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The Classical Period y After 1776, the field of economics, like the Industrial Revolution in which it was encased, gathered steam. y Nowhere was the activity more feverish than in England. So fertile was this age of economic analysis that the interval from 1776 to 1870 is now called the classical period. Adam Smith: System Builder y The new dawn of capitalism that the Physiocrats so eagerly looked forward to had not yet arrived in 1776- but it was certainly on its way. y And it was helped along by the publication in that year of a book: Adam Smith s Inquiry into the Nature and Causes of the Wealth of Nations. y Adam Smith was born in a small village in Kirkcaldy, Scotland, where his widowed mother raised him. At age fourteen, as was the usual practice, he entered the University of Glasgow on scholarship. From his youth, Smith exhibited the signs of what psychiatrists night call the professorial syndrome. He later attended Balliol College at Oxford, graduating with an extensive knowledge of European literature and an enduring contempt for English schools. y He returned home, and after delivering a series of well-received lectures was made first chair of logic (1751), then chair of moral philosophy (1752), at Glasgow University. y Although not a handsome man, Smith s other charms endeared him to his friends and students. He described himself as a beau in nothing but my books. To be sure, he was among the leading philosophers of his day. y Smith s reputation as a philosopher rested largely on his very important work, The Theory of Moral Sentiment. That work was an attempt to identify the origins of moral judgments, or moral approval and disapproval. In it, Smith perceived man as a creature of self-interest who nevertheless seemed capable of making moral judgments on the basis of considerations other than selfishness. y The Theory of Moral Sentiments and its problems attracted immediate interest and fame for its author. y Informed opinion tends to view The Wealth of Nations as a logical extension of The Theory of Moral Sentiments, although that is by far not a unanimous judgment.

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y He left academia in 1764 to tutor the young duke of Buccleuch. For more than two years they traveled throughout France and into Switzerland, an experience that brought Smith into contact with his contemporaries Voltaire, Jean-Jacques Rousseau, Francois Quesnay, and Anne-Robert-Jacques Turgot. With the life pension he had earned in the service of the duke, Smith retired to his birthplace of Kirkcaldy to write The Wealth of Nations. It was published in 1776, the same year the American Declaration of Independence was signed and in which his close friend David Hume died. In 1778 he was appointed commissioner of customs. In this job he helped enforce laws against smuggling. In The Wealth of Nations, he had defended smuggling as a legitimate activity in the face of unnatural legislation. Adam Smith never married. He died in Edinburgh on July 19, 1790. y Today Smith s reputation rests on his explanation of how rational self-interest in a freemarket economy leads to economic well-being. It may surprise those who would discount Smith as an advocate of ruthless individualism that his first major work concentrates on ethics and CHARITY. In fact, while chair at the University of Glasgow, Smith s lecture subjects, in order of preference, were natural theology, ethics, jurisprudence, and economics, according to John Millar, Smith s pupil at the time. In The Theory of Moral Sentiments, Smith wrote: How selfish so ever man may be supposed, there are evidently some principles in his nature which interest him in the fortune of others and render their happiness necessary to him though he derives nothing from it except the pleasure of seeing it. y At the same time, Smith had a benign view of self-interest, denying that self-love was a principle which could never be virtuous in any degree. Smith argued that life would be tough if our affections, which, by the very nature of our being, ought frequently to influence our conduct, could upon no occasion appear virtuous, or deserve esteem and commendation from anybody. y Charity, while a virtuous act, cannot alone provide the essentials for living. Self-interest is the mechanism that can remedy this shortcoming. Said Smith: It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest. y Someone earning money by his own labor benefits himself. Unknowingly, he also benefits society, because to earn income on his labor in a competitive market, he must produce something others value. In Adam Smith s lasting imagery, By directing that industry in such a manner as its produce may be of greatest value, he intends only his

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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. y The Wealth of Nations, published as a five-book series, sought to reveal the nature and cause of a nation s prosperity. Smith saw the main cause of prosperity as increasing division of labor. Using the famous example of pins, Smith asserted that ten workers could produce 48,000 pins per day if each of eighteen specialized tasks was assigned to particular workers. Average PRODUCTIVITY: 4,800 pins per worker per day. But absent the division of labor, a worker would be lucky to produce even one pin per day. y Just how individuals can best apply their own labor or any other resource is a central subject in the first book of the series. Smith claimed that an individual would invest a resource for example, land or labor so as to earn the highest possible return on it. Consequently, all uses of the resource must yield an equal rate of return (adjusted for the relative riskiness of each enterprise). y Smith used this insight on equality of returns to explain why wage rates differed. Wage rates would be higher, he argued, for trades that were more difficult to learn, because people would not be willing to learn them if they were not compensated by a higher wage. His thought gave rise to the modern notion of HUMAN CAPITAL. Similarly, wage rates would also be higher for those who engaged in dirty or unsafe occupations, such as coal mining and butchering; and for those, like the hangman, who performed odious jobs. In short, differences in work were compensated by differences in pay. Modern economists call Smith s insight the theory of compensating wage differentials. y Smith vehemently opposed MERCANTILISM the practice of artificially maintaining a trade surplus on the erroneous belief that doing so increased wealth. The primary advantage of trade, he argued, was that it opened up new markets for surplus goods and also provided some commodities from abroad at a lower cost than at home. With that, Smith launched a succession of free-trade economists and paved the way for David Ricardo s and JOHN STUART MILL s theories of COMPARATIVE ADVANTAGE a generation later. y Adam Smith has sometimes been caricatured as someone who saw no role for government in economic life. In fact, he believed that government had an important role to play. Like most modern believers in free markets, Smith believed that the government should enforce contracts and grant patents and copyrights to encourage inventions and new ideas. He also thought that the government should provide public works, such as roads and bridges, that, he assumed, would not be worthwhile for

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individuals to provide. Interestingly, though, he wanted the users of such public works to pay in proportion to their use. y One definite difference between Smith and most modern believers in free markets is that Smith favored retaliatory tariffs. Retaliation to bring down high tariff rates in other countries, he thought, would work. The recovery of a great foreign market, he wrote will generally more than compensate the transitory inconvenience of paying dearer during a short time for some sorts of goods. y Smith s writings are both an inquiry into the science of economics and a policy guide for realizing the wealth of nations. Smith believed that economic development was best fostered in an environment of free COMPETITION that operated in accordance with universal natural laws. Because Smith s was the most systematic and comprehensive study of economics up until that time, his economic thinking became the basis for classical economics. And because more of his ideas have lasted than those of any other economist, some regard Adam Smith as the alpha and the omega of economic science. Nature of Smith s Economic System y Adam Smith is today considered the father of economics because he was above all a system builder. y His system combined a theory of human nature and a theory of history with a peculiar form of natural theology and some hardheaded observations of economic life. y The three main features of his central analysis are the division of labor, the analysis of price and allocation, and the nature of economic growth. Natural Law and Property Rights y Economics was a new discipline, broadly defined as political economy. The chief political and economic problem that he set out to define and resolve was the relation of the individual to the state and the proper function of the state in relation to its matters. y The Physiocrats had extolled a natural order based on natural law as opposed to positive law. For them, natural law reflected the mind of the creator, as inferred by human reason. y Both the Physiocrats and Smith argued in essentially this vein. y Sir Alexander Gray has pointed out that natural law is easier to talk about than to codify.

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y Natural law implied a restriction of the functions of the government, in the interests of the liberty of the individual. y Natural harmony exists in the economic world that makes government interference in most matters both unnecessary and undesirable. y The invisible hand, the doctrine of natural liberty, the wisdom of God are all part of the argument. Human Nature y The inexpediency of control and the desirability of natural liberty become even more compelling when we consider the mechanism that drives Smith s society. y There were two innate features of the psychology of humans. y First is that as humans, we are interested primarily in things nearest us. y The second characteristic is the overwhelming desire of everyman to better his condition. y In The Theory of Moral Sentiments, sympathy is that human faculty which holds selfinterest in check, whereas in The Wealth of Nations, competition is the economic faculty that restrains self-interest. y Monopoly represents unbridled self-interest and the consequent destruction of economic welfare. y Competition, will force all sellers to lower their prices to attract more customers, and the natural outcome of that action is lower consumer prices and improved economic welfare. A Theory of History: Self-Interest and Economic Growth y Self-interest, the development of property rights, and the division of labor were all intertwined in the historical process of economic growth. y Smith s conceptual history of civilization identified four evolutionary stages. The first two were the hunting and pastoral periods of prefeudal, nomadic cultures. These were followed by the farming stage, and finally the commercial era.

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y Self-interest brings about important sociopolitical evolution and economic growth. Civil society is to a major extent a consequence of private property and the accumulation of wealth. y Serfdom was an institution in which peasants were tied to the land and owed a certain amount of labor to the landlord. But as peasants accumulated small surpluses, they found that they could buy back this obligation by paying money rents to the landlords in lieu of labor services. y The Wealth of Nations contains much more than Smith s celebrated attack on mercantilism (monopolies) and his justification of natural liberty (laissez faire) y Book 1 treats of the division of labor, of the origin and use of money, and of the determination of price, wages, profits and rent. y Book II contains Smith s oft-maligned theory of capital and interest. y In Book III, the reader is treated to a lengthy review of the economic development of Europe from ancient times to the 18th century. y Book IV discusses different systems of political economy. y And Book V concludes with a lengthy treatise on taxation and fiscal policy in 18th century in Britain. The Microeconomic Foundations of The Wealth of Nations y Smith emphasized growth in national wealth. y His microeconomic concern for economic growth rested, as it should have, on certain microeconomic foundations, notably the theory of value. The Theory of Value y The division of labor, Smith charged, arises from a propensity in human nature to exchange, for which each trader must have a surplus over his intermediate needs with which to trade. y Money enters the picture because it makes trade more convenient insofar as it is generally acceptable and portable. y Value than is determined by the rules that people naturally observe in exchanging goods for money or for one another.

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y Money is, of course, the most common measure of value. But Smith was likewise aware of the shortcomings of monetary measures, since the value of money itself changes over time. y Capitalist economies are marked by capital accumulation and individual property rights in land and other resources. Thus in the more advanced societies, according to Smith, market value is resolved into three component parts: wages, profit and rent. Market Price versus Natural Price y Smith discussed the natural and market price of commodities. He set up a dichotomy between actual (i.e. market) price and natural price. y The former is determined by the interaction of supply and demand in the short run; the latter, by long run costs of production. y Economic reality is different from theory because it entails conditions that slow or prevent smooth and certain adjustments to long-run equilibrium. Wages y Wages are determined by productivity. y As soon as land becomes private property, the landlord demands his share of the annual produce, and as soon as capital accumulation occurs, the capitalist does likewise. y The existence of a wages-fund is, simultaneously, a rationale for saving (i.e. accumulation), an explanation of wages and profit , and a determinant of population growth. y In the long run, Smith views wage rates as determined by costs of workers maintenance and reproduction. y The natural wage is a subsistence one, but subsistence simply means the minimum payment that workers insist on before they are willing to have children. In the short run, however, wage rates may be above or below the long run equilibrium. A summary of the inequalities of wages and profits arising from the nature of the employment: 1. Wages vary in inverse proportion to the agreeableness of the employment. 2. Wages vary in direct proportion to the cost of learning the business.

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3. Wages vary in inverse proportion to the constancy of employment. 4. Wages vary in direct proportion to the trust that must be placed in the employee. 5. Wages vary in inverse proportion to the probability of success. Profit and Interest y Smith regarded profit as a return to capital rather than a return to entrepreneurship, so his theory of profits is outdated by contemporary standards. y He defined profit as revenue derived from stock (i.e. capital) by the person who manages or employs it, whereas interest he defined as revenue derived from stock by the person who does not employ it himself, but lends it to another. y Interest alone cannot explain all profit, although it is a good indication of profit. Rent y Smith s discussion of rent centers on three factors: monopoly elements, residential surplus idea and alternative costs. y He defined rent simply as the price paid for the use of land. y The sum of annual rent is usually determined by contractual arrangement between the landlord and the tenant. y Rent is price determined rather than price determining. Smith s Macroeconomic: Blueprint for Economic Growth Division of Labor y Joseph Schumpeter has observed that for Adam Smith, the division of labor is practically the only factor in economic progress. y Smith concluded that there are three advantages of division of labor: 1. An increase in skill and dexterity of every worker y y The saving of time The invention of machinery o The Role of Capital

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y While division of labor starts the growth process, it is capital accumulation that keeps it going. Key elements in the growth process are the nature, accumulation, and employment of stock. y The larger the last share, the greater the growth potential of any nation.

UTILITY, POPULATION, AND MONEY ULITARIANISM JEREMY BENTHAM y Jeremy Bentham was an English philosopher and political radical. He is primarily known today for his moral philosophy, especially his principle of utilitarianism, which evaluates actions based upon their consequences. The relevant consequences, in particular, are the overall happiness created for everyone affected by the action. Influenced by many enlightenment thinkers, especially empiricists such as John Locke and David Hume, Bentham developed an ethical theory grounded in a largely empiricist account of human nature. He famously held a hedonistic account of both motivation and value according to which what is fundamentally valuable and what ultimately motivates us is pleasure and pain. Happiness, according to Bentham, is thus a matter of experiencing pleasure and lack of pain. y Although he never practiced law, Bentham did write a great deal of philosophy of law, spending most of his life critiquing the existing law and strongly advocating legal reform. Throughout his work, he critiques various natural accounts of law which claim, for example, that liberty, rights, and so on exist independent of government. In this way, Bentham arguably developed an early form of what is now often called legal

positivism. Beyond such critiques, he ultimately maintained that putting his moral theory into consistent practice would yield results in legal theory by providing justification for social, political, and legal institutions.

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y y

The greatest happiness is for the greatest number The general interest of the country is measured by the sum of the individual interests in the community.

Bears a resemblance to the ancient Greek philosophy Hedonism, but the biggest difference is that Hedonism prescribes happiness for individuals without reference to the public interest while Utilitarianism added some ethical doctrine that happiness must should be in line with society happiness.

MORAL ARITHMETIC y From a policy standpoint there are two distinct ways in which the principle of utility (self-interest) has been interpreted. One rests on the belief in a natural identity of interests, the other on the belief in an artificial identity of interests. Adam Smith championed the natural identity thesis, which placed a great deal of confidence in natural order and harmony. He believed that the individual self-interests of human nature harmonize of their own accord in a free economy; consequently his basic prescription promoted essentially a laissez faire policy. Bentham, however, took a different tack. Although admitting that individuals are chiefly self-interested, Bentham denied any natural harmony of egoisms. Crime, for example, provides a case of selfinterested behavior that violates the public interest. The very fact that crime existed was for Bentham sufficient proof that natural harmony did not. The central tenet of Bentham's philosophy, therefore, was that the interest of each individual must be identified with the general interest, and that it was the business of the legislator to bring about this identification through direct intercession. Thus it was in the form of the artificial identity of interests framework that Bentham first adopted the utility principle. His doctrine came to be known as utilitarianism. y The values of different pleasures are added for the individuals, but the value of given pleasure must be multiplied by the number of people who experienced it , and the value elements that make up the value of each pleasure must be multiplied by each other.

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All of this presupposes a kind of "moral arithmetic," which Bentham saw as analogous to the mathematical operations required of Newtonian physics. The operations of moral arithmetic are not all of the same kind, however. The values of different pleasures are added for individuals, but the value of a given pleasure must be multiplied by the number of people who experience it, and the various elements that make up the value of each pleasure must also be multiplied by each other. One distinctly economic facet of this welfare theory lies in Bentham's choice of money as the measure of pain and pleasure. Money, of course, is subject to diminishing marginal utility as more of it is acquired, which Bentham recognized, though he did not explore the marginalist principle as thoroughly as some of his successors did. In other words, Bentham was more of a utilitarian than a marginalist. He therefore did not take part in the marginalutility revolution that reoriented the general theory of value

FELICIFIC CALCULUS The felicific calculus is an algorithm formulated by utilitarian philosopher Jeremy Bentham for calculating the degree or amount of pleasure that a specific action is likely to cause. Bentham, an ethical hedonist, believed the moral rightness or wrongness of an action to be a function of the amount of pleasure or pain that it produced. The felicific calculus could, in principle at least, determine the moral status of any considered act. The algorithm is also known as the utility calculus, the hedonistic calculus and the hedonic calculus. Seven Factors y y y y y y y Intensity of pleasure and pain Duration Certainty or uncertainty Propinquity or remoteness Fecundity or chance it has of being followed by sensations of the same kind Its purity or the chance it has not being followed by the sensations of the opposite kind Extent, number of people who are affected

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CALCULATIONS OF WELFARE Begin with any one person of those whose interests seem most immediately to be affected by it and take an account: 1 Of the value of each distinguishable pleasure which appears to be produced by it in the first instance.

2 Of the value of each pain which appears to be produced by it in the first instance.

3 Of the value of each pleasure which appears to be produced by it after the first. This constitutes the fecundity of the first pleasure and the impurity of the first pain.

4 Of the value of each pain which appears to be produced by it after the first. This constitutes the fecundity of the first pain and the impurity of the first pleasure.

5 Sum up all the values of all the pleasures on the one side, and those of all the pains on the other. The balance, if it be on the side of pleasure, will give the good tendency of the act upon the whole, with respect to the interests of that individual person; if on the side of pain, the bad tendency of it upon the whole.

6 Take an account of the number of persons whose interests appear to be concerned; and repeat the above process with respect to each. Sum up the numbers expressive of degrees of good tendency... in regard to... the whole: do this again with respect to each individual, in regard to whom the tendency of it is bad upon the whole. Take the balance; which, if on the side of pleasure, will give the general good tendency of the act... if on the side of pain, the general evil tendency with respect to the same community

Probably anticipating criticism of the impracticability of his welfare theory, Bentham admitted that he did not expect the felicific calculus to be followed pursuant to every moral judgment or

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legislative enactment. But he enjoined legislators and administrators always to keep the theory in view, for as close as the actual process of evaluation comes to it, the nearer it will be to an exact measure.

EVALUATION y y y y Subjective The weight of qualitative pleasure/pain Fallacy of composition Narrow approach on human behavior

Population THOMAS MALTHUS y Malthus was interested in everything about

POPULATIONs.

He accumulated figures on

births, deaths, age of marriage and child bearing, and economic factors contributing to longevity. His main contribution was to highlight the relationship between food supply and population. Humans do not overpopulate to the point of starvation, he contended, only because people change their behavior in the face of economic incentives. y Noting that while food production tends to increase arithmetically, population tends to increase naturally at a (faster) geometric rate, Malthus argued that it is no surprise that people thus choose to reduce (or check ) population growth. People can increase food production, Malthus thought, only by slow, difficult methods such as reclaiming unused land or intensive farming; but they can check population growth more effectively by marrying late, using contraceptives, emigrating, or, in more extreme circumstances, resorting to reduced HEALTH CARE, tolerating vicious social diseases or impoverished living conditions, warfare, or even infanticide. Malthus was fascinated not with the inevitability of human demise, but with why humans do not die off in the face of such overwhelming odds. As an economist, he studied responses to incentives.

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Malthus is arguably the most misunderstood and misrepresented economist of all time. The adjective Malthusian is used today to describe a pessimistic prediction of the lockstep demise of a humanity doomed to starvation via overpopulation. When his hypothesis was first stated in his best-selling An Essay on the Principle of Population (1798), the uproar it caused among non-economists overshadowed the instant respect it inspired among his fellow economists. So irrefutable and simple was his illustrative side-by-side comparison of an arithmetic and a geometric series food increases more slowly than population that it was often taken out of context and highlighted as his main observation. The observation is, indeed, so stark that it is still easy to lose sight of Malthus s actual conclusion: that because humans have not all starved, economic choices must be at work, and it is the job of an economist to study those choices.

Malthus addressed many other issues. His Principles of Political Economy (1820) was the first text to describe a
DEMAND schedule

as separate from the quantity demanded at a

given price. His exposition of demand curves clarified the debate on SAY s law and gluts (to which he objected in the long run on the grounds that markets self-adjust). His work centered on contrasting the long run, as exemplified by population growth, with the short run, reflected by cyclical events such as those affecting agriculture. Writing before the INDUSTRIAL REVOLUTION, Malthus did not fully appreciate the impact of technology (i.e., pesticides, refrigeration, mechanized farm equipment, and increased crop yields) on food production. y Malthus died in 1834, before seeing economics characterized as the dismal science. That phrase, coined by Thomas Carlyle in 1849 to demean JOHN STUART MILL, is often erroneously thought to refer to Malthus s contributions to the economics of population growth. y Population increase geometrically but the means of subsistence increase in arithmetic progression

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Positive check War Famine pestilence

Preventive check Moral restraints Abortion Contraception

LIMITATIONS y To make the theory operational in a predictive sense is reliable information about the magnitude of the given prominence of the theory y y Faulted for overlooking the other checks Underestimated the advancement of technology in agriculture

PRECLASSICAL MONEY THEORY Money stimulates trade. CLASSICAL THEORY y y y y The bullion report is the first argument against the discretionary theory in money. Money as regulator of value. Paper money is an efficient way substitute to metallic money. The difference between the natural rate interest and bank rate of interest.

Conclusion y y Self-interest became the dominant explanation of economic activity. Malthus s Population theory entered the economic analysis as an endogenous variable and became an integral part of the theory of income distribution. y The quantity theory of money provides an analytical structure for understanding and explaining the changes of aggregate price level.