Classical economics (1776 1890)

Interested mainly in long-run economic

processes (economic growth; distribution of
income over time etc.)
Optimistic about the workings of free markets
(markets are in some sense optimal
mechanisms)

Main classical economists

Adam Smith (1776-1790), Wealth of Nations
1776
David Ricardo (1772-1823), Principles of
Political Economy and Taxation, 1817

John Stuart Mill (1806-1873), Principles of

Political Economy, 1848

Economists related to classical

economics
Thomas Robert Malthus (1766-1834):
demographic theory used by classicals
Heterodoxy versus orthodoxy
Karl Marx (1818-1883): borrowed some
classical ideas, but rejected most of others

Adam Smith (1723-1790)

Adam Smith
Scottish economist, philosopher, wrote also on law,
rhetoric and even astronomy
Professor of Moral Philosophy at Glasgow University
from 1752 to 1764
Interested in broad social questions, not only
economic ones
Influenced by his teacher Francis Hutcheson (16941746) and by his personal friend philosophereconomist David Hume (1711-1776)

Adam Smith
Often called the father of economics, because he was able to
synthesize his and previous achievements into one coherent,
integrated system explaining:
how markets function (price determination),
how economic growth operates,
what policies accelerate economic growth,
how domestic economy interacts with others (international trade),
what is the appropriate role for the state in the economy, etc.
Not a great theoretical economist (but advanced e.g. price theory,
growth theory, trade theory, etc)
Biggest impact in terms of promoting and popularizing the economic
policy and economic worldview of free market capitalism with very
limited government interventionism (state as a night watchman,
minimal state role in the economy)
Direct and largest impact in Anglo-Saxon countries, but through Americanization
of culture in the XX century also in other regions (e.g. in Poland)

Adam Smith
Main economic work:
Inquiry into the Nature and Causes of the
Wealth of Nations, 1776
Wrote also on: rhetoric, the law, and even
astronomy

Subject and methodology of the Inquiry into the

nature and causes Wealth of Nations
Main problem causes of the national
income, forces of the economic growth and
policies for encouraging growth
Methodology deductive reasoning combined
with historical description

Smiths economic policy

Contextual economic policy policy prescriptions are based
not only on economic theory, but also on historical, political
and institutional circumstances (prescriptions are contextual)
Non-contextual economic policy policy prescriptions based
only on economic theory
Ricardian vice (after David Ricardo) tendency in modern
economics to deduce policy conclusions only on the basis of
highly abstract theoretical models

Smiths assumptions
in matters of economic policy
humans maximize their own interest
(rationality)

competitive markets exist (free movement of

the factors of production, no government
obstacles to that)

Smiths economic policy

There is a natural process at work in the
economy, which leads from private selfinterest to the public good for society.
So a harmony emerges out of potentially
conflicting self-interests

The process is described as working through

invisible hand (of markets)

Smiths invisible hand a quotation from

the Wealth of Nations
As every individual, therefore, endeavours as much as he can both to employ his
capital in the support of domestic industry, and so to direct that industry that its
produce may be of the greatest value; every individual necessarily labours to render
the annual revenue of the society as great as he can.
He generally, indeed, neither intends to promote the public interest, nor knows how
much he is promoting it.
By preferring the support of domestic to that of foreign industry, he intends only his
own security; and by directing that industry in such a manner as its produce may be of
the greatest value, 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.
Nor is it always the worse for the society that it was no part of it. By pursuing his own
interest he frequently promotes interest of the society more effectually than when he
really intends to promote it. I have never known much good done by those who
affected to trade for the public good. (emphasis added)

Reconstruction of invisible hand idea in modern terms

(based on the whole book, not only on the quotation)
Economic agents are self-interested (not interested in social goals)
Agents maximize their objectives (e.g. profits)
In international trade they prefer investing home than abroad
(for security reasons) if rates of return are similar
There is a free international trade
Invisible hand mechnism leads to a good (or even optimal)
situtation for the whole society, understood as:
1) the greatest possible stock of capital is accumulated
(engine of economic growth)
2) prices of consumer goods are the lowest possible
3) consumers preferences are satisfied.

What is the invisible hand mechanism?

Invisible hand = process of market
competition
Competition among capitalists result in commodities being produced at
the minimal cost covering opportunity costs of the factors of production
(the lowest feasible cost).
If profits above a normal rate of return exist in any sector of the economy,
other firms will enter these industries and profits will fall to zero
(improved allocation of resources between sectors); supply will rise
pushing down prices to those covering only costs of production
Capitalists driven by the profit motive produce commodities that are
desired by consumers.
Capitalists accumulate capital and the rate of economic growth is high.

Smiths arguments for laissez-faire

The phrase laissez-faire is French and literally means "let [them] do",
but it broadly implies "let it be," "let them do as they will," or "leave it
alone".
So it implies a free market based economy with no or minimal state
interventionism (regulations, coercion, restrictions, taxes, etc.)
Did not prove rigorously that markets without (or with little)
interventionism (a system of laissez-faire) lead to the best possible
economic order
For example, did not prove that producers employ the optimal (the
most efficient) combination of factors of production or that consumers
buy the optimal (maximizing satisfaction) bundle of commodities
But pointed to (and analyzed informally) some steps in such a
reasoning (low prices, high growth)
Opposed monopoly realized that monopoly prices are higher than
competitive prices
Reviewed past mercantilist regulations and analyzed their inefficiency

Smiths view on the role of the government

(night-watchman state, minimal state)
Adam Smith advocated only qualified (not complete) laissezfaire policy; he saw some exceptions from laissez-faire:
system of justice;
national defence;
provision of quasi-public goods (roads, bridges, navigable
canals, post-office, basic education etc.):
last duty of the sovereign or commonwealth is that of erecting
and maintaining those public institutions and those public works
which though they may be in the highest degree advantageous to a
great society are, however, of such a nature that the profits could
never repay the expenses to any individual or small number of
individuals, and which it therefore cannot be expected that any
individual or small number of individuals should erect."

Smiths impact on economic policy

Provided a detailed analysis and understanding of
benefits of free markets and the process of competition
Supported laissez-faire policy
Influenced the theory and practice of economic policy in
England and the whole industrialized world from 19th
century on, especially in the US
Laissez-faire policy as an economic worldview of the
American society.
Promoted also all around the world
The power of economic ideas: compare advantages and
disadvantages of the American vs Scandinavian economies

Theoretical acheivements of A. Smith

Theory of economic growth

Theory of international trade
Value theory (theory of relative prices)
Distribution theory

Smiths theory of economic growth

Wealth of a nation = an annual flow of
material goods (services not included,
unproductive labor)
Consumption, not production is the ultimate
end of economic activity

Wealth of nations should be measured in per

capita terms

What are the causes of the wealth of nations?

Wealth of a nation

Productivity of labour

Ratio of productive to
unproductive labor

Division of labour

The extent of the

market
Accumulation of capital

What is missing in this theory?

GPT
Domestication of plants
Domestication of animals````
Smelting of ore
Wheel
Writing
Bronze
Iron
Water wheel
Three-Masted Sailing Ship
Printing
Factory system

Steam Engine
Railways
Iron Steamship

Internal Combustion Engine

Electricity

Automobile
Airplane
Mass Production
Computer
Lean Production
Internet
Biotechnology
Nanotechnology

Spillover Effects
Neolithic Agricultural Revolution
Neolithic Agricultural
Revolution, Working animals
Early metal tools
Mechanization, Potter's wheel
Trade, Record keeping
Tools & Weapons
Tools & Weapons
Inanimate power, Mechanical systems
Discovery of the New World, Maritime
trade, Colonialism
Knowledge economy, Science
education, Financial credit
Industrial Revolution, Interchangeable
parts
Industrial Revolution, Machine tools
Suburbs, Commuting, Flexible location
of factories
Global agricultural trade, International
tourism, Dreadnought Battleship
Automobile, Airplane, Oil
industry, Mobile warfare
Centralized power generation, Factory
electrification,Telegraphic
communication
Suburbs, Commuting, Shopping
centres, Long-distance domestic
tourism
International tourism, International
sports leagues, Mobile warfare
Consumerism, Growth of US economy
Digital Revolution
Growth of Japanese economy
Electronic
business, Crowdsourcing, Social
networking,Information warfare
Genetically modified
food, Bioengineering, Gene therapy
Nanomaterials, Nanomedicine

Source: Lipsey and Carlaw (2005)

Date

Classification

9000-8000 BC

Process

8500-7500 BC

Process

8000-7000 BC
40003000 BC
3400-3200 BC
2800 BC
1200 BC
Early Middle Ages

Process
Product
Process
Product
Product
Product

15th Century

Product

16th Century

Process

Late 18th Century

Organisation

Late 18th Century

Product

Mid 19th Century

Product

Mid 19th Century

Product

Late 19th Century

Product

Late 19th Century

Product

20th Century

Product

20th Century

Product

20th Century
20th Century
20th Century

Organisation
Product
Organisation

20th Century

Product

20th Century

Process

21st Century

Process

Benefits from the division of labour - pin factory

example
Without specialization productivity was:
maximum 20 pins a day per worker
With extensive specialization productivity rose to 4800
pins a day per worker
Why?
Learning by doing
Saving time
Small improvements to tools
Are there any downsides of extensive job or task specialization?

But there is also the ugly face of specialization

In the progress of the division of labour, the employment of the far greater part of those who
live by labour, that is, of the great body of the people, comes to be confined to a few very simple
operations, frequently to one or two. But the understandings of the greater part of men are
necessarily formed by their ordinary employments. The man whose whole life is spent in
performing a few simple operations, of which the effects are perhaps always the same, or very
nearly the same, has no occasion to exert his understanding or to exercise his invention in finding
out expedients for removing difficulties which never occur. He naturally loses, therefore, the habit
of such exertion, and generally becomes as stupid and ignorant as it is possible for a human
creature to become. The torpor of his mind renders him not only incapable of relishing or bearing
a part in any rational conversation, but of conceiving any generous, noble, or tender sentiment,
and consequently of forming any just judgment concerning many even of the ordinary duties of
private life. []. It corrupts even the activity of his body, and renders him incapable of exerting his
strength with vigour and perseverance in any other employment than that to which he has been
bred. His dexterity at his own particular trade seems, in this manner, to be acquired at the
expence of his intellectual, social, and martial virtues.
But in every improved and civilized society this is the state into which the labouring poor, that is,
the great body of the people, must necessarily fall, unless government takes some pains to
prevent it. (WN V.i.f: 782)
Is this an accurate description of work reality today?
How to prevent it?

Smiths value theory

The problem: what determines the relative
prices of goods in the economy?
Value in exchange versus value in use
Value in exchange = market price of a good
Value in use = power of a good to satisfy
human wants, total utility from consumption
of this good

Water-diamond paradox
How it is possible that:
1. the value in exchange (price) of a diamond is so high,
while its value in use (total utility) is so low for
consumers.
2. the value in exchange (price) of water is so low, while
its value in use (total utility) is so high.

So, there seems to be no connection between

value in exchange and value in use
Paradox solved at the end of 19. cenutry: Price is
related to MU, not TU

Smiths theories of exchange value

Developed two theories:
1. labour cost theory of value
2. cost of production theory of value
Introduced two analytical states (models) of the
economy:
- Primitive economy (only one factor of production
labour)
- Advanced economy (three factors of production
capital, labour and land)

Labour cost theory of value

Exchange value is determined by the quantity of labour
required to produce the unit of a good: p1/p2 = a1/a2
How to measure this required quantity of labuor?
Which persons labour?
Not only time (hours of work) matters, when you are to
measure quantity of labour what about stress, difficulty or
displeasures of various kinds of labour?
The theory has a problem when applied to the model of
primitive economy and it is likely irrelevant for the advanced
model.

Cost of production theory of value

Relative prices of two goods = relative cost of production of
those goods:
p1/p2=C1/C2,
where C is the sum of wage rate, land rent and profit rate paid
in the process of production of a unit of a good

What are the problems with this theory?

What determines wages, profits and land rents?
What about the role of demand?
Applicable only in the long-run in the situation of perfectly
elastic supply

Summary of Adam Smiths economics

Extremely influencial, especially in economic policy (laissez-faire)
Intrested mainly in understanding the process of competition,
workings of the free market, economic policy and causes of
economic growth
Supporter of (qualified) laissez-faire: policy of government nonintervention (3 exceptions)
Contextual economic policy
His theories of economic growth, value and distribution inspired
later classical economists
Provided a grand vision of the free market economy, guided by the
invisible hand, that leads from private interests to social optimum.