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Mathematical Interpretation for Classical Thoughts According to classical thoughts, production function of an economy has described as follows. O= f (L, K, N, T) O= Total Production L= Labour Force N= Natural Resources T= Technology It was based on following assumptions. 1) Capital accumulation depends on profit K = f (P) 2) Improvements in technology depends on investment T =f (I) 3) Investment depends on the rate of profits I =∆K=f (R) ∆K =Net added to capital stock R= Profits 4) Profits depend on labour supply and the level of technology R =f (L, T) P = Profit L= Labour T = Technology 5) The size of the labour force depends on the wage rates L = f (W) L = Labour W = Wage 6) The wage rates depend on the level of investment W = f (I) W = wages I = Level of investment 7) Total output is identical (equals) to profits, Wages and rents O ≡ f (P, W, R) O = Output P = Profit W = Wages R = Rent Criticisms for Classical Thoughts Classical thoughts of economic growth was critiqued due to some limitations of fundamentals (Pathirage, J. M. P. 2011). Ignorance of the middle class Neglecting the role of state sector Pessimistic thinking and unrealistic laws Wrong notions on profits and wages However it is accepted that classical thoughts of economic growth were based on the macroeconomic perspectives rather than micro viewpoints focused as in neo classical economic thoughts. Session 3 CLASSICAL ECONOMISTS Thoughts presented during 18 and 19 centuries were viewed as classical thoughts. These thoughts were presented by leading classical economists namely as Adam Smith, Thomas Malthus, Jean Baptist Say, and David Ricardo and John Stuart Mill. Adam Smith Scottish Philosopher and political economist Adam Smith is honored as the father of modern economics. It presumed that his ideas were influenced by the views of Physiocrats in France who believed that “Government of nature” and trade and industry were not sources for wealth but agriculture is the real economic movers. According to Wikipedia, the free encyclopedia, his biography was summarized as follows. Adam Smith 16 June 1723 NS Born (5 June 1723 OS) Kirkcaldy, Fife, Scotland 17 July 1790 (aged 67) Died Edinburgh, Scotland Nationality Scottish[1] University of Glasgow Alma mater Balliol College, Oxford Notable work The Wealth of Nations, The Theory of Moral Sentiments Western philosophy Classical economics Political philosophy, ethics, Main interests economics Classical economics, modern free market, Notable ideas division of labour, the "invisible hand" Region School Signature Source: From Wikipedia, the free encyclopedia, www.adamsmith.com Smith laid the foundations of classical free market economic theory from his wellknown book, An Inquiry into Nature and Causes of The Wealth of Nations published in 1776. He wrote his first classic book on “The Theory of Moral Sentiments in 1759 and attempted to explain human behavior and ethical values. As a precursor to the modern academic discipline of economics, Smith explained the hidden secret of public welfare, through the analysis of price mechanism acted as an invisible hand to solve basic economic questions I. e. what?, how? and for whom. He also explained how rational self-interest and competition can lead to economic prosperity. Smith’s views on economic growth and development has presented on key notions as Follows: Laissez Faire Smith argued that Laissez faire or the less governance or less intervention by the government is required factor for economic development. Invisible Hand Smith explains how self-interest or the selfish is worked for the benefit of the society. He argued that whole society is benefitted inevitably when butcher, brewer and baker made their products on their selfinterest. Thus self- interest that motivated on profit maximization is invisibly determined the sanctity’s needs i. e. what produce? how produce and what quantity etc. Finally he showed that price mechanism that determine on the demand and supply will solve the basic economic questions of the society, Free Trade Smith said that trade restrictions advocated by mercantilists would limit the world production, consumption and public welfare. Therefore, he advised to promote free trade among nations by specializing products which have the absolute advantage by each country. Division of labour Smith advocates division of labour and specialization as the key factor of growth, enhanced by machinery and international trade. Division of labour and specialization would increase productivity and reduce per unit costs. According to his example of pin industry, if one person produce everything, he is able to produce few units but the factory divided to 18 sections and persons asked to produce a part or a component more products could be manufactured. It increases due to three reasons. By increasing per head production By saving time through reducing labour movements from one work to another work By using machineries He also advocated that division of labour and specialization could promote at international level through the international trade. Labour theory of Value Classical thoughts were essentially based on the Smith’s concept of labour theory of value, which was based on following notions. 1. Labour is the only factor of production and is homogeneous (no quality difference) 2. The cost or the price of goods depends exclusively on the amount of labour. For instance if USA could produce cloth using less number of labour units than UK, USA has the cost efficiency in making cloth than UK The theory of Absolute Advantage and International Trade Smith’s trading principle is the principle of absolute advantage. Trade on Smith’s absolute advantage principle was based on division of labour, which means specialization in the production of only few goods by nations will lead to increase the efficiency and production. In a two country, two goods model, specialization and trade would benefit when one nation has absolute cost advantage in producing one good and the other nation would also has the similar advantage in producing other good. Smith mentioned that productivity of factor inputs are the major determinant of production cost and thereby productivity are based on natural and acquired (man-made) advantages. The natural advantage refers to natural resources such as climate, land, soil and locations etc. and acquired resources refer to special abilities and human skills of nations. Thus, under given natural or acquired advantages in the production of goods, a country could get the absolute cost advantage and access to international market through specialization the respective good at lower cost, becoming more competitive than the trading partner. Economic Growth According to supply driven model of growth presented by Smith, output is related to inputs of labour, land and capital. Thus, economic growth which is the increase of output is related to population growth, investment, land growth and increase in the productivity. Smith believes that the society is dependent on the economy’s ability to sustain its increasing workforce (population), investment that rely on the rate of savings and Land growth that dependent on the ability to acquire more lands or increasing productivity. Smith’s model suggests that an economy will increase the growth permanently in the long run due to division of labor, specialization and technological progress. Smith assumed that accumulated resources and technology in the past, permits to maintain a level of per capita income at the zero time. Specialization with research and development, learning by doing and innovations cause to increase per capita income from y (a) to y© in the long run (see figure3.1). Figure 3.1: Smiths’ Long Run Growth However, he also thought that in spite of increasing returns and technological development, an economy would ultimately become stagnation or stationary position by shrinking profits and savings of capitalists due to increased labour rates to be paid labourers. Thus Smith’s vision of a free market economy was based on three principles i. e. secure property, capital accumulation, market extension and division of labour (www.economic thoughts, Wikipedia, 2016). Though Smith criticized the government intervention and regulate human actions, he believed that the government have to play there legitimate functions. Erecting and maintaining certain public works and public institutions. (Provide public goods) Avoid creating cartels because of their tendency to limit production and quality of goods and services Avoid monopoly and monopolistic competition which could distort the benefits of free market. Though Smith’s vision of economic development was presented in in 18th century, his thoughts are still practiced by many economists and countries due to its validity and practicability. Liberalism and neo liberalism spread over the world today is entirely based on the thoughts of Adam Smith. David Ricardo David Ricardo (18 April 1772 – 11 September 1823) was an English political economist. He was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill (www.David Ricardo, Wikipedia. 2016). He had become a wealthy stock market trader and a member of the British Parliament. He also live at the time of industrialization and the France revolution. Ricardo’s biography was summarized as follows. David Ricardo Portrait of David Ricardo by Thomas Phillips, circa 1821. This painting shows Ricardo, aged 49, just two years before his death. Born 18 April 1772 London, England Died 11 September 1823 (aged 51) Gloucestershire, England Nationality British Ethnicity Jewish School or tradition Classical economics Influences Smith · Bentham Influenced Ricardian Socialists · George ·John Stuart Mill · Sraffa ·Wicksell · Barro · Joh n Ramsay McCulloch · Karl Marx · Franz Oppenheimer Contributions Ricardian equivalence, labour theory of value, comparative advantage, law of diminishing returns, Economic rent[1] Quoted From Wikipedia, the free encyclopedia, www.adamsmith.com Economic Thoughts of Ricardo were influenced by the views of Adam Smith (1723-1790) and Jeremy Bentham (1748-1832) who famous as a radical thinker at that time. Ricardo’s main publication is known as “principles of political economy and Taxation”, which contains critique of barriers to international trade and distribution of national income. Ricardo’s contribution to classical economic thoughts is outlined as follows. Diminishing Return to Land Cultivation It is assumed that labour is only variable input to fixed extent of land and when increase the additional amount of labor, productivity will decrease after certain units as long as technology is fixed. He believed that land is fixed and population grows relative to land and therefore productivity of labor will decrease. Distribution of Income According to Ricardo national income of the country distributes among three parties as follows: Workers who receive wages fixed to a level at which they can survive Landlords who earn a rent Capitalists who own capital and receive a profit Factors of Production Ricardo mention that economic activities determine on three production factors such as land, labor and capital. Labour theory of value As explained by Ricardo, cost or price of a commodity is determined by exclusively from its labour content. Thus Ricardo said that value of a good or services is determined on the labour cost or the wage rates rather than land or capital which he assumed as fixed. Ricardo modified Smith’s views in this regard. Likewise, the size of the labour force depends on the wage rates L = f (W). Ricardo shows two level of wages such as natural wage that equal to subsistence level and actual wage that equal to market price. Iron law of wages: Ricardo also agrees with views of Robert Malthus and a subsistence wage to be paid labours just for their survival because increasing wages will cause to increase food prices and to decrease the profits of landlords Rent Ricardo said that rental value is the payment to be paid to landlords by cultivator for the quality and fertility of the land. He said fertility and productivity vary between land and the quality of the land change the productivity. The principle of Comparative Advantage and Gains from International Trade According to Ricardo countries can mutually gain from international trade which based on the principle of comparative advantage. According to him, comparative advantage is determined either on greatest relative cost advantage or least absolute cost disadvantage. Ricardo believed that gains from trade would offset by perceived gain from trade protection. Ricardo also believed that countries can improve both production and consumption through mutually beneficial Trade. Steady Growth Ricardo’s growth and development model like Smith’s model is function of capital accumulation, Capital accumulation depends on reinvestment of profits. Ricardo believed that when population grows relative to land productivity of the labour on land will diminish and consequently food will become relatively scare leading to increase the price. Wages will need to increase if labours are to survive. Rental of lands is also increased as fixed asset. All these factors caused to decline profits of investors (Landlords). Thus economy become steady state as investment decline. According to Ricardo, the only way to avert stagnation is to promote international trade as he advocated by the principle of comparative advantage. International trade will increase the prices of commodity leading to increase wages, rents and profits of investors. According to Thirwall (2008) Ricardo has thought economy as one big farm, in which food (corn) and manufactures are consumed in fixed proportion. Thus the Ricardo’s model of the economy could be illustrated as follows. Figure 3.2: Ricardo’s model of the economy Corn R Z Average product P Y W X MP O L L2 Labor Subsistence wage The figure 3.2 shows that with an employment of L, total output is ORZL. The rent is determined by the difference between the average and marginal product (MP) of the labour as indicated in PRZY. Wages are equal to WPYX. When output increase and marginal product (MP) of labour falls to the subsistence wage level and profit will disappear. As profit falls in farm capital will move to industries. Thomas Robert Malthus Thomas Robert Malthus Born 13 February 1766 Westcott, Surrey, England Died 29 December 1834 (aged 68) Bath, Somerset, England Nationality Field School or tradition English demography, macroeconomics Classical economics Alma mater Jesus College, Cambridge Influences David Ricardo, Jean Charles Léonard de Sismondi Influenced Charles Darwin, John Maynard Keynes, Alfred Russel Wallace Contributions Malthusian growth model Quoted From Wikipedia, the free encyclopedia, www.adamsmith.com