History of economic thought

Modern economic thought is generally considered to have originated in the late eighteenth century with the work of David Hume and Adam Smith, and Adam Smith has come to be regarded as the founder of classical economics. (Earlier approaches are described in the article on the History of pre-classical economic thought.) The nineteenth and twentieth centuries saw major developments in the methodology and scope of economic theory, and the process of development continues.

Nineteenth century economists applied deductive reasoning to axioms considered to be self-evident, and to simplifying assumptions which were thought to capture the essential features of economic activity. That methodology yielded concepts such as elasticity and utility, tools such as marginal analysis, and theorems such as the law of comparative costs. An extension of the relationships governing transactions between consumers and producers was considered to provide all that was necessary to understand the behaviour of the national economy.

The development, in the early 20th century, of systems of economic statistics enabled economists to use inductive reasoning to test theoretical findings against observed economic behaviour, and to develop new theories. Independently of that change, the concept emerged of the national economy as a closed interactive system. Such a system was found to behave in ways that could not be derived by aggregating the behaviour of its components. Analysis of the new concept provided explanations of recessions, unemployment and inflation that were not previously available. The application of empirical data and inductive reasoning to the new concept enabled those theories to be refined, and led to the development of forecasting models that could be used as tools of economic management.

The late 20th and early 21st centuries have seen further theoretical and empirical refinements and significant advances in the techniques of economic management.

Overview: categories of economic thought

Historians categorise economic thought into “periods” and “schools”, and tend to attribute each innovation to one individual. That is helpful for the purpose of exposition, although the reality has been a story of interwoven intellectual threads, crossing some categories and often persisting through all of them; and in which advances attributed to particular individuals have often been prompted by the work of others. For example, the quantity theory of money, that achieved prominence in the twentieth century and is associated with the name of Milton Friedman, was first formulated at least three centuries earlier. Many of those threads - such as the concept of value and the nature of economic growth - that have permeated the categories referred to as "Classical economics" and "Neoclassical economics", had an earlier origin in "Pre-classical economics", which is the subject of a separate article. (The prefix "classical" is used to denote the adoption in the late eighteenth century of an approach which was inspired by the enlightenment and the methodology of the physical sciences, and which abandoned previous tendencies to examine the subject in the context of ethics, religion and politics.) Preoccupation with those threads was overshadowed in the twentieth century by the responses of "Keynesianism" and "monetarism" to the problems of unemployment and inflation, but the development of neoclassical economics started before that time and has continued thereafter. (The boundary between the "classical" and "neoclassical" categories is marked mainly by the rejuvenation of the value thread by the concept of "utility" and the associated explanation of price in terms of "supply and demand".) The introduction - thereby and subsequently - of new tools of exploration has since led to the vigorous development of that and other threads, and an expansion in the scope of economics into many new directions.

Classical Economics

The contribution of David Hume

The Scottish philosopher, David Hume was an early exponent of what was later known as monetary economics, and an opponent of "Mercantilism". (That was the term subsequently applied to the then current policy, which was founded upon the belief that a nation's wealth consisted mainly of its gold and silver. Governments accordingly subsidised exports so as to promote inflows of gold and silver, and restricted imports in order to discourage outflows.) He contested the mercantilist thesis, partly on the grounds that an inflow of money would cause inflation , but also on the grounds that nations would benefit from the international specialisation that would result from the introduction of free trade. More generally, he argued that all government intervention in commerce tended to obstruct economic progress.

The Wealth of Nations

A major advance in the development of economics occurred with the publication in 1776 of Adam Smith's An Inquiry into the Nature and Causes of The Wealth of Nations . It was a comprehensive treatment of the subject, using deductive logic in a similar way to its use in the physical sciences. Its main purpose was to recommend changes of economic policy in the interests of economic growth. Adam Smith argued that the division of labour was the main cause of economic growth, and that government intervention in commerce was its main impediment. He advocated government spending upon what are now termed public goods such as defence, law enforcement and the infrastructure, and upon the education of the children of people who could not afford it – and, by implication, upon nothing else. He identified what he considered to be the economic drawbacks of all forms of taxation (except the taxation of land values) and of the deficit financing of public expenditure. He examined the relation of price to value and concluded that the “natural price” of a product was the same as its cost of production, and that divergences from it would eventually be bargained away. Adam Smith is thought to have got many of his ideas from his friend David Hume and from conversations with the French economist, Francois Quesnay (and his fellow "Physiocrats"), but he had a far greater influence upon economic thought.

Jean-Baptiste Say

Jean-Baptiste Say was an influential advocate of Adam Smith's teaching in French government circles, but his best-known contribution was what came to be known as "Say's Law of Markets". Later paraphrased as "supply creates its own demand", it stated that, although there could be an imbalance between the supply and the demand for particular products, no such imbalance could exist for the economy as a whole. Say's Law remained part of mainstream classical economics until it was challenged by John Maynard Keynes. It embodied the (unstated) postulate that all payments for goods are immediately spent on other goods. That postulate reflected the belief that money plays no part in the functioning of the economy (beyond its role as a medium of exchange) because it would be irrational to acquire money savings and so forfeit benefits in terms of consumption or investment.

Malthus

In his influential Essay on the Principle of Population Thomas Malthus postulated that the population would grow at a geometric rate (2, 4, 8, 16...) while food production could only increase arithmetically (1, 2, 3, 4 ....) and concluded that the food supply would eventually be insufficient to support the population. That conclusion led him to oppose the introduction of the Poor Law and to advocate the protection of agriculture. In other respects he followed Adam Smith in opposing government intervention in commerce. Evidence in support of his postulates was lacking at the time and they have since been found to be mistaken.

David Ricardo

With minor reservations, David Ricardo accepted and extended Adam Smith’s teaching. In his major work,The Principles of Political Economy and Taxation he accepted the concept of a value-determined “natural price”, although he considered value to be determined by labour content rather than cost. Following Adam Smith’s lead, he also developed the “wage-fund” concept that the amount available for the payment of wages is fixed at any particular level of capital investment, so that an increase in the supply of labour would lead to a reduction in wage rates. He pioneered a definition of rent as the difference between the produce of a unit of labour on the land in question and its produce on the least productive land in use, and in a further extension to Adam Smith’s work, he explored the incidence of taxation on wages, profits, houses and rent, identifying in each case (but with the exception of rent) its harm to the economy. Probably his most influential contribution, however, was his development of his Law of Comparative Advantage which challenged the intuitive belief that the trading of a product is possible only with those with a lesser ability to produce it. Ricardo produced a logical demonstration that there can be mutually beneficial trade between two countries, one of which is better able than the other to produce all of the commodities that are traded.

Marxist economics

Karl Marx adapted Ricardo's concept of labour value and put it to an entirely different use. In his analysis, as in Ricardo's, labour consumption determines value - which Marx termed exchange value. But Marx regarded each labourer as a product whose exchange value is determined by the labour inputs required to feed, clothe and train him. In return, as Marx saw it, the capitalist receives a labourer's use value, which is determined by the utility of his products. Marx noted that a labourer's use value normally exceeds his exchange value, and he termed the difference surplus value. Like Adam Smith and his "classical" predecessors, he was preoccupied with the subject of economic growth but, unlike them, he saw technical progress as a major contributor, in addition to as the accumulation of physical capital. If technical progress were to slow down, however, he considered that the only way to maintain growth would be to invest more and more in machinery and buildings, as a result of which the rate of profit on new investment would fall leading to a further reduction in growth. Also, Marx was probably the first economist to make a systematic attempt to explain the fluctuations in economic activity known as the business cycle. In his view, any departure from the conditions necessary for steady growth would lead to the accumulation of unwanted stocks, producing a downturn in economic activity until price-cutting to get rid of them put the process into reverse.

In his major work, Das Kapital Marx puts his findings in an historical, concludes that economic conditions shape history, and forecasts a breakdown of the capitalist system and its replacement by socialism.

Other contributions

Among the many lesser contributors to classical economic theory, the best-known was John Stuart Mill. His Principles of Political Economy, although intended by the author merely to bring together the works of others, offered some fresh insights into increasing returns to scale and their consequences for the development of monopolies, and anticipated (though not in those terms) the neoclassical concepts of elasticity and the determination of price by the interaction of supply and demand.

Writing during the classical period but without recognition at the time was the French economist and mathematician Antoine Augustin Cournot, who set out the mathematical basis for the Theory of the Firm and used differential calculus to demonstrate the profit-maximising requirement of equality between marginal cost and marginal revenue, thus anticipating some of the more important developments of neoclassical economics.

Keynesian macroeconomics

The contribution of John Maynard Keynes

The most important contribution to economic thought by John Maynard Keynes was his examination of the factors determining the levels of national income and employment, and the causes of economic fluctuations. His major (and hard to read) work, the General Theory of Employment, Interest and Money, contains a sustained attack on much of the thinking of classical economics - mainly on the grounds that their postulates were unrealistic. His first target was Say's law of markets with its denial of the possibility of a general deficiency of demand. He challenged its implicit assumption that money is no more than a medium of exchange by drawing attention to the speculative demand for money. Secondly, he attacked the classical economists' contention that it was the interest rate that reconciled savings plans with investment plans, claiming that the level of savings was largely determined by the level of national income. Thirdly, he rejected the classical economists' assumption that any tendency for unemployment to rise would be corrected by a reduction in the general level of wages, substituting the contention that "wages are sticky downward". Having substituted his assumptions for those of his predecessors, he advanced the thesis that a deficiency of demand could occur if there was an excess of planned savings over planned investment, because such an excess could be removed only by a reduction in national income. The implication of that thesis was that the economy could settle down into a condition of high unemployment, lacking the self-righting mechanism envisaged by the classical economists.

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Institutional schools

German historicism was represented by Werner Sombart (1863-1941), and historical sociologist Max Weber (1864-1920). In his classic The Protestant Ethic and the Spirit of Capitalism (1905) Weber stressed the importance of Protestant value systems in forming a capitalist mindset and rational outlook toward calculating the future. Vilfredo Pareto (1848-1923) [1] made numerous contributions to the study of inequality, showing that in modern societies wealth distributions are heavily skewed in an exponential manner (so that a few people are very rich rich, and most are poor). In addition Pareto defined "Pareto optimality," which is widely used in welfare economics and game theory. A distribution of wealth is "Pareto optimal" if no one can be made better off without someone else being made worse off. A standard theorem is that a perfectly competitive markets create distributions of wealth that are Pareto optimal.

The most widely read American economist was Thorstein Veblen (1857-1929), a witty commentator on capitalism, the leisure class, and conspicuous consumption. More pedantic but more influential was John R. Commons (1862-1945), who stressed legal frameworks, historical development and practical collection of statistics; he ignored theoretical mathematical models. Commons dominated economics at the University of Wisconsin, where his disciples preached strong government regulation and intervention in the economy, and designed the Social Security pension system that went into effect in 1935. John Kenneth Galbraith was a major spokesman for liberalism and the planned economy, as he poked fun at capitalism and promoted the New Deal Coalition.

The main development of Business Cycle Theory, led by Wesley Clair Mitchell (1874-1948) and sponsored by the National Bureau of Economic Research from the 1920s into the 21st century, used massive amounts of statistical data, but at first avoided macroeconomic theory. Important exponents included two economists who headed the Federal Reserve System, Arthur Burns (1904-1987) and Alan Greenspan (1926- ).

Leonid Vitalyevich Kantorovich (1912-1986), and Wassily Leontief (1906-1999) developed the "input-output" technique; it was used mostly in planned and developing economies for determining the levels of resources necessary to produce according to a given plan.

The marginalist revolution

In the 1870s, three economists became 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 would eventually put an end to the The Classical School 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 dominated economics in Britain from the 1870s well into the 20th century. Among his major contributions to economic theory was his explanation that the price mechanism operates by the interplay of supply and demand, replacing the contention of earlier economists that price is determined by the cost of supply. He was responsible for developing numerous concepts still used in economics, such as elasticity of demand and consumers' surplus, as well as the diagrams used to explain them.

Marshall's work was refined and further developed, and continues to be extended to this day. Neoclassical economists have built magistral 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.

International trade theory

Bertil Ohlin, (1899-1979), professor of economics at the Stockholm School of Economics (1929-65) and longtime leader of the Swedish Liberal party shared the 1977 Nobel Prize for economics with British theorist James E. Meade (1907-1995) for their "path-breaking contribution to the theory of international trade and international capital movements."

The Keynesian revolution

Keynesianism, introduced by Cambridge (England) economist John Maynard Keynes in 1936, and revised by John Hicks, dominated mainstream economic thought from 1936 to the early 1970s. Keynes' ideas on the causes of unemployment revolutionized macroeconomic theory and profoundly altered government's involvement in the economy. Instead of micromanagement of prices and factories, the Keynesian model told governments to regulate the overall supply and demand, through taxation and budget deficits or surpluses. In the 1970s economists became increasingly critical of Keynesian ideas, because it could not handle stagflation (the real-life combination of high unemployment and high inflation), and because because of problems with the micro-foundations regarding issues such as the "consumption function." The leading British Keynesians were Sir John Hicks (1904-1989) and Richard Stone (1913-1991) The leading American Keynesians were Alvin Hansen (1887-1975) at Harvard, Paul Samuelson (1915- ) and Franco Modigliani (1918- ) at MIT, and James Tobin (1918-2005) at Yale. Milton Friedman (1912-2006) at the University of Chicago was the leading critic of Keynesianism, though his own alternative theory of monetarism was found wanting in practice.

The monetarist "counterrevolution"

While the Keynesian-Neoclassical synthesis took over the profession, an unregenerate rearguard of neo-classical economists centred at the University of Chicago continued to exist. See Chicago School of Economics They never accepted the possibility of involuntary unemployment or the desirability of 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. Originally a Keynesian and a strong supporter of unemployment programs (which employed Friedman and his wife during the Great Depression), he began attacking the consumption function component of the New Deal model in the 1950s. He was mainly responsible for what is known as the Monetarist counterrevolution of the 1970s. In 1968 he announced the Keynesian model was liable to "stagflation" and could not be used to "fine tune" the economy. The prediction proved accurate in the 1970s with the failure of Keynesian models to explain or resolve the "stagflation" of the 1970s, (which combined high unemployment and high inflation), the free market prescriptions of monetarism became a serious alternative. They were espoused by many governments in the 1980s (Reagan in the US, Thatcher in the UK, Mulroney in Canada), and, perhaps more importantly, by the central banks of most industrialized countries. In practice, however, monetarism was too inflexible to set policy and all the central banks stopped using it by the 1990s.

The Chicago School of Microeconomics

The Chicago School of Economics not only challenged established theories in macroeconomics, they pioneered the expansion of microeconomics to include antitrust and many unexpected topics, such as marriage and divorce, criminal behavior, and slavery. The main tool was price theory as developed by Ronald Coase (1910- ), George Stigler (1911-1991) and Gary Becker (1930 - ).