THE EVOLUTION OF ECONOMIC

THINKING

 BASIC IDEAS OF ADAM SMITH

 EVOLUTION OF MICROECONOMIC & MACROECONOMIC THINKING DURING 19 TH C

 THINKING BEHIND KEYNESIAN ECONOMISTS

 THINKING BEHIND MONETARIST/NEW CLASSICAL ECONOMISTS

 GROWING ROLE OF BEHAVIOURAL ECONOMICS

 CONCEPT OF CIRCULAR ECONOMY

 BASIC IDEAS OF ADAM
SMITH
18 CENTURY
TH

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Under the MERCANTILIST Theory – objective of every country was to earn more & more Wealth (Gold &
Silver) through Trade and prevent the Gold & Silver from Leaving the country so barriers were put on imports
In 1776 – The First REVOLUTION in Economic Thought was brought in by ADAM SMITH – Father of
Economics.
He Published a book– “An Inquiry Into the Nature & Causes of the Wealth of Nations in 1776 . This is
also known “The Wealth of Nations”
ADAM SMITH’S VIEWS

1. Wealth or Prosperity of the Nation is not based on its accumulation of Gold & Silver but on the value of
goods and services produced i.e. Gross National Income (GNI)

2. He believed that repressive governments were not essential to the workings of the economy and believed in
the working of the markets wherein behaviour of individuals in the market will produce desirable results.

3.He believed that every individual behaves in a SELF – INTERESTED Way which means everyone does
what his in his best interest. This behaviour increases COMPETITION

4. COMPETITION controls self interest and also leads to the production of goods & services that are mostly
wanted. This will also prevent the growth of Monopolies.

Notable Contribution to Economics –

INVISIBLE HAND of Markets
All decisions regarding “what to produce” and “how to produce” are guided by the “INVISIBLE HAND” and
there is no need for govt. intervention. This is also called LAISSEZ FAIRE Economy which means free
market without govt. intervention.
4. Role of govt. is limited to national defence, security , justice and provision of infrastructure and all this should be
financed by taxation.

5. When producers seek to maximise profits they also maximise the satisfaction to consumers which is known as utility.
So when the producers produce goods with maximum utility they also create jobs and wealth for the nation as a whole.

6. He identified the benefits of Specialization & Division of Labour and said Economic Growth is dependent on Division
of Labour i.e. dividing work as per the skills of the workers which will help increase the productivity.

7. He Extended this idea of Specialization to International Trade and Gave the theory of Absolute Advantage wherein
each country should specialise in the production of the good in which it is good at and export the same. This way all
countries will be better off.

8. He also believed in the “LABOUR THEORY OF VALUE” which states that the value or price of a good is the sum of
the value of all the labour that was used in producing the good

ADAM SMITH is best known for the idea of self interested behaviour of decision makers without
govt. intervention results in competitive markets that give rise to a more efficient use of resources and
greater output, thus benefitting the society. This is the INVISIBLE HAND Of the MARKETS.
19 Century
th

Classical Economics
David Ricardo
Jeremy Bentham
John Stuart Mill
Thomas Mathus
Jean Baptiste Say
Classical economists especially Jeremy Bentham & John Stuart Mill developed the concept of
UTILITARIANISM which means an action is right if it promotes the most happiness for the largest number of
people.

Main Ideas of CLASSICAL ECONOMISTS

The Classical economists were concerned about the concept of i.e. what gives things their value and what
determines their price.

• Concept of UTILITY or satisfaction derived from consuming something is central to an idea of value which
helps to determine the price.

• Total Utility of consuming something is not what is important rather it is the marginal utility i.e. satisfaction
derived from consuming an additional/extra unit that is what matters.

• These ideas were use and Prof. Marshall gave the Law of Demand & the Demand curve

• Ricardo developed the Theory of Comparative Advantage for International Trade

Till 19th Century there was no distinction between Micro & Macro levels of analysis

Say’s Law in Classical Macroeconomics

Supply Creates its own Demand

This can be linked to the CIRCULAR FLOW MODEL.

Hence, there is no problem of unemployment under normal circumstances and the economy tends towards
full employment in the absence of any government intervention.

But this idea was questioned during GREAT DEPRESSION of 1930s.

NEOCLASSICAL SCHOOL OF ECONOMICS
EMERGED IN 1870
WILLIAM JEVONS
LEON WALRAS
CARL MENGER
 Main Difference between Classical & Neoclassical
Theories

• Determination of the Value or Price of a product

Adam Smith & other classical economists said that the price of a product is determined by the costs of labour and
other inputs in the production process. So their focus is primarily on production/supply side.

Neoclassical economists believed that the value of a good is determined by the utility / satisfaction that the good
brings to an individual. Hence, utility can be measured in monetary terms. So they moved towards the
mathematical analysis

The consumers decide whether to consume or not depending on how much that extra unit brings them. Eg. The
Law of Diminishing Marginal Utility.

So the neoclassical economists placed more emphasis on the Demand Side

Prof Marshall – gave the Demand & SUPPLY GRAPHICAL MODELS

Various assumptions were laid down while making the models

Eg. Consumers behave Rationally to maximise utility . Producers also behave rationally to maximise profits.
Hence both are working in their own self interest.

Neoclassical Model is also know as “Rational Choice Theory”

This is consistent with Adam Smith “Invisible Hand”

Neoclassical Period was a period of MARGINAL REVOLUTION

Before the time of MARGINAL REVOLUTION, economics was formally referred to as

“POLITICAL ECONOMY” and the approach was more philosophical but with the marginal
revolution the discipline became known by its modern term “ECONOMICS”
THE MARXIST CRITIQUE OF CLASSICAL
ECONOMICS

KARL MARX
Karl Marx famous book – Capital: Critique of a Political Economy (DAS KAPITAL – 1867)

• He predicted that the laws of capitalist development will eventually lead to a downfall of capitalism- (free
market system based on private ownership of means of production and with the main objective to maximise
profits)

• He believed in the labour theory of value and said that the value of a good was determined by the amount of
labour used to produce it but the price actually paid for a good was far greater than the value of labour that goes
in producing it which is measured by the wages paid to the workers so this extra received by the producer is
SURPLUS VALUE

• SURPLUS VALUE results in exploitation of workers by the owners of the factors/ employers
 • He observed that Feudalism has been replaced by capitalism which inturn would be replaced by Communism

• As COMPETITION would increase employers would hire more machines and it would increase their cost thereby
reducing SURPLUS VALUE and hence declining their profits.

• With fall in profits less workers will be employed and the workers will be pitted against the capitalists leading to the
overthrowing of capitalists and communism would spread wherein people will take over the charge of the factories.

His ideas didn’t materialise but capitalism did undergo a severe crises during the period of GREAT DEPRESSION
in 1930s and GLOBAL RECESSION of 2008.
COMMUNISM that was there in 20th century was because of force and not because of the collapse of capitalism.
 THE 20TH CENTURY
KEYNESIAN REVOLUTION

JOHN MAYNARD KEYNES

 In 1936 he published a book-
THE GENERAL THEORY OF EMPLOYMENT, INTEREST & MONEY

MAIN IDEAS-
• He emphasised on the role of govt.in managing the level of TOTAL/AGGREGATE DEMAND.
• He said that the massive unemployment created during the period of GREAT DEPRESSION cannot be overcome on its own.
Govt Intervention is very important

His ideas were entirely opposite of the neoclassicals as-

I1.t went against the notion of AUTOMATICALLY STABILIZING MARKETS ( so govt. intervention was required)
He acknowledged that while market forces will eventually lead to full employment of resources in the long run as said by
neoclassicals but according to him this will take a very very long time and the consequences might be too damaging.

He said WAGES are DOWNWARD STICKY. Hence, govt. intervention is very important

2. It was believed that all sectors should operate within their means and not overspend. But Keynes proposed that in order for
governments to stimulate the economy by increasing AD they should run into budget deficits.
Keynesian Economics is also referred as the DEMAND SIDE THEORY or DEMAND MANAGEMENT. He
focussed on the role of fiscal & monetary policies to attain MACROECONOMIC OBJECTIVES.

But his theory didn’t work during 1970s as prices of oil increased and the economies faced STAGFLATION (
unemployment +inflation)
NEW CLASSICAL ECONOMICS
MONETARISM

MILTON FRIEDMAN

ROBERT LUCAS
 In 1970s, due to the first OIL SHOCK countries faced the problem of STAGFLATION which lead to
the emergence of two schools of thought- Monetarists & New Classicals

Monetarists believed that changes in money supply will have major effects on output in the short Run and the
price levels in the Long Run

New Classicals put emphasis on the importance of individual’s “RATIONAL EXPECTATIONS” of

inflation & Govt. actions

Both the theories ( although different) focus on the ROLE OF MARKETS in bringing the economy back to a
situation where there is full employment without any govt. intervention.

It rejects KEYNESIAN ECONOMICS and advocates a return to the classical idea of automatic full
employment through the working of a Laissez Faire economy. Thus its called NEW CLASSICAL THEORY
 21ST CENTURY
BEHAVIOURAL ECONOMICS AND THE DIALOGUE
WITH PSYCHOLOGY

RICHARD THALER ( GOT A NOBEL PRIZE IN 2017)

CAS SUNSTEIN
 NEO CLASSICALS believed that human beings behave RATIONALLY

But as per BEHAVIOURAL ECONOMICS – Consumer Behaviour is NOT RATIONAL.

It studies the decision making process of ACTUAL HUMAN BEINGS rather than RATIONAL HUMAN
BEINGS.

Richard Thaler & Cas Sunstein in their Book –

Nudge: Improving decisions about health, wealth and happiness
State that –
Consumers can be “nudged” to make choices voluntarily that are better for them and also better for the society.
Eg .Legislation forcing producers to print nutritional values on the lables of processed food is “nudging”
consumers to make healthier choices

NUDGE THEORY is used to help people make better

decisions
CRITICISMS OF NUDGE THEORY
Any form of govt. intervention may be accused of taking away individual rights
Govts. May not always know what is best for people and so cannot be trusted to choose how to nudge
people
CIRCULAR ECONOMY ( REFRAMING ECONOMICS
IN THE 21ST CENTURY)
LINEAR ECONOMY

It follows a Take, make ,Waste Approach

We take natural resources from the environment and use them to produce new products. Once used, these products are
disposed into the environment where they end in landfill sites or are incinerated, creating pollution.

Hence, a LINEAR ECONOMY is responsible for the overexploitation and degradation of natural resources. This presents
many challenges to sustainability
 CIRCULAR ECONOMY

It follows a “regenerative “ and “restorative”

approach.
Products are specifically designed to be long lasting and the materials for
new products come from reusing and recycling old products.

There is much more emphasis on the design, maintenance, repair,

refurbishment
Advantages forand remanufacture of products.
Businesses-
Businesses gain in terms of cost savings and compliance with national
environmental regulations.

Principles of a circular economy are consistent with many SUSTAINABLE DEVELOPMENT

GOALS (SDGs)

In 2019 the EU released a comprehensive report on the implementation of its Circular Economy
Action Plan.
 The Doughnut Economy- Kate Raworth

Doughnut economics: How to think like a 21st Century Economist

(video)

Kate Raworth is the author of the influential book, Doughnut Economics. In

this video interview she concisely explains what the “doughnut” is, and
why we need to pay attention to it. Chapter 3 of her book provides an
insightful summary of the circular economy in relation to building new
economic prosperity.
http://xmltwo.ibo.org/publications/DP/Group3/d_3_econo_tsm_2002_1/en/economics_circul
ar_economy_en.mp4
 Rethinking progress: The Circular economy. Ellen MacArthur Foundation. 2011.
Also available from: https://www.youtube.com/.
http://xmltwo.ibo.org/publications/DP/Group3/d_3_econo_tsm_2002_1/en/rethinking_progress_en.mp4

A short animation by Ellen MacArthur Foundation explaining what the circular economy is. It explores how by changing
our perspective we can redesign how our economy works. It raises the question of how creativity and innovation can be
used to build a restorative economy.

The Performance Economy (video)

http://xmltwo.ibo.org/publications/DP/Group3/d_3_econo_tsm_2002_1/en/performance_economy_en.mp4
Walter Stahel explains the concept of circularity that is present in the natural world and applies it to the world created by
humans through the concept of the performance economy (goods as services).
Circularity is intended to be a more intelligent use of resources that aims to create more from less and replace the current
linear economy.
Tim Jackson–Economics of a circular economy (video)

An excellent video by Ellen MacArthur Foundation exploring what an economy is for, the issues surrounding a
growth-based economy, and the potential advantages of a circular economic model.

http://xmltwo.ibo.org/publications/DP/Group3/d_3_econo_tsm_2002_1/en/economics_circular_economy_en.mp4
Doughnut economics: How to think like a 21st Century Economist (video)

Kate Raworth is the author of the influential book, Doughnut Economics. In this video interview she concisely
explains what the “doughnut” is, and why we need to pay attention to it. Chapter 3 of her book provides an insightful
summary of the circular economy in relation to building new economic prosperity.
Doughnut economics: How to think like a 21st Century Economist. 2017. https://www.youtube.com/. Disruptive Innovation
Festival (DIF)
Raworth, K. 2017. Doughnut Economics: Seven Ways to Think Like a 21st Century Economist. White River Junction, USA.
Chelsea Green Publishing.
Doughnut Economics—an economy fit for the 21st Century (series of videos)
This series of short animations takes a look at the traditional story of economics and challenges the goal of GDP in favour of
a regenerative approach.
Kate Raworth: Exploring doughnut economics. Kate Raworth. 2013–19. https://www.kateraworth.com/animations/.
Johan Rockstroëm introduces the Planetary Boundaries (video)
This TED Talk highlights the work of the Stockholm Resilience Center’s work on identifying the nine planetary boundaries
and where we are overshooting them. This provides students with a clear understanding of some of the consequences of
economic growth.
Time: 18:41 minutes