Chapters 5, 6, 7, and 8
Study Guide by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Oser Summary Main Page
Chapter 5: The Classical School: Adam Smith
Adam Smith (1723-1790) was the founder of the classical school and the author of An Inquiry into the Nature and Causes of the Wealth of Nations published in 1776 (his monumental work). Prior to that time he had published his Theory of Moral Sentiments in 1759. He spent more than two years in France and established friendships with the physiocrats including Quesnay and Turgot.
Laissez Faire and the Harmony of Interest
Smith advocated laissez faire and nonintervention by government in business. At that time governments were particularly wasteful, corrupt, inefficient, and granted special privileges to the detriment of society. If left to pursue their own self interest, individuals would serve society although this was not their intention. He referred to this as guidance by an invisible hand. He advocated the free enterprise doctrine to both domestic and international trade, and provided a devastating attack on mercantilism. Foreign trade would overcome the narrowness of the home market and promote a better division of labor. He was suspicious of businessmen and did not trust the government. When businessmen meet together even for merriment, the conversation ends in a conspiracy against the public to raise prices. Smith viewed kings and ministers as the biggest spendthrifts in society, and he attacked government intervention for the special interest of businessmen.
Smith believed there were three major functions for government:
1. Defense: To protect society from foreign attack.
2. To establish and administer justice within the country. The law should enforce the performance of contracts. Control over the issue of paper money and interest rates was acceptable. Tariffs were also acceptable to protect a defense industry, and to equalize the tax burden on industries.
3. To erect and maintain those public works and institutions that private enterprise cannot undertake profitably, e.g., bridges, canals, roads, harbors, post offices, coinage, schools, and churches. Public works should be financed by taxes, but taxes should be equal (not regressive), certain as to time of payment and amount paid, levied when most convenient to the contributor, and collected at minimum cost.
The Economic Laws of a Free-Enterprise Society
According to Smith there are two kinds of value:
1. Value in use - the utility of a particular object, and
2. Value in exchange - the power that the possession of an object gives to purchase other goods.
Labor is the real measure of the value of all commodities, but the growth of capital pollutes a simple labor theory of value. Where capital investments are important, goods will be exchanged for other goods, for money, or for labor at a higher price to cover wages and the profits of the entrepreneur.
Smith believed that demand did not influence the value of commodities since their value was determined by the cost of production including wages, profit, and rent. Smith assumed constant cost per unit, but if there is increasing or decreasing unit cost, Smith's principle becomes invalid.
Smith referred to natural prices as long-run prices that are the lowest prices an entrepreneur would accept and continue to sell his goods. Actual or market prices could be above, equal to, or below the natural price since market prices depend on the short-run aberrations of supply and demand. According to Smith, short-run supply and demand are not fundamental determinants of price, but they cause price fluctuations.
Smith opposed the low wage doctrine of mercantilism writing that the minimum rate of wages must be high enough to enable a workman and his family to survive and perpetuate the labor supply.
Profit should be high enough to compensate for the risk of loss and to provide a surplus for the entrepreneur. Interest was not viewed as a separate distributive share, but instead a deduction from profit.
Rent is the price paid for the use of land, a natural monopoly price, a surplus that varies with the fertility and location of the land. Smith did not recognize that land is not normally rented under monopoly conditions.
The role of money and debt was de-emphasized by the classical school. Smith viewed paper money as useful as gold and silver and noted that it cost much less to produce. He deplored the growth in public debt and thought public debt and the interest paid on it would probably ruin all the great nations of Europe in the long run.
Economic Development
Labor was considered the source of all value and the division of labor increased productivity, although labor specialization was limited by the extent of the market. Smith's emphasis was on improved dexterity rather than improved technology as the cause of increased productivity. He believed that real rents of land would rise for two reasons: improvements in cultivation, and improvements in industry causing a decline in the price of manufactured goods relative to farm products. This would make the exchange value of farm products relatively more valuable. Productive labor stores up labor in a salable commodity. Unproductive labor includes kings, soldiers, churchmen, lawyers, doctors, musicians, dancers and others who provide services. Other productive labor included artificers, manufacturers, and merchants, but the labor of farmers and country laborers was considered more productive since livestock and nature also add value. Services vanish in the simultaneous act of production and consumption, and cannot be accumulated.
Chapter 6: The Classical School: David Ricardo
David Ricardo (1772-1823) published On the Principles of Political Economy and Taxation in 1817. Ricardo was a deductive thinker who made sweeping generalizations he called economic laws, and he changed the emphasis of economic analysis from production to distribution. The prosperity of a nation depends on the total production and how it is distributed among three classes: landowners, capitalists, and laborers. Ricardo was concerned about how and why a certain pattern of distribution of limited output developed among a growing population.
The Bullion Controversy
To prevent the Bank of England from over issuing currency and control inflation, Ricardo proposed a gold bullion standard that was adopted by Parliament in 1819.
Value and Price
Ricardo was mainly concerned with relative values, and was committed to the labor theory of value. Commodities derive their exchange value from two sources: their scarcity, and the quantity of labor required to obtain them. The exchange value of a commodity depends on the labor time required to produce it. There were some problems with the simple labor theory of value including: where the ratios of capital to labor are different, how profits could be explained if all value was derived from labor time, and how to explain rent. Ricardo believed profits would not influence the relative values of goods. Commodities would sell for more or less than their labor time if more or less capital supported their production, or if there were temporary fluctuations in supply and demand. But long-run values would depend on the cost of production.
Wages and Profits
Ricardo considered the natural price of labor to be that which enables workers to subsist and to perpetuate themselves without either increasing or decreasing their numbers. This became known as the iron law of wages. The market price would fluctuate around the natural price. When the market price of labor rises above the natural price, the population increases, increasing the supply of labor, and wages subsequently fall back to or below their natural level.
Ricardo believed that rates of profit in different industries would tend to equalize, and profits and wages would vary inversely. One increases at the expense of the other. Wage increases come out of profits because an increase in prices to offset the rise in wages would require more money. Increased prices would cause gold to flow out of the country because prices abroad would be lower than at home. The money supply would fall and prices could not rise.
In the third edition of On the Principles of Political Economy and Taxation, Ricardo inserted a chapter called On Machinery raising the possibility of technological unemployment. He claimed that he was previously incorrect in his belief that the introduction of machinery would help all three major classes. Instead the sudden introduction of machinery would benefit the landlord and the capitalist, but would be injurious to labor. If more capital was invested in machinery, less would be available to pay wages and cause technological unemployment in the short run.
Rent and the Law of Diminishing Returns
In 1815, four authors published pamphlets about rent including Malthus, Edward West, Ricardo and Robert Torrens. Ricardo modestly gave most of the credit to Malthus and West, but he developed it most clearly and completely. The corn laws (tariffs on grain imports) generated the development of rent theory. Ricardo wrote that rent is that portion of the produce of the earth that is paid to the landlord for the use of the original and indestructible powers of the soil. Although the value of farm produce is based on the labor required, the better land produces a surplus that is taken by the landowner as rent. Rent also arises because of the law of diminishing returns. As successive units of capital and labor are added to a piece of land while technology is held constant, each addition unit of investment will add less to the output than previous units. Otherwise, all of the food for all the world could be grown in a flower pot. The land that is located closer to the market will yield extra returns because of transport cost, and these returns represent rent. Rent was viewed as price-determined, not price-determining since (from Ricardo's perspective) land did not have alternative uses.
Ricardo thought that the rate of profit would fall as the population increased because of the increasing difficulty of growing enough food. As profits fell curbing the accumulation of capital and investment, the stationary state would prevail since the limits of food production would limit further expansion of the population. At this state every available surplus would have been appropriated as rent.
Ricardo saw laissez faire as the ideal policy in both foreign trade and domestic affairs. Wages, like all other contracts should be left to the fair and free competition of the market, and should never be controlled or interfered with by the legislature.
The Theory of Comparative Advantage
Ricardo made a lasting contribution to economic thought with his theory of comparative advantage. His free-trade policy for manufactured goods was based on the idea that a more efficient country should export those commodities in which it has the lowest comparative cost, and import those whose comparative cost is highest. The theory of comparative advantage helps explain international trade, although the problems involved in international trade are more complicated than Ricardo's simplified model.
Chapter 7: The Classical School: Thomas Robert Malthus
Thomas Robert Malthus (1766-1834) was a member of the clergy, an author, and a professor of history and political economy in the East India College of England. His publications included An Essay on the Principle of Population in 1798 and Principles of Political Economy in 1820. Malthus and Ricardo were friends, but disagreed on almost every aspect of economics except Malthus' analysis of the population. His main contributions were his theories related to population and market gluts.
Overview of Malthusian Theories
The Social Background of Malthusian Theories
By 1798 unemployment, poverty, and disease were showing the effects of the industrial revolution. Malthus' pessimistic outlook was a reaction to his fathers optimistic belief in the perfectibility of man that was based on the works of Godwin and Condorcet. William Godwin (1756-1836) had written about the voluntary good will and sense of justice of individuals guided by the ultimate rule of reason. Godwin believed in the perfectibility of the human race through continuous advances toward higher rationality and increased well-being. The Marquis de Condorcet (1743-1794) favored universal suffrage for men and women and wrote that social progress was based on three fundamental principles: equality among nations, equality of individuals within a nation, and the perfectibility of mankind. Condorcet proposed a wide distribution of property, social security, and universal free education for both men and women. He believed that the population would increase as a result of these reforms, but that the food supply would increase more rapidly. To Malthus, Godwin and Condorcet stood for the excesses of the French Revolution. His work appealed to the conservatives as an able defense of the status quo.
The Essence of the Malthusian Population Theory
Malthus presented his law of population in the first edition of An Essay on the Principle of Population. According to this law, population when unchecked would increase in a geometrical ratio while subsistence would increase at best only in an arithmetical ratio. He perceived certain checks on the population including preventive checks that reduced the birth rate, and positive checks that increased the death rate. He favored moral restraint as a preventive check, but disapproved of birth control and prostitution as vices. Positive checks to population included famine, misery, plague, and war. If the positive checks were somehow overcome, people would face starvation. To Malthus, poverty and misery were the natural punishment for the lower classes when they did not restrain their multiplication. His recommended policy was that there should be no government relief of the poor, since this would only cause them to have more children survive and make the population problem worse.
The Essence of the Malthusian Theory of Gluts
In Book II of his Principles of Political Economy Malthus developed a theory of the inadequacy of effective demand to maintain full employment. Since workers produce a value greater than their wages (profit), they cannot buy the total output produced. Unless investment is high enough to absorb the surplus, goods will remain unsold. This raises the question of who will consume the surplus? There must be a class of people who are willing and able to consume more than they produce. Otherwise the mercantile classes could not continue to profitability produce more than they consume. Malthus favored unproductive consumption by landlords (hiring servants etc.), but opposed excessive consumption financed by the government. War, on the other hand offered another way to stimulate the economy and eliminate gluts. Malthus recommended government spending on public works only in times of acute distress. Ricardo endorsed Malthus' population theory, but he did not admit the possibility of chronic unemployment.
How were Malthusian Doctrines Valid, Useful, or Correct in Their Time?
Malthusian population theory served the wealthy, property owners, and landlords. Widespread poverty seemed to require an explanation, and population theory provided a plausible explanation. His theory of gluts was the earliest analysis of the problem of unemployment and the idea that the economic system is not self-adjusting.
How did the Malthusian Doctrines Outlive their Usefulness?
The Malthusian theory of population is based on the law of diminishing returns, but this law is only valid under static conditions where technology remains constant. Malthusian pessimism resulted from underestimating the possibility of increasing agricultural productivity. Although the theory of gluts was the first attempt to explain unemployment, it was a theory of under consumption, not a theory of business cycles, and it did not include modern fiscal and monetary controls that were unknown at that time.
Chapter 8: The Classical School: Bentham, Say, Senior, and Mill
Bentham
Jeremy Bentham (1748-1832) was a supporter of the classical school and made some original contributions to its philosophy and economic theory. The central theme of his work has been referred to as utilitarianism, or the greatest happiness principle. The underlying concept is hedonism, the idea that each man seeks his own greatest happiness. In An Introduction to the Principles of Morals and Legislation published in 1780 Bentham developed the principle of utility that "approves or disapproves of every action whatsoever, according to the tendency which it appears to have to augment or diminish the happiness of the party whose interest is in question." Utility is the property of any object to produce benefit, advantage, pleasure, good, or happiness, or to prevent mischief, pain, evil, or unhappiness.
Bentham's doctrines promoted progress, reform, wider democracy, and the improvement of social conditions, but led to insoluble contradictions and confusions. At that time the laboring poor had no voice in social or political affairs, and were expected to be subservient and hard working to enhance the power of the nation, the glory of the rulers, and the wealth of the industrial and commercial class, and idle aristocrats. Yet Bentham said men are men regardless of social position, and that legislators ought to promote the total happiness of the community. In his view, the state should serve the people, instead of the people serving the state. He did not accept laissez faire as a dogmatic principle. Bentham believed that the state should promote the greatest happiness of the greatest number, or as he described it, an artificial harmony of interests. Wealth was viewed as a measure of happiness, but increasing wealth has diminishing returns. Bentham recognized that equalizing incomes would deprive the rich of their feeling of security and destroy the incentives to work, and in doing so appears to have at least partially repudiated the conclusions of his own theory. However, his commitment to the greatest good for the greatest number led him to advocate many democratic reforms including universal manhood suffrage, equal electoral districts, vote by secret ballot, a system of national education, public works to provide employment in slack times, and a prison system that would reform criminals rather than punish them.
There are several problems with Bentham's economic theory. The assumption that people are rational and the best judge of their own self interest is of doubtful validity, developing a quantitative measure of utility is problematic, and the idea that the sum of the interest of several members of a community is the interest of the community is invalidated by Bentham's own "fallacy of composition", i.e., assuming that something that is true for one (or a part) is true for all (or the whole). Utilitarianism is also deficient in viewing all value judgments in terms of quantities of pleasure since qualitative measures of happiness may be more important. Providing a service to humanity may be a more satisfying goal than selfishly seeking one's own happiness.
Bentham's concept of human nature became the foundation of the economic systems of Ricardo, Mill, and the early marginalists such as William Stanley Jevons. Man was considered as perfectly rational, work was believed to be painful, and a man would work until the marginal utility of his earnings equaled the marginal disutility of labor.
Say
Jean Baptiste Say (1767-1832) published A Treatise on Political Economy (translated from the original in French) in 1803. He opposed the labor theory of value and substituted supply and demand that were regulated by the cost of production and utility. He added the entrepreneur to the other factors of production (i.e., land, labor and capital), and developed the theory that general overproduction was impossible because supply creates its own demand. This theory became known as Say's Law of Markets and dominated economic thinking until Keynes relegated it to a position of minor importance.
Senior
Nassau William Senior (1790-1864) published An Outline of the Science of Political Economy in 1836. His work moved toward the neoclassical theory that triumphed after 1870. In his view, economists should concern themselves with wealth, not happiness. The exchange value of goods depends on demand and supply, and the concept of marginal utility underlies the concept of demand, while supply depends on the cost of production. The costs of production are the labor of workers and the abstinence of the capitalists. Senior disagreed with Adam Smith, and considered lawyers, doctors, and teachers as productive. In his view the terms productive and unproductive should be applied to consumption, not production. Consuming lace, embroidery, jewelry, tobacco, gin and beer were unproductive in that they diminished the quantity of commodities without adding to workers' capacities to produce. He was opposed to trade unions and limiting the work day to twelve hours for adults. He thought that shortening the working day by more than one hour would cause the capitalist to lose money because foreign producers would gain an advantage.
Mill
John Stuart Mill (1806-1873) was the last great economist of the classical school. He made some significant original contributions, departed from some of the key concepts developed by Smith and Ricardo, and although Mill was raised in the Benthamite tradition, finally rejected Bentham's narrow view that human beings were motivated by nothing more than the desire for self-gratification. His Principles of Political Economy published in 1848 became the leading textbook in the field until Alfred Marshall's Principles of Economics was published in 1890. The text was divided into five books: I. Production, II. Distribution, and III. Exchange (the laws of a stationary and unchanging society or Statics), and IV. Influence of the Progress of Society on Production and Distribution, and V. Of the Influence of Government. (a theory of motion, of progressive changes and ultimate tendencies, or Dynamics).
In the first book Mill analyzed three factors of production: land, labor, and capital. Productive labor was defined as labor that produced utilities embodied in material objects. Labor that yielded a material product only indirectly was also included, e.g., educators. Unproductive labor does not terminate in the creation of material wealth, i.e., exchange value. Capital is the result of saving, and is the accumulated stock of the produce of labor. Every addition to capital provides labor additional employment, or additional remuneration, and enriches the country or the laboring class. Increases in capital depend on the surplus product after the necessities are supplied to all engaged in production, and the inclination to save. The real barriers to increasing production do not include labor and capital, but the limited extent of land and its limited productiveness based on the law of diminishing returns to agriculture.
In Book II of Principles of Political Economy, Mill abandoned Ricardo's idea of the inevitable laws of distribution. He challenged the classical school's belief in the permanence of natural law. He favored a broader distribution of property and a reduction of large heritable fortunes. He accepted the wages-fund theory that wages depended on the demand and supply of labor. Wage rates could not rise except by increasing the aggregate funds employed in hiring labor, or by a reduction in the number of laborers. As a result, he believed that government could not establish a minimum wage above the equilibrium level. The wage-fund theory was used by some as a basis for opposing unionism, but Mill thought workers should have the right to combine to raise their wages even though he thought unions were seldom effective. The wages-fund theory was flawed in that there is no predetermined amount of capital that must go to labor. Mill recognized this later in a book review published in Fortnightly Review in 1869, and that unions could raise wages to a certain extent. The price of labor determines the size of the wage fund rather than the other way around. Profit has three parts including interest, insurance, and wages that are the rewards for abstinence, risk, and the exertion implied in the employment of capital. The rate of profit, allowing for differences in risk, attractiveness of different employments, and natural or artificial monopolies, tends toward equality in all spheres.
Price expresses the value of a commodity in terms of its power of purchasing other commodities. Effectual demand is one of the determinants of value, and demand means quantity demanded (a demand schedule). The interaction of demand and supply results in a market value. The minimum exchange value is the cost of production. Mill added the law of international values to the law of comparative advantage. The idea is that the value of an imported product depends on the cost of production of the thing that is exported to pay for it. The terms of exchange with another country depend on the strength and elasticity of demand for the products in that country.
In Book IV (Influence of the Progress of Society on Production and Distribution) Mill forecast the continuing mastery of man over nature, increasing production and population, and the growing role of corporations. Improvements in industrial production would be offset by diminishing returns in agriculture and mining. The rate of profit would continue to decline as the threat of war declined, and improvements in education and justice reduced the risk of investment. Growth in capital would not cause market gluts because Say's Law of Markets would keep the economy operating at full employment. The final result of progress was a stationary state where increased production was not an important object. Instead, what would be needed is a better distribution supported by stricter restraint on population. The working classes will increase their intelligence, education, and desire for independence, leading to a population that will decline in relation to capital and employment. Profit sharing business and cooperative enterprises will improve conditions, and this is preferable to full blown socialism.
In Book V (Of the Influence of Government), Mill defended laissez faire, but introduced a number of exceptions noting that government should provide education, regulate child labor, operate natural monopolies such as gas and water, and do those things that serve the interest of mankind, but are not profitable to individuals such as geographic and scientific exploration.
Mill wrote a number of other books including System of Logic (1843), On Liberty (1859), Considerations on Representative Government (1861), and Subjection of Women (1869) showing that he was an outstanding political scientist, social philosopher, and champion of the democratic way of life.
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Go to the next Chapter. Chapter 9: The Rise of Socialist Ideologies (Summary).
Go to Chapter 1 and the links to all Chapters. (Summary).
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Martin, J. R. Not dated. A note on comparative economic systems and where our system should be headed. (Note).
Milanovic, B. 2019. Capitalism, Alone: The Future of the System That Rules the World. Harvard University Press. (Summary).
Miller, E. L. 1992. Questions That Matter: An Invitation To Philosophy, Third Edition. Chapter 18: Utilitarianism. McGraw-Hill, Inc. (Summary).
Piketty, T. 2014. Capital in the Twenty-First Century. Belknap Press. (Note and Some Reviews).
Porter, M. E. and M. R. Kramer. 2011. Creating shared value: How to reinvent capitalism and unleash a wave of innovation and growth. Harvard Business Review (January/February): 62-77. (Summary).
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