Classical school of thought

Lecture 9 Ms. Salma Shaheen

The Classical School of Thought

• Adam smith is the founder of classical school.• He has been described as the father of ‘father

of political economy’.• His work ‘Wealth of nation’ (1776) is generally

regarded as the starting point of classical school.

• Thus the Adam smith, Jeremy Bentham, Thomas Robert Malthus, David Ricardo, J.B. say and J.S. Mill are all the leading economist of classical school.

• The essential features of classical School• The entire philosophy of classical school was based on

economic liberalism.• The classical writers believed in personal liberty, private

property and individual initiative and private enterprise.• Classical features are as follows:• 1) the classical economist believed in laissez –fair.

That government is best which governed least.• 2) they believed in a market economy based on free

and perfect competition.• 3) They assumed condition of full employment. they

thought that economy was self adjusting and tend toward full employment without govt, intervention.

• 4) They believed that individual by seeking their own interest would serve the best interest of society. In other words they believe on the harmony of interests.

• 5) The classical emphasized the importance of all economic activities especially the industry.

• 6) The classical economist provided a method of analyzing the economy and economic laws that operate with in them.

• 7) the classical economist looked at the economy as a whole. That is what we call the macroeconomic approach in modern times.

• Adam Smith (1723-1790)• Adam smith was born in Kircadly, Scotland in 1723. • He was educated at the universities of Glasgow

and Oxford.• He became professor first of logic and than of

moral Philosophy at Glasgow.• He came in France and remain in contact with

leading Physiocrats of the day. • Physiocrats left profound influence on Adam smith.• In 1778, Adam smith was appointed as

commissioner of customs in Edinburgh. He held that post for the remaining year of his life.

• He died in 1790.

• Adam smith published his Theory of Moral Sentiments in 1759.

• After that , he concentrated his attention less on ethical doctrines and more on jurisprudence and political economy.

• Adam smith published his “Wealth of nation” in 1776.• The full name of the book is ‘An enquiry into the Nature

and causes of the wealth of Nation’• Adam smith was a first economist who deal with

economic problems in a systematic manner.• Adam smith’s wealth of nation was a challenge to

mercantilism.• According to smith, the wealth of nation can be

increased by adopting the principle of division of labour.

Chief contributions

• Built a coherent and logical theory of how the economy works

• The elements of Smith's theory were mostly already available in the writings of earlier writers.

• However, in those earlier writings, good ideas coexisted alongside numerous other bad ideas

• Somebody had to figure out which theories were useful and which were useless and combine the useful theories into a consistent and persuasive overall theory that could be used reliably to think about society.

• This is what Smith did. For this he is called the father of economics.

Theory of Moral Sentiments

Theory of Moral Sentiments

• This book was an argument against the views of writers such as Hobbes and Rousseau who argued that the pursuit of self-interest, an important human instinct, inevitably leads to a cruel and terrible society.

• Smith argued that we are able to imagine what others are going through; we are able to understand with the sufferings of others.

• We feel pain when we see the pain of others.

• We can act to reduce the pain of others in order to reduce our own discomfort, if nothing else.

• So, it is perfectly consistent to believe that human beings pursue self-interest and are generous towards others.

Passions, bias, moral rules• Sometimes our passions cause us to do bad

things. • We have an instinctive tendency to defend

ourselves even when we know that we did something bad.

• This leads to a bias that prevents us from seeing that we did something bad.

• This problem is partially corrected by the wide acceptance of moral rules in a society.

• When the moral rules are clear cut, a misdeed may so clearly violate a moral rule that it might be impossible even for the perpetrator to deny the misdeed, bias notwithstanding.

Laws• At times, even moral rules may not be enough

to keep society together• In that case, laws and the enforcement of

those laws would be necessary to keep society together.

• However, unlike Hobbes and Rousseau, Smith did not believe that, in the absence of a structure of laws, society would inevitably fall down to disorder.

The Wealth of Nations

Wealth of Nations

• The causes of economic progress and the creation of wealth was Adam Smith’s main topic of interest– David Ricardo, by contrast, focused on how wealth is

shared among different groups in society• According to Smith, the wealth of a nation derives

from the level of the technology in use. • The level of technology and its rate of

improvement depend on the division of labor.

• According to smith ‘the political economy is an inquiry into the nature and causes of wealth of nations’

• In his book he tells that wealth of nation can be increased by the division of labour.

• Smith discussed three reasons why a greater division of labor may increase productivity. –Practice makes perfect– Less waste of time between tasks–More mechanization

Division of labor, extent of the market, economic progress

• The division of labor is determined by the extent of the market.

• This creates the possibility of an ever-expanding economy. – For example, if the extent of the market increases—perhaps

because of an expansion of trade within the country or with another country—there will be greater division of labor, which will lead to improvements in the level of technology, which will lead to greater national income, which will lead to another increase in the extent of the market, which will lead to another increase in the division of labor, which will lead to another increase in the level of technology, and so on and on.

• Labour is the main source of wealth of nation.• After saying that labour is the source of wealth,

smith makes the point that division of labour will increase the productivity of labour and thereby the wealth of nation.

• Division of labour refers to the specialization of labour in different industries or different process with in the industry.

• In his famous example of Pin making industry

• “one man draws out the wire; another straightens it, a third cuts it, a forth points it ………..and the important business of making pin in this manner divided it into eighteen distinct operations.”

• If one man performed all the above operations he will produce one pin or so in day.

• but on the other hand division of labour was practices then the average production of each man was 4800 pins.

• According to him the division of labour is limited by the size of the market.

• In those industries which produce goods for international market, there will be great scope for division of labour.

• Division of labour has the following advantages.

• 1) Increased output:• Division of labour will increased the output per worker,

as he described in his example of pin industry.• 2) Increase in skill of labour:• By doing the same kind of work, labour gets a great skill

in his particular line.• 3) saving in Time:• By practicing the same kind of work, labour get

specialization in his field, so he takes less in order to produce the same thing.

• 4) Introduction of machinery• It smooth the way for introduction of machinery. In other

words, division of labour is the mother of invention.

• Smith was not aware of disadvantages of division of labour.

1) For instance , extreme division of labour will leads monotony of work.

2) A worker by doing the same type of work again and again would find no pleasure in his work.

3) Division of labour will also cause immobility of labour. And there will be greater risk of

unemployment in times of bad trade.

Division of labor and capital• Division of labor is enabled by capital• In a backward, agricultural economy, people

produce, on a regular basis, the simple things they need.

• When workers specialize in the production of more complex goods, production may take time

• The worker can be sustained during the lengthy production period only when capitalists can make loans

• In this way, the accumulation of additional capital enables additional division of labor

• Division of labour necessitates exchange. This leads onto the discussion of money as means of exchange and to the value.

• After discussing the problem of value and price in his book, smith discuses the problem of wages, profit and rent.

• Then he criticized the mercantilist and Physiocrats.

Luxury spending not crucial• Earlier writers had argued that the growth of

an economy depended heavily on the luxury spending by the rich; the poor consumed just the bare necessities and, therefore, more would not be produced unless the rich would buy the extra output.

• Smith argued that this idea was false. – If the rich saved any money they would lend it to

businessmen (to earn interest).

– The businessmen would borrow the money and

spend it on capital equipment.

– Therefore, all income would be spent and all

production would be purchased.

– There was no need to encourage luxury spending.

– In fact, the more the rich saved the greater would

be the level of investment by businesses and the

faster would be the rate of growth.

Free Trade• Smith was in favor of free trade. • He derived his support for free trade among

nations by basing it on the obvious desirability of trade among individuals: – "It is the maxim of every prudent master of a

family, never to attempt to make at home what it will cost him more to make than to buy".

• According to Smith, free trade expands the extent of the market and, thereby, allows greater division of labor

• Further he was a great favour of free trade, he prefer two kinds of protectionist tariff.

1) Those tariff that protect the domestic industry essential to the defense of the country.

2) those who equalize the tax burden on the particular domestic industry by imposing tariff on import of that goods.

• Smith also suggest that free trade is to be introduced in a country after a long period of protectionism, it should be done gradually in order to avoid unemployment.

• Value• According to Smith , there are two kinds of valuei) value in useIi) value in exchange.• The first one expresses the utility of some

particular object and second one refers to the power of purchasing other goods.

• For example, nothing is more useful as water but it has little value in exchange.

• On the other hand diamond has little value in use but greater value in exchange.

• Smith believed that the labour is the main source of value. According to him the value of things depend on amount of labour employed in the production.

• Smith make the distinction between the natural price and market price.

• ‘when the price just cover the ordinary rate of rent , wages and profits expended in preparing and marketing the commodity, its sells at its natural price.’

• ‘The market price may be below or above this, depending upon the supply actually on the market and the effectual demand-------- the demand of those who are willing to pay the natural price.’

Theory of value

• Smith used different theories of value at different points in the Wealth of Nations

• His discussion is at times contradictory

Theory of value: labor

• For primitive economies sustained by hunting and fishing, Smith adopted the Labor Theory of Value– This was adopted by Classical economists such as

Smith, Malthus and Ricardo. – But even in such a case, there is no standard unit

of labor. The hardship and cleverness involved can vary from task to task

• Some criticism of the labor theory of value:• There is difficulty in measuring labor or cost of

production. Smith used time as his measuring rod. But all workmen are not of equal efficiency. So less skilled may take longer than the skilled labor. So more labor put into more production.

• Misdirect labor can not have value. If labor is incapable of fulfilling the purpose for which it was intended can have no value.

• It fails to explain the value of rare things. Such as work of art or antiques. It is the great weakness of any theory of value, if it dose not explain the value of all the things.

Theory of value: unit cost

• When analyzing the industrialized economy of the Great Britain of his time, Smith thought of the ‘natural price’ (or, long run price) of a product as the cost of all resources used in production

• Cost includes wages (payment for labor), rent (for land), and profit (for the capital of the entrepreneur).

• Note: price = unit cost does not mean profits = zero; it only means supernormal profits = zero.

• Profit is what the entrepreneur gets for risk-taking

• As workers need to be paid even if the output is not ready for sale, the entrepreneur is essentially a money lender to the workers. Therefore, profit also includes what we call interest today

• From today's point of view the classical theory of value, which denies the influence of demand and identifies production cost as the only influence on prices, has some validity in the long run but is not useful for short run analysis.

Prices signal opportunity

• In Smith’s view of the workings of the market system, any short-run deviation of the market price from the long-run price would trigger the forces of competition—by which Smith meant profit-seeking entry and loss-avoiding exit—which would eventually take the market price to its long-run level.

Wages: Iron Law of Wages

• Smith used different theories of the wage rate at different times

• One was a form of the Iron Law of Wages – This theory held that wages are by and large equal

to the subsistence level of wages. – If wages exceed the level that is just enough to

keep the worker and his dependents alive, there will be an increase in population that will drive wages down to the subsistence level.

-If wages fall below what the workers need to stay alive, population will fall and wages will rise to the subsistence level.

• This meant that any increase in total output went not to the workers but to capitalists who would save and invest in machinery that would make possible further division of labor and technological progress.

Wages: bargaining

• The wage rate depends on the bargaining power of workers and businesses

• Employers can plan with greater ease because employees are numerous

• In Great Britain at Smith’s time, employers’ agreement was allowed but unions were not. There were laws against raising wages, but none against lowering them

• It is clear that Smith had a very complex view of the nature of a market economy

Rent

• Smith had multiple theories of rent, some of them contradictory

• Smith thought of rent as a residual that is leftover after wages and profits had been paid out of total output.

• Wages would be reduced to the subsistence level, as we saw before.

• Competition would gradually reduce the rate of profit to a low level that would also be uniform across all industries.

• Therefore, only those who earn rent income would benefit from progress.

• Smith has given a number of explanations for rent.

• At one place he describes it as monopoly price. At other time, when he discusses the commodity prices, he includes the rent of land as an element of cost and therefore a determinant of the product price.

• In some other context, he tells that rent is determined by the prices.

• He considers that high or low rent is the effect of high or low product price.

• Smith was not disposed favorably to land lord as a class.

Falling rate of profit

• Economic progress depends on profits• But Smith believed that the rate of profits

would fall over time, because of competition among capitalists

• This implied a slowing rate of growth over time

Profit and interest:• Smith was of the opinion that wages and profit

moves in opposite direction.• As more and more capital is accumulated, the

mutual competition among the owner of capital for investment in the same trade will tend to lower its profit.

• However smith made certain exception to the statement that wages and profit moves in opposite direction.

• For instance in new colonies both wages and profit may be high and in “stationary state” both wages and profit may be low.

• According to smith, interest is the ‘compensation which the borrower pays to the lender, for the profit which has an opportunity of making by the use of money.’

• He believed that interest could vary with profit.

The Invisible Hand

• Smith's argument that the pursuit of self-interest can lead to a socially efficient outcome is the crowning beauty of the Wealth of Nations.

The Invisible Hand

• “[E]very individual … generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. … he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. …”

The Invisible Hand

• Consumer sovereignty and business competition are the key components of Smith’s argument that the pursuit of individual self interest leads to an excellent social outcome

• Consumer sovereignty ensures that consumer needs determine what gets produced

• Business competition ensures that prices are driven down to unit cost

• Thus, without any government control, the most beneficial goods get produced, and at the lowest possible price

Competition is key

• Smith was doubtful of businessmen – He believed that, given the chance, businessmen

would do anything to reduce competition among themselves and then form a group to gang up on consumers and charge them more than the competitive price.

• In this sense, Smith may be considered a pioneer of the modern economic approach to the politics of lobbying.

• Capital:• Smith has realized the importance of role of

capital in the economic development of a nation.• He was aware of the fact that the capital

accumulation is essential for the Industrial development of a nation.

• In his book he mentioned that capital appears in three forms:– As an instrument of production.– As a source of revenue– As a fund maintaining the workmen.

• Further smith has classified capital into three portions.

1) the first portion is used for immediate consumption, , it affords no revenue or profit (e.g. stock of food, clothes etc.)

2) The second portion is fixed capital which affords a revenue or profit without circulating or changing masters (e.g. machines, improvement of land etc.)

3) The third portion is circulating capital, which affords a revenue, only by circulating or changing masters (e.g. money, material, complete work in hands of merchant or manufacturer which are not yet dispose of)

• Smith believed that income which is not consumed become the investment.

• In other words , as “an act of saving at once become an act of investment, saving is equal to investment”

• He did not pay much attention to the problem of hoarding.

• We should also remember that Smith was in the favour of labour intensive investment during the development process.

• The role of Money• Classical economist in general de-emphasize

the importance of money.• It was Adam Smith who had established this

tradition. • Infact he attacked the mercantilist mainly

because they over-emphasized the role of money.

• According to Smith, a nation’s true wealth consist ‘not only in its gold and silver, but in its land, houses and consumables goods of all different kinds’

• Money only serve as a instrument for the circulation of the wealth and for the measurement of value.

• Money does not add to the revenue of the society.

• But it is the ‘great wheel of circulation’.• It facilitate the circulation of goods and it is

the production of goods that makes up the revenue.

• Smith believed that paper money was preferable to gold and silver. For the paper money required much less effort to produce.

• Laissez- fair and the harmony of Interest• Smith believed in the natural organization of

economic order under the influence of personal interest.

• He was greater advocate of Laissez fair---- non intervention by govt, in business.

• According to him Govt, are wasteful, corrupt and incompetence.

• He believed that individual was led by ‘an invisible hand’ to do good for the society. In other words he believed that the interest s of the individuals coincide with the interest of society.

• Smith advocate the free trade.• He believed that free foreign trade would

promote greater division of labour.• While the mercantilists believed that each

nation enriched itself at the expense of its neighbor.

• Smith believed in an international harmony of interests: ‘the wealth of neighboring nation, however, though dangerous in wars and politics , is certainly advantageous in trade…..

• As a rich man is likely to be better customer to the industrious people in his neighborhood , than a poor, so is likewise a rich nation.’

• Role of Govt.• Smith advocate the minimum role for the

state in economic affairs.• He believed that state could perform the

following three major functions.

1) To protect society from foreign attack.2) To establish the administration of justice within

the country.3) To erect and maintain the public works and

institutions that private entrepreneur cannot undertake privately.

• He justified legal control over the interest rates, state administration of Post Office, control over the issues of paper money by bankers, compulsory elementary education etc.

•

• Canons of Taxation• Smith recommended taxation to finance govt.

activities.• He has laid down some rules for a good tax

system. They are known as canons of taxation.1) Canon of equity:

It is bases on the principles of justice and ability to pay. He tells that people should pay taxes according to their respective abilities.

2) Canon of Certaintythere must be certainty about the tax which an individual has to pay .

• Things like the time payment, the manner of payment and the quantity to be paid should be plain and clear to tax player. A tax should not be arbitrary.

3) Canon of convenience: A tax should be levied in such a manner that it is convenient for the tax payer to pay it.

4) Canon of Economy:Taxes should be collected at minimum cost to the government.

• Q #1 which school of thought emphasis on capitalism.

• Ans: physiocrates