Economic

View on Man:

- Views man as a rational (utilitarian) individual

Views on Society:
- Views society as a place where trade and exchange occurs.

HISTORICAL DEVELOPMENT & PROPONENTS:

The effective birth of economics as a separate discipline may be traced to
the year 1776, when the Scottish philosopher Adam Smith published An
Inquiry into the Nature and Causes of the Wealth of Nations. There was, of
course, economics before Smith: the Greeks made significant
contributions, as did the medieval scholastics, and from the 15th to the
18th century an enormous amount of pamphlet literature discussed and
developed the implications of economic nationalism (a body of thought
now known as mercantilism). It was Smith, however, who wrote the first
full-scale treatise on economics and, by his magisterial influence, founded
what later generations were to call the “English school of classical political
economy,” known today as classical economics.
PROPONENT #1: ADAM SMITH
He was born in a small village in Kirkcaldy, Scotland, where his widowed
mother raised him. At age fourteen, as was the usual practice, he entered
the University of Glasgow on scholarship. He later attended Balliol
College at Oxford, graduating with an extensive knowledge of European
literature and an enduring contempt for English schools.
He returned home, and after delivering a series of well-received lectures
was made first chair of logic (1751), then chair of moral philosophy
(1752), at Glasgow University.
He left academia in 1764 to tutor the young duke of Buccleuch. For more
than two years they traveled throughout France and into Switzerland, an
experience that brought Smith into contact with his contemporaries are
Voltaire, Jean-Jacques Rousseau, François Quesnay, and Anne-Robert-
Jacques Turgot. Today Smith’s reputation rests on his explanation of how
rational self-interest in a free-market economy leads to economic well-
being.

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One generation after the publication of Smith’s tome, David
Ricardo wrote Principles of Political Economy and Taxation (1817). This
book acted, in one sense, as a critical commentary on the Wealth of
Nations. Yet in another sense, Ricardo’s work gave an entirely new twist
to the developing science of political economy. Ricardo invented the
concept of the economic model—a tightly knit logical apparatus consisting
of a few strategic variables—that was capable of yielding, after some
manipulation and the addition of a few empirically observable extras,
results of enormous practical import. At the heart of the Ricardian system
is the notion that economic growth must sooner or later be arrested because
of the rising cost of cultivating food on a limited land area.
PROPONENT #2: DAVID RICARDO
After his family disinherited him for marrying outside his Jewish faith,
Ricardo made a fortune as a stockbroker and loan broker. When he died,
his estate was worth more than $100 million in today’s dollars. At age
twenty-seven, after reading Adam Smith’s The Wealth of Nations, Ricardo
got excited about economics.
Ricardo first gained notice among economists over the “bullion
controversy.” In 1809 he wrote that England’s inflation was the result of
the Bank of England’s propensity to issue excess banknotes. In short,
Ricardo was an early believer in the quantity theory of money, or what is
known today as monetarism.
In his Essay on the Influence of a Low Price of Corn on the Profits of
Stock (1815), Ricardo articulated what came to be known as the law of
diminishing marginal returns.
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An essential ingredient of this argument is the Malthusian principle—
enunciated in Thomas Malthus’s “Essay on Population” (1798): according
to Malthus, as the labour force increases, extra food to feed the extra
mouths can be produced only by extending cultivation to less fertile soil or
by applying capital and labour to land already under cultivation—with
dwindling results because of the so-called law of diminishing returns.
Although wages are held down, profits do not rise proportionately, because
tenant farmers outbid each other for superior land. As land prices were
increasing, Malthus concluded, the chief beneficiaries of economic
progress were the landowners
PROPONENT #3: THOMAS MALTHUS
Malthus was interested in everything about populations. His main
contribution was to highlight the relationship between food supply and
population. Humans do not overpopulate to the point of starvation, he
contended, only because people change their behavior in the face of
economic incentives.
Noting that while food production tends to increase arithmetically,
population tends to increase naturally at a (faster) geometric rate, Malthus
argued that it is no surprise that people thus choose to reduce (or “check”)
population growth.
Malthus died in 1834, before seeing economics characterized as the
“dismal science.” That phrase, coined by Thomas Carlyle in 1849 to
demean John Stuart Mill, is often erroneously thought to refer to Malthus’s
contributions to the economics of population growth.
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In 1848 John Stuart Mill’s restatement of Ricardo’s thought in
his Principles of Political Economy brought it new authority for another
generation. After 1870, however, most economists slowly turned away
from Ricardo’s concerns and began to reexamine the foundations of the
theory of value—that is, to explain why goods exchange at the prices that
they do. As a result, many of the late 19th-century economists devoted
their efforts to the problem of how resources are allocated under conditions
of perfect competition.

PROPONENT #4: JOHN STUART MILL

The eldest son of economist James Mill, John Stuart Mill was educated
according to the rigorous expectations of his Benthamite father. He was
taught Greek at age three and Latin at age eight. By the time he reached
young adulthood John Stuart Mill was a formidable intellectual, albeit an
emotionally depressed one. After recovering from a nervous breakdown,
he departed from his Benthamite teachings to shape his own view of
political economy.
Surprisingly, though, Mill was not a consistent advocate of laissez-faire.
His biographer, Alan Ryan, conjectures that Mill did not think of contract
and property rights as being part of freedom. Mill favored inheritance
taxation, trade protectionism, and regulation of employees’ hours of work.
Interestingly, although Mill favored mandatory education, he did not
advocate mandatory schooling. Instead, he advocated a voucher system for
schools and a state system of exams to ensure that people had reached a
minimum level of learning.
Mill spent most of his working life with the East India Company. He
joined it at age sixteen and worked there for thirty-eight years. He had little
effect on policy, but his experience did affect his views on self-
government.

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Before proceeding, it is important to discuss the last of the classical
economists, Karl Marx. The first volume of his work Das Kapital appeared
in 1867; after his death the second and third volumes were published in
1885 and 1894, respectively. If Marx may be called “the last of the
classical economists,” it is because to a large extent he founded his
economics not in the real world but on the teachings of Smith and Ricardo.
They had espoused a “labour theory of value,” which holds that products
exchange roughly in proportion to the labour costs incurred in producing
them. Marx worked out all the logical implications of this theory and
added to it “the theory of surplus value,” which rests on the axiom that
human labour alone creates all value and hence constitutes the sole source
of profits.
PROPONENT #5: KARL MARX
Marx was born in Trier, Prussia (now Germany), in 1818. He studied
philosophy at universities in Bonn and Berlin, earning his doctorate in Jena
at the age of twenty-three. His early radicalism, first as a member of the
Young Hegelians, then as editor of a newspaper suppressed for its derisive
social and political content, preempted any career aspirations in academia
and forced him to flee to Paris in 1843. It was then that Marx cemented his
lifelong friendship with Friedrich Engels. In 1849 Marx moved to London,
where he continued to study and write, drawing heavily on works by David
Ricardo and Adam Smith. Marx died in London in 1883 in somewhat
impoverished surroundings. Most of his adult life, he relied on Engels for
financial support.
At the request of the Communist League, Marx and Engels coauthored
their most famous work, “The Communist Manifesto,” published in 1848.
A call to arms for the proletariat—“Workers of the world, unite!”—the
manifesto set down the principles on which communism was to evolve.
Marx held that history was a series of class struggles between owners of
capital (capitalists) and workers (the proletariat). As wealth became more
concentrated in the hands of a few capitalists, he thought, the ranks of an
increasingly dissatisfied proletariat would swell, leading to bloody
revolution and eventually a classless society.
According to Marx, capitalism contained the seeds of its own destruction.
Communism was the inevitable end to the process of evolution begun with
feudalism and passing through capitalism and socialism. Marx wrote
extensively about the economic causes of this process in Capital. Volume
one was published in 1867 and the later two volumes, heavily edited by
Engels, were published posthumously in 1885 and 1894.
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Through the last three decades of the 19th century, economists of the
Austrian, English, and French schools formulated their own interpretations
of the marginal revolution. The Austrian school dwelt on the importance of
utility as the determinant of value and dismissed classical economics as
completely outmoded. Austrian economist Eugen von Böhm-
Bawerk applied the new ideas to the determination of the rate of interest,
an important development in capital theory.

PROPONENT #6: EUGEN VON BOHM-BAWERK

One of the leading members of the Austrian school of economics—an

approach to economic thought founded by Carl Menger and augmented by
Knut Wicksell, Ludwig von Mises, Friedrich A. Hayek, and Sir John
Hicks. Böhm-Bawerk’s work became so well known that before World
War I, his Marxist contemporaries regarded the Austrians as their typical
bourgeois, intellectual enemies. His theories of interest and capital were
catalysts in the development of economics, but today his original work
receives little attention.

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The English school, led by Alfred Marshall, sought to reconcile their work
with the doctrines of the classical writers. Marshall based his argument on
the observation that the classical economists concentrated their efforts on
the supply side in the market while the marginal utility theorists were
concerned with the demand side. In suggesting that prices are determined
by both supply and demand, Marshall famously used the paradigm of a
pair of scissors, which cuts with both blades. Seeking to be practical, he
applied his “partial equilibrium analysis” to particular markets and
industries.

PROPONENT #7: ALFRED MARSHALL

He is the dominant figure in British economics (itself dominant in world

economics) from about 1890 until his death in 1924. His specialty was
microeconomics—the study of individual markets and industries, as
opposed to the study of the whole economy. In his most important book,
Principles of Economics, Marshall emphasized that the price and output of
a good are determined by both supply and demand: the two curves are like
scissor blades that intersect at equilibrium. Modern economists trying to
understand why the price of a good change will start by looking for factors
that may have shifted demand or supply, an approach they owe to
Marshall.

The concept of consumer surplus is another of Marshall’s contributions.

He noted that the price is typically the same for each unit of a commodity
that a consumer buys, but the value to the consumer of each additional unit
declines. A consumer will buy units up to the point where the marginal
value equals the price. Therefore, on all units previous to the last one, the
consumer reaps a benefit by paying less than the value of the good to
himself. The size of the benefit equals the difference between the
consumer’s value of all these units and the amount paid for the units. This
difference is called the consumer surplus, for the surplus value or utility
enjoyed by consumers.

Marshall was born into a middle-class family in London and raised to enter
the clergy. He defied his parents’ wishes and instead became an academic
in mathematics and economics.

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It was Léon Walras, though, living in the French-speaking part of
Switzerland, who carried the marginalist approach furthest by describing
the economic system in general mathematical terms. For each product, he
said, there is a “demand function” that expresses the quantities of the
product that consumers demand as dependent on its price, the prices of
other related goods, the consumers’ incomes, and their tastes. For each
product there is also a “supply function” that expresses the quantities
producers will supply dependent on their costs of production, the prices of
productive services, and the level of technical knowledge. In the market,
for each product there is a point of “equilibrium”—analogous to the
equilibrium of forces in classical mechanics—at which a single price will
satisfy both consumers and producers.

PROPONENT #8: LEON WALRAS

Separately but almost simultaneously with William Stanley Jevons and

Carl Menger, French economist Leon Walras developed the idea of
marginal utility and is thus considered one of the founders of the “marginal
revolution.” But Walras’s biggest contribution was in what is now called
general equilibrium theory. Before Walras, economists had made little
attempt to show how a whole economy with many goods fits together and
reaches an equilibrium. Walras’s goal was to do this. He did not succeed,
but he took some major first steps. First, he built a system of simultaneous
equations to describe his hypothetical economy, a tremendous task, and
then showed that because the number of equations equaled the number of
unknowns, the system could be solved to give the equilibrium prices and
quantities of commodities. The demonstration that price and quantity were
uniquely determined for each commodity is considered one of Walras’s
greatest contributions to economic science.

Walras’s father, the French economist Auguste Walras, encouraged his son
to pursue economics with a particular emphasis on mathematics. After
sampling several careers—he was for a while a student at the school of
mines, a journalist, a lecturer, a railway clerk, a bank director, and a
published romance novelist—Walras eventually returned to the study and
teaching of economics. In that scientific discipline Walras claimed to have
found “pleasures and joys like those that religion provides to the faithful.”
Walras retired in 1902 at age fifty-eight.
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It is not difficult to analyze the conditions under which equilibrium is
possible for a single product. But equilibrium in one market depends on
what happens in other markets (a “market” in this sense being not a place
or location but a complex array of transactions involving a single good).
This is true of every market. And because there are literally millions of
markets in a modern economy, “general equilibrium” involves the
simultaneous determination of partial equilibria in all markets.

Walras’s efforts to describe the economy in this way led the Austrian
American Joseph Schumpeter, a historian of economic thought, to call
Walras’s work “the Magna Carta of economics.” While undeniably
abstract, Walrasian economics still provides an analytical framework for
incorporating all the elements of a complete theory of the economic
system. It is not too much to say that nearly the whole of modern
economics is Walrasian economics, and modern theories of money,
employment, international trade, and economic growth can be seen as
Walrasian general equilibrium theories in a highly simplified form.

PROPONENTS #9: JOSEPH SCHUMPETER

Schumpeter argued on this basis that some degree of monopoly is

preferable to perfect competition. Competition from innovations, he
argued, is an “ever-present threat” that “disciplines before it attacks.” He
cited the Aluminum Company of America as an example of a monopoly
that continuously innovated in order to retain its monopoly.

Schumpeter was also a giant in the history of economic thought. His

magnum opus in the area is History of Economic Analysis, edited by his
third wife, Elizabeth Boody, and published posthumously in 1954. In it
Schumpeter made some controversial comments about other economists,
arguing that Adam Smith was unoriginal, Alfred Marshall was confused,
and Leon Walras was the greatest economist of all time.

Born in Austria to parents who owned a textile factory, Schumpeter was

very familiar with business when he entered the University of Vienna to
study economics and law. He was one of the more promising students of
Friedrich von Wieser and Eugen von Böhm-Bawerk, publishing at the age
of twenty-eight his famous Theory of Economic Development. In 1911
Schumpeter took a professorship in economics at the University of Graz.
He was minister of finance in 1919. With the rise of Hitler, Schumpeter
left Europe and the University of Bonn, where he was a professor from
1925 until 1932, and emigrated to the United States. In that same year he
accepted a permanent position at Harvard, where he remained until his
retirement in 1949. Schumpeter was president of the American Economic
Association in 1948.
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The years between the publication of Marshall’s Principles of
Economics (1890) and the stock market crash of 1929 may be described as
years of reconciliation, consolidation, and refinement for the marginalists.
The three schools of marginalist doctrines gradually coalesced into a single
mainstream that became known as neoclassical economics.

Marshall’s concept of “external economies and diseconomies” (any

external effects, either positive or negative, that a firm or entity might have
on people, places, or other markets) was developed by his leading pupil at
the University of Cambridge, Arthur Pigou, into a far-reaching distinction
between private costs and social costs, thus establishing the basis of
welfare theory as a separate branch of economic inquiry. This era also saw
a gradual development of monetary theory (which explains how the level
of all prices is determined as distinct from the determination of individual
prices), notably by Swedish economist Knut Wicksell. In the 1930s the
growing harmony and unity of economics was rudely shattered, first by the
simultaneous publication of American economist Edward
Chamberlin’s Theory of Monopolistic Competition and British
economist Joan Robinson’s Economics of Imperfect Competition in 1933,
then by the appearance of British economist John Maynard
Keynes’s General Theory of Employment, Interest and Money in 1936.

The institutionalists are more difficult to categorize. Institutional

economics, as the term is narrowly understood, refers to a movement in
American economic thought associated with such names as Thorstein
Veblen, Wesley C. Mitchell, and John R. Commons. These thinkers had
little in common aside from their dissatisfaction with orthodox economics,
its tendency to cut itself off from the other social sciences, its
preoccupation with the automatic market mechanism, and its abstract
theorizing.

The second major breakthrough of the 1930s, the theory of income

determination, stemmed primarily from the work of John Maynard
Keynes, who asked questions that in some sense had never been posed
before. Keynes was interested in the level of national income and the
volume of employment rather than in the equilibrium of the firm or the
allocation of resources. He was still concerned with the problem of
demand and supply, but “demand” in the Keynesian model means the total
level of effective demand in the economy, while “supply” means the
country’s capacity to produce. When effective demand falls short of
productive capacity, the result is unemployment and depression;
conversely, when demand exceeds the capacity to produce, the result is
inflation.
POST WAR ERA
The 25-year period following World War II can be viewed as an era in
which the nature of economics as a discipline was transformed. First of all,
mathematics came to permeate virtually every branch of the field. As
economists moved from a limited use of differential and integral calculus,
matrix algebra represented an attempt to add a quantitative dimension to a
general equilibrium model of the economy.
Matrix algebra was also associated with the advent of input-output
analysis, an empirical method of reducing the technical relations between
industries to a manageable system of simultaneous equations. A closely
related phenomenon was the development of linear programming and
activity analysis, which opened up the possibility of applying numerical
solutions to industrial problems. This advance also introduced economists
to the mathematics of inequalities (as opposed to exact equation).
New developments in economics were not limited to methodological
approaches. Interest in the less-developed countries returned in the later
decades of the 20th century, especially as economists recognized their long
neglect of Adam Smith’s “inquiry into the causes of the wealth of nations.”
There was also a conviction that economic planning was needed to lessen
the gap between the rich and poor countries. Out of these concerns came
the field of development economics, with offshoots in regional economics,
urban economics, and environmental economics.

METHOD EMPLOYED/BRANCHES:
The first way to split economics is microeconomics and macroeconomics.

 Microeconomics – concerned with individual markets and small aspects of the

economy.
 Macroeconomics – concerned with the whole aggregate economy. Issues such as
inflation, economic growth and trade.

Branches of economics
1. Classical economics

Classical economics is often considered the foundation of modern economics. It was

developed by Adam Smith, David Ricardo, Jean-Baptiste Say. Classical economics is
based on
 Operation of free markets. How the invisible hand and market mechanism can
enable an efficient allocation of resources.
 Classical economics suggests that generally, economies work most efficiently
when government intervention is minimal and concerned with the protection of
private property, promotion of free trade and limited government spending.
 Classical economics does recognise that a government is needed for providing
public goods, such as defence, law and order and education.
2. Neo-classical economics

Key people: Leon Walrus, William Jevons, John Hicks, George Stigler and Alfred
Marshall.

Neo-classical economics built on the foundations of free-market based classical

economics. It included new ideas such as

 Utility maximisation.
 Rational choice theory
 Marginal analysis. How individuals will make decisions at the margin – choosing
the best option given marginal cost and benefit.
Neo-classical economics is often considered to be orthodox economics. It is the
economics taught in most text-books as the starting point for economics teaching. The
tools of neo-classical economics (supply and demand, rational choice, utility
maximisation) can be used in new fields and also for critiques.

3. Keynesian economics

Key people: John Maynard Keynes, Paul Samuelson.

Keynesian economics was developed in the 1930s against a backdrop of the Great
Depression. The existing economic orthodoxy was at a loss to explain the persistent
economic depression and mass unemployment. Keynes suggested that markets failed to
clear for many reasons (e.g. paradox of thrift, negative multiplier, low confidence).
Therefore, Keynes advocated government intervention to kick-start the economy.

Keynesian economics is credited with creating macroeconomics as a distinct study.

Keynes argued that the aggregate economy may operate in very different ways to
individual markets and different rules and policies were needed.

Keynes didn’t reject all elements of neo-classical economics but felt new ideas were
needed for the macro-economy – especially with the economy in recession.

 Keynesian economics
4. Monetarist economics

Key people: Milton Friedman, Anna Schwartz.

Monetarism was partly a reaction to the dominance of Keynesian economics in the post-
war period. Monetarists, led by Milton Friedman argued that Keynesian fiscal policy was
much less effective than Keynesians suggested. Monetarists promoted previous classical
ideals, such as belief in the efficiency of markets. They also placed emphasis on the
control of the money supply as a way to control inflation.

Monetarist economics became influential in the 1970s and 1980s, in a period of high
inflation – which appeared to illustrate the breakdown of the post-war consensus

 Monetarism
5. Austrian economics

Key people: Ludwig Von Mises, Carl Menger

This is another school of economics that was critical of state intervention, price controls.
It is broadly free-market. However, it criticised elements of classical school – placing
greater emphasis on the individual value and actions of an individual. For example,
Austrian economists argue the value of a good reflects the marginal utility of the good –
rather than the labour inputs.

6. Marxist economics

Key people: Karl Marx

Emphasises unequal and unstable nature of capitalism. Seeks a radically different

approach to basic economic questions. Rather than relying on free-market advocate state
intervention in ownership, planning and distribution of resources.

7. Neo-liberalism/Neo-classical

A modern interpretation of classical economics. Considerable overlap with monetarism.

Essentially concerned with the promotion of free-markets, competition, free trade,
privatisation, lower government involvement, but some minimal state intervention in
public services like health and education. Few identify as ‘neo-liberal’ – sometimes used
as a term of abuse.

APPLICATION IN DAILY LIFE:

Buying goods which give the highest satisfaction for the price
This is common sense, but in economics, we give it the term of marginal utility theory.
The idea is that a rational person will be evaluating how much utility (satisfaction) goods
and services give him compared to the price. To maximise your overall welfare, you will
consume a quantity of goods where total utility is maximised given your budget. For
example, is it worth paying extra charges by airlines, such as paying for more leg-room?
Or pay to get priority boarding? Economics suggests we need to evaluate the marginal
benefit of these services compared to the marginal cost. See: Extra charges by airlines

Sunk cost fallacy

A sunk cost is an irretrievable cost, something we cannot get back. For example, suppose
we sign up for a gym membership at $40 a month for a whole year. We are committed to
paying $480, whether we go or not. If we are feeling unwell, should we go to the gym to
get our money’s worth or should we write off the sunk cost and maximise our marginal
utility for that particular day? See: sunk cost fallacy

Opportunity Cost
The first lesson of economics is the issue of scarcity and limited resources. If we use our
limited budget for buying one type of good (food), there is an opportunity cost – we
cannot spend that money on other goods such as entertainment. Opportunity cost is an
intrinsic aspect of most economic choices. We may like the idea of lower income tax, but
there will be an opportunity cost – in this case, less government revenue to spend on
health care and education.

There’s no such thing as free parking

Another example of opportunity cost – no one likes to pay for parking, but would we be
better off if parking was free? Most likely not. If parking was free, demand might be
greater than supply causing people to waste time driving around looking for a parking
spot. Free parking would also encourage people to drive into city centres rather than use
less environmentally friendly forms of transport. It would increase congestion; therefore
although we would pay less for parking, we would face extra less obvious costs.