ECONOMIC THEORIES

I INTRODUCTION

Economics, social science concerned with the production, distribution, exchange, and consumption of goods and services. Economists focus on the way in which individuals, groups, business enterprises, and governments seek to achieve efficiently any economic objective they select. Other fields of study also contribute to this knowledge: psychology and ethics try to explain how objectives are formed; history records changes in human objectives; sociology interprets human behaviour in social contexts.

Standard economics can be divided into two major fields. The first, price theory or microeconomics, explains how the interplay of supply and demand in competitive markets creates a multitude of individual prices, wage rates, profit margins, and rental changes. Microeconomics assumes that people behave rationally. Consumers try to spend their income in ways that give them as much pleasure as possible. As economists say, they maximize utility. For their part, entrepreneurs seek as much profit as they can extract from their operations.

The second field, macroeconomics, deals with modern explanations of national income and employment. Macroeconomics dates from the book, The General Theory of Employment, Interest, and Money (1936), by the British economist John Maynard Keynes. His explanation of prosperity and depression centres on the total or aggregate demand for goods and services by consumers, business investors, and governments. Because, according to Keynes, inadequate aggregate demand increases unemployment, the indicated cure is either more investment by businesses or more spending by government, and consequently larger budget deficits.

II HISTORY OF ECONOMIC THOUGHT

Economic issues have occupied people’s minds throughout the ages. Aristotle and Plato in ancient Greece wrote about problems of wealth, property, and trade. Both were prejudiced against commerce, feeling that to live by trade was undesirable. The Romans borrowed their economic ideas from the Greeks and showed the same contempt for trade. During the Middle Ages the economic ideas of the Roman Catholic Church were expressed in the canon law, which condemned usury (the taking of interest for money loaned) and regarded commerce as inferior to agriculture.

Economics as a subject of modern study, distinguishable from moral philosophy and politics, dates from the work, Inquiry into the Nature and Causes of the Wealth of Nations (1776), by the Scottish philosopher and economist Adam Smith. Mercantilism and the speculations of the physiocrats were precursors of the classical economics of Smith and his 19th-century successors.

A Mercantilism

The development of modern nationalism during the 16th century shifted attention to the problem of increasing the wealth and power of the various nation-states. The economic policy of the leaders of that time, known as mercantilism, sought to encourage national self-sufficiency. The heyday of the mercantilist school in England and western Europe occurred from the 16th to the early 18th centuries.

Mercantilists valued gold and silver as an index of national power. Without the gold and silver mines in the New World from which Spain drew its riches, a nation could accumulate these precious metals only by selling more merchandise to foreigners than it bought from them. This favourable balance of trade necessarily compelled foreigners to cover their deficits by shipping gold and silver.

Mercantilists took for granted that their own country was either at war with its neighbours, recovering from a recent conflict, or getting ready to plunge into a new war. With gold and silver, a ruler could hire mercenaries to fight, a practice followed by King George III of Great Britain when he used Hessian troops during the American War of Independence. As needed, the monarch could also buy weapons, uniforms, and food to supply the soldiers and sailors.

Mercantilist preoccupation with precious metals also inspired several domestic policies. It was vital for a nation to keep wages low and the population large and growing. A large, ill-paid population produced more goods to be sold at low prices to foreigners. Ordinary men and women were encouraged to work hard and avoid such extravagances as tea, gin, ribbons, ruffles, and silks. It also followed that the earlier that children began to work, the better it was for their country’s prosperity. One mercantilist writer had a plan for children of the poor: “When these children are four years old, they shall be sent to the county workhouse and there taught to read two hours a day and be kept fully employed the rest of the time in any of the manufactures of the house which best suits their age, strength, and capacity.”

B Physiocracy

Physiocracy was briefly in vogue in France during the second half of the 18th century as a reaction against the narrow and restrictive policies of mercantilism. The founder of the school, François Quesnay, was a doctor at the royal court of King Louis XV. His major work, the Tableau économique, an attempt to trace income flows through the economy, crudely anticipated 20th-century national income accounting. All wealth, in the doctrine of the physiocrats, originates in agriculture; through trade, wealth is distributed from farmers to other groups. The physiocrats were partisans of free trade and laissez-faire. They maintained that the revenue of the state should be raised by a single direct tax levied on the land. Adam Smith met the leading physiocrats and wrote—for the most part, favourably—of their doctrines.

C The Classical School

As a coherent economic theory, classical economics starts with Smith, continues with the British economists Thomas Robert Malthus and David Ricardo, and culminates in the synthesis of John Stuart Mill, who as a young man was a follower of Ricardo. Although differences of opinion were numerous among the classical economists in the three-quarters of a century between Smith’s Wealth of Nations and Mill’s Principles of Political Economy (1848), members of the group agreed on major principles. All believed in private property, free markets, and, in Mill’s words, that “only through the principle of competition has political economy any pretension to the character of a science”. They shared Smith’s strong suspicion of government and his ardent confidence in the power of self-interest represented by his famous “invisible hand”, which reconciled public benefit with individual pursuit of private gain. From Ricardo, classicists derived the notion of diminishing returns, which held that as more labour and capital were applied to land, yields after “a certain and not very advanced stage in the progress of agriculture steadily diminished”.

Through Smith’s emphasis on consumption, rather than on production, the scope of economics was considerably broadened. Smith was optimistic about the chances of improving general standards of life. He called attention to the importance of permitting individuals to follow their self-interest as a means of promoting national prosperity.

Malthus, on the other hand, in his enormously influential book An Essay on the Principle of Population (1798), imparted a tone of gloom to classical economics, arguing that hopes for prosperity were fated to founder on the rock of excessive population growth. Food, he believed, would increase in arithmetic ratio (2-4-6-8-10 and so on), but population tended to double in each generation (2-4-8-16-32 and so on), unless that doubling was checked either by nature or human prudence. According to Malthus, nature’s check was “positive”: “The power of population is so superior to the power of the earth to produce subsistence for man, that premature death must in some shape or other visit the human race”. The shapes it took included war, epidemics, pestilence and plague, human vices, and famine, all combining to level the world’s population down to the world’s food supply.

The only escape from population pressure and the horrors of the positive check was in voluntary limitation of population, not by contraception, rejected on religious grounds by Malthus, but by late marriage and, consequently, smaller families. These pessimistic doctrines of classical economists earned for economics the epithet of the “dismal science”.

Mill’s Principles of Political Economy was the leading text on the subject until the end of the 19th century. Although Mill accepted the major theories of his classical predecessors, he held out more hope than did Ricardo and Malthus that the working class could be educated into rational limitation of their own numbers. Mill was also a reformer who was quite willing to tax inheritances heavily and even to allow government a larger role in protecting children and workers. He was far more critical than other classical economists of business behaviour and favoured worker ownership of factories. Mill thus represents a bridge between classical laissez-faire economics and an emerging welfare state.

The classical economists also accepted Say’s Law of Markets, the doctrine of the French economist Jean-Baptiste Say. Say’s law holds that the danger of general unemployment or “glut” in a competitive economy is negligible because supply tends to create its own matching demand up to the limit of human labour and the natural resources available for production. Each enlargement of output adds to the wages and other incomes that constitute the funds needed to purchase added output.

D Marxism

Opposition to the classical school of economics came first from early socialist writers such as the French social philosopher Claude Henri de Rouvroy, Comte de Saint-Simon and the British reformer Robert Owen. It was Karl Marx, however, who provided the most important social theories.

To the classical vision of capitalism, Marxism was in large measure a sharp rebuttal, but to some extent it embodied variations of classical themes. Marx adopted, for example, a version of Ricardo’s labour theory of value. With a few qualifications, Ricardo had explained prices as the result of the different quantities of human labour needed to produce different finished products. For Ricardo, this theory of value was an analytical convenience, a way of making sense of the multitude of different prices in shops. For Marx, the labour theory was a clue to the inner workings of capitalism, the master key to the inequities and exploitation of an unjust system.

An exile from Germany, Marx spent most of his mature years in London, supported by his friend, the German revolutionary Friedrich Engels, and by the proceeds from occasional contributions to newspapers. He conducted his extensive research in the reading room of the British Museum. Marx’s historical studies convinced him that profit and other property income are the proceeds from force and fraud inflicted by the strong on the weak.

“Primitive accumulation” in English economic history was epitomized by the record of land enclosure. In the 17th and 18th centuries, landowners used their control of Parliament to rob their tenants of traditional rights to common lands. Taking these lands for their own use, they drove their victims reluctantly into cities and factories.

Deprived both of tools and land, British men, women, and children had to work for wages. Thus, Marx’s central conflict was between so-called capitalists who owned the means of production—factories and machines—and workers or proletarians who possessed nothing but their bare hands. Exploitation, the heart of Marxist doctrine, is measured by the capacity of capitalists to pay no more than subsistence wages to their employees and extract for themselves as profit (or surplus value) the difference between these wages and the selling price of market commodities.

Although in the Communist Manifesto (1848) Marx and Engels paid grudging tribute to the material achievements of capitalism, they were convinced that these were transitory and that the internal contradictions within capitalism would as surely terminate its existence as earlier in history feudalism had faltered and disappeared.

On this point Marx wrote not in the tradition of English classical economics but rather out of his training in the metaphysics of the German philosopher G. W. F. Hegel. Hegel interpreted the movement of human history and thought as a progression of dialectics: thesis, antithesis, and synthesis. For example, a thesis might be a set of economic arrangements such as feudalism or capitalism. Its opposite or antithesis was, say, socialism as opposed to capitalism. The clash between thesis and antithesis evolved into the higher stage of synthesis—in this case communism, which unites capitalist technology with social public ownership of factories and farms.

In the long run, Marx believed that capitalism was certain to falter because its tendency to concentrate income and wealth in ever fewer hands created more and more severe crises of excess output and rising unemployment. For Marx, capitalism’s fatal contradiction was between improving technological efficiency and the lack of purchasing power to buy what was produced in ever larger quantities.

According to Marx, the crises of capitalism were certain to manifest themselves in falling rates of profit, mounting hostility between workers and employers, and ever more severe depressions. The outcome of class warfare was fated to be revolution and progress towards, first, socialism and ultimately communism. In the first stage a strong state would still be required in order to eliminate the remnants of capitalist opposition. Each person’s work would be rewarded according to the value of his or her contribution. Once communism was achieved, the state, whose central purpose was class domination, would wither away, and each individual would in the utopian future be compensated according to need.

E The Neo-Classicists

Classical economics proceeded from the assumption of scarcity, such as the law of diminishing returns and Malthusian population doctrine. Dating from the 1870s, Neo-Classicist economists such as William Stanley Jevons in Great Britain, Léon Walras in France, and Karl Menger in Austria shifted emphasis from limitations on supply to interpretations of consumer choice in psychological terms. Concentrating on the utility or satisfaction rendered by the last or marginal unit purchased, Neo-Classicists explained market prices not by reference to the differing quantities of human labour needed to produce assorted items, as in the theories of Ricardo and Marx, but rather according to the intensity of consumer preference for one more unit of any given commodity.

The British economist Alfred Marshall, particularly in his masterly Neo-Classicist work Principles of Economics (1890), explained demand by the principle of marginal utility, and supply by the rule of marginal productivity (the cost of producing the last item of a given quantity). In competitive markets, consumer preferences for low prices of goods and seller preferences for high prices were adjusted to some mutually agreeable level. At any actual price, then, buyers were willing to purchase precisely the quantity of goods that sellers were prepared to offer.

As in markets for consumer goods, this same reconciliation between supply and demand occurred in markets for money and human labour. In money markets, the interest rate matched borrowers with lenders. The borrowers expected to use their loans to earn profits larger than the interest they had to pay. Savers, for their part, demanded a price for postponing the enjoyment of their own money. A similar accommodation had to be made in wages paid for human labour. In competitive labour markets, wages actually paid represented at least the value to the employer of the output attributed to hours worked and at least acceptable compensation to the employee for the tedium and fatigue of the work.

By implication, if not direct statement, the tendency of Neo-Classical doctrine has been politically conservative. Its advocates distinctly prefer competitive markets to government intervention and, at least until the Great Depression of the 1930s, insisted that the best public policies were echoes of Adam Smith: low taxes, thrift in public spending, and annually balanced budgets. Neo-Classicists do not inquire into the origins of wealth. They explain disparities in income as well as wealth for the most part by parallel differences among human beings in talent, intelligence, energy, and ambition. Hence, men and women succeed or fail because of their individual attributes, not because they are either beneficiaries of special advantage or victims of special handicaps. In capitalist societies, Neo-Classical economics is the generally accepted textbook explanation of price and income determination.

F Keynesian Economics

John Maynard Keynes was a student of Alfred Marshall and an exponent of Neo-Classical economics until the 1930s. The Great Depression bewildered economists and politicians alike. The economists continued to hold, against mounting evidence to the contrary, that time and nature would restore prosperity if government refrained from manipulating the economy. Unfortunately, approved remedies simply did not work. In the United States, Franklin D. Roosevelt’s 1932 landslide presidential victory over Herbert Hoover attested to the political bankruptcy of laissez-faire policies.

New explanations and fresh policies were urgently required; this was precisely what Keynes supplied. In his enduring work The General Theory of Employment, Interest, and Money, the central message translates into two powerful propositions. (1) Existing explanations of unemployment were declared to be nonsense: neither high prices nor high wages could explain persistent depression and mass unemployment. (2) Instead, an alternative explanation of these phenomena was proposed focused on what was termed aggregate demand—that is, the total spending of consumers, business investors, and governmental bodies. When aggregate demand is low, Keynes theorized, sales and jobs suffer; when it is high, all is well and prosperous.

From these generalities flowed a powerful and comprehensive view of economic behaviour—the basis of contemporary macroeconomics. Because consumers were limited in the amounts that they could spend by the size of their incomes, they could not be the source of the ups and downs of the business cycle. It followed that the dynamic forces were business investors and governments. In a recession or depression, the proper thing to do was either to enlarge private investment or create public substitutes for the shortfalls in private investment. In mild economic contractions, easy credit and low interest rates (monetary policy) might stimulate business investments and restore aggregate demand to a figure consistent with full employment. More severe contractions required the sterner remedy of deliberate budget deficits either in the form of spending on public works or subsidies to afflicted groups.

G Mathematical Economics

Both Neo-Classical price theory and Keynesian income theory have been illustrated by the mathematics of calculus, linear algebra, and other sophisticated techniques. The most powerful and popular—if not necessarily the most successful—alliance of economics with mathematics and statistics occurs in the speciality called econometrics. Econometricians are model builders who link together hundreds or even thousands of equations that purport to explain the behaviour of an entire economy. As forecasting tools, econometric models generally are used by both corporations and government departments, although their record of accuracy is neither better nor worse than that of alternative ways of looking into the future.

Operations research and input-output analysis are two additional specialities in which economic analysis and higher mathematics operate in tandem. Operations research stresses a systems approach to problems. Typical puzzles involve coordinating the functions of a multiple-plant corporation, fabricating many products, and using equipment so as to minimize costs and maximize efficiency. Researchers make use of the expertise of engineers, economists, industrial psychologists, statisticians, and mathematicians.

In the words of its inventor, the Russian-American economist Wassily Leontief, input-output analysis tables “describe the flow of goods and services between all the individual sectors of a national economy over a stated period of time”. Although constructing such a table is a challenge, this method has had a major impact on economic thinking. It is now widely used in socialist as well as capitalist countries.

III ECONOMIC SYSTEMS

All organized communities mix, in various proportions, market activity and government intervention. Private markets themselves differ widely in the degree of competition under which they operate, all the way from single-firm monopolies to the fierce rivalry among hundreds of retailers. Much the same point applies to government intervention, which ranges from mild and comparatively uncoercive manipulation of tax, credit, contract, and subsidy policies through mandatory controls over wages and prices to the detailed central planning of Communist countries.

Even those societies most completely committed to central planning, however, grudgingly modify official ideology by some concessions to private enterprise. For example, the former USSR allowed its farmers, although organized in collective enterprises, to market crops grown on their own small plots. During the Communist period in Poland, most farming was in the hands of individual owners. Yugoslavia experimented in worker management of factories during its Communist period.

Similar variation exists among capitalist economies. In most of them, the government owns and operates railways and airlines. Even where outright government ownership or operation is exceptional, as in Japan, the central government exerts tremendous influence over economic activity. The United States, the most devoted of major capitalist economies in terms of the free enterprise system, has nevertheless rescued faltering corporations such as Lockheed and Chrysler and has, for all practical purposes, converted a number of major defence contractors into federal subsidiaries. Many American economists have come to accept the concept of a “mixed economy”, combining private initiative with some government control.

A Free Enterprise

The major differences between Communist and capitalist economic organization concern ownership of factories, farms, and other enterprises, as well as contrasting principles of pricing and income distribution. In most capitalist economies the majority of gross national product (GNP) is directly generated by profit-making business enterprises, farmers, and such voluntary non-governmental entities as private universities, hospitals, cooperatives, and foundations. In recent years many countries have followed Great Britain in privatizing many previously government owned enterprises, and introducing competition in many services (such as health and education). This worldwide trend towards Privatization has significantly reduced government interference in the operation of industry and reduced government influence over price setting. Indeed, the most important price controlled by public influence is the price of money—that is, the rate of interest.

Although opposition to both controls and national planning is strong in the developed world, governments have repeatedly resorted to these measures in times of emergency, such as during World War II and the Korean War. In general, however, free-enterprise economies consider state ownership of productive facilities and government interference in price setting as deplorable exceptions to the rule of private ownership and price determination through the mediation of competitive markets.

B Central Planning

Precisely the reverse attitude towards economic central planning has been the case in China and certain other Communist countries. Although private enterprises are increasingly being tolerated, and no centrally planned economy has been able to function without some reliance on private ownership of agricultural land, the dominant ideology favours state planning over competitive price setting, at least in theory, and public ownership of factories, farms, and large retail establishments.

Strictly speaking, there is no reason why a democratic community could not freely choose to plan production, prices, and the distribution of income and wealth. In contemporary experience, however, central economic planning has generally run parallel to Communist party control of political life. Nonetheless, important differences exist in the strictness of these constraints in different Communist countries and even within the same country at different times. It is also true that capitalism has frequently been accompanied by repressive government, as for example in Chile and Brazil.

The gravest problems of capitalism are unemployment, inflation, and economic injustice. Parallel problems in centrally planned economies include underemployment, rationing, bureaucracy, and scarcity of many consumer items.

C Liberal Socialist Economies

Falling somewhere between societies that emphasize either central planning or free enterprise are those that practice social democracy or liberal socialism. Examples of social democracy are the Scandinavian countries, Sweden in particular. Sweden organizes the bulk of productive activity under private ownership but regulates this activity closely, intervenes to protect the jobs of workers, and redistributes substantial portions of profits and large individual incomes to low-income groups. The validity of such a system has recently been thrown into doubt by increasing evidence of structural economic problems in Sweden.

On the other hand, the former Socialist Republic of Yugoslavia from the 1950s through the 1980s supplied an example of a liberal socialist society. Although the Communist party dominated, censorship was mild, emigration was easy, religion was freely exercised, and a unique mixture of state ownership, worker management, and private enterprise combined to operate a comparatively prosperous economy.

IV CURRENT ECONOMIC PROBLEMS

Between 1945 and 1973, the economies of the industrialized nations of Western Europe, Japan, and the United States grew fast enough to vastly improve living standards for their residents. A similarly favourable growth was registered by some, but far from all, of the developing or industrializing nations, in particular such thriving South East Asian states as Singapore and South Korea, as well as the island of Taiwan and Hong Kong S. A. R. Clearly several circumstances contributed to this almost unique historical performance. After the devastation of World War II, a substantial rebuilding boom, combined with lavish flows of aid from the United States, generated rapid growth in Western Europe and Japan. American multinationals invested heavily in the rest of the world. Perhaps most important of all, energy was plentiful and cheap.

A Energy Problems

By 1973, increasing international demand made oil a scarce and valuable commodity. At that time the Organization of the Petroleum Exporting Countries (OPEC), which controls the bulk of the world’s oil reserves, seized the opportunity to sharply raise prices. OPEC’s policies dramatically reduced the possibilities of rapid economic growth both in the industrialized countries and in those developing nations without oil of their own. Oil, which in the autumn of 1973 cost $2 per barrel, sold in mid-1981 at nearly 20 times that figure. For rich countries, their oil import bill was the equivalent of a tremendous annual transfer of claims on their output and wealth to OPEC suppliers. Developing world importers borrowed enormous sums, mostly from major banks in Western Europe and the United States. Staggering under the interest payments, poor nations have been compelled to slow the pace of their development plans. Although the sharp oil price decline in the mid- and late 1980s greatly benefited consumers in oil-importing nations, it added immensely to the burdens of oil exporters such as Mexico, Nigeria, Venezuela, and Indonesia.

B Inflation and Recession

Some advanced economies, notably Japan and West Germany (now part of the united Federal Republic of Germany), fared better than others during the 1970s and 1980s. All of them, however, confronted persistent combinations of high inflation, severe unemployment, and sluggish economic growth. OPEC’s transformation of the world energy market increased inflation by raising not only petrol and home-heating fuel charges but also the prices of all the important manufactures into which petroleum enters, among them chemical fertilizers, plastics, synthetic fibres, and pharmaceutical products. These higher prices reduce purchasing power in much the same manner as would a severe new tax. Reduced purchasing power in turn depresses sales of consumer items, resulting in layoffs of factory and sales personnel. The entire procedure has a spiralling effect in all sectors of the economy.

C The Role of Government

The various economic problems of recent decades have stimulated serious debate about the proper role of public policy. Parties on the political left in Europe advocated more controls and more planning. In the 1980s a different solution was offered by the Conservative party government of Prime Minister Margaret Thatcher in Great Britain and by the Republican administration of President Ronald Reagan in the United States. In both countries, attempts were made to diminish taxation and government regulation on private enterprise and thus, by enlarging the potential profits of corporations, encourage additional investment, higher productivity, and renewed economic growth. These were the central elements of supply-side economics, the guiding doctrine of the two leaders.

Implicit in this government decision to provide businesses with increased incentives to invest, take risks, and work harder were the hopes that technology would reduce the costs of alternatives to oil as an energy source and that the non-energy sectors of the economy, such as data processing and scientific agriculture, would experience rapid growth as a result of encouragements to invention and innovation.

D Underdeveloped Economies

Poor nations desperately need aid from the rich nations in the form of capital and of technological and organizational expertise. They also need easy access to the markets of the industrialized nations for their manufactures and raw materials. However, the political capacity of rich nations to respond to these needs depends greatly on their own success in coping with inflation, unemployment, and lagging growth rates. In democratic communities, it is exceedingly difficult to generate public support for assistance to foreign countries when average wage earners are themselves under serious financial pressure. It is no easier politically to permit cheap foreign merchandise and materials to freely enter markets when they are viewed as the cause of unemployment among domestic workers. Development economics is thus more intimately tied than most to political circumstances.

E Outlook for the Future

By the early 1990s, the dissolution of the Soviet Union, coupled with the fall of Communist governments in most of Eastern Europe, underlined the trend away from fully centrally planned economies and towards a fully free market system. Seeking to overcome a legacy of inefficiency and mismanagement, the post-Communist nations found themselves competing with developing countries for investment capital and technological assistance.

Opinions differ as to how long sustained economic growth can continue. Optimists pin their hopes on the ability to improve crop yields and enhance industrial productivity through technological innovation. Pessimists point to diminishing resources, unchecked population growth, excessive military spending, and the reluctance of rich countries to share their wealth and expertise with less fortunate nations. While many developing nations have managed remarkable growth rates recently, government instability, endemic corruption, and wide swings in economic policy make the economic prospects for others seem even less auspicious.

 

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