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History of economic thought
Presentation 6
Petr Wawrosz
Classical political
economy
Historical background
• The seventeenth century: the emergence of the
idea of an autonomous sphere of economic
relations.
• The classical economists produced their
„magnificent dynamics“ during a period in which
capitalism was emerging from feudalism and in
which the industrial revolution was leading to
vast changes in society.
• The period of inventions and discoveries: e.g.
steam engine
Historical background
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The central problem of European political philosophy in the period from the
beginning of the Renaissance to the French Revolution was that of accounting for
social life without having to resort to metaphysical presuppositions. In the Middle
Ages, social consensus was maintained by two fundamental principles: authority
and faith, both justified by the assumption of the existence of God. The problem of
modern social thought was: how is social life possible if those two principles and
their metaphysical justification are left aside?
One answer to this question was given by Machiavelli and Hobbes: the natural
egoism of man makes free social life impossible and the absolute State necessary;
the principle of authority is based on the monopoly of power, and does not need
to be legitimized. It is based on violence, and only obtains obedience through its
strength. The citizens, mindful of a primitive ‘social contract’ of subjection and
driven by the survival instinct and the desire for security, can do nothing else but
obey. Civil society originates from repeated acts of obedience. The alternative
would be social disintegration and the law of the jungle. So power gives
foundation to the State, and the State makes harmonious social life possible.
This solution was certainly applicable to the absolutist States of the sixteenth and
seventeenth centuries. It was no longer tenable after 1649, the year of the
proclamation of the English Commonwealth, and, above all, after the Glorious
Revolution (1688) and the Declaration of Rights (1689).
Basic characteristics
• Most of the main contributors to the classical tradition - and all of
its founding fathers - viewed the economic order as analogous to
the physical universe depicted by Newtonian mechanics. Economic
affairs were regarded as governed by laws which, though
ascertainable by man, lay beyond his direct control. In their day-today business, men were still well advised to understand the
properties of these laws in order to guide their actions intelligently.
It was indeed an important objective of economic studies to
propagate an understanding of the significance of these laws.
• God created the universe together with the laws that regulate it
and then he stood aside. There is no need for his continual
intervention to hold the world together, as it is completely selfregulating. Furthermore, as the natural order is rational, it can be
understood by human intelligence.
Basic characteristics
• In the hands of classical economists the
'natural order' became a weapon with which
to attack the state regulation and protection
associated with the mercantilist era.
Basic characteristics
• The analysis of economic growth over extended time
periods. Though the theoretical literature of classicism
was to deal with a variety of issues, an overriding
concern with the theme of economic growth too
precedence in the moulding of its analytical categories.
• Theory interested in questions of long-term economic
development, and focused their attention on the
evolution of the economic system as a whole, at the
level of economic aggregates.
• The Laissez-faire Message of Classical Political
Economy.
Basic characteristics
• What distinguished Smith, Mill and others from many
later sociologists and economists was their ambition to
define economics in a broad manner and to be
interested in the insights of other social sciences.
• It is no accident that most classical economists had
some training in philosophy or were themselves
philosophers: Smith was a moral philosopher; Malthus
studied mathematics and natural philosophy; Mill was
trained in both political economy and philosophy, and
published books in economics, philosophy, politics and
social theory.
Adam Smith
(1723 – 1790)
Basic facts about life
• Studied at Glasgow university and at Oxford.
• Became professor at Glasgow university.
• The Theory of Moral Sentiments (1759):
foundation of moral sentiments
• Spent some time in France, met the Physiocrats.
• An Inquiry into Nature and Causes of the Wealth
of Nation (1776) (shortly: Wealth of nation)
• Customs inspectror.
Wealth of nation
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Divided into 5 books:
1. Microeconomic, price theory
2. capital accumulation, financial systém
3. historical: development of capital
accumulation
• 4. international trade, criticism of
mercantelsim
• 5. public sector, taxes and public expenditures
Price theory
• Example: hunting of a beaver takes 2 more time than hunting of a
deer → the price of beaver must be twice of the price of deer.
• Generally: the relative prices of commodities are determined by the
relative amounts of labor needed to produce them.
• Smith widen his theory: the prices are determined by cost of
production (wages, rents for use of land, profits, costs of capital
goods).
• Wages, rents, profits tend toward their normal level („natural
price“). The natural price . . . is, as it were, the central price, to
which the prices of all commodities are continually gravitating’
• The market price can differ from natural price.
• However it cannot stay for long below → the owners withdraw the
resources for market.
• The market price is possible to be higher due to use of resources of
unusual quality or a monopoly granted by the government.
Division of labor (DoL)
• The division of labor is a process by which a particular
productive operation is subdivided into a certain number of
separate operations, each of which is carried out by a
different person. With the division of labor the worker’s
skill increases, the idle time in transferring a worker from
one activity to another is reduced and, above all, technical
progress is stimulated.
• The division of labor is limited by the size of the market, is
only possible when the economy can produce for a
sufficiently large market, and can be intensified only if the
market is expanding.
• Smith‘s opinion: division of labor → enlargement of the
markets → increases in labor productivity, and
• so on; a real virtuous circle of growth.
Accumulation of capital
• Drives DoL.
• Fixed capital: consisting of machinery, plant, buildings,
etc.
• Circulating capital: is used to buy raw materials and pay
for labor and energy
• The wages fund is that part of the circulating capital
which is used to pay the workers. In real terms, it is a
part of the goods produced in a productive cycle which
is used to pay the workers in the successive cycle.
Wages are paid before the product is sold, and for the
capitalist, who advances them, they are capital.
The theory of income distribution
• Smith divided society into 3 classes.
• The landowners: who do not own productive capital, are not
interested in its enlargement and have no incentive to save and
accumulate capital. Their propensity to save is zero, and they make
no contribution to the growth of the wealth of the nation.
• The workers: only possess their labor. The competitive forces on the
labor market push real wages down to subsistence levels. But with a
subsistence wage the propensity to save must be zero.
• The capitalists: possess the productive capital and aim to increase
it. This means they have a very high propensity to save. It follows
that the higher the proportion of the national income going to
profits, the higher the growth in the wealth of the nation. The
general interest of the nation, therefore, coincides with that of the
bourgeois class.
The theory of income distribution
• Wages: determined by the bargaining power of
the parties, fewer employers than workers.
• Level of subsistence: wages must be at least so
high that the workers can survive (he and his
family, including 4 children).
• If demand for labor is higher than supply of labor
wage can be higher than the level of subsistence.
• In real life wages reflect the particular
circumstances pertaining to different positions
(including how difficult and expensive is to learn
the profession).
The theory of income distribution
• The owner of capital takes a larger risk, so
they expected higher profit than wage of
workers.
• Time factor.
• Remuneration is influenced by government
intervention.
The invisible hand
• "It is not from the benevolence of the butcher,
the brewer or the baker that we expect our
dinner, but from their regard to their own selfinterest... [Every individual] intends only his
own security, only his own gain. And he is in
this 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 society more effectually than when he really
intends to promote it."
The invisible hand
• „Every individual necessarily labors 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 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. I have never known much good
done by those who affected to trade for the public
good.”
The invisible hand – today
interpretation
• Each individual strives to become wealthy "intending
only his own gain" but to this end he must exchange
what he owns or produces with others who sufficiently
value what he has to offer; in this way, by division of
labor and a free market, public interest is advanced.
• Smith assumed that individuals try to maximize their
own good (and become wealthier), and by doing so,
through trade and entrepreneurship, society as a
whole is better off. Furthermore, any government
intervention in the economy isn't needed because the
invisible hand is the best guide for the economy.
Free competition
• Invisible hand requires free entry to and exit from
industry otherwise the market price is higher than
natural price
• Free competition can be destroyed including the facts
the sellers have an incentive to collaborate in order to
increase their market power.
• Market as a set of institutions: private ownership, ban
on monopolistic practices, etc.
• Smith had a concept of man as a subject blessed with
multiple selves, whose soul was characterized by
different and contrasting sentiments. Broadly speaking,
there are selfish and altruistic sentiments.
International trade
• Criticism of mercantilism: support of export
and restrictions to the import prevents the
market system from functioning efficiently.
The function of the state
• To protect society against violence and
invasion from other societies.
• To protect each single member of society
against injustice and oppression from other
members of society.
• To offer public goods (necessary good that
market does not offer).
Tax principles
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Every taxpayer have to contribute to the state income to the same extent. This,
however, raises a question what does to "the same extent" mean? It can be
interpreted as giving to the state budget the same percentage of income by every
taxpayer * what is called a flat tax nowadays (this view was supported by Adam
Smith) or diversifying the tax rate between taxpayers. Within the second approach,
taxpayers that have bigger income should pay bigger percentage of that income to
the state budget, so the tax progression is applied.
Every taxpayer has to be sure how much taxes he will have to pay. According to
Adam Smith, this rule is of great importance. He indicated it as one of the most
important features of the tax system. The confidence on how much tax should be
paid determines often the overall condition and assessment of the tax system.
Every tax should be collected at the time and in the manner that is most
appropriate for the taxpayer. Adam Smith shows that this is very important as well
for the taxpayer, because then he can pay taxes on time, and for the tax collector,
because then he can collect taxes on time.
Every tax should return to the society in the value similar to the value of the tax
collected from the society. The perfect situation would be that the same value that
was collected comes back to the society, however this would mean no
administration costs, which is impossible. However, the lower the administration
costs, the better for the tax system.
Is there conflict between The Theory of Moral
Sentiments and The Wealth of nation?
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ToMS: a man as basically a moral and altruistic being.
WoN: emphasizes self-interest.
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Self-interested behavior is not sufficient to generate social harmony in the
presence of perfect liberty. Some form of moral and institutional restraint
is necessary. Human nature is endowed with altruistic sentiments, like
benevolence, which prompts the individual to please his fellow men and
directly generates co-operative behavior.
Human nature is also endowed with altruistic sentiments, like
benevolence, which prompts the individual to please his fellow men and
directly generates co-operative behavior.
Attention for another is a fundamental part of human nature, and
therefore that to assume its existence is essential to the understanding of
all human choices, including economic ones.
This system of rules guarantees orderly functioning of the market without
the individuals having continuously to resort to enforcement to compel
their counter-parties to play by the ‘rules of the game’.
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Other representatives of classical
political economy
List of names
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Jean Baptiste Say (1767 – 1832)
Thomas Malthus (1766 – 1834)
David Ricardo (1772 – 1823)
Nassau Senior (1790 – 1864)
John Stuart Mill (1806 -1873)
Historical background
• The thirty-year period from the Congress of Vienna (1815) to the
1848 revolutions was of crucial importance for the history of
Europe. It is known as the ‘Age of Restoration’. In reality, it was a
period of deep economic and social changes and sharp political
crises; a period full of conflicts, marked as it was by the attempt of
the aristocratic powers to restore the traditional absolutist order
just when the Industrial Revolution was definitively undermining
the economic foundations of that order.
• In some of countries, political uprisings led by democratic forces
occurred repeatedly and with increasing intensity during the thirtyyear period until the great revolutionary upheaval in 1848, but they
were always defeated. The reason for this can perhaps be traced to
the small mass base that the existing social structures offered the
democratic movements; and underlying this situation was
undoubtedly the slow process of capitalist accumulation.
Historical background – the Corn law
(1816) in England
• The Napoleonic wars, by drastically reducing the
imports of food supplies, had provoked a
substantial increase in the prices of cereals, in
particular corn; the prices of manufacturing
goods, on the other hand, had increased less
rapidly than agricultural products and wages.
• The Corn law: Tariffs were fixed at such a high
level that corn, the foreign prices of which were
much lower than the internal ones, could not
enter the country at all.
• Abbolished 1846.
Jean Baptiste Say (1767 – 1832)
• Say’s Law or Say’s Law of Markets: the production is
the source of demand. One’s ability to demand goods
and services from others derives from the income
produced by one’s own acts of production. Wealth is
created by production not by consumption. My ability
to demand food, clothing, and shelter derives from the
productivity of my labor or my nonlabor assets. The
higher or lower that productivity is, the higher or lower
is my power to demand other goods and services.
• John Maynard Keynes, in 1936, famously formulated
Say's Law as: "From the time of Say and Ricardo the
classical economists have taught that supply creates its
own demand...“
Thomas Malthus
• An Essay of the Principle of Population (1798):
• Population increases in a geometrical ratio (the passion between
sexes is necessary and will remain nearly in the present state).
• Subsistence only in an arithmetical ratio (food is necessary to the
existence of man).
• The affirmations are based on the research, but biased.
• Malthus supposed decreasing returns to scale in agriculture.
• Subsistence wages: if the real wage is higher, family have more
children (→ more income), lower the growth of labor forces → the
fall of the wages (the iron law of wages).
• Principles of Political Economy Considered with a View to their
Practical Application (1820): the theory of insufficient aggregate
demand.
David Ricardo
• The Principles of Political Economy and
Taxation (1817): theoretical book with many
economic models:
- the theory of price formation and income
distribution
- the taxation theory and principles
- international trade an other issues.
David Ricardo
• Price theory: beaver – deer example: for hunting
beaver or deer we need weapon and other tools.
How they affect the price of goods?
• We can add to the time necessary for hunting the
animal also the time necessary for production all
tools.
• The importance of capital goods: if capital good
speeder the pruduction (capital intensive goofs)
they earn hihger interests. The value of interest
deviate the market price of final good from labor
value, deviation is about 6-7 percent.
David Ricardo
• Theory of rent (what the price of land
depends on): it is demand for goods that
influence the price of land. Is a good need
land for its production and demand for good is
high than demand for land will be also high
and landowners get high rent.
• The rare (scarce) good: the proce depends on
the demand, it is not posiible to increase
amount of the good.
David Ricardo
• Theory of international trade – theory of
comparative advantages:
• International trade increases the stnadard of
living. Even the country that is not best at any
activity can gain from international trade.
• The countries shold specilizy on activities with
their lower opportunity costs (compare to
OPC of other countries).
David Ricardo
• The table tells us how many people (per years)
are necessary to produce 1 unit of wine or
cloth.
• England wine OPC: 120/100 = 1,2 cloth
• Portugal wine OPC: 80/90 = 0,88 cloth.
• Portugal has in wine production lower OPC
and should produce wine.
England
Portugal
Wine
120
80
Cloth
100
90
David Ricardo
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Theory of taxation
What is the burden of taxation?
„Weight dead loss.“
„There are no taxes which do not weaken the
economy‘s power to accumulate“
• Ricardian equivalence.
John Stuart Mill
• Principles of political economy (1848) – first
economic text-book – economics was taught
from the book till 90th 19th century.
• Essays on Some unsettled Questions of
Political Economy (1844)
• On Liberty (1859): the bible of liberalism?
John Stuart Mill
• The price theory: first introduced supply and demand
analysis – the price of commodity tends to adjust the level
where supply equals demand.
• The question of over-production.
• The law of diminishing returns: leads to stationary state.
• Supported equal access to basic educating for all (both rich
and poor). The upper class should not take responsibility
for poor.
• Supported free competition. Although he had sympathy for
socialistic movement he condemned its tendency to reduce
competition and said that it is not in compliance with
interest of working class.
John Stuart Mill
• The role of the state:
• To protect ownership rights = must be interpreted
narrowly as that ensuring each individual the
right to his own produce or to what he has
legitimately obtained from other producers.
• Rent-seeking: the protection of some industries
against foreign competition may yield short-run
benefits for some groups, but for the country as a
whole it will in the long run be a harmful policy.
• Supported women rights