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The content of the course
1. Introduction
2. Methodology in economics
3. Pre-classical schools
4. Classical school
5. German Historical School
6. Socialist school
7. Marginalist school
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History of Economic Thought /Econ 3141
1. Introduction
Course objectives
The main objective of this course is to provide students
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The subject matter of Economics and its evolution
Economics is a social science that examines
the problems of relative scarcity societies face in material requisites of life;
It deals with the allocation of scarce resources which have alternative
uses.
Scarcity arises because of the desire to consume more goods and services
than are available or
scarcity arises because of unlimited wants and limited resources.
Since scarcity always prevails as human wants are unlimited the option is
mitigation rather than avoidance of scarcity
To mitigate the problem of scarcity, three directions were pursued
restrict wants ( by inducing moral restraint on demand ! Or by forcibly imposing austerity !)
or
increasing the supply of resources ( through discovery of new sources or through
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Introduction cont’d
Which ever way scarcity is addressed with the first two directions, the
third (social mechanism) was necessary as scarcity can not be
removed.
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The central focus of modern economic thought
and markets
Modern economic theory focuses largely on market processes of
allocating resources, which have replaced the others as primary
resource allocating mechanism.
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Questions to be asked in studying HET
What was the historical background of the school?
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These questions imply the possibility of formulation of a
.theory of economic theory
Can we formulate a theory to explain the development of economic theory?
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2 Introduction to the Methodology of economics
The history of economic thought is not only about the
evolution of economic theories. It is about the history of the
methodology of economics as well.
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What economists know is categorized into three general
areas :
how the economy works in addressing scarcity
( positive economics )
The aim of economics is to know how the economy works
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Methodology in economics Cont’d
Positive economics
The methodology of positive economics is formal and abstract.
Normative economics
relies on ethical judgments on what is best for society
forces.
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To answer the question “ how economists know that
they know” , economics has to answer more
fundamental questions:
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Methodology of science cont’d
Subjectivism
Reality is not independent of our individual or social thinking( reality
absolutist view )
Objective reality may exist but truths describing it are relative to
Science
Ancient Science
The ancient model of science was Aristotelian, which uses inductive
process to arrive at the definition of the essence of things and use
deduction to demonstrate why things must be what they are as
defined.
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Modern science (17 century onwards)
The philosophical foundation of science lies in positivism, which
claims that
The only authentic knowledge is that 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
Scientific method involves trained empirical observation integrated
with reason.
the importance of empirical verification is acknowledged and
reason is integrated with empirical observation.
Science used both the inductive method and deductive reasoning.
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Models of modern science
Inductivism
The earliest modern model of positive science is inductivism
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Logical positivism
provided the scientific method with stricter
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Models of Positive scientific explanation
Hypothetico-deductive model
It is the further development in the tradition of
hypothesisists.
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Kuhn’s scientific paradigms
Is based on history of science
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Imre Lakatos’s Scientific Research Programs
Integrates falsificationism of Popper with scientific paradigms of
Kuhn.
Scientists are engaged in the development of competing research
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Others
Methodological anarchy
internal consistency.
Sociological Approach to Method :
acceptability of theories.
Rhetorical approach to method :
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Instrumentalism and Economics (Freidman’s Essay)- Milton Freidman
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)
Operationalism of Paul Samuelson
contradicts Freidman by saying that good theories are based on
reasonable assumptions.
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.
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.
Heterogeneity of substance and methods in
economics -Amartya Sen
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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
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The general themes of Pre
classical economic thinkers
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The Classical school
Classical thinking fully developed:
the role of markets
value and distribution theories
the Importance of all economic resources and
activities
as fundamental assumption of self interested
economic behavior as basic to human nature
Statements on various “economic laws”
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The German Historical school
Emphasized
the role of government and the protection of
infant industries from competition
Evolution of economies and the corresponding
policies
Inductive and the historical method
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The Socialist school
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Marginalist school
Opposed socialism, trade unionism, and
government intervention
defended market allocation
stated that, although the value and
distribution theories of the classical
economists were inaccurate, their policy
views were correct.
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3.1 Pre classical Economic
thought
Hesiod(800 BC)
conditions
Xenophon( 400BC)
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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.
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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
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Aristotle on 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
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Aristotle on value
unjust.
Aristotle failed in formulating a theory of price.
Aristotle on Interest
Condemned interest, as usury, on the ground that money is a
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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
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3.2 Scholasticism and
Medieval Economic ideas
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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
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Development of Value theory under
scholasticism
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.
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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?
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Examples of Scholasticism
St. Thomas Aquinas and later Medieval thought.
In an attempt to reconcile religious doctrine with the
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The historical background cont’d
52
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
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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.
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Major Tenets of the school
Opposed to internal tolls and taxes and other restrictions on the internal
movement of goods,
They recognized that tolls and taxes could
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Major Tenets of the school
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.
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Major Tenets of the school
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
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Major Tenets of the school
Strong Central Government
Mercantilists promoted a strong central government as it
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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)
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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
Prohibition of imports
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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.
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How Valid , Useful and correct
was the school in its time ?
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.
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Which contribution of the school
were lasting contributions?
Direct contribution
Emphasis on international trade and laying the basis for the notion of
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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.
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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
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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 imported
commodities that could be manufactured in England
Favored large population
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3.4 The Physiocratic school
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Major tenets of Physiocracy
Natural Order
Laissez faire
Emphasis on agriculture
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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 used in production.
( Emphasis on agriculture)
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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.
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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.
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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.
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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.
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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 the 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.
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Francios Quesnay cont’d
78
Historical Back ground
of the School cont’d
80
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
81
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.
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4.1. Precursors of Classical
Economic thought
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Sir William Petty cont’d
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
85
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
gains
Not complete harmony in interests( this makes him different from
86
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
87
David Hume as a precursor
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4.2 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 Hume’s
philosophy and economic ideas 89
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
productivity.
90
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
91
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
92
Important works of Adam Smith cont’d
To finance these government activities Smiths recommended
Taxation. Taxes should be
Proportional to the revenue enjoyed under protection
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
93
Important works of Adam Smith cont’d
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
94
Important works of Adam Smith cont’d
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 or free goods)
Advanced economy where capital had accumulated and land
commanded a positive price.
Labor cost 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)
Labor command 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 the95
Important works of Adam Smith cont’d
96
Important works of Adam Smith cont’d
The long run price below which entrepreneurs will not sell their
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
commodities
Real price of a commodity is its command over labor, not its command
over money.
Wages : Smith addresses
The aggregate level of wages
100
Important works of Adam Smith cont’d
The structure of wages
With the underlying assumption of a society with perfect liberty to
wage differential theory actual wage rates for different jobs, the
actual wage structure, would vary according to the five factors:
Agreeableness of occupation
theory
Regularity of employment
101
Important works of Adam Smith cont’d
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. 102
Important works of Adam Smith cont’d
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. 103
Important works of Adam Smith cont’d
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.
104
Important works of Adam Smith cont’d
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.
105
4.3Thomas 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
106
4.2Thomas 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
107
Thomas Malthus
The Intellectual Setting that influenced Malthus
William Godwin
citizenry,
relied on the voluntary goodwill and sense of justice of the
110
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”
111
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
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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 subsistence
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
113
4.4 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.
114
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.
115
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
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David Ricardo cont’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.
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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
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
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David Ricardo
Exchange value does not depend on wages, profits , what matters
for exchange value is labor time required to produce the good.
Rent 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.
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David Ricardo
122
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)
123
David Ricardo
124
David Ricardo
Evaluation of Ricardo
Lasting Contributions to economic analysis
The use of abstract thinking
Weaknesses
Overemphasis on the law of diminishing returns in agriculture and
125
4.5 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)
126
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.
127
Other important classical thinkers
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
128
Other important classical thinkers
Nassau William Senior
He wished to separate the science of political economy from all :
value judgments,
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
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)
129
Other important classical thinkers
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 130
Other important classical thinkers
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 capital 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
131
Other important classical thinkers
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.
132
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 institutions
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’t have the effect of increasing the total wage payment
133
Other important classical thinkers,
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
135
5 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
136
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
137
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.
138
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 .
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,
More over the predictions that the working class will be more impoverished
140
5.1 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 ( composed of
leaders of industry)
This was one of the earliest proposals for central planning
143
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.
144
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.
145
5.2 Marxian Socialism
The differences from Utopian Socialists
Utopians preached dramatic reforms and their criticism of
147
Marxian socialism cont’d
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
148
Marxian socialism cont’d
P=S/(C+V)
Rate of surplus value ( S’)
S’=S/V
From these relationships it follows that
149
Marxian socialism cont’d
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
150
Marxian socialism cont’d
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
151
Marxian socialism cont’d
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
Class conflict
152
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