Major Schools of Economic Theory
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, 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.
Economic theories are constantly changing. Keynesian theory, with its emphasis
on activist government policies to promote high employment, dominated economic
policymaking in the early post-war period. But, starting in the late 1960s,
troubling inflation and lagging productivity prodded economists to look
for new solutions. From this search, new theories emerged:
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?
|
