Malthus
 Influences on Malthus‟s thinking
 The negative impacts of the Industrial Revolution and
growing urbanization were beginning to appear
 Controversies on growing poverty and what to do about it
 The legislation in 1795 of the latest of the series of “poor
laws” that stipulated the minimum income for the poor
families, and the following heated debate.
 The corn laws that placed tariff on imported grain and
the controversy
 The growing population and the pressure on food supply
90
Thomas Malthus
 The rising necessity to import food to England while the
Napoleonic wars kept the imports of food low and the
extreme prices of grains and land rent, which was
favorable to English Landlords
 The growing concern, after the defeat of Napoleon, of
English land lords on the surge of imported grain that
would depress grain prices
 the urge by the landlords to lift up the floor prices of
imported grains, which stood against the business
interest that spoke against high tariffs
 The arguments that followed to repeal Corn Laws
91
Thomas Malthus
 The Intellectual Setting that influenced Malthus
 William Godwin
 A minister who turned anarchist and atheist.
 He opposed all coercion by the state and all collective action by
citizenry,
 relied on the voluntary goodwill and sense of justice of the
individual guided by the ultimate rule of reason
 Believed that the human race is perfectible through continuous
advance to rationality and increased well being
 A person‟s character depends on the social environment and
perfect society will produce perfect people.
 The major obstacles to progress are private property, economic
inequality and the coercive state
 Population growth is not a problem as humanity will refuse to
propagate when population reaches its limits. 92
Thomas Malthus
 The Marquis de Condorcet
 An eminent French mathematician of an aristocratic family, who was
skeptic in religion, a democrat in politics,a physiocrat in economics, and
a pacifist
 He welcomed and supported the French revolution
 He favored universal suffrage for men and women, opposed the
property qualification for voting and election to office
 He was persecuted by the revolution and went hiding for nine years .
 He wrote his most important work while hiding He wrote about social
progress based on three fundamental principles
 Equality among nations( which abolishes wars )
 Equality of individuals within nations( which overcomes social evils
and leads to perfections)

 The perfectibility of humanity
 Population would increase as a result of these beneficent reforms but

the food supply would increase even more rapidly. If not birth control
93
may have to be used.
Thomas Malthus
 Malthus rebelled against these ideas of Goodman and Condorcet
 He argued that misery is rooted in the prolific fertility of human race,
not in evil human institutions.
 Goodwin and Condorcet were promoting ideas such as the abolition
of War and hunger, which are remedies of overpopulation.
 Malthus’s Population Theory
 was an explanation to account for much of that poverty and misery
observable in the lowest classes of every nation
 His law of population states
 Population When un checked increases geometrically( 1, 2, 4, 8, 16,…)
 Subsistence increases at best arithmetically(1,2,3,4,5,6,7,8,9,…………..)
 Types of checks to population growth
 Preventive checks( reduce the birth rate)
 He approved Moral restraint such as postponing marriage, never
marry, strict moral conduct before marriage

 He disapproved what he called vice such as prostitution and
mechanical birth control

94
Thomas Malthus
 Positive checks( increase the death rate )
 These include famine, misery, plague and war, which
Malthus elevated to natural laws.

 He promoted the idea of facilitating these unfortunate evils
to increase mortality of the poor and control population

 He openly discouraged benevolent people who think they
are doing a service to mankind as mistaken.

 There must be no government relief for the poor( abolish
the poor laws)

 Accordingly the poor laws were amended in 1834. The law
aimed at making public assistance so unbearable that most

people would rather starve quietly than submit to its
indignities
 Malthus ideas rendered Political economy the “dismal
science”
95
Thomas Malthus
 Malthus‟s theory of market gluts
 Malthus developed the theory of the potential insufficiency of effective
demand
 Workers‟ wages < value of the production by the amount of profit
 Capitalists buy some of the extra output in the form of capital goods there by
increasing production but not in the habit of consuming all their profit
 Investment is undertaken in the final analysis only to provide for
consumption, but if the final product cannot be sold no further investment
will be forthcoming
 Spending by land lords and their retinue is essential to avoid the
glut(overproduction ) of the market.(the need for Un productive
consumption)
 Rent is surplus over the cost of production and its expenditure would add to
effective demand without adding to the cost of production.
 The policy implications was the Retention of the corn laws, which were
important to enrich the landlords and foster unproductive consumption
96
Thomas Malthus
 Malthus‟s theory of diminishing returns in agriculture
 Improvements made to a fixed amount of land would provide
increasingly smaller rises in yields
 Appreciation of demand and supply, rather than cost of production
alone, as determinants of price
 Assessment of Malthus
 Over rated the significance of rent
 His distinction between productive and unproductive consumption is inaccurate
 Over rated the significance of population growth relative to that of persistence
 He underestimated the possibility of enlarging agricultural produce
 Wages have been rising rather than being driven by biological subsistence
 He was moralizing than analyzing the means to limit population growth
 How ever his theory of population is still relevant to developing world
97
David Ricardo
 Was a contemporary of Malthus who further developed the
ideas of the classical school.
 Was the leading figure in demonstration of the possibilities
of using the abstract method of reasoning to formulate
economic theories.
 He was an outstanding example of a deductive thinker.He
called his broad generalizations economic laws the operation
of which in economics are as valid as the laws of physics in
the natural sciences.
 Although he was well acquainted with the facts of business
and economic life, he did not use the inductive method of
reasoning.
98
David Ricardo
 Ricardos ideas on the currency issue
 Amidst the prolonged war between France and England, when a panic
induced run on gold depleted the reserves in the Bank of England, the
Bank stopped paying gold on demand and people holding paper money
could not redeem it for gold.
 The price of gold gradually exceeded its mint parity price, a general price
inflation followed and “the currency question” was an issue of worry and
discussion.
 In his conclusion on “the currency question” he reaffirmed the quantity
theory of money. The Bank was over issuing paper currency because it
no longer was checked by the requirement to pay gold on demand By
increasing the money supply the Bank of England drove up prices of
commodities, thereby reducing the value of currency.
 The problem, according to Ricardo, was not the high price of gold,
rather the low value of the pound sterling.
 He suggested a return to the gold standard and after years of argument
his suggestion was passed by the parliament as law.
99
David Ricardo
 Ricardo‟s theory on diminishing returns and rent
 The law of diminishing returns and theory of rent developed
in response to the debate on the corn laws.
 Recardo was the first to use the concept of diminishing
returns to develop the theory of rent
 His definition of rent in perspective
 Rent is that portion of the produce of the earth, which is paid to
the land lord for use of the original and indestructible powers of
the soil
 Rent is the return on long run capital investment that are
amalgamated with the land and increase its productivity.
 Rent arises at both the extensive and intensive margin of
cultivation
100
David Ricardo c ont‟d
 THE THEORY OF EXCHANGE AND RELATIVE PRICES
 Recardo was concerned on relative( ratio of exchange between
commodities) rather than absolute value.
 Utility( subjective want satisfying power) or use value is not the measure
of exchange value, although it essential to it.
 Commodities derive their exchange value from two sources.
 Scarcity
 The value of non reproducible commodities( such as rare works of art, classic
books, coins etc where the supply is fixed) is determined by scarcity alone. Their
Value is independent of the quantity of labor originally necessary to produce
them.
 The quantity of labor required to obtain them
 Most commodities are reproducible, and the value of reproducible commodities is
determined by the labor time necessary to produce it.
 Unlike Smith who stated „labor theory of value‟ for primitive society and needed
„labor commanded‟ theory for advanced society, Recardo applied his labor theory
of value to advanced economy as well.
101
David Ricardo
 The labor time includes not only the work done in making the
commodity itself but the work embodied in the raw materials and
capital goods used up in the process of production.
 This approach, according to Ricardo, explains the causes of changes
of exchange value overtime.

 Ricardo attempted to account for differences in:
 capital labor ratio,
 the combination of skilled and unskilled labor( labor quality
differences)
 Wages, profit rates and rent among producers
 Two capitalists may employ the same quantity of labor in the production
of their goods and yet the goods they produce differ in value because of
the different quantities of fixed capital used by each. A commodity will
sell at more than its labor time value if more than average capital is
invested in its production.
 Ricardo recognized that not all labor is of equal quality. We can simply
think of the an hour of labor of a skilled labor as being double or triple
of the labor time of less skilled labor
 102
David Ricardo
 Exchange value does not depend on wages, profits , what matters
for exchange value is labor time required to produce the good.
 Rents does not figure in to the exchange value of a commodity.
Prices determine rent.
 Wages and profits vary inversely
 Labor does not have to receive the whole product simply because
labor is the source and measure of value.
 Ricardo makes a distinction between market prices and value(
natural price).
 Market prices deviate from the natural price due to accidental or
temporary fluctuations of demand and supply.
 Higher market prices lead to higher profits and attract capital , if
market prices fall below the natural price capital flows out of the
industry. These actions tend to equalize the rate of profit and tend to
keep market prices proportional to values.
 Short run prices depend on demand and supply while long run values
depend on real cost of production.
103
David Ricardo
 Ricardo on Distribution of income

 For Ricardo political Economy is a subject of enquiry in to
the laws which determine the division of the produce of
industry among the classes who concur in its formation,
rather than the enquiry in to the cause of wealth.
 His concern was for understanding the forces that determine
the shares of the national income accruing as wages , profits
and rents.
 Wages
 Labor, like all other goods that are bought and sold, has
natural price and market price.
 The natural price of labor is that that enables workers to subsist
and perpetuate themselves. It depends on the price of the
necessities of life
 Market price depend on supply and demand.
104
David Ricardo
 In the long run both the natural and market prices of labor rise
because of increased difficulty in producing food.
 However in the long run the worker gets a minimum wage of
subsistence( the Iron law of wages)
 Profits
 the rate of profit in different industries with in a country
tend to equalize.
 Higher profits come at the expense of wages and higher
wages come out of profits not passed on prices.
 The reason lies
 In the equation of exchange and
 in the international balance of payments.
105
David Ricardo
 The long run trend for the profit rate and the share of profit from
the national income would fall because of the increasing difficulty
of growing food for expanding population
 As population increases the increased demand for food raises it
prices and poorer land goes in to cultivation and better land will be
more intensively cultivated.This will raise rents, and nominal wages
to maintain subsistence wage.
 Falling rates of profit would curb accumulation and investment of
capital and would ultimately produce a stationary state.
 The stationary state would be reached when new investment
ceases, population no more expands,as the limit of food production
has been reached, and every available surplus goes as rent.
 Ricardo saw conflict of interest between workers and capitalists and
even deeper conflict between landlords and the rest of society.
106
David Ricardo
 Policy implications of Ricardo‟s theory of distribution
 Wages should be deregulated( opposed the poor laws)
 Tax rent would affect only rent ( agreed with Physiocrats)
 Rebuff and removal of the corn laws would benefit society( opposed
to Malthus)
 Ricardo‟s theory of comparative costs
 He made a strong argument for free trade based on the efficiency gains it
confers.
 Even if one country is more efficient than another in producing all
commodities trade between the two could be of mutual benefit ( Theory of
comparative advantage)
 Each Nation should produce the product for which it has a relative
advantage; that is, the product for which it has the lowest domestic
opportunity cost.
 In formulating this theory, Ricardo assumed immobility of factors(that
capital and labor did not flow between countries)
107
David Ricardo
 He implicitly assumed that cost will remain constant as

output increased.Otherwise specialization would not
proceed to its fullest extent
 Ricardo on unemployment
 He maintained that full production and employment
normally would prevail.
 He raised the possibility of technological unemployment
in the short run
108
David Ricardo
 Evaluation of Ricardo
 Lasting Contributions to economic analysis
 The use of abstract thinking
 The theory of comparative advantage
 Employment of marginal analysis
 The presentation on the law of diminishing returns in agriculture
 Extending economic analysis to include distribution of income
 Weaknesses
 Overemphasis on the law of diminishing returns in agriculture and
disregarded the role of technology and fast accumulation of capital

ion pushing total product up[wards
 Overemphasis of the idea that the land lords as a whole have no
interest in increased productivity of the land.

 The wrong assumption that land has only one use and has no
opportunity cost, therefore is not part of cost of production.

109
Other important classical thinkers
 Jeremy Bentham
 Bentham boasted that he was the spiritual father of James mill,
James was the spiritual father of Ricardo and there he was the
spiritual grandfather of Ricardo
 The central theme of Bentham‟s thought is Utilitarianism( the principle
of the greatest happiness to the greatest number of people)( Note that
hedonism centers on the individual)
 Money is the instrument that measures the quantity of pleasure or pain
 ( cardinal utility)
 Bentham argued that wealth is a measure of happiness but it has

diminishing marginal utility as it increases.This idea supported the
distribution of income.However the tendency towards equality by
redistribution creates insecurity and loss of incentive. When ever
equality and security are in opposition equality should give way.
 Individuals themselves , not government, are generally the best judge
of their interest and well being.
110
Bentham
 Criticism
 Economic
 Pleasure and pain are subjective and is extremely
difficult to make interpersonal comparison of utility and
using money paid in the market as a measure is not
satisfactory as what people are willing to pay are greater
than what they actually pay.
 Philosophical and ethical criticisms
 Good life is more than the narrow definition of happiness
 It is better to be a human being dissatisfied than a pig satisfied.
 Happiness is not the object of life.Life has no object. Life is an
end in itself.
111
 Jean Babtist Say
 On value , costs of Monopoly, and entrepreneurship
 Opposed the labor theory of value and replaced it with supply and
demand, which in turn are regulated by cost of production and utility
(though more advanced thinking than Ricardo he didn‟t how ever show the price and
quantity schedules as A. Marshall)
 Monopoly Costs are efficiency losses,( deadweight losses) plus use of
scarce resources to protect monopoly interests
 He emphasized Entrepreneurship as a fourth factor of production on
top of the traditional factors land labor and capital
 Law of markets
 general Overproduction is impossible . Supply creates its own
demand
112
 Nassau William Senior
 He wished to separate the science of political economy from all :
 value judgments,
 policy pronouncements and

 efforts to promote welfare
 ( In today‟s thinking it is Known as the separation of positive and normative
economics)
 Senior put forward four “empirically verifiable” principles of economics from
which integrated theory could be deduced
 The principle of income or utility maximization
 Principles of population
 Principle of capital accumulation
 Principle of diminishing returns
 The exchange value of goods depends on supply and demand underlying the
concept demand is the concept of diminishing utility of goods(a concept that was
later developed by Marginalists ).Supply depends on the subjective cost of
production,i.e., the sum of sacrifices required to produce goods. That were the
labor of workers and the abstinence of the capitalists ( abstinence is anew
term in economics lexicon contributed by Senior)
113
 Senior disagreed with the distinction of productive and
unproductive labor of Smith who thought producers of
service were unproductive workers.
 To senior the proper distinction is between productive
and unproductive consumption. In the class of
Unproductive consumption were the use of jewelry,
tobacco, beer etc which diminish the power to produce.
 Falling out from his own prescription on what an
economist should do ( should not give any advice apart
from telling the truth alone) he had policy positions on
the :
 poor laws
 trade unions
 Factory acts 114
 John Stuart Mill(The last great Economist of the Classical school)
 Production( the productive factors, labor , capital and land)
 He defined wealth as all useful things that possess exchange value.Only
material are included
 Productive labor is the exertion that produces( directly and indirectly) utilities
embodied in the material objects.
 Unproductive labor is that which does not terminate in the production of
material wealth.
 Capital is the accumulated stock of the produce of labor.
 Increase in capita depends on surplus and the disposition to save.
 Every increase of capital is capable of giving additional employment to labor.
 If the capitalist spend less on luxury consumption and more on investment,
the wage fund and the demand for labor would rise.
 If population rises the increased demand for necessities by wage earners
offsets the decreased demand for luxuries by capitalists
 If population rises in less proportion to capital accumulation wages would
rise and luxury consumption of the workers would supplement that of
employers
115
 Thus the limit of wealth is never the deficiency of consumers but of
producers and productive powers.
 What are the limits to production?
 Labor is not one of them because population increases geometrically,
though population is limited by fear of want rather than by want itself.
 Since the increase of capital depends on the surplus produced and the
disposition to save, the greater the profit that can be made from
capital the stronger the motive for accumulation. Hence the limit
does not from capital.
 Land and its limited productiveness is the real barrier to increases in
production. There is increasing returns to scale in manufacturing while
there is decreasing returns to scale in agriculture( applied the short
run law of diminishing returns only on agriculture) This distinction
arise from the assumption that capital can be increased indefinitely
while land cannot.
 The distinction between the short run concept of diminishing returns
and the long run concept of returns to scale was important insight.
116
Other important classical thinkers,
John Stuart Mill
 On Distribution
 The laws and conditions of production of wealth partake of the
character of natural laws, but that does not hold for distribution since
they are a matter of solely human intuitions
 On profit: profit is composed of three parts:- interest( the reward for
abstinence), insurance( rewards to risk) and wages of superintendence
 Allowing for differences in risk and other reasons behind the
components of profit, the profit in all spheres of the employment of
capital tend to be equal. In the long run profit will tend to diminish.
 On Wage Fund
 Wages depend mainly on labor supply and demand
 Demand for labor depends on the wage fund( capital kept aside for the
payment of wages), presupposes unitary elasticity of demand for labor
 Supply of labor depends on the number of people seeking work.
 Minimum wage set by government above the equilibrium wage doesn‟
have the effect of increasing the total wage payment
117
John Stuart Mill
 Mill recognized, like Smith did, Expenditures on education partly
represent present investment justified by later wage returns( human
capital theory)
 On Exchange
 Price expresses the value of a thing in relation to money.
 The value of a commodity is measured by its general power to
purchase other commodities
 The value of a commodity cannot rise higher than its estimated
use value to the buyer
 Effectual demand (desire plus purchasing ability) is one
determinant of value
 But differing quantities are demanded at different values
 Since demand depended on value and value depended on
demand it led Mill to introduce the demand schedule and

this was a great leap in the theory of value.
118
John Stuart Mill
 Mill understood supply schedules and elasticity of supply as well.
 He classified goods in to three types
 Goods absolutely limited in quantity (goods of inelastic supply
where demand is of greater importance to determine value)
 Goods the supply of which is perfectly elastic( the majority of
goods fit in this category; value is determined by cost of production, production
can expanded without limit at constant cost)
 Goods where a limited quantity can be produced at a given cost( goods that fall
in between the above two categories, those with a relative elastic supply; if more
is wanted it has to be produced at higher costs; the value of such goods depends
on the most costly portion of the supply required)
 In his contribution on international trade , Mill introduced the concept of
elasticity of demand to explain how the gains from trade would be
divided among countries; Ricardo‟s trade theory was incomplete in this
respect
119
The Socialist thought
 Historical background
 The industrial revolution and advent of large factories brought to an end
to the agricultural village handcraft economy
 Around the factories misery was a way of life
 Industrial accidents brought little or no compensation
 Political rights did not exist and unions were illegal
 Poverty of the great masses was dominant
 It was questionable whether the mechanical invention reduced the day‟s
toil of human beings.
 Types of Socialism
 Utopian Socialism
 State socialism
 Christian socialism
120
The Socialist thought
 Anarchism
 Marxian Socialism( scientific socialism)
 Communism
 Revisionism
 Syndicalism
 Guild socialism
 Commonalities of Socialism
 Repudiation of class harmony
 Opposition to laissez faire( anarchists were exceptional)
 Rejection of Say‟s Law( capitalism is doomed to crisis or stagnation)
 Belief in the perfectibility of people and their ability to be free of
selfish interest
 Advocacy of collective action
121
Whom did socialism benefit?
 The moderate groups ( utopian,
Christian and Gild socialists) claimed to
represent every body with emphasis on
workers.
 The extreme groups (Anarchists,
Syndicalists, Marxists ) proclaimed class
struggle against the rich, to promote
the interest of the working class.
122
The validity of socialism in its time
 The socialists concentrated on the problems
that the status quo failed to address: poverty
and recurring business crises .
 The socialists promoted factory laws, unions,

sanitary reforms, cooperative associations,
workers compensation laws, pensions etc
which were opposed by the classical thinkers.
 Addressing these issues were valid concerns
123
Lasting contributions of socialism
 Many of the tenets of socialism have not stood the test of time. The reorganization
of society along socialist lines has not brought about the hoped for:
 freedom,
 increased collective activity for the common good
 Better standards of morality and justice
 Greater security for the individual etc
 More over the predictions that the working class will be more impoverished
under capitalism has not occurred
 However socialist have left behind lasting economic ideas of:
 the socialist economic thought of state planning and the ownership of the means
of production
 policy recommendations now institutionalized in capitalist countries, such as
social security, workers compensation, unemployment compensation, minimum
wage, overtime pay rules, etc
 the analysis of the growth of monopoly power, problems of income distribution,
and the reality of the business cycle
124
Utopian Socialists : Henri Comte de Saint Simon
 He developed his socialist ideas before the working class movement took
shape in France and hence didn‟t appeal to the workers to rise against
their employers
 Made a religion of work
 Suggested an industrial parliament consisting of three chambers,
invention( composed of artistes and engineers), reviewing( composed of
scientists), execution 9 composed of leaders of industry)
 This was one of the earliest proposals for central planning
 The prosperity of France can only exist through the effects of the
progress of the sciences, fine arts, and professions. The Princes, the great
household officials , the Bishops, marshals, the idle landowners contribute
nothing directly to the progress of the sciences, fine arts and the
professions, rather they hinder their progress by depriving them of what
they should have been entitled.
 He has enthusiasm for large scale industry
125
Utopian Socialists :Charles Fourrier
 Disliked large scale production , mechanization, and centralization

 Believed that competition leads to wasting of resources
 Commerce to him was pernicious and corrupt
 To remove social problems he believed that organizing cooperatives called phalanxes
was necessary and made an elaborate plan for the cooperative communities.
 Agriculture and handicraft production would predominate and the output of wealth would
increase tenfold over that of the chaotic private industry.
 Eg: a large granary would be more economical to build and easier to guard against fire than 300
small ones
 People living together in honor and comfort would eliminate theft and eliminate the expense in
guarding against it
 the economies of a common kitchen and apartment rather than separate dwellings were carefully
worked out.
 The phalanxes would provide a minimum subsistence regardless of contributions
 Within the Phalanxes the problem of who would be assigned to perform the dirty work
was solved by Fourrier identifying children as the most disposed and appropriate as they
love dirt.
 The surplus produced by the cooperatives would be divided 5/12 to labor, 4/12 to capital
and 3/12 to talent and skill
 The cooperative movement is in part the living monument of Fourrier.
126
Utopian Socialists :Simonde De Sismondi
 He criticized Say‟s Law
 He was one of the early contributors to the business cycle theory
 Pointed out the possibility of over production and crisis.
 He thought that the subsistence level of wages and capital funds
available for investment through bank credit lead to booms
 and the increased output and the limited demand result in periodic
crisis.
 due to narrow home markets industry will be compelled to open up
foreign markets , which will necessarily result in nationalistic wars
 Economic imperialism is inherent in capitalism
 He suggested a relatively modern prescription for glut cure
i.e. public works
 He was the first to use the term proletary to mean the wage laborer
127
Robert Owen
 His central thesis was that the environment molds human
nature and people are not truly responsible for their action.
 Providing better conditions for work would produce better
people.
 He appealed to the government to enact the factory
legislations and succeeded partially
 Denounced all established religions because they taught
people are responsible for their deeds and evils.
 One should try to serve the community and thereby
achieve happiness. This stood in opposition to the classical
idea of pursuit of self interest would serve society.
128
Own cont‟d
 Own introduced his reforms in his own factory. His
employees worked hard and he made good profits.
However his partners objected to his extravagance
 Having failed to convince capitalists and government to
organize the poor in villages of cooperation, he organized
his own in Indiana on 30000 acres , to sweep away
capitalism and the competitive system.
 Whereas Fourrier had allowed profit on capital invested in
Utopian colonies , Owen favored only a fixed interest rate
until the owners voluntarily give it up.
 In three years time the colony failed.
129
Marxian Socialism
 The differences from Utopian Socialists
 Utopians preached dramatic reforms and their criticism of
capitalism and its alleged evils was on moral grounds

 Marx believed that capitalism had inherent internal
contradictions that would ensure its eventual demise

 These internal contradictions necessitate social revolution (
social revolutions are inevitable)

 Socialism replaces capitalism as a result of the operation of
laws of social development that could be uncovered by

scientific analysis rather than reliance ( scientific socialism )
 The fall of capitalism and the triumph of socialism does not
come through moral criticisms and wishful thinking but

through class struggle and revolutions
130
Marxian socialism cont‟d
 Ricardo‟s Labor theory of value
 Socialists sharp criticism of the classical economics
 Darwin‟s evolution theory as a historico- natural basis
 Hegel‟s dialectics - the process of conflict and unity of
opposite ideas ( thesis + anti thesis = synthesis ),
 Feuerbach‟s materialism–the primacy of material being to
ideas, which served to formulate his historical materialism
 Marx „s Methodology
 Macro to micro
 Dialectical and Historical materialism
131
 The law of motion of capitalist society
 The analysis is founded on
 The labor theory of value and socially necessary labor
time
 Components of value as C+V+S
where C- constant capital

V- Variable capital
S- Surplus value
 The theory of exploitation - the distinction between labor
power and labor time

 Capital accumulation and falling rate of profit
 Profit , and organic composition of capital
132
 Organic Composition of capital ( Q)

Q=C/(C+V)
 Rate of Profit(P)
P=S/(C+V)
 Rate of surplus value ( S‟)
S‟=S/V
 From these relationships it follows that
P=S‟(1-Q) , which means

the rate of profit declines with the growth of organic
composition of capital but increases with the rate of surplus
value
133
 Reasons for increasing organic composition of capital is the drive for
temporary higher profits by reducing costs through promotion of
efficient production
 The greater the efficiency of production the lower the value of
labor power i.e., the number of hours required to produce that

required for subsistence , hence the greater the amount of
profit per day.
 Marx‟s offsetting forces to the falling rate of profit
 Increasing S‟ through raised pace of work on lengthened hours of
work
 temporary cuts of wages below value
 cheapening the constant capital
 setting new labor intensive industries that use the army of
unemployed
 cheapening constant and variable capital through international trade
and colonial opportunities
134
 Capital Accumulation and Crisis
 marx believed that Says law , at best applies only to
simple commodity production
where Commodity – Money - Commodity is the
norm
 Under large scale capitalist production the process of
exchange becomes M-C-M‟ where M‟>M

 The relation M>M‟ is destroyed through the competitive
process where rates of profit fall, loses occur to some and

go out of business while others buy them cheap.
 Starting with cheap capital restores the rate of profit and
another cycle begins to come to deeper crises in

magnitude the next time.( business cycle)
135
 The dynamics of capital accumulation and recurring business
cycles centralize the ownership of capital and concentrate
wealth in few hands.
 The accumulation and centralization of capital on the one
hand and the impoverishment of workers ( in relative and
absolute terms )sets the stage for class conflict.
 Summary of Marx’s Law of motion of capitalism
 Labor theory of value, Theory of exploitation,
 Capital Accumulation
 Falling rate of profit , Business Cycle ,Technological Unemployment
 Centralization and Accumulation of capital,
 Immiserization and the reserve army of unemployed
 Class conflict
 The fall of capitalism

136
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History of Economic Thought

and deviant thinkers from the orthodoxy of this era in shaping

 Whichever way scarcity is addressed there arises a

 Modern economic theory focuses largely on market processes

free and competitive market at its best, democratic politics ,

Stability and growth in the context of the assumed specific

the institutions, in society.( Note that these institutions

A theory of economic theory

individually or socially constructed) and it is not possible to assert the

circumstances ( the relativist view)

 The method involves trained empirical observation integrated with

 The progress in methodology of science

is its nature of falsifiability, or refutability

researchers try to solve puzzles posed within the

which may be adjusted to defend the hard core.

the hard core assumptions be considered.

 Good theory abstracts from reality in a useful way

 For this realism of assumptions is irrelevant.( F- twist)

 Reflected on aspects of their Economic lives and

 Private ownership of property – an incentive to greater economic

 The necessity of division of labor based on the best natural ability

 Recognized the distinction between Value in use and value

 Scholastic writers were educated monks who tried to

 The concept of the Just price of scholastics taken

 Just price equivalent to utility?

 Just price equivalent to total cost of production?

 Just price equivalent to the prevailing market price?

 The harsh scholastic view on USURY gradually

( equity and justice)

 Mercantilism is known for its emphasis on exports and

 Entry barriers for new producers

imports , the drain of species from a country in any one

 Sir William Petty

 The term physiocrat means the rule of nature.

 Taxation on land owner

 Inter relatedness of the economy

 The physiocrats introduced the concept of natural order to

 Peasants ultimately would gain from the ideas of the

 Industry was an activity that was extremely low in productivity

 Regarding rent, he believed that nature, not the worker,

 The industrial revolution was beginning and gaining momentum in England

 How was the school valid, useful or correct in its time?

• Sir William Petty as a precursor of the classical school

 What were the shortcomings of this analysis?

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 Refer books for more discussions 70

 Used the concept entrepreneurship for the first time.

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 To erect and maintain public works that private entrepreneurs

can not undertake profitably

 To finance these government activities Smiths recommended

 Extension of harmony of interests and laissez faire to

 Labor theory of value in advanced economy:

 For A. Smith Demand does not influence the value of

 The growth of wages overtime

 The aggregate level of wages

The rate of increase of national wealth determines the demand for