MAIN IDEAS CLASSICAL SCHOOL
Classical school: economic liberalism
1. Limited government intervention
Enforcing property rights, public education, national defense
2. Self-interested economic behavior
Profits, wages
3. Harmony of interests
Serve society’s interest best by pursuing private interest
4. All economic resources and activates important
Land, labor, capital, entrepreneurial ability
5. Economic laws
Laws of comparative advantage, law of diminishing returns, labor theory of value, etc.
Pre ADAM SMITH
1. Aristotle
2. Scholastics
3. Mercantilism
4. Pre-classicist: David Hume
5. Quesnay and Physiocrats
Aristotele
1. Exchange can only come about if there is a potential surplus from the transactions that
parties can share
Money simplifies transaction
2. Principle of diminishing marginal returns
Scholastics
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Priests and teachers at medieval universities of 13th century
Determination of a just price= in the interest of society
“Natural price” : price emerging under free and effective competition, without
monopoly, resource waste or deceitful behavior.
Cost of production
Consumers perception of utility of good
Mercantilism
Positive surplus in balance of trade
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Limited import:
Only raw materials, most production domestic.
Promote export:
Inflow of silver and gold
Aim was to promote country”s military and economic power relative to that of other
countries.
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Favorable balance of trade as a measure for welfare
Pre-Classicist: David Hume (1711-1776)
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No effort of money stock on real economy ( this is opposite to mercantilists)
Long-run theory
International adjustment following domestic money shock
Contours for later developed quantity theory of money (MV=PT).
Quesnay (1694-1774) and Pysiocrats
Tableau Economiqe (1759)
-National accounts model
-Empirical knowledge about model parameters
Supplements to tablets:
-Agricultire is basis for economic wealth
-Government should promote free competition and free trade: “ laissez faire, laissez
passer”.
ADAM SMITH
Famous book : Wealth of Nations
Price theory = theory of value (1)
Value in use
Value in exchange
Labor theory of value: relative prices are determined by relative prices are determined by
relative production costs.
Price Theory (2)
Smith: Wages/rents/profits all tend towards the “natural price”.
Natural price corresponds to normal levels of cots
Market price is the price that prevails in the market:
Supply vs effectual demand
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Excess supply: natural price > market price
Little supply: natural price < market price
Long term:
market price </ natural price
market prce > natural price
Returns to production factors – 1
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Wages
Employment contracts
At least subsistence level
Wages may differ as to reflect noneconomics (dis)advantages:
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Eases or hardship of employnment
Level of trust and responsibility
Regulaarity of employnemnt
Difficulty /expensiveness to learn employment
Probability of success in employment
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Foundation of theory of compensating wage differentials
Returns to Production Factors – 2
Profits
-Differences in risk
-Compensation for management and supervision of business
Rents
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Tenant’s income – natural costs (wages/profit)
Residual pay
Hence, wages/profits cause high prices, but rents are effect of high prices.
Assumptions:
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Free and unregulated markets
Market Mechanism and Competition
Perfect competition: “system of perfect liberty”
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Absence of monopoly
Free entry and exit
Profit maximization by producers
Degree of competition increases with the number of sellers
Competition is key to understanding Smith’s invisible hand mechanism.
Public interest
Competition is good for economic efficiency,
As resources are devoted to most efficient uses, and hence output is maximized
But a just distribution of resources could not be achieved by the market alone.
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Inequalities may arise