Major Schools of Economic Theory

Adam Smith, fatherOf modern economics

IntroductionThe word “economics” is derived from the Greek

word oikonmikos which means skilled in household management.

Although the word is very hold the discipline of economics is a relatively recent development.

Modern economic thought emerged in the 17th and 18th centuries as the western world transformed from an agrarian to an industrial society.

Despite the enormous differences between then and now, the economic problems with which society struggles remain the same:

• How do we decide what to produce with our limited resources?

• How do we ensure stable prices and full employment of our resources?

• How do we provide a rising standard of living both for ourselves and for future generations?

Mercantilists and Mercantilism

•Mercantilism was the economic philosophy that held a nation’s wealth came primarily from the accumulation of gold and silver. Nations without mines could obtain gold and silver only by selling more goods than they bought from abroad.Thomas Paine

Physiocrats

Francois Quesnay

•Physiocrats, was a group of 18th century philosophers, developed the idea of the the economy as a circular flow of income and output. They also advocated laissez- faire economics. They opposed the Mercantilist idea of promoting trade at the expense of agriculture.

Classical School of Economics

The Wealth of Nations

by Adam Smith

•In the Wealth of Nations, Adam Smith identified the three factors of production: land, labor, and capital. •Smith believed the “ideal economy was a self-regulating one. That is to say, that it automatically satisfies the needs of the populace. He called as the “invisible hand.” •Smith also supported the idea of laissez-faire capitalism.

•David Ricardo focused on the “distribution of wealth” among landowners on one side and capital on the other. He believed when population growth and capital “pressed down” on a fixed supply of land, that this would push rents up and wages and profits down.

•Thomas Malthus used the idea of “diminishing returns” to explain low living standards. He believed that a rapidly growing population against a limited amount of land meant diminishing returns to labor. He believed this would lead to chronically low wages, which would limit the standard of living. • He also questioned idea of a market economy that would be able to produce full employment.

•John Stuart Mill parted company from the other Classical economists in the area of distribution of income. •Mill believed that society may be efficient in allocating resources but not in distributing income. He maintained that society must get involved.

Marginalist School

• Marginalist economists emphasized that prices also depend on the level of demand, which in turn depends upon the amount of consumer satisfaction provided by individual goods and services.•They provided modern macroeconomics with basic analytical tools of demand and supply and consumer utility.•Finally they pushed the idea that land, labor, and capital receive returns equal to their contributions to production. Sometimes this was used to justify existing distribution of income.

Marxist School

•The Marxist School challenged Classical theory. Karl Marx saw capitalism as an “evolutionary” phase in economic development. He believed capitalism would eventually destroy itself. •Marx believed in the labor theory of value which states that all production belongs to labor because workers produce all value in society. He also believed that the market system allows capitalists, (the owners of machinery and factories) to exploit workers by denying them a fair share of what they produce. •He believed workers would eventually rise up and overthrow this type of capitalism.

Institutionalist School

•Institutionalists believed in government controls and social reform to bring about a more equal distribution of income.

•Reacting to the worldwide depression, John Maynard Keynes broke from the Classical tradition and wrote General Theory of Employment, Interest, and Money. •In the Classical view, most economists believed that in a recession, wages and prices would decline to restore full employment. Keynes believed that the direct government intervention was necessary to increase total spending.•These theories are the modernRationale for the use of government Spending and taxing to stabilize theeconomy (fiscal policy).

Summary

•Monetarism updates the Quantity Theory, the macroeconomic analysis before Keynes. It reemphasizes the role of monetary growth.

• Rational Expectations Theory provides a contemporary rationale for the pre-Keynesian tradition of limited government in the economy.

•Supply-side Economics recalls the Classical School’s concern with economic growth as a fundamental prerequisite for improving society’s material well-being. It emphasizes the need for incentives to save and invest if the nation’s economy is to grow.