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Classical Laissez Faire laissez-faire Classical Laissez-faire Economics The earliest organized school of economic thought is known as Classical. The father of this school is Adam Smith. Smith used the concept of the invisible hand to describe the role of the market in the allocation of resources. In the market, the interaction of demand and supply determines how much of a good will be produced and the price that is charged for that good. Absent any explicit guidance mechanism, the invisible hand guides participants in the market towards an outcome that efficiently allocates resources to the production of goods that society desires. Other important classical economists include David Ricardo who introduced and developed the concepts of comparative advantage and the benefits of an open economy that participates in international trade.
J. B. Says presented what is today known as Says Law: supply creates its own demand. Says law captures the essence of the classical school of thought. The statement that supply creates its own demand implies that by producing goods and services, firms create the jobs and incomes capable of buying those goods and services. With economic foundations based on the role of markets, a theory generally free of outside intervention, and emphasizing the role of production in determining income and economic output, the classical school of thought has several important implications: ?
The government should play a minimal role in determining the condition of the economy. The government does have an important place in areas such as providing a legal framework, preventing abuses of the market, and to sustain national defense. However, extensive government intervention will hinder the efficient operation of the market in the determination of prices of goods and services and the allocation of resources towards their production. ? The normal economic state of the economy is at full employment.
This implies that all workers that desire jobs will have them, and those who are unemployed voluntarily choose to be so. ? The government has a minimal role over the course of the business cycle, and left alone the economy will gravitate toward full employment. In the long run, unemployment is not an important public policy concern as the unemployment present will be voluntary. ? Economic analysis should emphasize the study of markets and how they effectively operate. An Early Theory of Value One of the most important questions early classical economists attempted to answer was how the value or price of a good is determined. Smith described how the interaction of supply and demand in the market determined a goods price.
Smith needed to go further and explain why two goods with identical demands would have different prices. According to Smith, the prices of goods are determined by what it costs to produce them. Since the majority input used in production during the eighteenth century was labor, Smith developed a labor-based theory of prices. The price of a good reflects the amount of labor used in its creation. One goods price is higher than another's because of the extra labor used in its production. However, in Smiths model the price of a good is independent of the amount produced, resulting in a horizontal supply curve.
From this base, Ricardo introduced the idea of diminishing returns in the factors of production. Diminishing returns in labor implies that as additional workers are used in production, the incremental output from each added worker is less than the output gained from hiring the previous worker. The quality of workers does not contribute to diminishing returns; rather, factors outside the individual workers control yield this result. Ricardo used the example of agriculture. Initially the best, most productive lands were farmed. But as the population grew, marginal lands were harvested, bringing down the yield per acre.
As a result, additional labor would be needed to produce an extra bushel of grain. Due to diminishing returns, the price of a good increases as the quantity produced increases, resulting in an upward-sloping supply curve. Taking Ricardo's law of diminishing returns one step further was Thomas Malthus. Malthus considered the increase in population that was occurring over time in comparison to the fixed supply of land. With diminishing returns prominent as increasing amounts of land are required to feed the growing population, there would eventually be a shortage of food. Agricultural output per acre would expand at a diminishing rate as increasingly marginal land was used to feed more and more people.
Eventually, Malthus predicted, famine and starvation would result. So far, Malthus predictions have not been realized on a global scale. Although starvation does occur, it is a result of local conditions. At the present time, world food production is sufficient to accommodate the worlds people.
Population growth accompanied by famine has not been a problem due to the technological changes that have made workers and land more productive. The use of increasing amounts of fertilizers and better capital has easily offset any diminishing returns due to the use of lower quality land. In many cases, prices of goods have fallen in the long-run as output has expanded. To complete the theory of price determination, Alfred Marshall looked at the margin. Along the producers supply curve, higher prices are required to increase the quantity supplied. The supply curve shows the increasing cost of making an additional (marginal) unit of the good; its upward slope reflects increasing marginal costs.
While along the consumers demand curve, lower prices are required to induce the consumer to buy that additional unit of the good produced. The downward slope of the demand curve reflects decreasing marginal usefulness. By combining demand and supply, Marshall showed how the two curves simultaneously determined price. A Great Depression A course in macroeconomics teaches the student the role of the government in dealing with business cycles. If economic thought had stopped with the classical economists, there would be no need for a course in macroeconomics. As mentioned, the classical economists believed that there was only a minimal role for the government in the economy.
The natural economic condition was at full employment, and the government should not interfere with the efficient operation of markets which yield that outcome. Economic recessions, even depressions, were temporary in nature. Left alone, the economy would return to a level consistent with potential output. And so the world of economic thought went until the Great Depression of the 1930 s.
For many industrialized nations, output plummeted and unemployment rates soared during the 1930 s. In the United States, unemployment reached 25 % and output dropped by over 30 % from the level reached in 1929. The classical argument that falling prices and interest rates would restore economic prosperity never occurred (1). The economy remained stuck. With high unemployment, there was not enough consumer income to stimulate consumption and aggregate demand. With falling demand for output, business investment sank.
High tariffs prevented an export-driven growth stimulus (2). (1) Flexible and falling prices, wages, and interest rates could offset an economic slowdown in several ways. In a business downturn, a decrease in labor demand and layoffs lead to a decrease in wages. Lower wages reduce the relative price of employing labor relative to capital and create an offsetting increase in the demand for labor. If prices fall further than wages, then purchasing power increases. Furthermore, with falling prices, the value of wealth holdings also increases both effects contribute to increased consumption, offsetting the initial decrease in aggregate demand that caused the economic downturn in the first place. Lower interest rates improve the return on investment, resulting in an increase in business investment and an increase in aggregate demand. (2) Several important factors combined to make the 1930 s a decade of extreme economic depression. ?
During the 1920 s, corporate, bank, and individual participation and speculation in the stock markets was very high. Investors, including banks, could buy stocks on margin, paying only a small percentage (for example, 10 %) of the stocks street value. This allowed for a tremendous amount of leveraging and exposure in equity assets with only a moderate cash outlay. In addition, banks could use customer deposits to buy stocks, further driving up share prices and increasing the potential fall in prices. And prices did fall. From October 1929 to the early 1930 s, many stock prices lost over 90 % of their value.
For many Americans, their savings and wealth evaporated almost overnight. ? As a result of the business downturn, demand for goods and services plummeted, U. S. corporations responded by lobbying Congress for increased protection from the import of foreign-made goods.
Congress complied. Led by Congressmen Smoot and Hawley, tariffs averaging 60 % were placed on imported goods. Since a tariff acts as a tax, this led to a corresponding increase in the price of these goods to the American consumer. Foreign countries immediately reciprocated, shutting off markets for U. S. exports.
Global trade contracted, leading to a further deterioration of the economy. ? With the economic downturn, incomes and tax payments declined. Believing a balanced budget was of primary importance, President Hoover raised income and corporate taxes, further decreasing disposable incomes and jobs. Stunned by the magnitude and duration of the Depression, classical economists went into a funk. The traditional classical solution to the business cycle allow prices, wages, and interest rates to adjust and wait it out, was not working. Wages, prices, and interest rates did fall, and yet output continued to sink further, while the unemployment rate soared well beyond any level justified as voluntary.
The traditional catalysts for economic growth, consumption, investment, and international trade were in a catatonic state. Massive unemployment, coupled with a devastating loss in wealth, left consumption moribund. Businesses had no reason to invest in expanding productive capacity when demand for their goods and services had fallen off a cliff. Finally, the Smoot-Hawley tariffs led to a substantial contraction in foreign trade activity and potential export markets in countries that were doing better economically. This left only one sector of aggregate demand with the potential to resurrect the economy: government spending.
John Keynes pointed out the obvious when traditional methods of economic stimulus fail, use the government as a last resort and use it forcefully. Keynes was an economist educated by classical scholars. He took their theory a step further and exposed the shortcoming, establishing his own ideas on the classical foundation and leaving his own school of economic thought and policy. Keynes pointed out several problems with classical theory.
An important point was that wages tended to be sticky and would not fall as much as prices during economic downturns. The result is an increase in real wages (w / p ) and a decrease in the demand for labor as the real cost of labor inputs increases. Keynes also developed the idea that during periods of economic weakness investment tends to be relatively interest-inelastic, or investment is relatively unresponsive to changes in the interest rate. Thus, a decrease in the rate of interest will have little or no stimulative impact on the investment component of aggregate demand. My conclusion is simple. In addition to their strong moral base in personal freedom, capitalism and competitive markets work to deliver substantial economic progress; communism, socialism, even large bureaucratic welfare state third ways do not work.
They sap individual incentive, initiative, and creativity and ultimately cannot deliver sufficiently rising standards of living to meet the expectations of their citizens for better material lives for themselves and their progeny. Episodic economic downturns or other perceived market failures create great opportunity for misplaced permanent expansion of governments role in the economy. Clearly, we have learned that government has a number of important roles to play in our economy and that we must remain vigilant to make sure that it plays only those necessary roles in the least intrusive manner possible. A consistent rules-based monetary policy, the lowest possible level and rates of taxation, less command and control in favor of more flexible market-oriented incentive regulation, slower growth of government spending including entitlement reform, and expanded open rules-based trade are surely the lessons of economic history and would surely be Adam Smiths wise prescription today.
The theme of this years NABE conference is Winners and Losers of the 21 st Century. Surely a large part of the answer to that implicit question is those who can stay closest to the limited government capitalist model in the face not only of the natural tendency of the governments role in the economy to grow, but also the incredible impending demographic pressures that will greatly reinforce this tendency. The calls for capital controls, greatly expanded taxes and spending, vast new regulation, extensive industrial policy, and dangerous protectionism threaten our economic progress and personal liberty. Such calls by pundits and decrier's of capitalism are frequent and occasionally frenetic, both inside and outside the economics profession. Of course, as economies evolve and conditions change (e. g. , due to changing demography), the role of government based on the sound market principles enunciated above may reasonably ebb and flow.
But capitalism once again needs its defenders, teachers, exemplars, and champions. The alternative models have proven historically, intellectually, and practically bankrupt. We would all be better off if the decrier's of capitalism remained permanently discontented.
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