Classical economics (also known as liberal economics) asserts that markets function best with minimal government interference. It was developed in the late 18th and early 19th century by Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Robert Malthus, and John Stuart Mill. Many writers found Adam Smith's idea of free markets more convincing than the idea, widely accepted at the time, of protectionism.
Adam Smith's The Wealth of Nations in 1776 is usually considered to mark the beginning of classical economics. The fundamental message in Smith's influential book was that the wealth of nations was based not on gold but on trade: That when two parties freely agree to exchange things of value, because both see a profit in the exchange, total wealth increases. Classical economics originally differed from modern libertarian economics in seeing a role for the state in providing for the common good. Smith acknowledged that there were areas where the market is not the best way to serve the public good, education being one example, and he took it as a given that the greater proportion of the costs of these public goods should be borne by those best able to afford them.
Classical economists observe that markets generally regulate themselves, when free of coercion. Adam Smith referred to this as a metaphorical "invisible hand," which refers to the notion that private incentives are aligned with society welfare maximization under certain competitive conditions. Smith warned repeatedly of the dangers of monopoly, and stressed the importance of competition.
There is some debate about what is covered by the term "classical economics", particularly when dealing with the period from 1830–75, and how classical economics relates to Neoclassical economics. In more recent times, those economists who see major flaws with the heavy theoretical basis of mainstream economics have looked to classical economics for what they consider a more realistic perspective. They praise classical economics as being more understandable to the average citizen than theoretical economics (citation needed).
In contrast to classical economics, Keynesian economics supports policies such as deficit spending, control of the money supply, and a graduated income tax to counter recession and income inequality. Most classical economists reject these ideas. They assert that state intervention makes recessions worse. Unlike mainstream economics, they blame the Great Recession on government interference in the economy.
Classical economics assumes flexible prices both for goods and wages and predicts that supply can create its own demand – in other words, that production will generate enough income to allow its own products to be purchased. The Model T Ford serves as real-world example of this idea, which can be generalized when the goods being produced are affordable and have a clear benefit to the buyer.
The classical economists produced their "magnificent dynamics" during a period in which capitalism was emerging from feudalism and in which the Industrial Revolution was leading to vast changes in society. These changes raised the question of how a society could be organized around a system in which every individual sought his or her own (monetary) gain. Classical political economy is popularly associated with the idea that free markets can regulate themselves.
Classical economists and their immediate predecessors reoriented economics away from an analysis of the ruler's personal interests to broader national interests. Adam Smith, and also physiocrat François Quesnay, for example, identified the wealth of a nation with the yearly national income, instead of the king's treasury. Smith saw this income as produced by labour, land, and capital. With property rights to land and capital held by individuals, the national income is divided up between labourers, landlords, and capitalists in the form of wages, rent, and interest or profits.
Henry George is sometimes known as the last classical economist or as a bridge. The economist Mason Gaffney documented original sources that appear to confirm his thesis arguing that neo-classical economics arose as a concerted effort to suppress the ideas of classical economics and those of Henry George in particular.
Classical economics is generally agreed (but see section Debates on the definition of classical economics below) to have developed into neoclassical economics – as the name suggests – or to at least be most closely represented in the modern age by neoclassical economics, and many of its ideas remain fundamental in economics. Other ideas, however, have either disappeared from neoclassical discourse or been replaced by Keynesian economics in the Keynesian Revolution and neoclassical synthesis. Some classical ideas are represented in various schools of heterodox economics, notably Georgism and Marxian economics – Marx and Henry George being contemporaries of classical economists – and Austrian economics, which split from neoclassical economics in the late 19th century.
Classical theories of growth and development
Analyzing the growth in the wealth of nations and advocating policies to promote such growth was a major focus of classical economists. John Hicks & Samuel Hollander, Nicholas Kaldor, Luigi L. Pasinetti, and Paul A. Samuelson have presented formal models as part of their respective interpretations of classical political economy.
Classical economists developed a theory of value, or price, to investigate economic dynamics. William Petty introduced a fundamental distinction between market price and natural price to facilitate the portrayal of regularities in prices. Market prices are jostled by many transient influences that are difficult to theorize about at any abstract level. Natural prices, according to Petty, Smith, and Ricardo, for example, capture systematic and persistent forces operating at a point in time. Market prices always tend toward natural prices in a process that Smith described as somewhat similar to gravitational attraction.
The theory of what determined natural prices varied within the Classical school. Petty tried to develop a par between land and labour and had what might be called a land-and-labour theory of value. Smith confined the labour theory of value to a mythical pre-capitalist past. Others may interpret Smith to have believed in value as derived from labour. He stated that natural prices were the sum of natural rates of wages, profits (including interest on capital and wages of superintendence) and rent. Ricardo also had what might be described as a cost of production theory of value. He criticized Smith for describing rent as price-determining, instead of price-determined, and saw the labour theory of value as a good approximation.
Some historians of economic thought, in particular, Sraffian economists, see the classical theory of prices as determined from three givens:
- The level of outputs at the level of Smith's "effectual demand",
- technology, and
From these givens, one can rigorously derive a theory of value. But neither Ricardo nor Marx, the most rigorous investigators of the theory of value during the Classical period, developed this theory fully. Those who reconstruct the theory of value in this manner see the determinants of natural prices as being explained by the Classical economists from within the theory of economics, albeit at a lower level of abstraction. For example, the theory of wages was closely connected to the theory of population. The Classical economists took the theory of the determinants of the level and growth of population as part of Political Economy. Since then, the theory of population has been seen as part of Demography. In contrast to the Classical theory, the determinants of the neoclassical theory value:
- technology, and
are seen as exogenous to neoclassical economics.
Classical economics tended to stress the benefits of trade. Its theory of value was largely displaced by marginalist schools of thought which sees "use value" as deriving from the marginal utility that consumers finds in a good, and "exchange value" (i.e. natural price) as determined by the marginal opportunity- or disutility-cost of the inputs that make up the product. Ironically, considering the attachment of many classical economists to the free market, the largest school of economic thought that still adheres to classical form is the Marxian school.
British classical economists in the 19th century had a well-developed controversy between the Banking and the Currency School. This parallels recent debates between proponents of the theory of endogeneous money, such as Nicholas Kaldor, and monetarists, such as Milton Friedman. Monetarists and members of the currency school argued that banks can and should control the supply of money. According to their theories, inflation is caused by banks issuing an excessive supply of money. According to proponents of the theory of endogenous money, the supply of money automatically adjusts to the demand, and banks can only control the terms (e.g., the rate of interest) on which loans are made.
Debates on the definition of classical economics
The theory of value is currently a contested subject. One issue is whether classical economics is a forerunner of neoclassical economics or a school of thought that had a distinct theory of value, distribution, and growth.
The period 1830–75 is a timeframe of significant debate. Karl Marx originally coined the term "classical economics" to refer to Ricardian economics – the economics of David Ricardo and James Mill and their predecessors – but usage was subsequently extended to include the followers of Ricardo.
Sraffians, who emphasize the discontinuity thesis, see classical economics as extending from Petty's work in the 17th century to the break-up of the Ricardian system around 1830. The period between 1830 and the 1870s would then be dominated by "vulgar political economy", as Karl Marx characterized it. Sraffians argue that: the wages fund theory; Senior's abstinence theory of interest, which puts the return to capital on the same level as returns to land and labour; the explanation of equilibrium prices by well-behaved supply and demand functions; and Say's law, are not necessary or essential elements of the classical theory of value and distribution. Perhaps Schumpeter's view that John Stuart Mill put forth a half-way house between classical and neoclassical economics is consistent with this view.
Georgists and other modern classical economists and historians such as Michael Hudson argue that a major division between classical and neo-classical economics is the treatment or recognition of economic rent. Most modern economists no longer recognize land/location as a factor of production, often claiming that rent is non-existent. Georgists and others argue that economic rent remains roughly a third of economic output.
Sraffians generally see Marx as having rediscovered and restated the logic of classical economics, albeit for his own purposes. Others, such as Schumpeter, think of Marx as a follower of Ricardo. Even Samuel Hollander has recently explained that there is a textual basis in the classical economists for Marx's reading, although he does argue that it is an extremely narrow set of texts.
Another position is that neoclassical economics is essentially continuous with classical economics. To scholars promoting this view, there is no hard and fast line between classical and neoclassical economics. There may be shifts of emphasis, such as between the long run and the short run and between supply and demand, but the neoclassical concepts are to be found confused or in embryo in classical economics. To these economists, there is only one theory of value and distribution. Alfred Marshall is a well-known promoter of this view. Samuel Hollander is probably its best current proponent.
Still another position sees two threads simultaneously being developed in classical economics. In this view, neoclassical economics is a development of certain exoteric (popular) views in Adam Smith. Ricardo was a sport, developing certain esoteric (known by only the select) views in Adam Smith. This view can be found in W. Stanley Jevons, who referred to Ricardo as something like "that able, but wrong-headed man" who put economics on the "wrong track". One can also find this view in Maurice Dobb's Theories of Value and Distribution Since Adam Smith: Ideology and Economic Theory (1973), as well as in Karl Marx's Theories of Surplus Value.
The above does not exhaust the possibilities. John Maynard Keynes thought of classical economics as starting with Ricardo and being ended by the publication of Keynes' own General Theory of Employment Interest and Money. The defining criterion of classical economics, on this view, is Say's law which is disputed by Keynesian economics.
One difficulty in these debates is that the participants are frequently arguing about whether there is a non-neoclassical theory that should be reconstructed and applied today to describe capitalist economies. Some, such as Terry Peach, see classical economics as of antiquarian interest.
- Classical general equilibrium model
- Classical liberalism
- Constitutional economics
- Neoclassical economics
- Perspectives on capitalism
- Political economy
- Smith, Adam (1759). Wealth Of Nations (1982 ed.). pp. 233–34.
- Smith, Adam (1776) An Inquiry into the Nature and Causes of The Wealth of Nations. (accessible by table of contents chapter titles) AdamSmith.org ISBN 1-4043-0998-5
- The General Theory of Employment, Interest and Money, John Maynard Keynes, Chapter 1, Footnote 1
- Cato Institute, A topical source of news relating to world events approached from a classical economic perspective, . For there publication which deals with longer term issues see:
- Baumol, William J. (1970) Economic Dynamics, 3rd edition, Macmillan (as cited in Caravale, Giovanni A. and Domenico A. Tosato (1980) Ricardo and the Theory of Value, Distribution and Growth, Routledge & Kegan Paul)
- O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 395. ISBN 0-13-063085-3.
- Gaffney, Mason (2006). The corruption of economics (PDF). London: Shepheard-Walwyn in association with Centre for Incentive Taxation. ISBN 0856832448.
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- Pierangelo Garegnani (1987), "Surplus Approach to Value and Distribution" in "The New Palgrave: A Dictionary of Economics"
- Samuel Hollander (2000), "Sraffa and the Interpretation of Ricardo: The Marxian Dimension", "History of Political Economy", V. 32, N. 2: 187–232 (2000)
- Terry Peach (1993), "Interpreting Ricardo", Cambridge University Press
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- Classical economics, Encyclopædia Britannica
- Great Economists: Classical Economics and its Forerunners by Economist Tyler Cowen, May 2013