Download Classical School: This is considered to be the first school of

Classical School:
This is considered to be the first school of economic thought. Let us start with a general overview of
what this school of thought propagates. By the way, I am an out-and-out Classical economist, so
forgive any biases that might creep in. Also understand, that even if it may seem so in this particular
article at times, one cannot conclude that Keynesian economics is flawed or classical economics is
flawed (there's no absolute right and wrong in economics, different theories are applicable under
different economic assumptions).
Definition and Groundwork for the Classical Economics Model
"By pursuing his own interest, he (man) frequently promotes that (good) of the society more
effectually than when he really intends to promote it. I (Adam Smith) have never known much good
done by those who affected to trade for the public good." - Adam Smith (1776), An excerpt from 'An
Inquiry into The Nature and Causes of The Wealth of Nations'.
Adam Smith is the great economist, who is known as the founder of the classical economics school of
thought. Though many others (David Ricardo, Thomas Malthus, John Stuart Mill, William Petty,
Johann Heinrich Von Thunen, etc.) have come and gone, and added a few things here and there, to the
classical theories, we will only be stressing on Adam Smith's version in this article.
The Classical economics theory is based on the premise that free markets can regulate themselves if
left alone, free of any human intervention. Adam Smith's book, 'The Wealth of Nations', that started a
worldwide Classical wave, stresses on there being an invisible hand (an automatic mechanism) that
moves markets towards a natural equilibrium, without the requirement of any intervention at all. In
better economic words, the division of labor and the free market will automatically tend toward an
equilibrium that advances public interests. Sounds fascinating? Let us see how.
Classical Economics Assumptions
Before working our way towards the working of this model, let us first know and understand the
assumptions. The idea, is that like any theory, if the founding assumptions do not hold, the theory
based on them is bound to fail. There are three basic assumptions. They are:
Flexible Prices: The prices of everything, the commodities, labor (wages), land (rent), etc. must be
both upwardly and downwardly mobile. Unfortunately, in reality, it has been observed that these
prices are not as readily flexible downwards as they are upwards, due a variety of market
imperfections, like laws, unions, etc. Say's Law: 'Supply creates its own demand'. The Say's law
suggests that the aggregate production in an economy must generate an income enough to purchase all
the economy's output. In other words, if a good is produced, it has to be bought. Unfortunately, this
assumption also does not hold good today, as most economies today are demand driven (production is
based on demand. Demand is not based on production or supply). Savings - Investment Equality: This
assumption requires the household savings to equal the capital investment expenditures. Now it takes
no genius to know, that this is rarely the case. Yet, should the savings not equal the investment, the
'flexible' interest rates should be able to restore the equilibrium.
Classical Economics - The Workings of An Economy
"Civil government, so far it is instituted for the security of property, is in reality instituted for the
defense of the rich against the poor, or of those who have some property against those who have none
at all." - Adam Smith from 'The Wealth of Nations', 1776.
All the normal principles of economics apply to classical economics as well. If all the assumptions
hold, classical economics works as follows.
Wage Markets
Classical economics negates the fact that there can be some unemployment (especially involuntary) in
an economy, because classical economists believe in the self-correcting mechanism of an economy.
Their contention is based on the following:


Whenever there is unemployment in an economy, it is usually a temporary disequilibrium
because it is an equilibrium caused by excess labor available at the current wage rate.
Whenever wages are high, there are always more people willing to work at that ongoing rate
and this is termed as unemployment. In an unregulated, classical economy, where wages are
perfectly flexible, the wage rates fall, eliminating the excess labor available and reducing the
unemployment back to equilibrium levels. How exactly does this happen? This happens
because all hirers favor their self-interest motives. When laborers are still available when he
pays them a lower wage, why should he pay more. He thus adjusts his wage rates downwards,
acting in the overall welfare of society, without knowing it.
Commodity Markets
The Say's law that equates the demand and supply in an economy actually applies to aggregates and
not single goods and commodities. Classical economists believe that the commodities markets will
also always be in equilibrium, due to flexible prices. If the supply is high and there is inadequate
demand for it, it is a temporary situation. The prices for the commodity in question, decrease, to
equate the demand and supply and bring the situation back to equilibrium. How does this work? Well,
what would you do if you had a commodity that you needed to sell but weren't able to secure a buyer.
You'd obviously reduce the prices step by step, in a trial and error manner and finally reach a price that
might tempt a buyer to buy. It is a similar case with the aggregate demand and supply, say the classical
theorists.
Capital Markets
In the beautiful free world of classical economics, no human intervention is required to lead the capital
markets to equilibrium as well. If the economy does not follow the last assumption and shows a
mismatch in savings and investments, the classical economists provide the evergreen solution - do
nothing, it is temporary and will correct itself. If savings exceed investment, the interest rates fall and
the market achieves equilibrium again. On the other hand, if savings fall short of investments, the
interest rates rise and once again, the economy reaches its own equilibrium. Let us now see how all the
markets come together in the classical economics model. One potential problem with the classical
theories is that Say's law may not be true. This may happen because not all the income earned goes
towards consumption expenditures. The total savings thus saved, translate into the missing potential
demand, which is the cause of the disequilibrium. When supply falls short of effective demand like
this, several things spiral downwards: producers reduce their production, workers are laid off, wages
fall resulting in lower disposable incomes, consumption declines reducing demand by further more
and starting a self-sustaining vicious cycle. However, classical economists argue that what happens to
the savings that started to the whole chain is the key solution here. If all of these savings go in as
investments, the interest rates adjust to bring the economy back to equilibrium once again, with
absolutely no problems at all. The only glitch, are all savings actually invested in reality? By
investment, classical economists mean capital generation, so I doubt it! But as one can see, according
to classical theories, there is really no need for any government intervention. No wonder then, that
they are against it, for they can provide good backing to all the arguments that state, that government
intervention cannot help, but can actually harm the economy in the long run.
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major
developers include Adam Smith, David Ricardo, Thomas Malthus and John Stuart Mill. Sometimes
the definition of classical economics is expanded to include William Petty, Johann Heinrich von
Thünen, and Karl Marx.
Adam Smith's The Wealth of Nations in 1776 is usually considered to mark the beginning of classical
economics. The school was active into the mid 19th century and was followed byneoclassical
economics in Britain beginning around 1870.
Classical economists attempted and partially succeeded to explain economic growth and development.
They produced their "magnificent dynamics" during a period in which capitalism was emerging from a
past feudal society and in which the industrial revolution was leading to vast changes in society. These
changes also raised the question of how a society could be organized around a system in which every
individual sought his or her own (monetary) gain.
Classical economists reoriented economics away from an analysis of the ruler's personal interests to a
class-based interest. Physiocrat Francois Quesnay and Adam Smith, for example, identified the wealth
of a nation with the yearly national income, instead of the king's treasury. Smith saw this income as
produced by labor applied to land and capital equipment. Once land and capital equipment are
appropriated by individuals, the national income is divided up between laborers, landlords, and
capitalists in the form of wages, rent, and interest.
History
Central Concepts
Value Theory
Classical economists developed a theory of value, or price, to investigate economic dynamics. Petty
introduced a fundamental distinction between market price and natural price to facilitate the portrayal
of regularities in prices. Market prices are jostled by many transient influences that are difficult to
theorize about at any abstract level. Natural prices, according to Petty, Smith, and Ricardo, for
example, capture systematic and persistent forces operating at a point in time. Market prices always
tend toward natural prices in a process that Smith described as somewhat similar to gravitational
attraction.
The theory of what determined natural prices varied within the Classical school. Petty tried to develop
a par between land and labor and had what might be called a land-and-labor theory of value. Smith
confined the labor theory of value to a mythical pre-capitalist past. He stated that natural prices were
the sum of natural rates of wages, profits (including interest on capital and wages of superintendence)
and rent. Ricardo also had what might be described as a cost of production theory of value. He
criticized Smith for describing rent as price-determining, instead of price-determined, and saw
the labor theory of value as a good approximation.
Some historians of economic thought, in particular, Sraffian economists (e.g., [1] or [2]), see the
classical theory of prices as determined from three givens:
1. The level of outputs at the level of Smith's "effectual demand",
2. technology, and
3. wages.
From these givens, one can rigorously derive a theory of value. But neither Ricardo nor Marx, the
most rigorous investigators of the theory of value during the Classical period, developed this theory
fully. Those who reconstruct the theory of value in this manner see the determinants of natural prices
as being explained by the Classical economists from within the theory of economics, albeit at a lower
level of abstraction. For example, the theory of wages was closely connected to the theory of
population. The Classical economists took the theory of the determinants of the level and growth of
population as part of Political Economy. Since then, the theory of population has been seen as part of
some other discipline than economics. In contrast to the Classical theory, the determinants of the
neoclassical theory value:
1. tastes
2. technology, and
3. endowments
are seen as exogenous to neoclassical economics.
Classical economics tended to stress the benefits of trade. Its theory of value was largely displaced
by marginalist schools of thought (such as the Austrian School) which sees "use value" as deriving
from the marginal utility that consumers finds in a good, and "exchange value" (i.e. natural price) as
determined by the marginal opportunity- or disutility-cost of the inputs that make up the product.
Ironically, considering the attachment of many classical economists to the free market, the largest
school of economic thought that still adheres to classical form is the Marxianschool.
Monetary Theory
British classical economists in the 19th century had a well-developed controversy between the
Banking and the Currency school. This parallels recent debates between proponents of the theory of
endogeneous money, such as Nicholas Kaldor, and monetarists, such as Milton Friedman. Monetarists
and members of the currency school argued that banks can and should control the supply of money.
According to their theories, inflation is caused by banks issuing an excessive supply of money.
According to proponents of the theory of endogeneous money, the supply of money automatically
adjusts to the demand, and banks can only control the terms (e.g., the rate of interest) on which loans
are made.
Debates on the definition of Classical Economics
The theory of value is currently a contested subject. One issue is whether classical economics is a
forerunner of neoclassical economics or a school of thought that had a distinct theory of value,
distribution, and growth.
Sraffians, who emphasize the discontinuity thesis, see classical economics as extending from Willam
Petty's work in the 17th century to the break-up of the Ricardian system around 1830. The period
between 1830 and the 1870s would then be dominated by "vulgar political economy", as Karl Marx
characterized it. Sraffians argue that: the wages fund theory; Senior's abstinence theory of interest,
which puts the return to capital on the same level as returns to land and labor; the explanation of
equilibrium prices by well-behaved supply and demand functions; and Say's law, are not necessary or
essential elements of the classical theory of value and distribution.
Perhaps Schumpeter's view that John Stuart Mill put forth a half-way house between classical and
neoclassical economics is consistent with this view.
Sraffians generally see Marx as having rediscovered and restated the logic of classical economics,
albeit for his own purposes. Others, such as Schumpeter, think of Marx as a follower of Ricardo.
Even Samuel Hollander[3] has recently explained that there is a textual basis in the classical economists
for Marx's reading, although he does argue that it is an extremely narrow set of texts.
The first position is that neoclassical economics is essentially continuous with classical economics. To
scholars promoting this view, there is no hard and fast line between classical and neoclassical
economics. There may be shifts of emphasis, such as between the long run and the short run and
between supply and demand, but the neoclassical concepts are to be found confused or in embryo in
classical economics. To these economists, there is only one theory of value and distribution. Alfred
Marshall is a well-known promoter of this view. Samuel Hollander is probably its best current
proponent.
A second position sees two threads simultaneously being developed in classical economics. In this
view, neoclassical economics is a development of certain exoteric (popular) views in Adam Smith.
Ricardo was a sport, developing certain esoteric (known by only the select) views in Adam Smith.
This view can be found in W. Stanley Jevons, who referred to Ricardo as something like "that able,
but wrong-headed man" who put economics on the "wrong track". One can also find this view in
Maurice Dobb's Theories of Value and Distribution Since Adam Smith: Ideology and Economic
Theory (1973), as well as in Karl Marx's Theories of Surplus Value.
The above does not exhaust the possibilities. John Maynard Keynes thought of classical economics as
starting with Ricardo and being ended by the publication of Keynes' General Theory of Employment
Interest and Money. The defining criterion of classical economics, on this view, is Say's law.
One difficulty in these debates is that the participants are frequently arguing about whether there is a
non-neoclassical theories that should be reconstructed and applied today to describe capitalist
economies. Some, such as Terry Peach[4], see classical economics as of antiquarian interest.