History of economic thought

Economics is a social science. It studies the production, distribution, and consumption of goods and services. The word 'economics', originally "rules of the house", comes from the Greek οἶκος (oikos: house) and νόμος (nomos: custom or law). Economics stems from the natural propensity of human beings to barter, to exchange or trade goods. Whilst there are no records of dogs ever having bartered bones, humans have been bartering all sorts of goods since pre-history. Economics as an independent science - and as we understand the word today - begins with the work of Adam Smith, The Wealth of Nations. . Before Smith, Economics was just a chapter in political science, the art of managing a state. This article will focus on economics since it became a science independent from politics. For the history of early economics leading up to the development of The Wealth of Nations see the article History of Ancient Economics.

Definition of Economics

Even the definition of economics is subject to controversy. Many economists view economics as the study of how scarce resources are allocated to satisfy alternative competing human wants. This is a "neo-classical" view first formulated by Lionel Robbins in 1935 and repeated in most economics texts; for example, Paul Samuelson, who, in his famous book Economics - An Introductory Analysis , defines Economics as:

the study of how men and society 'choose', with or without the use of money, to employ 'scarce' productive resources to produce various commodities over time and distribute them for consumption, now an in the future, among various people and groups in society.

However, a more traditional view is that "Economics is the subject concerned with the material welfare of individuals and groups in society" (Asimakopulos, 1978). or "The economic problem is the study of the process of providing for the material well-being of society". (Heilbroner), or the famous Alfred Marshall "Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing."

The list of acceptable definitions of economics is endless. Economics can be described as the study of those activities which, with or without money, involve exchange transactions among people. Economics is also the study of wealth.

One can play with definitions, but a favourite remains the one proposed by a Canadian economist, Jacob Viner (1892-1970) as "Economics is what economists do".

Introduction

The "Classical" period of economic thought began in 1776 with the publication of Adam Smith's The Wealth of Nations . Written during the gentle era of Enlightenment, the laissez-faire policies of Adam Smith did not anticipate the economic and social upheavals that the industrial era was about to unleash. Only 13 years later the French court was bankrupt and the French people took to the streets and beheaded their king; it was the French Revolution.

Among the economists who tried to understand the new phenomena three were outstanding: Jean-Baptiste Say , Thomas Robert Malthus and David Ricardo. They all had different visions for political economy after Smith. Of those, Ricardo was the most succesful and influential and laid the basis for the Classical Economy that would become the mainstream economy thought for the whole of the XIX century

Thomas Robert Malthus (1766-1834) is most famous for his "Essay on the Principle of Population" where he formulated the theory that population expanded at a geometric rate (or exponentially) while food production could only increase arithmetically. At a certain point, the population increase would outrun the food supply, and result in general misery. Malthus was one of the major inspirations for Darwin’s theory of Natural Selection, and his echoes can be found in today’s environmental literature that warn of depleting resources.

David Ricardo (1772-1823) was perhaps the most important of the XIXth century political economists. He combined Smith's labour theory of value with Malthus's population dynamics in a system which showed that capitalist economies would eventually result in a steady state of universal misery.

Ricardo's system depended on the idea of the marginal productivity of land, and was the inventor of the "marginal" concept. His idea was that the value of agricultural products (and hence food) was based on the amount of labour required to produce on the least fertile parcel of land. Hence the "Law of diminishing marginal productivity". Landlords owning land that was more fertile, and who could produce more for a given amount of land, obtained "rents". His conclusion was that the future was in buying land. He, of course, did not predict the tremendous increase in technology and productive capacity brought about by the capitalist system.

Ricardo was also responsible for the idea of comparative advantage in international trade . His classic example was between wine and clothing and England and Portugal. Portugal was more efficient than England in producing both cloth and wine, but England had a comparative advantage in cloth production. He showed that it would be advantageous for Portugal to specialize in wine and England to specialize in cloth, and to trade with each other. This resulted in more wine and cloth all around.

Karl Marx is the most famous of Ricardo's followers. In Samuelson's words, he was a "minor Ricardian" - and had little impact on the development of pure economic theory. His economics differed little from Ricardo's, but had different conclusions. He placed little emphasis on the diminishing marginal productivity of land, but more importance on the falling rate of profit. To Marx, capitalist competition would lead to the impoverishment of the "proletariat" or working class and a falling rate of profit. The ultimate resolution would be a communist revolution with the workers seizing power. Soon after the death of Karl Marx , a Marxian school of economics emerged under the leadership of Marx's inner circle of companions and co-writers, notably Friedrich Engels and Karl Kautsky , both of whom were German.

The marginalist revolution

In the 1870's, three economists were responsible for what is called the "marginalist revolution" - William Stanley Jevons , Carl Menger and Léon Walras . They, independently of each other, developed a new theory of value based on utility. The three are responsible for the concept of marginal utility , and the derivation of a downward sloping demand curve . The Marginalist Revolution put an end to the Classical Scholl and the era of the Neoclassical School , which lasts to today, began. This made possible the logical analysis of the "Producers's Decision" or how and why "producer" transforms factors of production into finished goods.

Alfred Marshall (1900-1920) was responsible for the combination of "demand" and "supply" ,where demand was based on "marginal utility". He was responsible for developing numerous concepts still used in economics, including: demand and supply curves or schedules and their equilibrium, "elasticity of demand" , consumer surplus, the distinction between short- and long-period, etc. Modern microeconomics] , the study of individual economic agents and individual markets, is a continuation and elaboration of his work.

Marshall's work was only the beginning. His work was refined and further developed, and continues to be extended to this day. Neo-classical economists have built a truly astounding logical edifice into a "Production Function" that rival Newtonian mechanics in completeness and rigour. The basis of neo-classical economics is maximisation under constraint, and this constantly involves the "marginal concept" . The tools developed by economists are even now beginning to be used by other social sciences such as anthropology, sociology and even psychology.

The Great Depression and Keynesianism

However, the edifice of neo-classical economics suffered a severe blow with the Great Depression of the 1930's. In competitive markets, unemployment is not supposed to occur. It can only be due to monopolistic forces preventing the demand and supply of labour from reaching equilibrium. This was clearly not the case in the 1930's.

Marshall's most famous disciple and pupil, John Maynard Keynes, attacked the neo-classical system with the publication of the General Theory of Employment, Interest and Money in 1936. Keynes showed that the depression was due to insufficient aggregate demand and advocated the need for government intervention to restore full employment. In the process, he created macro-economics.

Microeconomics is a continuation and elaboration of the work of the early neo-classicals. It deals with the behaviour of individuals and firms, and with individual markets. Other 1930's economists, Joan Robinson at Cambridge and Edwin Chamberlin in the U.S. developed the theory of imperfect competition. Joan Robinson was responsible for the idea that profit maximization involve the equation of marginal cost and marginal revenue, while Chamberlin was responsible for the idea of monopolistic competition and product differentiation.

Keynesianism became the orthodoxy in economics until well into the 1970's. In order not to abandon all the neo-classical economics that had been built up, the dominant economic ideology became the Keynesian-neo-classical synthesis. The basic idea was to let the government ensure full employment, and then neo-classical economics could be used to ensure the best allocations of resources. The Keynesian-neo-classical synthesis is generally associated with Paul Samuelson, who wrote the most influential ever textbook in economics. Most economics texts today are clones of Samuelson's text, generally following the same general outline. The 1950's and 60's were the heyday of Keynesian economics, when most economists believed that the judicious application of government intervention could smooth out the business cycle and ensure full employment without inflation.

The monetarist "counterrevolution"

While the Keynesian-neo-classical synthesis took over the profession, an unregenerate rearguard of neo-classical economists centred at the University of Chicago continued to exist. They never accepted the idea of involuntary unemployment or government intervention to ensure full employment, and strongly believed in the virtues of markets and laissez-faire. The most famous economist of the Chicago School is Milton Friedman. He was mainly responsible for what is known as the Monetarist counterrevolution of the 1970's. Not only did they succeed in bringing the Keynesian theory down, but they considerably extended the scope of microeconomics to include even education and family formation.

With the perceived failure of Keynesian economics to explain and do anything about the "stagflation" of the 1970's, the free market prescriptions of monetarism became much more popular, and were eventually espoused by many right wing governments in the 1980's (Reagan, Thatcher, Mulroney), and, perhaps more importantly, by the central banks of most industrialized countries.

Economics today and the Keynesian revival

However, the basic prescription of monetarism failed when it was attempted in the late 1970s and early 1980s. For some this meant moving to even more radical free market positions (Rational Expectations and Real Business Cycle theories), while others attempted to put Keynesian economics on a more sound microeconomic foundation such as the New Keynesian economics .

Economics today is in a state of crisis, with a number of contending schools and a whole lot of economists in between. The schools that can be distinguished include from left to right: Marxists, Neo-Ricardians, Post Autistic, Post Keynesians, New Keynesians, various degrees of Neo-classical-Keynesians, various degrees of Monetarists, Real Business Cycle, Rational Expectationist. They differ fundamentally about the amount and level of government intervention in the economy, ranging from almost total control for Marxists to complete libertarian laissez-faire for the Rational Expectationists.

However, a new dominant school or mainstream seems to be emerging: the "New Keynesians" . They reject the simplistic laissez-faire of the monetarists, but recognize many of their criticisms as valid and see some limitations to the ability of governments to act to cure all economic ills. They are particularly preoccupied with creating a proper microeconomic foundation for Keynesian economics. They focus mainly on rigidities, market imperfections, and the economics of information, which result in the need for some kinds of government intervention, but without the unbridled faith in the ability of government to solve all problems that Keynesians had in the 1950's and 60's. One of the leading new-keynesian economists is Joseph Stiglitz , who won the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001 a.k.a., imprecisely, Nobel in Economics.

Alternative Schools

Heterodox Tradition

The strain of economic thought that begins with the Utopians and Socialists (Jean-Jacques Rousseau, 1712-1788) and follows with The Fabian Socialists, Gustav Schmoller and the German Historical School, The English Historical School, The French Historical School, Thorstein Veblen and the American Institutionalist School, Joseph Schumpeter and Evolutionary Economics, The Soviet Planning Economists, The Neo-Marxians/Radical Political Economy and the New School for Social Research forms what is called the Heterodox Tradition and will be subjetct of another article.

Keynesians

John Maynard Keynes (1883-1946)

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. Keynes, 1936.

John Maynard Keynes reputedly made one of the the most important contributions for the science of Economics. His classic book, The General Theory of Employment, Interest and Money (1936) , Keynes's famous treatise, revolutionized both economics and the political science, bringing what is generally regarded as the most influential social science treatise of the XX Century. This single book permanently changed the way the world looked at the economy and the role of government in society.

After a brief period in the British civil service, Keynes returned to his alma mater, Cambridge, in 1909 where he published Indian Currency and Finance , considered to be the best book in English about the gold standard and his A Treatise on Probability (1921), which dismantled the classical theory of probability, launching what has since become known as the "logical-relationist" theory of probability.

In 1930 Keynes published his first major work on economics, the heavy two-volume A Treatise on Money which set out his Wicksellian Theory theory of the credit cycle. In it, the rudiments of a liquidity preference theory of interest are laid out. Friedrich von Hayek , the laissez-faire advocate, reviewed the Treatise so harshly that Keynes decided to ask Sraffa to review Hayek's own competing work and condemn it, no less harshly. The Keynes-Hayek conflict initiated a battle in the Cambridge-L.S.E. whose effects continue to the present day.

In the General Theory Keynes developed a theory that could explain the determination of aggregate output - and as a consequence, employment. He explained how the determining factor to be aggregate demand. Among the revolutionary concepts initiated by Keynes was the concept of a demand-determined equilibrium wherein unemployment is possible, the ineffectiveness of price flexibility to cure unemployment, a unique theory of money based on "liquidity preference", the introduction of radical uncertainty and expectations, the marginal efficiency of investment schedule breaking Say's Law (and thus reversing the savings-investment causation), the possibility of using government fiscal and monetary policy to help eliminate recessions and control economic booms. Indeed, with this book, he almost single-handedly constructed the fundamental relationships and ideas behind what became known as "macroeconomics".

The General Theory set up the The Keynesian Revolution which split the economics world in two generations: the young lining up behind Keynes; the old ralling to condemn it. John Maynard Keynes responded to his critics -- Jacob Viner , Dennis Robertson and Bertil Ohlin -- in a series of 1937 articles, which expanded upon his theory. A densely-written and difficult book, it was followed up immediately by elucidatory publications by the members of the Keynes's Circus , such as Joan Robinson , and young economists such as Roy Harrod and Abba Lerner .

Of particular importance was the 1937 article by John Hicks which introduced the Hicks-Hansen IS-LM Model of Keynes's theory that launched the "Neoclassical-Keynesian Synthesis" , which became the World's mainstream form of macroeconomics in the post-war era until the early 1970s.

Joan Robinson and the Cambridge Keynesians

"Cambridge Keynesians" refer to the unique group of British economists inspired by John Maynard Keynes's General Theory in a more "fundamentalist" way than the American Neo-Keynesians .

Their origin stems from the Keynes's Circus at Cambridge -- Joan Robinson, Richard Kahn, Piero Sraffa, Austin Robinson and James Meade. Although it followed upon Joan Robinson's original queries about capital aggregation (1954, 1956), Piero Sraffa "capital critique" set the radical "counter-revolutionary" tone of the Cambridge Capital Controversy that ensued with the American Neo-Keynesians .

The Robinson-Kaldor growth theory and the Cambridge Capital Controversy galvanized a new generation of "Cambridge Keynesians" -- such as Luigi Pasinetti, Piero Garegnani, John Eatwell, Geoff Harcourt -- to initiate the "Neo-Ricardian" research program, an attempt at an explicit marriage of Keynesian theory of effective demand and the Ricardian theory of value. In the course of their confrontation with Neo-Keynesian Synthesis, the Cambridge Keynesians found sympathizers in the American Post Keynesian school .

Franco Modigliani, James Tobin and the Neo-Keynesian Synthesis.

The "Neoclassical-Keynesian Synthesis" refers to the "Keynesian Revolution" , as interpreted by group of American economists in the early post-war period, which was centered in the Hicks-Hansen IS-LM Model first introduced by John Hicks (1937) and then expanded upon by Franco Modigliani (1944).

However the IS-LM model was unable to obtain the Keynesian result of an "unemployment equilibrium". The model tended to yield the Neoclassical result of "full employment". To explain the results of this system of equations, the Neo-Keynesians appealed to rigid money wages, interest-inelastic investment demand, income-inelastic money demand or some other imperfection to this system. Thus it became a "synthesis" of Neoclassical and Keynesian theory.

Later on the money demand function was derived from utility-maximization by William J. Baumol (1952) and James Tobin (1956, 1958) and the Neo-Keynesians added the Phillips Curve (Phillips, 1958; Lipsey, 1960) to account for inflation. The international sector was incorporated into an extended IS-LM system known as the Mundell-Fleming model

The "Neoclassical-Keynesian Synthesis" was wildly successful and dominated macroeconomics in the post-war period. For a long time, the Neo-Keynesian system was synonymous with the "Keynesian Revolution".

The Neo-Keynesian system came under attack in the late 1960s and early 1970s by Axel Leijonhufvud (1968) . However, the Neo-Keynesian system only came into serious trouble in the early 1970s, when a sustained bout of inflation and unemployment in the OECD countries, which became known as "stagflation", could not be explained by their models. Milton Friedman , the leader of the Monetarist School , proposed a "natural rate of unemployment hypothesis" that did seem consistent with the OECD experience. This natural rate hypothesis formed the basis of a "New Classical" macroeconomic theory, which has risen since the 1970s to replace Neo-Keynesianism as the new macroeconomic orthodoxy.

Abba Lerner and the American Post Keynesians

Abba P. Lerner was born in Russia, raised on the London East End and worked as a machinist, a capmaker, a Hebrew teacher, a Rabbinical student before enrolling in 1929 at the London School of Economics to which he was attracted by L.S.E.'s Fabian associations.

Lerner moved to the United States in 1937 where he taught at over a half-dozen universities, including the New School for Social Research . Lerner became of of the most important American Post Keynesians , along with Evsey Domar, Sidney Weintraub, Paul Davidson, Alfred S. Eichner, Hyman P. Minsky, Alain Barrère, Josef Steindl, Edward J. Nell and Athanasios Asimakopulos , the William Dow Professor of Political Economy in the Department of Economics at McGill University (Montreal), among others.

In 1934, Lerner wrote paper laying out the full Pareto-optimality conditions in a general equilibrium production economy, introducing the Paretian rule for efficiency, i.e. "that price equal marginal cost", P=MC .

His magnum opus,The Economics of Control: Principles of Welfare Economics (1944) synthesises his work on trade, welfare, socialism and Keynesian theory .

Lerner discovered the factor price equalization theorem (1947), but never published it. It was rediscovered in 1948 by Paul Samuelson and published in 1952.

Lerner was the first to recognize the importance of accounting for inflation in Neo-Keynesian theory and laid out his analysis in a remarkable series of articles and books (1944, 1947, 1949, 1951, 1972). In particular, he introduced the concept of "seller's inflation", a form of cost-push inflation which was to become central to Sideny Weintraub and Post Keynesian economics. In his analysis of inflation, Lerner was quite ahead of his time: he recognized the possibility of "stagflation", the unemployment-inflation trade-off of the "Phillips Curve" , what he called "high full employment" (a predecessor of the Friedman's NARU - natural rate of unemployment , the differential effects of expected and unexpected inflation and the theory of implicit contracts long before any of these concepts were discussed elsewhere.

Robert Clower, Axel Leijonhufvud and Disequilibrium Keynesianism

On an scholarly study On Keynesian economics and the economics of Keynes : a study in monetary theory (1968) Leijonhufvud (1968) differentiated between "Keynesian Economics" (Hicks-Samuelson type of synthesis) and "Economics of Keynes" (the work of J.M. Keynes) and essentially demonstrated that the two had little in common. He joined Clower in calling for a dynamic, "microfounded" formulation of Keynesian theory which explained underemployment equilibrium rather than merely referring to it as an imperfection. In particular, Leijonhufvud relies on differing speeds of quantity and price adjustments to create the coordination failures which yield protracted unemployment.

His later work in the 1970s and 1980s still mirrored this quest. In the 1990s, Clower and Leijonhufvud identified the fast-growing evolutionary theory and computational economics as moving in the right direction and founded a fledgling school, "Post Walrasian" , intent on harnessing macroeconomics to it.

Joseph E. Stiglitz and the New Keynesians

Introduction

Joseph E. Stiglitz is one of the most important leaders of the New Keynesians . In 2001 he shared the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001 a.k.a., imprecisely, Nobel in Economics with George A. Akerlof and A. Michael Spence "for their analyses of markets with asymmetric information". His career began at Yale, where he became a tenured professor at the age of 27. Stiglitz has also been a faculty member at Princeton, Oxford and Stanford universities. At the age of 29, he became a Fellow of the Econometric Society and is a member of the National Academy of Science. Stiglitz is also the recipient of the prestigious John Bates Clark Medal, awarded every two years to the American economist under the age of 40 who has made the most significant contributions to the subject.

Stiglitz has also become influential in the making and evaluation of economic policy in the last decade. He served on President Clinton's Council of Economic Advisers – first as a member and later as chairmanwith cabinet rank. He was later named chief economist of the World Bank. Since January 2000, Stiglitz has been a visiting professor at Columbia's Graduate School of Business and Department of Economics in the Graduate School of Arts and Sciences.

Noting that many of the major political debates over the past two decades have centered around one key issue: "the efficiency of the market economy", and the appropriate relationship between the market and the government, and based on his lifelong experiences, Stilglitz became to question the argument of Adam Smith (1776) that free markets led to efficient outcomes, "as if by an invisible hand", which has played a central role in these debates: it suggested that we could, by and large, rely on markets without government intervention. There was, at best, a limited role for government.

However his childhood told him otherwise. When he began the study of economics over forty years ago, Stiglitz was struck by the incongruity between the models that he was taught and the world that he had seen growing up, in Gary Indiana, a city whose rise and fall paralleled the rise and fall of the industrial economy. Founded in 1906 by U.S. Steel, and named after its Chairman of the Board, by the end of the century it had declined to but a shadow of its former self. But even in its heyday, it was marred by poverty, periodic unemployment, and massive racial discrimination. Yet the theories that Stiglitz was taught paid little attention to poverty, said that all markets "cleared" ­ including the labor market, so unemployment must be nothing more than a "phantasm", and that the profit motive ensured that there could not be economic discrimination. The central theorems argued that the economy was Pareto efficient and that, ino some sense,­ he had been living in the best of all possible worlds. It seemed to Stiglitz that he should be striving to create a different world. As a graduate student, he set out to try to create models with assumptions ­ and conclusions ­ closer to those that accorded with the real world he saw, with all of its imperfections.

Stiglitz contributions to Economics

Stiglitz helped create a new branch of economics, "The Economics of Information" exploring the consequences of information asymmetries and pioneering such concepts as adverse selection and moral hazard, which have now become standard tools not only of theorists, but of policy analysts. He has made major contributions to macro-economics and monetary theory, to development economics and trade theory, to public and corporate finance, to the theories of industrial organization and rural organization, and to the theories of welfare economics and of income and wealth distribution. In the 1980s, he helped revive interest in the economics of R&D.

His work has helped explain the circumstances in which markets do not work well, and how selective government intervention can improve their performance.

For Stiglitz there is no such a thing as Adam Smith's "invisible hand": "Adam Smith's invisible hand - the idea that free markets lead to efficiency as if guided by unseen forces - is invisible, at least in part, because it is not there".

External Links

• ARISTOTLE. Politics

• ARISTOTLE. Nicomachean Ethics

• ECONOMICS 100 ONLINE. Department of Economics at the University of Toronto<copyright K.J. Rea, 2000-2003 all rights reserved>. (A great "primer" to understanding the basic principles of Economics)

• MICROECONOMICS: Most important concepts explained in detail. Text and workable problems. WARNING: Internet Explorer will not work! Get "Firefox" or "Netscape" for free. Requires "Adobe Acrobat Reader" as a helper to your web browser. You will need "Excel 97" or higher running on your computer to use the spreadsheets.

• The History of Economic Thought Website <forever 'under construction'> ]

• World Wide Web Resources in Economics. Center for Innovative Education, Helsinki School of Economics, Finland. (An excellent sorce of links to the various Economics subdisciplines)

• Xenophon

See also

• Econometrics
• Economic Theory
• Econophysics
• History of Ancient Economics
• Macroeconomics
• Microeconomics
• Neuroeconomics

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