The Classical Background “Classical Economics” 1776-1870s: Adam Smith, David Ricardo, J. S. Mill




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TitleThe Classical Background “Classical Economics” 1776-1870s: Adam Smith, David Ricardo, J. S. Mill
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The Classical Background

  • “Classical Economics” 1776-1870s: Adam Smith, David Ricardo, J. S. Mill

  • Concerned with issues of long run growth and of maintaining growth

  • Consequences of growth for distribution of income

  • Policy concern with removing barriers to growth created by unwise government legislation


Major Components of Classical Economics

  • Theory of exchange value based on labour time or cost of production.

  • Water diamond paradox; use values not comparable.

  • Theory of Natural and Market Price and adjustment to Natural Price

  • Wage Fund Theory of Labour Demand

  • Population theory of labour supply and the subsistence wage



Major Components of Classical Economics

  • Theory of Rent and diminishing returns in agriculture

  • Ricardo’s corn model of falling rate of profit and eventual stationary state

  • Say’s Law

    • Tendency to equilibrium at full employment
    • Monetary factors as disturbing causes
  • Theory of gains from trade

    • Comparative advantage
    • Terms of trade


Challenges to Classicism: Internal Weaknesses

  • Theory of exchange value

    • Problems of cost side theories
    • J. S. Mill—cost of production of the most costly portion
  • Wage Fund Theory

    • J. S. Mill’s “recantation” of the wage fund theory
  • New Issues

    • Economies of scale and growth of industry
    • Business Cycles


Challenges to Classicism: German Historicism

  • Reaction against the non-historical nature of Ricardian economics

  • Different principles apply to different times and places

  • Evolutionary and theories of economic stages

  • Organic analogies

  • Importance of institutions, law, and ethics



German Historicism

  • National policy and role of the state

  • Historicism a major influence in Germany, America, and to a lesser extent in England

  • Historicism was a major influence from 1860-1880s

  • Economic History, empirical studies, social reform



Challenges to Classicism: Marxism

  • Marx used the labour theory of value to argue that profit came from the exploitation of labour

  • Labour was paid less than the value of its output

  • Elements of Classical economics used to cast a very negative light on capitalism

  • Marxism became influential in the 1880s, Socialist parties, labour unrest



Challenges to Classicism: Romanticism

  • The “romantic” critics of economics included Carlye and Ruskin

  • Saw economics as concerned only with material ends and not with anything “higher” or more spiritual--a narrow economic man

  • Concerned only with market valuations

  • Carlye and Mill and the “dismal science”



New Techniques: Forerunners of the Marginal Revolution

  • Marginalist ideas and analysis were being developed in Europe well before 1870 and the Marginal Revolution

  • Daniel Bernoulli (1700-1782)

    • Diminishing MU of income and the analysis of expected utility
  • William Gossen (1810-1854)

    • Gossen’s “First Law”: law of satiable wants. Implies diminishing MU
    • Gossen’s “Second Law” conditions for a utility maximum


Forerunners of the Marginal Revolution: Dupuit

  • Jules Dupuit (1804-1866)

    • Measurement of the utility of public works
    • Different people have different valuations of a good
    • Willingness to pay and consumer’s surplus
    • Setting of tolls to finance public utilities


Dupuit



Forerunners of the Marginal Revolution: Cournot

  • Augustin Cournot (1801-1877)

    • Early pioneer of the mathematical approach
  • Law of demand expressed as a general mathematical function: D=F(P)

  • D varies inversely with P

  • Continuous function

  • Analysis of monopoly, marginal revenue and profit maximization



Cournot

  • Cournot’s analysis of duopoly

    • Each firm sets an output given the output of the other
    • Reaction functions leading to an equilibrium
    • Cournot equilibrium is where each firm is doing the best it can given the other firm’s output
  • Example of two mineral springs with zero production costs

    • Market demand function P=100-Y where Y is total output of both firms
    • Profit for firm 1 = PxQ1
    • or Q1(100-Q1-Q2)
    • Profit for firm 2 = Q2(100-Q1-Q2)


Cournot



Cournot



Reasons for the Marginal Revolution

  • Decay of Classical economics

  • New techniques of marginal analysis

  • An answer to Romanticism

    • Utility maximization can accommodate ends other than purely material ones
  • An answer to Historicism

    • Menger and the “Methodenstreit”
  • An answer to Marx

    • Marginal productivity theory
  • Analogy to physics and use of calculus



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