1.2.2 Economic thought Notes

Origin of economic ideas in a historical context

18th century: Adam Smith and laissez faire

Adam Smith (1723-1790), often called the "Father of Economics," introduced foundational ideas to modern economics in his book, The Wealth of Nations (1776).

Adam Smith argued for minimal government intervention. He mainly advocated for:

• Invisible hand: market competition guides resources to their most efficient uses through self-interested actions.
• Division of labor: specialization in tasks boosts productivity and promotes economic growth.
• Free trade: countries should produce goods where they have an absolute advantage, fostering mutual benefits.

19th century economics

The development of classical economic thought

The 19th century saw significant advancements in economic thinking, building on the foundational ideas of Adam Smith. The ideas develop during this century are referred to as classical economics.

1. Economists of this era focused on issues such as:
   1. Economic growth: understanding how economies expand over time.
   2. Income distribution: analyzing how wealth is allocated within societies.
2. Key contributors to 19th century economics include:
   • David Ricardo: Explored theories of value, trade, and income distribution.
   • Jeremy Bentham and John Stuart Mill: Introduced utilitarianism, blending ethics with economics.

Classical microeconomics: utility

In the 19th century, philosophers like Jeremy Bentham and John Stuart Mill developed utilitarianism.

1. They emphasized the actions that maximize happiness for the greatest number.
2. Through this, the idea of utility was introduced in economics. Economist began to seeking utility maximisation.

The concept of margin

Classical economists were concerned with the concept of value. They wondered what exactly determined the pricing of goods and services:

1. Originally, economists believed it was the amount of labour than the production of each good and service required was the factor that determined its pricing.
2. However, when the concept of utility was introduced, this idea was re-evaluated.

Economist agreed that utility was central to the idea of the value of a good determining its pricing. However:

1. What is significant is not the overall satisfaction gained from consuming a good, but the additional satisfaction derived from consuming one more unit of it.
2. This concept is referred to as marginal utility.

Classical macroeconomics (Say's Law)

Classical economists sought to understand:

1. How could economies maintain full employment of their resources?
2. How could economies ensure that all goods and services produced were consumed?

Originally, it was believed that the market system inherently adjusted itself to prevent prolonged periods of unemployment (or economic stagnation). This concept, formalised by Jean Baptiste Say,

This perspective was formalised by Jean-Baptiste Say, became the building principle of classical macroeconomics: Say’s Law. This law suggests that supply creates its own demand:

1. The production of goods and services generates income for households, enabling them to purchase what is produced.
2. This continuous flow of income and spending ensures that all output is eventually bought.

Marxist critique of classical economic thought

Karl Marx presented a systematic critique of capitalism in his work "Capital: Critique of Political Economy." Marx:

1. Viewed capitalism as a system driven by the private ownership of production and the endless pursuit of profit.
2. Built upon the labour theory of value. However, he observed a gap between:
   1. The wages paid to workers.
   2. The actual price of goods, which he termed surplus value.
   3. The surplus value is the profit earned by factory owners.
   4. Marx argued that the surplus value arose from the exploitation of workers in order to maximise profits.

Marx argued that capitalism evolved from feudalism. He further argued that capitalism was inherently unstable because:

1. Intense competition forces capitalists to invest in machinery to reduce labor costs.
2. Over time, this reduces the surplus value generated by labor, leading to falling profits.
3. Increasing automation causes unemployment and poverty among workers, intensifying class struggles.
4. Marx argued that capitalism's colapse would eventually give way to communism.

20th century economics

Keynesian revolution

1. During the 19th century, Say’s Law dominated economic thought, asserting that supply creates its own demand.
2. This theory suggested that markets would naturally self-correct, preventing prolonged periods of unemployment.
3. However, the Great Depression of the 1930s shattered this belief, with an unseen economic contraction and high unemployment with no clear solution from classical economics.

With his 1936 revolutionary book The General Theory of Employment, Interest and Money John Maynard Keynes rejected the idea that economies always return to full employment on their own.

Previously, classical economists had believed that:

1. If demand and spending decreased, prices would drop, encouraging higher consumption and restoring full employment.
2. Falling output would lead to temporary unemployment, causing wages to decline.
3. Lower wages would incentivize businesses to hire more workers, restoring balance.

Keynes challenged these assumptions with the concept of sticky wages:

1. Wages do not easily decrease due to institutional factors.
2. Falling wages reduce workers’ purchasing power, further decreasing demand.
3. Producers, unable to lower prices due to high wage costs, contribute to a cycle of low output and unemployment.

Hence, Keynes advocated for active government intervention to address economic downturns. He argued that increased government spending on infrastructure projects, such as roads and schools, could stimulate demand.

Rise of macroeconomic policy

The Keynesian ideas helped establish the conviction that government intervention is needed when markets fail to self-correct. This led to a worldwide increase of economies developing macroeconomic policies: policies to intervene in the macroeconomic scale.

Monetarist / new classical revolution

During the early 1970s, the global economy experienced a phenomenon known as stagflation (simultaneous high inflation and stagnant growth), triggered by the first oil price crisis.

1. Until then, all periods of stagnant flow had been accompanied by low inflation.
   1. This was not the case during the 1973 oil embargo crisis.
   2. During the 1970s crisis, stagnation was accompanied by high inflation (we will find out why in Topic 3).
2. Keynesian economics, with its focus on aggregate demand, struggled to offer effective solutions to this type of inflation.
3. These challenges opened the door for alternative approaches: monetarism and new classical economics.

Monetarism and new classical economics, both advocated for self-correcting markets in the economy. They presented the ideas that:

1. Government intervention (minimum wages, labour unions...) is the causation of the economy not adjusting during economic downturns.
2. Market liberalisation (not intervening in the markets) leads economies toward full employment of resources, whereas government intervention prevents economiess from output maximisation.

21st century economics

Increasing dialogue with other disciplines such as psychology and the growing role of behavioural economics

The 21st century has seen increasing collaboration between economics and psychology, leading to the emergence of behavioural economics.

Behavioural economics challenges traditional assumptions that consumer decisions are entirely rational and only aim to maximise marginal utility. Behavioural economics argues that:

1. Consumers often lack complete information.
2. Consumer make decisions influenced by biases and emotions.

Nowadays, insights from behavioural economics are used to design policies that encourage socially desirable behaviours (e.g., saving more or reducing energy consumption).

Increasing awareness of the interdependencies that exist between the economy, society and environment and the need to appreciate the compelling reasons for moving toward a circular economy

Modern economics emphasises the interconnectedness of the economy, society, and environment, often referred to as the three pillars of sustainability:

1. People (society)
2. Profit (economy)
3. Planet (environment).

The circular economy

Traditional production models follow a linear approach:

1. Take: resources are extracted.
2. Make: resources are used to create products.
3. Dispose: resources are discarded as waste.

Since resources are scarce, disposing them after their use increases the rate at which they are depleted.

As an alternative, the circular economy model offers a sustainable alternative:

1. Goods are designed to be repaired, reused, or recycled, extending their lifespan.
2. Products are made from biological materials that can safely return to the environment, reducing pollution.

With this, the circular economy model aims to:

1. Maximise the value of resources during their use.
2. Recover and regenerate materials after their lifecycle end, using them once again.