The History of Economic Thought

LC Economics Syllabus

Economic System and Economic Thought • Brief historical outline of economic thought –

Smith, Marx, Keynes etc. • Market, centrally planned and mixed

economies.

Exam Questions OL

Short• 2009 Q9 Match• 2007 Q 9 Match • 2006 Q 4 Match• 2004 Q 8 Cannons of Tax• 2003 Q 7 Match• 2001 Q 4 Match

Long• 2010 Q 4 (b) Keynes - Mult• 2010 Q 5 (b) Smith - COT • 2008 Q 5 (c) Smith COT• 2005 Q 5 (c) Smith COT,

DOL• 1999 Q8

2007

Ordinary Level-Short Questions20

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2006

2004

2003

2001

Ordinary Level-Long Questions2005

2008

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2010- Question 4 (b)

2010- Question 5

Exam Questions HL

Short

• 2005 Q 8 Keynes • 2002 Q 4 Keynes• 2001 Q 8 Monetarists• 2000 Q 9 Smith

Long• 2010 Q 6 (b) Milton Friedman• 2009 Q 7(c) Ricardo• 2007 Q 4 (c)

Smith/Marshall/Keynes/Freidman• 2003 Q 8 (c) Smith

2010

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2009- Question 4

2009- Question 7

2007

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4

2006

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4

2006- Question 5

2003

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8

2002

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Short Questions

2005

2004

2002

State THREE contributions made to economic thought by the Monetarist economists.

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Watch out for the following definitions contained in this presentation!!

• Fiscal Policy• Monetary Policy• Consumer Surplus• Price Elasticity of Demand

(PED)• Cannons of Taxation• Quasi Rent• Protectionism• Laissez-faire

• Iron Law of Wages• Law of Diminishing Marginal

Returns• Economic Rent• Law of Comparative

Advantage• Say’s Law• The Multiplier• Liquidity Preference Theory

Early Economists

• Plato (427-347 BC)• Aristotle (384-422 BC)• Thomas Aquinas (1225-1274)

Not on the course but worth a look for interest sake!

Plato (427-347 BC)

Division of labor Currency system

Individual subordinate to the state

Public administration

& finance

Aristotle (384-322 BC)Unnatural wealth

unlimitede.g.. exchanging

MoneyMeasure of

wealthStore of value

Value in useValue in exchange

True/genuine wealthlimited

E.g.. agriculture, mining

Thomas Aquinas (1225-1274)

Christian principals co-exist witheconomic life

Morality of wealth depended

on its use

Concerned about money lending &

unjust price charged for it

Common ground

The Mercantilist (1500-1780)

• Thomas Mun (1571-1641)

• Believed that;1.Gold was the prime measure of a

countries wealth.2.Exploitation of colonies.3.Protectionism.

3. Unused agricultural land should be cultivated.

1. England was to become wealthy by exporting more goods than she imported.

2. England must reduce the consumption of all imported goods.

4. All domestic needs should be supplied by home industries.

5. Exporters should gain max benefit by obtaining high prices for essential goods and lower prices for more competitive goods.

6. All English exporters should use the English merchant fleet and keep as much of their costs as low as possible.

7. Trade from and to England could be increased by developing the country as a centre of exchange.

The Physiocrat (1750-1800)

• Francois Quesnay (1694-1774)• Wrote “Economic Table”.

• Believed that;1.Wealth had its origin in agriculture.2.Private ownership of property important.3.Non gov intervention (except for laws).4.Free trade.

In his famous book he set out the first attempt to explain the circular flow of income.He did this by comparing the flow of the economic resources in an economy to the circulation of blood.

He divided society into 3 distinct classes:1.The Working Class.2.The Landowners.3.The Sterile Class.

A country generated wealth from the surplus created by agriculture- “Produit Net”

He also showed how the surplus of agriculture spread throughout the country in his book.

Quesney’s Society

The Classical Economists

1. Adam Smith (1723-1790)2. Thomas Robert Malthus (1766-1834)3. David Ricardo (1772-1823)4. Jean Baptiste Say (1767-1832)5. John Stuart Mill (1806-1873)

Adam SmithClassical Economist

Scottish(1723 – 1790)“……The Wealth of

Nations”

Pursuit of self interest

Benefited individual therefore society

Division of LaborIncreases

productivity and a country’s wealth.

E.g.. it takes 18 different operations to

make a pin!

Labour theory of value & wealth

The value of an item is equal to the amount of labour that goes into producing it

Laissez-faireNo justification for

government intervention except for defense/justice

Invisible hand of competition

Allows self regulation to

operate ensuring economic progress

Free TradeWith no tariffs/tax, markets operate

effectively & trade to be spread

between nations

Cannons of Taxation

Fair tax system; equity

economy certainty

convenience

• Labour is the source of a country’s wealth.

• Wealth should be increased by the division of labour( showed this by the observation of straight pins.)

• Developed a labour theory of value; the value of an item is equal to the quantity of labour which it can demand in exchange for itself.

• Free competition ensured that prices were set freely.

• Encouraged free international trade.

• Role of the government- defence, education & education.

• Favoured taxation of rent to fund government and developed canons of tax: equity, economy, convenience & certainty.

• Wrote: wealth of nations.

The wealth of Nations(benefits of free trade)

• The pursuit of self interest- “what benefits the individual, best benefited the society.”

• Division of Labour- increased productivity increased the wealth in a country. He illustrated his theory with the example with the manufacture of pins.

• The labour of value theory- the value of an item was equal to the amount of labour that went into the producing the product. The value of anything is equal to the labour it can save you.

• Invisible hand of competition- Smith advocated the operation of a self regulating market, thus ensuring economic progress was achieved.

• State protection of property rights- encourages the accumulation of property wealth.

• Perfect competition- free entry into markets; profits are sufficient to reward entrepreneurs, inefficiencies penalised and price would be based on the cost of production. Monopolies would not persist.

• Laissez-faire- no justification for government intervention except for defence/ justice.

• Cannons of Taxation-to fund the state’s defence/justice systems taxation was necessary and he developed the four principles of fair tax system: Equity Economy Certainty Convenience.

• Paradox of value- Smith distinguished between “value in use” and “value in exchange”. Some items had a vast utility but are not exchanged, while others possessed little utility but could operate effectively and allow the gains from trade to be spread between nations.

• Smith advocated specialism of labour.

• He distinguished between productive and non productive labour.

Thomas Robert Malthus

Classical EconomistEnglish

(1776-1834)“The Principles of

Population”Applied the Law of Diminishing

Returns to Land

•Best land taken up first, then next best, then inferior….•At each stage the amount of food is less than before.

Iron Law of WagesWages will naturally tend towards the subsistence level (just enough to get by/ the equivalent of normal profit).If they get any higher, the population will rise and wages will be competed back down to subsistence level.

An increase in wage above subsistence level

= increase in population

= increase in supply of labour

=decrease in wage

If wages above the subsistence level population will.Therefore the supply of labour will and Wage Rates will . This would lead to a in population and force wages up to subsistence level.

Theory of Population & Food•Population grows geometrically (2,4,8,16,32).•Food grows arithmetically (1,2,3,4,5,6).•If population is not kept in check famine & disease would result.( The Green Revolution helped to avert his predictions.)•SOL did not fall in 19th C but his ideas were more relevant in the population explosion of the 20th C

David RicardoClassical Economist

English(1772-1823)

“The Principles of Political Economy & Tax”

Economic Rent

•If population increases inferior land used.•For use of land rent was paid.•Cost of producing on the best land was lower.•Food produced on good land earned a surplus over that produced on inferior land.•This surplus led to an increased rent payable for the use of good land.

Law of Comparative

Costs/Advantage

•Supported idea of free trade.•A country should specialise in the production of those goods in which it is relatively most efficient .•And trade for the remainder of it’s requirements.

Accepted the Subsistence Wage TheoryHe agreed that an

increase in wage above subsistence level= increase in population

=decrease in wage

Jean Baptiste Say (1767-1832)Wrote: “Treatise on Political Economy”

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Enterprise• Say said enterprise was the 4th Factor of Production . •The return being profit or loss.

Say’s Law

• “Supply creates it’s own demand”.• People make products they are most efficient at. • They exchange their surplus for money.• They use this to buy goods that they want. • Therefore the supply of goods creates a demand for goods.

If you make and manage to sell what you’re good at producing, you then have the money to demand what others can produce.

Supply creates its own demand.

Economic crisis & over production could not exist because production created demand.However they did occur and he explained this by the restrictions imposed on free trade.

According to Say, people work, not for its own sake, but only to satisfy their demand for goods & services.

Workers cannot satisfy all their own needs directly from their own work. Through specialism they can exchange their surplus of output for the surplus output of others.

Production is therefore an essential core of the demand for other goods.As a result there can never be overproduction.Aggregate Demand = Aggregate Supply – production on one side is reciprocated by demand on the other.

Say’s Law

John Stuart Mill (1806-1873)

Wrote: “Principals of

Political Economy…”

John Stuart Mill (1806-1873)Wrote: “Principals of Political Economy…”

• He advocated the following;1.Demand & supply were important in

assessing the value of a product. 2.Law of diminishing marginal returns. 3.Predicted the emergence of dominant

firms.4.Establishment of trade unions to

counteract the power of dominant firms. Mill became disillusioned by the capitalist system &

began to lean towards a mild form of socialism.

Recognised the importance of the LDMR

Wages are determined by the capital available to pay wages divided by the working population.Wages can be increased by:1.Cutting the population.

or2.Increasing the capital fund.

He believed that Demand & Supply were equally as important in determining Value.

The excess of earnings should be redistributed in order to increase welfare of society in general.

Correctly predicted the emergence of large companies and oligopolies due to economies of scale.

Saw a role for trade unions in moderating the power of large companies.

He was guided by the principle that the individual has the right to do whatever he wishes as long as it causes no harm to others.

“Nothing can be done for Ireland without transforming the rural population from cottier tenants into ….land proprietors (owners)”.

JS Mill, “Principles of Political Economy” (1848)

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Karl Marx (1818-1883)

Karl Marx (1818-1883)

ProfitLabour produced a surplus value which

was profit for employers

Saw a class division:Two tiered society

=unequal distribution of wealth

Capitalists (owners)Proletariat (workers)

Profits invested in technology

Reduced need for labor =

unemployment

Social revolutionWhere proletariat would take public

ownership of the FOP

PredictedGrowth of oligopolies

ForecastedEmergence of trade

cycles

He overlooked the power of the trade unions to improve the rights of the workers.

Marx inspired many communist regimes, such as the Soviet Union that collapsed in 1991.

CapitalismSocialismCommunism

Labour theoryPeople required to

work more hours than necessary to

generate the income needed to pay their

wages.

Karl MarxSocialistGerman

(1818-1883)“The Communist

Manifesto”

Labour Theory of Value• The value of a good was the cost needed to produce

the good.• Labour paid just enough to raise a family but

workers were required to work a number of hours in excess of this.

• For this he was producing profit/value for his employer.

• This excess value was called the “Surplus Value” and represented the exploitation of the workers by the capitalist.

• Marx predicted a worker revolution to collectively seize the means of production.

• He believed that since workers generated all the income they deserved all the profits.

• The exploited working class would grow in numbers, organise themselves, revolt and over throw capitalists.

• The workers would then redistribute wealth.• A Communist society could be created to replace Capitalism- it

would be a classless society with no need to struggle.• He downplayed the role of land, labour, capital and especially

enterprise in generating income and profit.

Criticism ofKarl Marx

• Despite what Marx believed, the growth of unions ensured protection of working class and improved the.

• Middle & professional classes emerged.• Technology did not lead to mass

unemployment.• The Labour theory of value has been

discarded: Labour is useless without land or capital.

• He falsely predicted that the advances of technology would lead to mass unemployment.

However• Predictions on emergence of oligopolies &

trade cycles came true.

The Neo-classical Economists Alfred Marshall (1842-1924)

•Came up with the concept of elasticity.•Introduced the concept of short & long runs.•Introduced the concept of Diminishing Marginal Utility.•Scissors analogy. •Quasi-rent•Saw a role for government in the economy.

Theory of ValueThe value of an item is determined;•SR by utility and demand•LR by cost of production

Alfred MarshallNeo-classical

English(1842-1924)

“The Principles of Economics & Money, Credit & Commerce”.

Distribution of income/wealth

The return to each FOP is determined by their marginal utility

Growth of monopolies could be prevented

by;•Gov regulation•Consumer information•More accountability

Quasi RentEconomic rent earned

by FOP in SR when D>S

Consumer Surplus

The difference between what a consumer actually pays for a good and the maximum which he/she would have been willing to pay rather than going without it.

Price-elasticity of demand

Quantified buyers’ sensitivity to price changes

Marginal Revenue ProductivityThe return to each FOP is determined by its MPP- i.e. the productivity of the last unit of FOP used to produce output.

CompetitionRegulated economic activity as well as some government intervention.

Marshall’s scissors analogy.

• Demand & supply are interdependent just like the blades of a scissors.

• One cannot cut without the help of the other.

Keynesian Economists

• John Maynard Keynes (1883-1946)

• Studied at Eton and Cambridge. • Wrote: Treatise on Money

(1930), The General Theory of Employment, Interest & Money (1936)

John Maynard Keynes (1883 – 1946) He wrote The General Theory of Employment Interest and Money. He represented the UK government at the Versailles peace conference in 1919 and at Bretton Woods in 1944. He strongly criticized the laissez- faire balanced budget policies of the UK government in the 1920’s and 1930’s. He maintained that full employment was not a natural state and that economies could settle in equilibrium at less than full employment i.e. an economy could slide into a slump and stay there. His unorthodox views created a storm among the establishment but he stuck to his view that the government would have to intervene in the economy, increase its own spending and raise aggregate demand to the full employment level. Keynes was not in favour of overthrowing capitalism but instead put forward ideas to support it. Keynes also had his Liquidity Preference Theory of Interest Rates and The Multiplier. Keynes was into controlling the economy through fiscal policy and demand management.

John Maynard KeynesKeynesian

British (1883-1946)

“The General Theory of Employment, Interest &

Money”

Investment decisions

Depends on expectations not rate of interest

3 reasons (motives) for

holding money

Favored government intervention

•It is the job of the government to run the economy•Gov should stimulate demand in a recession by spending money (fiscal policy).•Gov can use fiscal policy (any action taken by the government which alters current revenue &

exp) to create full employmentIf

Inv<Saving=LeakageLeads to a decrease in

national income & employment

Liquidity preference

theory

•Transaction motive•Precautionary •Speculative

The multiplierShows the relationship between an initial injection into the circular flow of income and the eventual total increase in

national income.

KEYNESIAN ECONOMICS.

Keynesian economics was born during the Great Depression of the 1930s and has been, for the most part, followed in most capitalist countries ever since. English economist John Maynard Keynes (1883-1946) argued that self-adjusting market forces would take a long time to restore full employment. He held that the government should intervene to increase aggregate demand through the use of fiscal policy, which involves government spending and taxation. By increasing government spending, for instance, jobs will be created which will increase income levels, which will increase the aggregate demand for goods and services and thus create new jobs.

Modern Keynesians (also, known as neo-Keynesians) recommend monetary policy, in addition to fiscal policy, to manage the level of aggregate demand. An increase in the money supply, for example, leads to a decrease in the interest rate which increases private investment and consumption, boosting the aggregate demand in the economy.

An increase in aggregate demand under the Keynesian system, however, not only generates higher employment but also leads to higher inflation. This causes a policy dilemma—how to strike a balance between employment and inflation. According to laws that were enacted following the Great Depression, policy makers are expected to use monetary and fiscal policies to achieve high employment consistent with price stability.

The Monetarists

Milton Friedman (1912-2009)

Wrote:•A Monetary History of the United States 1867-1960•Inflation- Causes and Consequences.•Free to Choose.

Nobel Prize winner 1976

Believed in privatisation & deregulation.

Supported Laissez-faire and the free market.

Milton FriedmanMonetarist

(1912 -2009)“A Monetary History of the US”

Monetary policyShould be the main instrument used by the government to manage the economy.(Actions taken by the gov/ECB which influences the money supply, interest rates and availability of credit).

Control of money supplyControl inflation by strict control of money supply.Restrict loans & high interest rates.

Reduction in inflationLeads to increases competitiveness,cheaper exports & job creation in the long run.Companies keep wage increases to a minimum to avoid cost-push inflation.Low inflation creates stable wages & prices, encourages investment, increases national competiveness and as a result generates economic growth and jobs.

Laissez faire•Minimum state intervention•De-regulation of markets•Privatisation

Supply side policies

Improve market efficiency, boost supply, reduce the power of trade unions.

Monetarist:i.e. advocates use of interest rate and restricted money flow to control inflation.

He believed that government spending in a recession would only lead to inflation

Friedman supported Laissez-faire & the free market.

The Shock Doctrine

Advisor to Nixon, Pinochet, Thatcher, Regan & GW Bush Jnr

Other Modern Economists

• Supply-siders• J. K. Galbraith (1908-2006)

Supply-sider theoristsLate 20th Century

1. Economy developed by stimulating the supply of goods.

2. Reduce taxes, encourage work, investment & government revenue.

3. Deregulation & privatisation encourages competition, increase word production & reduce prices.

• Controversial because it advocates reduction of higher rates of tax which benefits the wealthy.

• However supply siders claim that reducing tax rates will lead to increased tax revenue.

• This is because increasing tax rates is a disincentive to work & invest.

J. K. GalbraithMaverick

Keynesian/liberalist(1908-2006)

• Wrote the book “The Affluent Society”.• Recommended that

governments should increase tax to reduce conspicuous consumption.

• Warned of economic power of multinational oligopolies.