The purpose of this lecture is to explain the intellectual framework of mainstream, contemporary economics operates. Most textbooks, inlcuding the one used in this class do not begin at this point. They jump right into to presenting a mathematical framework without explaining why, nor where this framework comes from, nor the advantages and disadvantages of this framework. The problem with doing this is that it implies that there is a single way to do economic analysis with little or no controversy. To fully understand the strengths and weaknesses, good and bad applications, and appropriate and inappropriate implications of mainstream economic theory one must understand how the theory was developed and how it is structured. We will develop this understanding over all all three quarters this year.

Classical and Neo-Classical Economic Theory.

Contemporary, mainstream economics is called Neo-Classical Theory or Neo-Classical Economics. It is called Neo-Classical, because it is a return, to a degree, to Classical theory.  Classical Economic Theory was developed between the mid 1700s and the mid-1800s, and includes the 5 major economists: Adam Smith, Thomas Malthus, David Ricardo, John Stuart Mill, and Karl Marx. Neo-classical theory is based predominatley upon Smith's and Ricardo's work. Neo-classical theory was initially developed in the late 1800s and early 1900s.

Classical Economic Theory.

Classical economic theory is a primary contribution of the philosophical movement known as Classical Liberalism. Classical liberalism arose as a philosophical movement in the mid-1700s as the anti-feudalist  ideology which argued that rights and freedom are embedded in the individual person not the feudalist state (i.e. monarchy). Emphasizing individual freedom of landowning citizens over fealty to the monarch Liberalism was a critique of feudalism which had already begun to unravel well before democratic governments began to emerge. Classical Liberal philosophy argued that governments are only legitimate when based upon the consent of the governed and when the government protects the rights and freedpms of the individual. As such, classical liberlaism was the philosophical basis of the modern democratic state and the ideology of early capitalism.

Adam Smith (1723 - 1790).    Adam Smith provided, perhaps, the most complete vision of Classical Liberalism when he presented these concepts in a coherent economic theory, The Theory of the Free Market, in his book,  An Inquiry into the Nature and Casues of the wealth of Nations. Smith's free market theory argued that  in an unregulated market individuals pursuing their own self-interest generate competition, which results in prices independently adjusting. These price adjustments inform consumers and producers of the true costs of their decisions. By making decisions on these accurate prices and true costs consumers and producers create transactions in which the market always balances, the amount of goods produced always equals the amount of the goods purchased. This market equilibrium cannot be improved upon, and can only be distorted by any form of intervention, regulation, or government action.

We will analyze free market theory in far more detail in all three courses, but especially in Microeconomics and Macroeconomics. While this theory is familiar and the basis of most contemporary, mainstream economics, as academics we should not simply assume it is entirely accurate. It is a theory, and as such it needs to proven to be accurate.

Thomas Malthus (1766 - 1834).    Thomas Mathus is the next major Classical economist. His contributions are valued far more highly today than during his lifetime. Although Malthus was a whole hearted disciple of Smith, he was the first economist to analyze the problems of capitalism. Because both his personality and analysis was so dour a journalist dubbed economics "the dismal science" based upon Malthus' work. The three major problems that Malthus tried to understand were poverty, depressions, and over-population. You can see why he is still so influential today.

Poverty. Malthus was disturbed that poverty not only persisted, but had grown, while capitalism had flourished in England, the country had become not only wealthier, but the world's dominant economy. The contradiction he saw was that England as a whole was far wealthier but poverty had become worse, with large urban poor populations concentrated in ghettos. Why had a clearly superior  economic system failed to alleviate poverty?

Depressions. In his time depressions were well known and called "gluts", periods of over-supply, too many goods, not enough buyers. Malthus' concern was why would a self-balancing economy continue to get stuck in persistent periods of gluts? The central thesis of Smith's theory is that the free market is completely self-adjusting, thus deep, prolonged, persistent gluts should not occur.

Over-population. Perhaps Malthus is most famous and infamous for his analysis of population. He is famous for it because his general predictions have proven to be eerily accurate 150 years after his death. He is infamous for the same analysis because the mathematics he used to make the predictions was actually wrong. Malthus argued that capitalism will result in such economic growth that the population will eventually outstrip the world's natural resources. He argued that capitalism would make populations wealthier and healthier. As people have more income they eat better and have better shelter. This results in longer lives and higher fertility (fewer childhood deaths). Thus, capitalism will result in a massive population increase which could not be supported by the natural resource base. This is the part he appears to have gotten right.

His error was in the details. He argued that as capitalism grew, populations would grow geometically (2, 4, 8, 16,...) but food production would only grow arithmetically (1, 2, 3, 4,...). This was inaccurate for two reasons. First, once economies grow to a certain level of prosperity their populations stop growing and even decline as parents put less time and effort into having and raising children. Secondly, agricultural output has grown far faster than population. Even with over 6 billion people on the planet, world wide we produce plenty of food for everyone to receive a healthy caloric intake of 2,000 calories per day. Hunger today is a distributional and political problem not a productive or economic problem. Of course, that won't always be true, and that again is where his conclusions, in the end, were accurate, even if his math was wrong. His math was wrong becasue he could not have foreseen either the turn around in population dynamics when people become prosperous enough, nor the enormous technological changes that have increased agricultural output.

While Malthus was never satsified with his own analysis (he lamented in a letter written to Ricardo that while he had never succeeded in proving that he was right about his theories he was going to die believing he was right) his real contribution was not these three disconnected areas, but what he thought the answer was. Malthus believed all three of these problems, persistent poverty, prolonged depressions, and over-population were all generated by the market economy itself. This was a conclusion that he not only had not proven, but that he did not want to prove being an advocate for the free market. However, in the last 100 years others have relied on his work to identify various ways that the free market reproduces poverty and depressions, and over-exploits resources.

David Ricardo (1772 - 1823). David Ricardo is the father of  Free Trade theory. Indeed, he proved that  Smith's Free Market  Theory is just a specific case of Free Trade theory. In essence they are the same theory. One cannot logicaly support  free markets and simultaneously reject free trade. Here is a simple version of his proof. Smith argues that two people free of regulation will negotiate a transaction that benefits each of them and government intervention can only undermine those benefits. This is true whether the people live in London, or one in London and one in Liverpool, or one in London and one in Paris. Government intervention in any of these private transactions will only lower the benefits gained by the people involved in the private transaction. Of course, his full proof is far more sophisticated than this, but this reflects the underlying essence of the two theories.

John Stuart Mill (1808 - 1873). John Stuart Mill is the originator of Social Welfare Economics, which is a body of economic theory that argues that an economy that is as prosperous as capitalism has the ability, responsibility, and self-interest to ensure that everyone in the society shares in the benefits of the economy. The essence of this view is that the economy ought to produce the greatest good for the greatest number of people. This is a major aspect of Utilitarianism. While he was a proponent of free markets, he argued that government intevention was justified if it was in the interest of society as whole. In other words, if it produced more benefits for more people. Thus, he supported progressive taxation, an end to slavery, universal suffrage, women's equality, public education, and other casues. Social welfare economics became the basis for both the Social Democratic economies of northern Europe and the "welfare state", a government that seeks to re-distribute inequitable levels of wealth to ensure that even the poorest in the population participate in and benefit from the economy.

Karl Marx (1818 - 1883). Karl Marx is, of course, the major contributor to socialist and communist theory. You may wonder why he is considered a Classical theorist if he was anti-capitalist? The answer is that he was heavily influenced by Smith and Ricardo, and in many ways considered himself a student of theirs, and he has provided, perhaps, the most complete structural analysis of capitalism.

People have a tendency to misunderstand or misrepresent Marx's economic analysis often confusing it with his politics. Marx famously declared himself "not a marxist", nor a utopian socialist, but a "scientific socialist". To become a scientific socialist he wrote, one had to master Smith and Ricardo's works. According to Marx, Smith and Ricardo had created a science of economics.

Marx also considered capitalism to be the most progressive economic system ever, even likely to be more productive than socialism. Following Smith and Ricardo, he recognized that no system better linked personal incentives with efficiency and productivity, and thus he claimed that capitalism would change the face of the world and not cease to spread until it had developed the entire world. He felt that socialism and communism would be superior because, they would be more democratic and egalitarian, not because they would be more productive.

Contradictions. Marx's work cannot be easily summarized in such a short space. One example, is his use of "dialectical materialism" to analyze all economies. Dialectical materialism is Marx's theory that all societies develop by resolving contradictions between their economy, their civil society, and their political structure. In this view, every society evolves by resolving problems that the earlier society created, but could not resolve without fundamentally changing. Of course, in time the new society would create new contradictions which it could not resolve without fundamental change. These changes had to be revolutionary, in both the sense of fundamental change, and in the sense that the elite who benefitted most from the existing society would resist any change which reduced their influence (think of the role of banks in both the financial crisis and in the bailout solution).

The Increasing Concentration of Capital. An example, of one contradiction of capitalism that Marx analyzed and that we will look at in Micro, is the "increasing concentration of capital". Smith and Ricardo's analysis of the free market argued that markets could not be dominated by monopolies or oligopolies (a few companies that control the market) because there would always be sufficeint incentives for small upstart companies to undersell large companies and thereby undermine their dominance. In fact, this does happen. Think of the emergence of Microsoft undermining the monopoly of IBM.

However, Marx argued that this reasoning and process does not reflect the essential reality of how capitalism is actually structured to work.  Marx argues  that a fundamental contradiction of a free market, which free markets cannot resolve, is that competition automatically generates anti-competitive market strategies which almost always result in an uncompetitive market. Free markets cannot ensure market competition, only government intervention can. He points out that all of the following analysis is in Smtih and Ricardo and is accurate, only the conclusion is Marx's.

Here is the reasoning: Market competiton rewards the most efficient producers. By being more efficient a producer lowers its production costs. This allows it to either sell a product for a lower price and gain market share (i.e. more sales) or sell the product at the market price and gain more profit. Either way the most efficient firm ends up growing more rapidly than its less efficient competitors. However. the most efficient firms are not stupid, the very fact that they have innovated more rapidly means that they know they have to re-invest in new research and development to continue their productivity advantage. But because they have already grown more rapidly they have more money to re-invest and therefore, are more likely to to grow more rapidly in the next period. Overtime the most efficient producer out grows all other producers and dominates the market.  A competitive market has naturally evolved into an uncompetitive monopoly. If you add in the ability of large firms to lobby and influence legislation their economic power now transfers over to political power, and small competitiors are at even a greater disadvantage. This is an example of the kind of analytic contribution Marx has made to understanding markets.

The Classical Definition of Economics.

I have summarized very briefly the contributions of the major Classical economists to illustrate both their breadth and similarities. It is clear that they covered a wide range of analysis regarding how markets function. They also had different beginning points and focuses of their analysis. They were engaged in an open ended debate. While each believed there own analysis to be correct, none insisted that all economic analysis conform to what he had created. Marx probably came the closest by arguing that any serious economic analysis had to start with a mastery of Smith and Ricardo. Their analysis covered both the strengths and problems of markets. I have done this to capture a perspective of economic analysis that is lost or at least narrowed when we move on to Neo-Classical Economics.

In the day of the classicals there was not a definition of economics. In fact, it was not even called economics and was not even a separate discipline or area of study. At that time it was called Political-Economy and was a sub-discipline of Moral Philiosophy. This is relevant because the most common definition of Classical economics seeks to capture the essence of what all of these economists did as a group even though they were already dead and gone.

The Classical definition of economics: Economics is the study of the production, distribution, and growth of wealth in society. Keep a few things in mind with this definition.

First, it is based upon concrete economic activities: actual production, distribution, and growth.

Second, let's be clear about the meaning of distribution. There are a few terms in economics which economists use in very specific ways that are different than the common definitions, and even different from the way the term is used in Business, FInance, or Accounting classes. Distribution is one of tose terms. In economics, distribution ALWAYS refers to distributing the benefits of production. Who gets paid? Who owns the product? How is income and wealth distributed across the entire economy? Why do some people get a wage, salary,  commission, profit, rent, or interest? It NEVER means the distribution of goods from a producer to a wholesaler to a retail outlet to a consumer.

Third, note that this definition and the analysis that classicals performed is open-ended and open to different methods. It is not restricted to either a single method or single result.

Neo-CLassical Economic Theory.

Neo-classical economic theory began to emerge at the very end of the 1800s. In this early stage it was referred to as "Marginalism".  Neo-classical economics married portions of Classical economics with mathematical modelling as used in Newtonian physics, especially calculus. We will cover this transition in more detail at the beginning of Econ 201. For now it is important to know what part of Classical theory was incorporated and the role of calculus in economics.

The original Marginalists were mathematicians and sometimes physicists who began to apply the tools of mathematical models, as used in Newtonian physics and in engineering, to economics. They believed that if they could translate Smith's and Ricardo's analysis into mathematical proofs the could prove that economics was a "true" or "hard" science (not simply moral philosophy) and furthermore that they could prove Smith's and Ricardo's theories were true, that free trade and free markets always produced better results than any other institutional structure, whether governmental, religious, or civil. They thought they could prove that governmental intervention always hindered the economic benefits of the free market.

The Neo-clasical approach translates Free Market and Free Trade Theory into mathematics by applying a single mathematical method of analysis to all economic questions. The mathematical method that is used is "constrained maximization", which is a calculus technique that calculates the optimal (either the maximum or minimum) result of a process, beginning from a specified point.

In other words, from this perspective it did not matter if you were trying to analyze price adjustments (Smith); poverty, depressions, and population (Malthus); international trade (Ricardo); distributing benefits (Mill); production and competition (Marx), all economic analysis must be based upon the same method of calculating the maximum results gained from some initial set of resources. Every economic issue is reduced to the same mathematical calculation. Consumers are analyzed as trying to gain the maximum benefit from a specific shopping budget. Producers are analyzed as trying to gain the maximum profit from a specific set of costs (also a budget). Government is analyzed as trying maximize the benefit to society of government actions from a specific set of resources (i.e. a budget). Every economic question is analyzed the same way.

Furthermore, as implied above this was not necessarily an open process, following the results of the models wherever they led, but was intended to prove both that both economics was a true science, and that Smith and Ricardo were right. This is the essence of contemporary, mainstream economics as taught in the U.S. and increasingly around the world.

The Neo-Classical Definition of Economics.

Unlike the Classical definition which we have put together after the classicals were dead and gone, the Neo-Classical definition is currently accepted even as we use Neo-classical economics.

The Neo-Classical Definition of Economics: Economics is the study of how individuals and societies optimally allocate scarce rsources to meet their needs and desires.

Note the following:

First, this definition emphasizes how decisions are made.

Second, this definition emphasizes what the optimal or best result is for every economic decision.

Third, this definition claims all economic issues are analyzed the same way, using constrained maximization.