The word "economics" is derived from oikonomikos, which means
skilled in household management. Although the word is very old, the discipline
of economics as we understand it today is a relatively recent development.
Modern economic thought emerged in the 17th and 18th centuries as the western
world began its transformation from an agrarian to an industrial society.
Despite the enormous differences between then and now, the economic
problems with which society struggles remain the same:
- How do we decide
what to produce with our limited resources?
- How do we ensure
stable prices and full employment of our resources?
- How do we provide a
rising standard of living both for ourselves and for future generations?
Progress in economic thought toward answers to these questions tends to
take discrete steps rather than to evolve smoothly over time. A new school of
ideas suddenly emerges as changes in the economy yield fresh insights and make
existing doctrines obsolete. The new school eventually becomes the consensus
view, to be pushed aside by the next wave of new ideas.
This process continues today and its motivating force remains the same
as that three centuries ago: to understand the economy so that we may use it
wisely to achieve society's goals.
Mercantilism was the economic philosophy adopted by merchants and
statesmen during the 16th and 17th centuries. Mercantilists believed that a
nation's wealth came primarily from the accumulation of gold and silver.
Nations without mines could obtain gold and silver only by selling more goods
than they bought from abroad. Accordingly, the leaders of those nations
intervened extensively in the market, imposing tariffs on foreign goods to
restrict import trade, and granting subsidies to improve export prospects for
domestic goods. Mercantilism represented the elevation of commercial interests
to the level of national policy.
Physiocrats
Physiocrats, a group of 18th century French philosophers, developed the
idea of the economy as a circular flow of income and output. They opposed the
Mercantilist policy of promoting trade at the expense of agriculture because
they believed that agriculture was the sole source of wealth in an economy. As
a reaction against the Mercantilists' copious trade regulations, the
Physiocrats advocated a policy of laissez-faire, which called for minimal
government interference in the economy.
The Classical School of economic theory began with the publication in
1776 of Adam Smith's monumental work, The Wealth of Nations.
The book identified land, labor, and capital as the three factors of
production and the major contributors to a nation's wealth. In Smith's view,
the ideal economy is a self-regulating market system that automatically
satisfies the economic needs of the populace.
He described
the market mechanism as an "invisible hand" that leads all
individuals, in pursuit of their own self-interests, to produce the greatest
benefit for society as a whole. Smith incorporated some of the Physiocrats'
ideas, including laissez-faire, into his own economic theories, but rejected
the idea that only agriculture was productive.
While Adam Smith emphasized the production of income, David Ricardo
focused on the distribution of income among landowners, workers, and
capitalists. Ricardo saw a conflict between landowners on the one hand and
labor and capital on the other. He posited that the growth of population and
capital, pressing against a fixed supply of land, pushes up rents and holds
down wages and profits.
Thomas Robert Malthus used the idea of diminishing returns to explain
low living standards. Population, he argued, tended to increase geometrically,
outstripping the production of food, which increased arithmetically. The force
of a rapidly growing population against a limited amount of land meant
diminishing returns to labor. The result, he claimed, was chronically low
wages, which prevented the standard of living for most of the population from
rising above the subsistence level.
Malthus also questioned the automatic tendency of a market economy to
produce full employment. He blamed unemployment upon the economy's tendency to
limit its spending by saving too much, a theme that lay forgotten until John
Maynard Keynes revived it in the 1930s.
Coming at the end of the Classical tradition, John Stuart Mill parted
company with the earlier classical economists on the inevitability of the
distribution of income produced by the market system. Mill pointed to a
distinct difference between the market's two roles: allocation of resources and
distribution of income. The market might be efficient in allocating resources
but not in distributing income, he wrote, making it necessary for society to
intervene.
Classical economists theorized that prices are determined by the costs
of production. Marginalist economists emphasized that prices also depend upon
the level of demand, which in turn depends upon the amount of consumer
satisfaction provided by individual goods and services.
Marginalists provided modern macroeconomics with the basic analytic
tools of demand and supply, consumer utility, and a mathematical framework for
using those tools. Marginalists also showed that in a free market economy, the
factors of production -- land, labor, and capital -- receive returns equal to
their contributions to production. This principle was sometimes used to justify
the existing distribution of income: that people earned exactly what they or
their property contributed to production.
The Marxist School challenged the foundations of Classical theory.
Writing during the mid-19th century, Karl Marx saw capitalism as an
evolutionary phase in economic development. He believed that capitalism would
ultimately destroy itself and be succeeded by a world without private property.
An advocate of a labor theory of value, Marx believed that all
production belongs to labor because workers produce all value within society.
He believed that the market system allows capitalists, the owners of machinery
and factories, to exploit workers by denying them a fair share of what they
produce. Marx predicted that capitalism would produce growing misery for
workers as competition for profit led capitalists to adopt labor-saving
machinery, creating a "reserve army of the unemployed" who would
eventually rise up and seize the means of production.
Institutionalist economists regard individual economic behavior as part
of a larger social pattern influenced by current ways of living and modes of
thought. They rejected the narrow Classical view that people are primarily
motivated by economic self-interest. Opposing the laissez-faire attitude
towards government's role in the economy, the Institutionalists called for
government controls and social reform to bring about a more equal distribution
of income.
Reacting to the severity of the worldwide depression, John Maynard
Keynes in 1936 broke from the Classical tradition with the publication of the
General Theory of Employment, Interest, and Money. The Classical view assumed
that in a recession, wages and prices would decline to restore full employment.
Keynes held that the opposite was true. Falling prices and wages, by depressing
people's incomes, would prevent a revival of spending. He insisted that direct
government intervention was necessary to increase total spending.
Keynes' arguments proved the modern rationale for the use of government
spending and taxing to stabilize the economy. Government would spend and decrease
taxes when private spending was insufficient and threatened a recession; it
would reduce spending and increase taxes when private spending was too great
and threatened inflation. His analytic framework, focusing on the factors that
determine total spending, remains the core of modern macroeconomic analysis.
Summary
Monetarism updates the Quantity Theory, the basis for macroeconomic
analysis before Keynes. It reemphasizes the critical role of monetary growth in
determining inflation.
Rational Expectations Theory provides a contemporary rationale for the
pre-Keynesian tradition of limited government involvement in the economy. It
argues that the market's ability to anticipate government policy actions limits
their effectiveness.
Supply-side Economics recalls the Classical School's concern with
economic growth as a fundamental prerequisite for improving society's material
well-being. It emphasizes the need for incentives to save and invest if the
nation's economy is to grow.
These theories and others will be debated and tested. Some will be
accepted, some modified, and others rejected as we search to answer these basic
economic questions: How do we decide what to produce with our limited
resources? How do we ensure stable prices and full employment of resources? How
do we provide a rising standard of living both for now and the future?
