Macro Economics Project

NCBA&E
The Classical School Of Thought

Presented To:
Ma’am Zunnaira

Presented By:
Muhammad Qasim Ali
 The Classical School of Thought

What Is Classical Economics?

Classical economics is a broad term that refers to the dominant school of thought for economics in the
18th and 19th centuries. Most consider Scottish economist Adam Smith the progenitor of classical
economic theory. However, Spanish scholastics and French physiocrats made earlier contributions.
Other notable contributors to classical economics include David Ricardo, Thomas Malthus, Anne Robert
Jacques Turgot, John Stuart Mill, Jean-Baptiste Say, and Eugen Böhm von Bawerk.

 Adam smith is the founder of classical school.

 He has been described as the father of ‘father of political economy’.

 His work ‘Wealth of nation’ (1776) is generally regarded as the starting point of classical school.

 Thus the Adam smith, Jeremy Bentham, Thomas Robert Malthus, David Ricardo, J.B. Say and J.S.
Mill are all the leading economist of classical school.

 The essential features of classical School

 The entire philosophy of classical school was based on economic liberalism.

 The classical writers believed in personal liberty, private property and individual initiative and
private enterprise.

 Classical features are as follows:

 The classical economist believed in laissez –fair. That government is best which governed
least.

 They believed in a market economy based on Free and perfect competition.

 They assumed condition of full employment. They thought that economy was self-adjusting
and tend toward full employment without govt., intervention

• The essential features of classical School

• The entire philosophy of classical school was based on economic liberalism.

• The classical writers believed in personal liberty, private property and individual initiative and
private enterprise.

• Classical features are as follows:

 The classical economist believed in laissez –fair. That government is best which governed
least.
 They believed in a market economy based on Free and perfect competition.
 They assumed condition of full employment. They thought that economy was self-adjusting
and tend toward full employment without govt., intervention
 • 4) They believed that individual by seeking their own interest would serve the best interest of
society. In other words they believe on the harmony of interests.

• 5) The classical emphasized the importance of all economic activities especially the industry.

• 6) The classical economist provided a method of analyzing the economy and economic laws that
operate with in them.

• 7) The classical economist looked at the economy as a whole. That is what we call the
macroeconomic approach in modern times.

• Adam Smith (1723-1790)

• Adam smith was born in Kircadly, Scotland in 1723.

• He was educated at the universities of Glasgow and Oxford.

• He became professor first of logic and then of Moral Philosophy at Glasgow.

• He came in France and remain in contact with leading Physiocrats of the day.

• Physiocrats left profound influence on Adam Smith.

• In 1778, Adam smith was appointed as commissioner of customs in Edinburgh. He held that post
for the remaining year of his life.

• He died in 1790.

• Adam smith published his Theory of Moral Sentiments in 1759.

• After that, he concentrated his attention less on ethical doctrines and more on jurisprudence
and political economy.

• Adam smith published his “Wealth of nation” in 1776.

• The full name of the book is ‘An enquiry into the Nature and causes of the wealth of Nation’

• Adam smith was a first economist who deal with Economic problems in a systematic manner.

• Adam smith’s wealth of nation was a challenge to Mercantilism

• According to smith, the wealth of nation can be increased by adopting the principle of division
of labor.

Chief contributions
• Built a coherent and logical theory of how the economy works

• The elements of Smith's theory were mostly already available in the writings of earlier writers.

• However, in those earlier writings, good ideas coexisted alongside numerous other bad ideas

• Somebody had to figure out which theories were useful and which were useless and combine
the useful theories into a consistent and persuasive overall theory that could be used reliably to
think about society.

• This is what Smith did. For this he is called the father of economics.
Theory of Moral Sentiments
• This book was an argument against the views of writers such as Hobbes and Rousseau who
argued that the pursuit of self-interest, an important human instinct, inevitably leads to a cruel
and terrible society.

• Smith argued that we are able to imagine what others are going through; we are able to
understand with the sufferings of others.

• We feel pain when we see the pain of others.

• We can act to reduce the pain of others in order to reduce our own discomfort, if nothing else.

• So, it is perfectly consistent to believe that human beings pursue self-interest and are generous
towards others.

Passions, bias, moral rules

• Sometimes our passions cause us to do bad things.

• We have an instinctive tendency to defend ourselves even when we know that we did
something bad.

• This leads to a bias that prevents us from seeing that we did something bad.

• This problem is partially corrected by the wide acceptance of moral rules in a society.

• When the moral rules are clear cut, a misdeed may so clearly violate a moral rule that it might
be impossible even for the perpetrator to deny the misdeed, bias notwithstanding.

Laws
• At times, even moral rules may not be enough to keep society together

• In that case, laws and the enforcement of those laws would be necessary to keep society
together.

• However, unlike Hobbes and Rousseau, Smith did not believe that, in the absence of a structure
of laws, society would inevitably fall down to disorder.

Wealth of Nations
• The causes of economic progress and the creation of wealth was Adam Smith’s main topic of
interest

– David Ricardo, by contrast, focused on how wealth is shared among different groups in society

• According to Smith, the wealth of a nation derives from the level of the technology in use.

• The level of technology and its rate of improvement depend on the division of labor.

• According to smith ‘the political economy is an inquiry into the nature and causes of wealth
of nations’

• In his book he tells that wealth of nation can be increased by the division of labor.
 • Smith discussed three reasons why a greater division of labor may increase productivity.

• Practice makes perfect

• Less waste of time between tasks

• More mechanization

Division of labor, extent of the market, economic progress

• The division of labor is determined by the extent of the market.

• This creates the possibility of an ever-expanding economy.

– For example, if the extent of the market increases—perhaps because of an expansion of trade within
the country or with another country—there will be greater division of labor, which will lead to
improvements in the level of technology, which will lead to greater national income, which will lead to
another increase in the extent of the market, which will lead to another increase in the division of labor,
which will lead to another increase in the level of technology, and so on and on.

• Labor is the main source of wealth of nation.

• After saying that labor is the source of wealth, smith makes the point that division of labor will
increase the productivity of labor and thereby the wealth of nation.

• Division of labor refers to the specialization of labor in different industries or different process
with in the industry.

• In his famous example of Pin making industry

• “One man draws out the wire; another straightens it, a third cuts it, a forth points it and the
important business of making pin in this manner divided it into eighteen distinct operations.”

If one man performed all the above operations he will produce one pin or so in day

• But on the other hand division of labor was practices then the average production of each man
was 4800 pins.

• According to him the division of labor is limited by the size of the market.

• In those industries which produce goods for international market, there will be great scope for
division of labor.

• Division of labor has the following advantages.

• 1) Increased output:

• Division of labor will increased the output per worker, as he described in his example of pin
industry.

• 2) Increase in skill of labor:

• By doing the same kind of work, labor gets a great skill in his particular line.

• 3) Saving in Time:
 • By practicing the same kind of work, labor get specialization in his field, so he takes less in order
to produce the same thing.

• 4) Introduction of machinery

• It smooth the way for introduction of machinery. In other words, division of labor is the mother
of invention.

• Smith was not aware of disadvantages of division of labor.

1) For instance, extreme division of labor will leads monotony of work.

2) A worker by doing the same type of work again and again would find no pleasure in his work.

3) Division of labor will also cause immobility of labor. And there will be greater risk of
unemployment in times of bad trade.

Division of labor and capital

• Division of labor is enabled by capital

• In a backward, agricultural economy, people produce, on a regular basis, the simple things they
need.

• When workers specialize in the production of more complex goods, production may take time

• The worker can be sustained during the lengthy production period only when capitalists can
make loans

• In this way, the accumulation of additional capital enables additional division of labor

• Division of labor necessitates exchange. This leads onto the discussion of money as means of
exchange and to the value.

• After discussing the problem of value and price in his book, smith discuss the problem of wages,
profit and rent.

• Then he criticized the mercantilist and Physiocrats.

Luxury spending not crucial

• Earlier writers had argued that the growth of an economy depended heavily on the luxury
spending by the rich; the poor consumed just the bare necessities and, therefore, more would
not be produced unless the rich would buy the extra output.

• Smith argued that this idea was false.

– If the rich saved any money they would lend it to businessmen (to earn interest).

– The businessmen would borrow the money and spend it on capital equipment.

– Therefore, all income would be spent and all Production would be purchased.

– There was no need to encourage luxury spending.

 – In fact, the more the rich saved the greater would be the level of investment by businesses and
the faster would be the rate of growth.

Free Trade
• Smith was in favor of free trade.

• He derived his support for free trade among nations by basing it on the obvious desirability of
trade among individuals:

– "It is the maxim of every prudent master of a family, never to attempt to make at home what it will
cost him more to make than to buy".

• According to Smith, free trade expands the extent of the market and, thereby, allows greater
division of labor

• Further he was a great favor of free trade, he prefer two kinds of protectionist tariff.

1) Those tariff that protect the domestic industry essential to the defense of the country.

2) Those who equalize the tax burden on the particular domestic industry by imposing tariff on
import of that goods.

• Smith also suggest that free trade is to be introduced in a country after a long period of
protectionism, it should be done gradually in order to avoid unemployment.

Value
According to Smith, there are two kinds of value

I) Value in use

ii) Value in exchange.

• The first one expresses the utility of some particular object and second one refers to the power
of purchasing other goods.

• For example, nothing is more useful as water but it has little value in exchange.

• On the other hand diamond has little value in use but greater value in exchange.

• Smith believed that the labor is the main source of value. According to him the value of things
depend on amount of labor employed in the production.

• Smith make the distinction between the

Natural price and market price

• “When the price just cover the ordinary rate of rent, wages and profits expended in preparing
and marketing the commodity, its sells at its natural price”.

• “The market price may be below or above this, depending upon the supply actually on the
market and the effectual demand---the demand of those who are willing to pay the natural
price”.
Theory of value
• Smith used different theories of value at different points in the Wealth of Nations

• His discussion is at times contradictory

• For primitive economies sustained by hunting and fishing, Smith adopted the Labor Theory of
Value

– This was adopted by Classical economists such as Smith, Malthus and Ricardo.

– But even in such a case, there is no standard unit of labor. The hardship and cleverness
involved can vary from task to task.

Theory of value
• Some criticism of the labor theory of value:

• There is difficulty in measuring labor or cost of production. Smith used time as his measuring
rod. But all workmen are not of equal efficiency. So less skilled may take longer than the skilled
labor. So more labor put into more production.

• Misdirect labor cannot have value. If labor is incapable of fulfilling the purpose for which it was
intended can have no value.

• It fails to explain the value of rare things. Such as work of art or antiques. It is the great
weakness of any theory of value, if it does not explain the value of all the things.

Theory of value: unit cost

• When analyzing the industrialized economy of the Great Britain of his time, Smith thought of
the ‘natural price’ (or, long run price) of a product as the cost of all resources used in
production

• Cost includes wages (payment for labor), rent (for land), and profit (for the capital of the
entrepreneur).

• Note: price = unit cost does not mean profits = zero; it only means supernormal profits = zero.

• Profit is what the entrepreneur gets for risk- taking

• As workers need to be paid even if the output is not ready for sale, the entrepreneur is
essentially a money lender to the workers. Therefore, profit also includes what we call interest
today

• From today's point of view the classical theory of value, which denies the influence of demand
and identifies production cost as the only influence on prices, has some validity in the long run
but is not useful for short run analysis.

Prices signal opportunity

In Smith’s view of the workings of the market system, any short-run deviation of the market price
from the long-run price would trigger the forces of competition—by which Smith meant profit-seeking
entry and loss-avoiding exit—which would eventually take the market price to its long-run level.
Wages: Iron Law of Wages
• Smith used different theories of the wage rate at different times

• One was a form of the Iron Law of Wages

– This theory held that wages are by and large equal to the subsistence level of wages.

– If wages exceed the level that is just enough to keep the worker and his dependents
alive, there will be an increase in population that will drive wages down to the
subsistence level.

– If wages fall below what the workers need to stay alive, population will fall and wages
will rise to the subsistence level.

– This meant that any increase in total output went not to the workers but to capitalists
who would save and invest in machinery that would make possible further division of
labor and technological progress.

Wages: bargaining
• The wage rate depends on the bargaining power of workers and businesses

• Employers can plan with greater ease because employees are numerous

• In Great Britain at Smith’s time, employers’ agreement was allowed but unions were not.
There were laws against raising wages, but none against lowering them

• It is clear that Smith had a very complex view of the nature of a market economy

Rent
• Smith had multiple theories of rent, some of them contradictory

• Smith thought of rent as a residual that is leftover after wages and profits had been paid out of
total output.

• Wages would be reduced to the subsistence level, as we saw before.

• Competition would gradually reduce the rate of profit to a low level that would also be uniform
across all industries.

• Therefore, only those who earn rent income would benefit from progress.

• Smith has given a number of explanations for rent.

• At one place he describes it as monopoly price. At other time, when he discusses the
commodity prices, he includes the rent of land as an element of cost and therefore a
determinant of the product price.

• In some other context, he tells that rent is determined by the prices.

• He considers that high or low rent is the effect of high or low product price.

• Smith was not disposed favorably to land lord as a class.

Falling rate of profit
• Economic progress depends on profits

• But Smith believed that the rate of profits would fall over time, because of competition
among capitalists

• This implied a slowing rate of growth over time

Profit and interest

• Smith was of the opinion that wages and profit moves in opposite direction.

• As more and more capital is accumulated, the mutual competition among the owner of capital
for investment in the same trade will tend to lower its profit.

• However smith made certain exception to the statement that wages and profit moves in
opposite direction.

• For instance in new colonies both wages and profit may be high and in “stationary state” both
wages and profit may be low.

• According to smith, interest is the “Compensation which the borrower pays to the lender, for
the profit which has an opportunity of making by the use of money.”

• He believed that interest could vary with profit.

The Invisible Hand

• Smith's argument that the pursuit of self- interest can lead to a socially efficient outcome is the
crowning beauty of the Wealth of Nations.

• “Every individual … generally, indeed, neither intends to promote the public interest, nor
knows how much he is promoting it. He intends only his own gain, and he is in this, as in
many other cases, led by an invisible hand to promote an end which was no part of his
Intention”

• Consumer sovereignty and business competition are the key components of Smith’s argument
that the pursuit of individual self-interest leads to an excellent social outcome

• Consumer sovereignty ensures that consumer needs determine what gets produced

• Business competition ensures that prices are driven down to unit cost

• Thus, without any government control, the most beneficial goods get produced, and at the
lowest possible price

Competition is key
• Smith was doubtful of businessmen

– He believed that, given the chance, businessmen would do anything to reduce competition among
themselves and then form a group to gang up on consumers and charge them more than the
competitive price.
 • In this sense, Smith may be considered a pioneer of the modern economic approach to the
politics of lobbying.

• Capital:

• Smith has realized the importance of role of capital in the economic development of a nation.

• He was aware of the fact that the capital accumulation is essential for the Industrial
development of a nation.

• In his book he mentioned that capital appears in three forms:

– As an instrument of production.

– As a source of revenue

– As a fund maintaining the workmen.

Competition is key
• Further smith has classified capital into three portions.

1) The first portion is used for immediate consumption, it affords no revenue or profit (e.g. Stock
of food, clothes etc.)

2) The second portion is fixed capital which affords a revenue or profit without circulating or
changing masters (e.g. machines, improvement of land etc.)

3) The third portion is circulating capital, which afford a revenue, only by circulating or changing
masters (e.g. money, material, complete work in hands of merchant or manufacturer which are
not yet dispose of)

Competition is key
• Smith believed that income which is not consumed become the investment.

• In other words , as “an act of saving at once become an act of investment, saving is equal to
investment”

• He did not pay much attention to the problem of hoarding.

• We should also remember that Smith was in the favor of labor intensive investment during the
development process.

The role of Money

• Classical economist in general de-emphasize the importance of money.

• It was Adam Smith who had established this tradition.

• Infect he attacked the mercantilist mainly because they over-emphasized the role of money.

• According to Smith, a nation’s true wealth consist ‘not only in its gold and silver, but in its
land, houses and consumables goods of all different kinds’
 • Money only serve as an instrument for the circulation of the wealth and for the measurement
of value.

• Money does not add to the revenue of the society.

• But it is the ‘great wheel of circulation’.

• It facilitate the circulation of goods and it is the production of goods that makes up the revenue.

• Smith believed that paper money was preferable to gold and silver. For the paper money
required much less effort to produce.

Laissez- fair and the harmony of Interest

• Smith believed in the natural organization of economic order under the influence of personal
interest.

• He was greater advocate of Laissez fair---- nonintervention by govt., in business.

• According to him govt., are wasteful, corrupt and incompetence.

• He believed that individual was led by ‘an invisible hand’ to do good for the society. In other
words he believed that the interest s of the individuals coincide with the interest of society.

• Smith advocate the free trade.

• He believed that free foreign trade would promote greater division of labor.

• While the mercantilists believed that each nation enriched itself at the expense of its neighbor.

• Smith believed in an international harmony of interests: ‘the wealth of neighboring nation,

however, though dangerous in wars and politics, is certainly advantageous in trade.

• As a rich man is likely to be better customer to the industrious people in his neighborhood than
a poor, so is likewise a rich nation.

Role of Govt.
• Smith advocate the minimum role for the state in economic affairs.

• He believed that state could perform the following three major functions.

1) To protect society from foreign attack.

2) To establish the administration of justice within the country.

3) To erect and maintain the public works and institutions that private entrepreneur cannot
undertake privately.

• He justified legal control over the interest rates, state administration of Post Office, control
over the issues of paper money by bankers, compulsory elementary education etc.

Canons of Taxation
• Smith recommended taxation to finance govt. Activities.
 • He has laid down some rules for a good tax system. They are known as canons of taxation.

Canon of Equity
It is bases on the principles of justice and ability to pay. He tells that people should pay taxes according
to their respective abilities.

Canon of Certainty
There must be certainty about the tax which an individual has to pay.

Things like the time payment, the manner of payment and the quantity to be paid should be plain and
clear to tax player. A tax should not be arbitrary.

Canon of Convenience
A tax should be levied in such a manner that it is convenient for the tax payer to pay it.

Canon of Economy
Taxes should be collected at minimum cost to the government.

References
https://courses.lumenlearning.com

https://www.amosweb.com

https://www.investopedia.com

https://www.britannica.com