I thought it might be of some interest, especially for readers with little or no formal background in economics, to compose a very brief overview of the main schools of thought in the history of economics. This may help to provide some context for modern policy and theoretical debates, such as those pertaining to the determination of output and employment, the rate of interest, prices and inflation. Being so brief, these posts will give only a hint of the scope or complexities of the subject.
Over time, economists working in alternative paradigms have focused on different questions and applied contrasting analytical methods. The questions raised within a paradigm are often strongly influenced by the historical context in which the theoretical approach is born, including the social and political circumstances of the time. Nevertheless, some central controversies and areas of difference can be identified.
This post provides a very brief introduction to the approach of the classical political economists. In later posts, I will hopefully give similarly brief overviews of Marx, the neoclassical tradition and Keynesian economics. I say “hopefully” because self-discipline is not always the greatest forte here at heteconomist.
Classical Political Economy
The beginnings of classical political economy can be dated back at least to William Petty. The most famous of the classical economists is Adam Smith (The Wealth of Nations appeared in 1776). The classical approach was arguably taken to its most developed form by David Ricardo (On the Principles of Political Economy and Taxation, published in 1817).
The classical economists viewed capitalism in terms of three key economic classes: landlords, the owners of productive land; capitalists, the owners of the means of production (factories, machinery), who possess the wherewithal to pay for raw materials and hire workers; and the workers themselves, who receive wages.
Workers’ real wages were assumed to gravitate to the subsistence level (the amount necessary for the reproduction of the workers and their families). The subsistence level was not usually conceived as a purely physical measure, but included a cultural element. For example, the wage that was regarded as necessary for subsistence of the worker in a more developed economy was likely to be higher than the amount considered necessary in a less developed economy, because the living standards to which people became accustomed would probably influence their impressions of what was a sufficient wage.
Landlords were paid a rent by capitalists for use of their land.
At the end of the production period, when output had been sold, the amount left over after wage and rent payments had been made went to capitalists as profit.
In the classical economists’ view, economic growth is possible to the extent that capitalists reinvest their profits rather than devote them to their own consumption. For this reason, investment would increase and more growth would occur, the larger the share of profits in national income. This implied that low real wages and rents enabled more rapid economic growth.
Since real wages were assumed to gravitate to the subsistence level, under normal conditions these could not be reduced further. Otherwise the working class would not be reproduced. Thus classical economists (especially Ricardo) saw rent as the main drain on capitalist growth.
This reflects the predominant social conflict in Ricardo’s time between capitalists (the rising dominant class) and landlords (the receding dominant class of the old feudal system).
An Exception: Malthus on Underconsumption
Malthus argued that landowners served a useful purpose as a source of consumption demand. He suggested that the motive to expand production would be weakened in the absence of consumer demand for the resulting output.
Ricardo, the leading classical economist of his day, and others, rejected Malthus’ argument on the grounds of Say’s Law: the notion that ‘supply creates its own demand’. The idea is that every act of production at the same time creates a demand for other goods. Production creates income that is then available to spend on other commodities. What this law implicitly assumes is that all saving is invested. The classical economists did not actually appear to make a distinction between saving and investment, so in that sense Ricardo’s position was a logical one.
The relationship between Say’s Law and Unemployment
Often it is asserted that the classical theory implied an automatic tendency to full employment under capitalism. This assertion is not altogether wrong, but it is deceptive.
The usual argument is as follows. Classical economists accepted Say’s Law (setting aside Malthus and other underconsumptionists). Thus any output produced would find a buyer. There could never be a deficiency in demand. This is correct within the classical framework. But there still remained the possibility that current productive capacity might be insufficient to employ the entire workforce at subsistence wages. In this case, there would be an automatic tendency for productive capacity to be fully utilized, but no immediate tendency to full employment. The existing productive capacity could be too small to employ the entire workforce.
This raised the question of how full employment would be restored in the case of insufficient productive capacity.
The answer was that the size of the labor force would adjust itself to productive capacity (not the other way round). In the most extreme case, if wages were already at strict physical subsistence levels, and then wages fell further, excess workers would die off until the size of the labour force was appropriate to the existing productive capacity.
Labor Shortage During Rapid Industrialization
During periods of rapid industrialization, the more likely process involved a labor force that was periodically too small for the rapidly expanding productive capacity. Here, the onus was once again on the size of the labor force to adjust to productive capacity. The way this occurred was for more people to be drawn out of (or expelled from) pre-capitalist spheres of the economy (e.g. peasants working the land) and converted into wage labor (i.e. introduced into the labor force). The same process happens to this day in many parts of the world. In industrialized economies, the same thing essentially occurs when a formally one-income household becomes a two-income household. The second household member is to some extent drawn out of a non-capitalist sphere (the sphere of unpaid child care, housework, etc.) and drawn in to the capitalist production system. At the same time, certain aspects of the household’s activities that were previously run along non-capitalist lines also enter capitalist production relations (e.g. when laundry is now dropped off at the local dry cleaners, or the household members eat out more often, etc.).
During periods of rapid growth, classical political economy suggested that the strong demand for labor could result in a temporary increase in real wages above the prevailing cultural subsistence level. This would tend to act as a check on the rate of growth (due to falling profit margins). Nevertheless, during such periods, it was possible that some of the workers’ temporary gains could become permanent, by bringing about a change in customary living standards, and hence perceptions of what constituted cultural subsistence requirements.
Subsistence Wages and the Malthusian Population Principle
In the very long run, wages were argued to rest at the culturally determined subsistence level. However, for periods shorter than the very long run, wages could remain above or below this ‘natural’ level. The adjustment of wages back to cultural subsistence was thought to follow from the Malthusian population principle. When wages stayed below the natural level for extended periods, it was assumed that workers would slow their rate of procreation. Growth of the labor force would slow. This would reduce the supply of labor relative to demand and eventually restore wages to the natural level.
In the reverse case where wages were above subsistence for extended periods, it was assumed that birth rates would increase, once more adjusting the size of the labor force in line with labor demand, and lowering wages back down to the natural level.
Natural versus market price
The classical idea that some economic variables had a natural value extended beyond wages to all prices. For classical economists, the natural price of a commodity was determined by the cost of producing it. Competition would tend to equalize profit rates across sectors, so that prices in the long run tended to values that were essentially determined by costs plus a natural rate of profit.
In this perspective, the role of supply and demand was limited to temporary and accidental effects. For a while, if demand for a commodity was strong relative to its supply, this would put upward pressure on its market price. But if the excess demand persisted, the classical economists supposed that more investment would flow into the sector, which would raise output and lower price until the rate of profit was restored to the level being received elsewhere in the economy.
For the classical economists, then, fluctuations in demand affected market prices, but not the natural price. The natural price was the long-run value that the market price would tend to converge to, on average.
For Ricardo and his followers, the determinant of this natural price was the amount of labor ‘embodied’ in (or applied in the production of) the commodity. Included in this labor was not just the new labor performed by living workers during the current production process, but also the labor that had gone into the production of any non-labor inputs (e.g. machines, raw materials) in previous production periods. In other words, Ricardo developed a ‘labor theory of value’, traces of which were also to be found in the work of Smith.
For example, suppose a wooden chair took a total of 6 hours to produce. This might involve 2 hours to produce the means of production (chopping down a tree, cutting up the wood) and 4 hours for a worker to shape the wood into a chair. In that case, the value of the chair was said to be 6 hours of labor time. Since this was the cost (in time) of producing the chair, the price of the chair would gravitate to the monetary equivalent of 6 hours of labor time.
This conception of price is very different to the neoclassical explanation of price, which involves a comparison of supply (influenced by scarcity) and demand (including the subjective ‘utility’ attached to the commodity by consumers). However, the view that prices are cost-determined is shared, in broad terms, by a number of non-neoclassical schools of thought.
The reason Ricardo considered scarcity and ‘utility’ to be unimportant in the determination of natural price was alluded to above, but requires further explanation. Ricardo’s argument was linked to the classical conception of competition. This was different from the notion of ‘perfect competition’ used in neoclassical theory. For the classical economists, and also later for Marx, the defining property of competition was the free mobility of capital, and had nothing to do with the size of firms or whether they were price makers or price takers.
Suppose, initially, that a particular commodity was very scarce relative to its demand. In Ricardo’s theory, this would cause its market price temporarily to be well above its natural price (or value). But provided the commodity was of a kind that was reproducible (i.e. could be replicated if only more resources were allocated to its production), then competition would ensure that the divergence of market price from natural price would only be temporary. When capitalists noticed that the commodity’s price was above its value – and hence that profit rates were higher for the producers of this commodity than was the norm elsewhere in the economy – they would react by investing more capital in this sector. In doing so, production of the commodity would increase, raising supply relative to demand. This process would continue until the profit rate associated with producing this particular commodity had fallen back to the normal profit rate achievable elsewhere in the economy. At this point, the market price would have converged to the natural price.
The Economy as a Natural Phenomenon
The Classical economists had a noticeable tendency to view the existing economic order as in some sense natural, or the result of the forces of nature. This tendency went much deeper than what is apparent from the preceding brief summary. Capitalists had a natural, inbuilt desire to pursue profit. Landlords were inherently lazy. Workers had a natural tendency toward more rapid procreation if wages rose above cultural subsistence. In other words, members of the various classes were regarded as behaving the way they did due to natural drives and urges, basic to human nature.