History of economic thought

Economics is a social science. It studies the production, distribution, and consumption of goods and services. The word 'economics', originally "rules of the house", comes from the Greek οἶκος (oikos: house) and νόμος (nomos: custom or law). Economics stems from the natural propensity of human beings to barter, to exchange or trade goods. Whilst there are no records of dogs ever having bartered bones, humans have been bartering all sorts of goods since pre-history. Economics as an independent science - and as we understand the word today - begins with the work of Adam Smith, The Wealth of Nations. . Before Smith, Economics was just a chapter in political science, the art of managing a state. This article will focus on economics since it became a science independent from politics. For the history of early economics leading up to the development of The Wealth of Nations see the article History of Ancient Economics.

Definition of economics

Even the definition of economics is subject to controversy. Many economists view economics as the study of how scarce resources are allocated to satisfy alternative competing human wants. This is a "neo-classical" view first formulated by Lionel Robbins in 1935 and repeated in most economics texts; for example, Paul Samuelson, who, in his famous book Economics - An Introductory Analysis , defines Economics as:

the study of how men and society 'choose', with or without the use of money, to employ 'scarce' productive resources to produce various commodities over time and distribute them for consumption, now an in the future, among various people and groups in society.

However, a more traditional view is that "Economics is the subject concerned with the material welfare of individuals and groups in society" (Asimakopulos, 1978). or "The economic problem is the study of the process of providing for the material well-being of society". (Heilbroner), or the famous Alfred Marshall "Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing."

The list of acceptable definitions of economics is endless. Economics can be described as the study of those activities which, with or without money, involve exchange transactions among people. Economics is also the study of wealth.

One can play with definitions, but a favourite remains the one proposed by a Canadian economist, Jacob Viner (1892-1970) as "Economics is what economists do". Economics is far from being an exact science. Formal economics is awash in ostensible experts who disagree on the most basic questions of theory and evidence; some Nobel laureates who shared the same prize may have diametrically opposed views on some economic issues. "(...)changes in the economy mean that economic theories are continually being applied under new circumstances, under which they have never been tested". Schumpeter's insight clarifies the matter:

Let us begin in a thoroughly common-sense manner. What distinguishes the 'scientific' economist from all the other people who think, talk, and write about economic topics is a command of techniques that we class under three heads: history, statistics, and 'theory'. The three together make up what we shall call Economic Analysis.

Of these three fundamental fields, economic history -- which issues into and includes present day facts -- is by far the most important. I wish to state right now that if, starting my work in economics afresh, I were told that I could study only one of the three but have my choice, it would economic history that I would choose. And this on three grounds.

First the subject matter of economics is essentially a unique process in historic time. Nobody can hope to understand the economic phenomena of any epoch, including the present, who has not an adequate command of historical facts and an adequate amount of historical sense or of what may be described as historical experience.

Second, the historical report cannot be purely economic but must inevitably reflect also 'institutional' facts that are not purely economic: therefore it affords the best method for understanding how economic and non-economic facts are related to one another and how the various social sciences would be related to one another.

Third, it is, I believe, the fact that most of the fundamental errors currently committed in economic analysis are due to a lack of historical experience more often than to any other shortcoming of the economist's equipment.

Classical economy

The "Classical" period of economic thought began in 1776 with the publication of Adam Smith's The Wealth of Nations . Written during the gentle era of Enlightenment, the laissez-faire policies of Adam Smith did not anticipate the economic and social upheavals that the industrial era was about to unleash. Only 13 years later the French court was bankrupt and the French people took to the streets and beheaded their king; it was the French Revolution.

Among the economists who tried to understand the new phenomena three were outstanding: Jean-Baptiste Say , Thomas Robert Malthus and David Ricardo. They all had different visions for political economy after Smith. Of those, Ricardo was the most succesful and influential and laid the basis for the Classical Economy that would become the mainstream economy thought for the whole of the XIX century

Thomas Robert Malthus (1766-1834) is most famous for his "Essay on the Principle of Population" where he formulated the theory that population expanded at a geometric rate (or exponentially) while food production could only increase arithmetically. At a certain point, the population increase would outrun the food supply, and result in general misery. Malthus was one of the major inspirations for Darwin’s theory of Natural Selection, and his echoes can be found in today’s environmental literature that warn of depleting resources.

David Ricardo (1772-1823) was perhaps the most important of the XIXth century political economists. He combined Smith's labour theory of value with Malthus's population dynamics in a system which showed that capitalist economies would eventually result in a steady state of universal misery. On his On the Principles of Political Economy and Taxation Ricardo set the theoretical fundaments of the Classical Economy.

Ricardo's system depended on the idea of the marginal productivity of land, and was the inventor of the "marginal" concept. His idea was that the value of agricultural products (and hence food) was based on the amount of labour required to produce on the least fertile parcel of land. Hence the "Law of diminishing marginal productivity". Landlords owning land that was more fertile, and who could produce more for a given amount of land, obtained "rents". His conclusion was that the future was in buying land. He, of course, did not predict the tremendous increase in technology and productive capacity brought about by the capitalist system.

Ricardo was also responsible for the idea of comparative advantage in international trade . His classic example was between wine and clothing and England and Portugal. Portugal was more efficient than England in producing both cloth and wine, but England had a comparative advantage in cloth production. He showed that it would be advantageous for Portugal to specialize in wine and England to specialize in cloth, and to trade with each other. This resulted in more wine and cloth all around.

Karl Marx is the most famous of Ricardo's followers. Marx challenged the foundations of Classical theory. Writing during the mid-19th century, Karl Marx saw capitalism as an evolutionary phase in economic development. He believed that capitalism would ultimately destroy itself and be succeeded by a world without private property. In Samuelson's words, he was a "minor Ricardian" - and had little impact on the development of pure economic theory. His economics differed little from Ricardo's, but had different conclusions. He placed little emphasis on the diminishing marginal productivity of land, but more importance on the falling rate of profit. To Marx, capitalist competition would lead to the impoverishment of the "proletariat" or working class and a falling rate of profit. The ultimate resolution would be a communist revolution with the workers seizing power. Soon after the death of Karl Marx , a Marxian school of economics emerged under the leadership of Marx's inner circle of companions and co-writers, notably Friedrich Engels and Karl Kautsky , both of whom were German.

The marginalist revolution

The Prussian civil servant Hermann Heinrich Gossen (1810-1859) was the first one to formulate in 1854, in an obscure book writen in German , "The Second Gossen Law" or "the law of diminishing marginal utility", which was actually the first "marginalist law"; but Gossen's work was dismissed by his conteporaries and remained completely unknown until 1878. In the 1870's, three economists became responsible for what is called the "Marginalist Revolution" - William Stanley Jevons , Carl Menger and Léon Walras . They, independently of each other, developed a new theory of value based on utility. The three are responsible for the concept of marginal utility , and the derivation of a downward sloping demand curve . The Marginalist Revolution would eventually put an end to the The Classical Scholl and the era of the Neoclassical School , which lasts to today, began. This made possible the logical analysis of the "Producers's Decision" or how and why "producer" transforms factors of production into finished goods.

Alfred Marshall (1900-1920) was responsible for the combination of "demand" and "supply" ,where demand was based on "marginal utility". He was responsible for developing numerous concepts still used in economics, including: demand and supply curves or schedules and their equilibrium, "elasticity of demand" , consumer surplus, the distinction between short- and long-period, etc. Modern microeconomics , the study of individual economic agents and individual markets, is a continuation and elaboration of his work.

Marshall's work was only the beginning. His work was refined and further developed, and continues to be extended to this day. Neoclassical economists have built a truly astounding logical edifice into a "Production Function" that rival Newtonian mechanics in completeness and rigour. The basis of neo-classical economics is maximisation under constraint, and this constantly involves the "marginal concept" . The tools developed by economists are even now beginning to be used by other social sciences such as anthropology, sociology and even psychology.

The Great Depression and Keynesianism

However, the edifice of Neoclassical economics suffered a severe blow with the Great Depression of the 1930's. According to the Neoclassical economists unemployment is not supposed to occur in competitive markets, the "invisible hand" should clear the markets. For neoclassicals unemployment can only occur if monopolistic forces prevent the demand and supply of labour from reaching its natural equilibrium. Predictions based on neoclassical models were indicating exactly the opposite of what was really going on during the 1930's; average salaries fell over one third of their pre-recession values, and yet unemployment kept growing.

Marshall's most famous disciple and pupil, John Maynard Keynes, attacked the prevailing economic thought, contesting one of the main "dogmas" and pilars of the neoclassical system, the Say's law (Supply creates its own demand), with the publication of the General Theory of Employment, Interest and Money , in 1936. Keynes work showed how the depression was being caused by insufficient aggregate demand and advocated the need for government intervention to restore full employment. In the process, he created macroeconomics.

Microeconomics is a continuation and elaboration of the work of the early neoclassicals. It deals with the behaviour of individuals and firms, and with individual markets. Other 1930's economists, Joan Robinson at Cambridge and Edwin Chamberlin in the U.S. developed the theory of imperfect competition. Joan Robinson was responsible for the idea that profit maximization involve the equation of marginal cost and marginal revenue, while Chamberlin was responsible for the idea of monopolistic competition and product differentiation.

Keynesianism became the orthodoxy in economics until well into the 1970's. In order not to abandon all the neoclassical economics that had been built up, the dominant economic ideology became the Keynesian-neo-classical synthesis. The basic idea was to let the government ensure full employment, and then neoclassical economics could be used to ensure the best allocations of resources. The Keynesian-neo-classical synthesis is generally associated with Paul Samuelson, who wrote the most influential ever textbook in economics. Most economics texts today are clones of Samuelson's text, generally following the same general outline. The 1950's and 60's were the heyday of Keynesian economics, when most economists believed that the judicious application of government intervention could smooth out the business cycle and ensure full employment without inflation.

The monetarist "counterrevolution"

While the Keynesian-Neoclassical synthesis took over the profession, an unregenerate rearguard of neo-classical economists centred at the University of Chicago continued to exist. They never accepted the idea of involuntary unemployment or government intervention to ensure full employment, and strongly believed in the virtues of markets and laissez-faire. The most famous economist of the Chicago School is Milton Friedman. He was mainly responsible for what is known as the Monetarist counterrevolution of the 1970's. Not only did they succeed in bringing the Keynesian theory down, but they considerably extended the scope of microeconomics to include even education and family formation.

With the perceived failure of Keynesian economics to explain and correct the "stagflation" of the 1970's, the free market prescriptions of monetarism became much more popular, and were eventually espoused by many right wing governments in the 1980's (Reagan, Thatcher, Mulroney), and, perhaps more importantly, by the central banks of most industrialized countries.

Economics today and the Keynesian revival

However, the basic prescription of monetarism failed when it was attempted in the late 1970s and early 1980s. For some this meant moving to even more radical free market positions (Rational Expectations and Real Business Cycle theories), while others attempted to put Keynesian economics on a more sound microeconomic foundation such as the New Keynesian economics and the Keynesian Revival.

Economics today is in a state of crisis, with a number of contending schools and a whole lot of economists in between. The schools that can be distinguished include. from left to right: Marxists, Neo-Ricardians, Post Autistic, Post Keynesians, New Keynesians , various degrees of Neo-classical-Keynesians, various degrees of Monetarists, Real Business Cycle, Rational Expectationist. They differ fundamentally about the amount and level of government intervention in the economy, ranging from almost total control for Marxists to complete libertarian laissez-faire for the Rational Expectationists.

However, a new dominant school or mainstream seems to be emerging: the "New Keynesians" . They reject the simplistic laissez-faire of the monetarists, but recognize many of their criticisms as valid and see some limitations to the ability of governments to act to cure all economic ills. They are particularly preoccupied with creating a proper microeconomic foundation for Keynesian economics. They focus mainly on rigidities, market imperfections, and the economics of information, which result in the need for some kinds of government intervention, but without the unbridled faith in the ability of government to solve all problems that Keynesians had in the 1950's and 60's. One of the leading new-keynesian economists is Joseph E. Stiglitz , who won the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001 (alias Nobel in Economics). Stiglitz is one of the expoents of the Keynesian Revival.

Alternative schools

The schools of economic thought which differ from the mainstream Neoclassical tradition are called "Heterodox". Among them one of the most important are the Keynesians (and their sub-divisions)

Heterodox tradition

The strain of economic thought that begins with the Utopians and Socialists (Jean-Jacques Rousseau, 1712-1788) and follows with The Fabian Socialists, Gustav Schmoller and the German Historical School, The English Historical School, The French Historical School, Thorstein Veblen and the American Institutionalist School, Joseph Schumpeter and Evolutionary Economics, The Soviet Planning Economists, The Neo-Marxians/Radical Political Economy and the New School for Social Research forms what is called the Heterodox Tradition; "heterodox" in the sense of a demarcation from the prevailing mainstream in Economics, and will be subjetct of another article.

Keynesians

John Maynard Keynes is reputedly one the most important figures in the entire history of economics. He revolutionized economics with his classic book, The General Theory of Employment, Interest and Money (1936). This is generally regarded as probably the most influential social science treatise of the 20th Century. It permanently changed the way the world looked at the economy and the role of government in society.

Keynesianism was the mainstream economic thought from the publication of Keynes's book until the early 1970's, when economists became increasingly critical of traditional Keynesian's ideas, partly because of their assumed lack of micro-foundations. However, the attempts to construct a new macroeconomics based on traditional microeconomics, with its assumptions of well functioning markets, was doomed to failure. Recessions and depressions, accompanied by massive unemployment, were symptomatic of massive market failures. The market for labor was clearly not clearing. This problem led a large group of economists, led by Stiglitz, to research on other aspects of traditional neoclassical models and try to improve them. Those efforts gave rise to a new "Keynesian Revival".

Thematic schools

Thematic Schools refer to those schools of economic thought which concentrate on the study of some particluar aspect of economics. The most important themes studied by the Thematic Schools are: Business Cycle Theory, Empirics and Econometrics, Imperfect Competition, Economic Development, Uncertainty and Information, Game Theory and Finance Theory.

Economics subdisciplines

Modern Economic Theory is divided in two main branches: Microeconomics which is concerned with the actions of "individual economic agents" and Macroeconomics which studies the aggregate economy.

Some of the Economics subdisciplines do not fit neatly into those major divisions, reaching parts of both; they are the "Comprehensive subdisciplines".

External links

• ECONOMICS 100 ONLINE. Department of Economics at the University of Toronto<copyright K.J. Rea, 2000-2003 all rights reserved>. (A great "primer" to understanding the basic principles of Economics)

• MICROECONOMICS: Most important concepts explained in detail. Text and workable problems. WARNING: Internet Explorer will not work! Get "Firefox" or "Netscape" for free. Requires "Adobe Acrobat Reader" as a helper to your web browser. You will need "Excel 97" or higher running on your computer to use the spreadsheets.

• The History of Economic Thought Website <forever 'under construction'> ]

• BACKHOUSE, Roger E. A History of Modern Economic Analysis. First published by Basil Blackwell, Oxford, 1985. ONLINE READABLE / DOWNLOADABLE Copyright Roger E. Backhouse 1985. This book is made available on the Web on condition that it is not used for commercial purposes. You may make a copy for your own use but may not sell copies.

• World Wide Web Resources in Economics. Center for Innovative Education, Helsinki School of Economics, Finland. (An excellent sorce of links to the various Economics subdisciplines)

• Xenophon

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See also

• Classical economy
• Econometrics
• Economic Theory
• Econophysics
• Finance
• Hedge fund
• History of Ancient Economics
• Information economics
• Keynesians
• Keynesian Revival
• Macroeconomics
• Microeconomics
• Neoclassical Schools (1871-today)
• Neuroeconomics
• Supply and demand

References

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