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My class handout

The following is a handout I gave to my students at Yukon College when I was teaching introductory economics. I think it would be useful for this article. Feel free to use, edit, change, improve my prose and remove my biases, etc. :-) Luigizanasi 12:22, 22 March 2007 (CDT)

SHORT NOTES ON THE HISTORY OF ECONOMICS

Definitions

Even the definition of economics is subject to controversy. The textbook definition talks about making choices in the face of scarcity. Many, if not most, 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. It is repeated in most economics texts.

However, a more traditional view is that "Economics is the subject concerned with the material welfare of individuals and groups in society" (Asimakopoulos, 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."

We can play with definitions, but my favourite remains the one proposed by a Canadian economist, Jacob Viner, as "Economics is what economists do".

A note on etymology

The word economy has its roots in the ancient Greek "oikonomia" (οί), from "oikos" – house, and "nomos" – manage. Thus economics was originally the science of household management, what we today call home economics. The famous ancient philosopher Aristotle did write a book entitled "Oikonomia", but he was concerned with the treatment of slaves rather than their supply or demand.

Economists first called their disciple "political economy" to show it dealt with the polity and not the household. However, the name changed to "economics" in the 20th century, presumably to make it sound more "scientific", using the same ending as the word physics.

SHORT HISTORY OF ECONOMICS

Adam Smith

Despite some predecessors, all economists agree that economics, or political economy, started in 1776 with the publication of Adam Smith's Enquiry into the Nature and Causes of the Wealth of Nations. The Scottish philosopher Adam Smith is considered the founder of economics, or political economy. The largest part of the book is devoted to explaining wages, profits and rents which were related to Labour, Capital, and Land (or natural resources). Smith explained prices through the cost of production, he had a purely supply side theory of value.

Smith is most famous for the idea of the "invisible hand" of the market resulting in the best solution for society. To quote a famous passage in the Wealth of Nations:

As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. ... By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. (Wealth of Nations, Cannan edition, p. 423)

This is a clear (at least in 18th century language) endorsement of "laissez-faire", and Smith believed that government intervention usually made things worse. However Smith was not a total advocate of free markets, he also keenly aware of monopoly power. In another passage contrasting this first statement:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

Smith's theory of value is of particular importance. He distinguished between "real" price and "nominal" price. Real price was the price in terms of labour while the nominal price was in money terms. He viewed demand as possibly affecting the nominal market price temporarily, but it would eventually return to its natural price. Smith, then, clearly had a labour theory of value and under-estimated the importance of demand.

Classical Economists

Smith was the first of the classical economists. They also include Malthus, David Ricardo, Karl Marx and John Stuart Mill, who all expanded on Smith's work and continued with the labour theory of value.

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 19th 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 product 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 (at least in economics, he is clearly little more than a follower of Ricardo and had little impact on the development of the discipline). 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. Based on the failure of Marx's predictions, his followers added "monopoly capital" and "imperialism" as explanations for the relative prosperity of capitalist economies.

The marginalist revolution

By the second half of the 19th century, it became obvious that classical economics led to results that were quite revolutionary, since they were based on a labour theory of value. However, classical economics could not explain value in terms of the usefulness of things; e.g. why diamonds, which are practically useless, should be worth so much more than water, which is a basic necessity.

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. However, the most significant impact has been to move economics from a study of the material welfare of humanity to the study of the efficient allocation of scarce resource. Their ideas about demand were soon extended from the theory of consumption to the theory of production.

Their theory re-established the legitimacy of laissez-faire. These people and their successors, are who we call the neoclassicals and most economists today would be neo-classical

Alfred Marshall (1900-1920) was responsible for the combination of demand and supply, where demand was based marginal utility. He was responsible for developing numerous concepts still used in economics, including: demand and supply curves or schedules and their equilibrium, elasticity, consumer surplus, the distinction between short- and long-period, etc. Modern micro-economics 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 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.

Micro-economics 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 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 micro-economics 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 (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 micro-economic 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. The author of our textbook, Joe Stiglitz is one of the leading figures of this school. He won the Nobel prize in Economics in 2001.

Released under the CC-BY-SA-NC license, unless the Citizendium foundation decides otherwise. Luigizanasi 12:22, 22 March 2007 (CDT)