CLASSICAL ECONOMICS: A theory of economics, especially directed toward macroeconomics, based on the unrestricted workings of markets and the pursuit of individual self interests. Classical economics relies on three key assumptions--flexible prices, Say's law, and saving-investment equality--in the analysis of macroeconomics. The primary implications of this theory are that markets automatically achieve equilibrium and in so doing maintain full employment of resources without the need for government intervention. Classical economics emerged from the foundations laid by Adam Smith in his book An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776. Although it fell out of favor in the 1930s, many classical principles remain important to modern macroeconomic theories, especially aggregate market (AS-AD) analysis, rational expectations theory, and supply-side economics.

CLASSICAL ECONOMICS:

A theory of economics, especially directed toward macroeconomics, based on the unrestricted workings of markets and the pursuit of individual self interests. Classical economics relies on three key assumptions--flexible prices, Say's law, and saving-investment equality--in the analysis of macroeconomics. The primary implications of this theory are that markets automatically achieve equilibrium and in so doing maintain full employment of resources without the need for government intervention. Classical economics emerged from the foundations laid by Adam Smith in his book An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776. Although it fell out of favor in the 1930s, many classical principles remain important to modern macroeconomic theories, especially aggregate market (AS-AD) analysis, rational expectations theory, and supply-side economics.

Classical economics can be traced to the pioneering work of Adam Smith (often referred to as the father of economics). The specific event launching the modern study of economics and classical economics was the publication by Adam Smith of An Inquiry into the Nature and Causes of the Wealth of Nations in 1776.

Classical economics dominated the study of economics for 150 years after it was introduced. This work not only launched the modern study of economics, it continues to provide the foundation for modernmicroeconomics. Classical economic principles were also adapted to macroeconomic phenomena and provided a guide for macroeconomic policy until the beginning of the Great Depression in 1929. Classical economics fell out of favor in the 1930s largely because it did not adequately explain the occurrence of high rates of unemployment during the Great Depression.

The term "classical economics" was coined in the first half of the 1800s by Karl Marx, who is considered by some as an important contributor to the development of classical economics and by others as a primary critic of this theory. The term gained new life in the early 1900s when John Maynard Keynes developed Keynesian economics as an alternative theory of macroeconomics.

Highlights of classical economics include:

• One, classical economics is based on three key assumptions--flexible prices, Say's law, and savings-investment equality.


• Two, the theoretical structure of classical economics is based on a view that the macroeconomy operates in aggregate according to the same basic economic principles that guide markets and other microeconomics phenomena.


• Three, the economic principles of classical economics indicate that aggregated markets, especially resource markets, automatically achieve equilibrium, meaning full employment',500,400)">full employment of resources is assured.


• Four, classical economics indicates that full employment is achieved and maintained without the need for government intervention and that government intervention is more likely to cause than to correct macroeconomic problems.

A Little History

Classical economics can trace its roots to Adam Smith in 1776. In The Wealth of Nations Adam Smith presented a comprehensive analysis of economic phenomena based on the notions of free markets and actions guided by individual self interests in a laissez faire environment. This work by Smith was motivated in large part as a critique of the existing merchantilist system.

Under mercantilism the ruling aristocracy directed economic activity with the primary goal of benefiting the ruling aristocracy. The merchantilist view was that the wealth of a nation was based on the wealth of the ruling aristocracy. Smith argued, quite convincingly, that the wealth of a nation was actually based on the productivity of resources, which was best achieved if the producers, consumers, and resource owners were left to their own "selfish" actions.

An efficient allocation of resources, higher living standards, and economic growth were achieved if producers sought higher profit and consumers sought greater satisfaction. Higher profit motivated producers to offer the most desired goods at the lowest expense. Greater satisfaction motivated to seek the most desired goods at the lost expense. The result is the best, more efficient use of available resources.

The classical framework developed by Adam Smith was enhanced, refined, and improved over the ensuring 150 years by a number of scholars. The basic principles were refined and applied to an assortment of topics and issues, including resource markets, international trade, economic development, and industrial activity--to name just a few. Much of this work remains relevant to the modern study of microeconomics, often termed neoclassical economics.

Economists also applied this classical framework to macroeconomic issues, especially unemployment, economic growth, and business-cycle stability. With this application a comprehensive theory of macroeconomics was developed that offered an explanation for macroeconomic phenomena and provided recommendations for government policies.

Three Key Assumptions

The classical study of macroeconomics emerged from a set of axioms and assumptions that were used for all economic analysis, such as wants and needs are unlimited, resources are limited, people are motivated by self interest, and more is preferred to less. However, three particular assumptions proved most important to the study of macroeconomic phenomena--flexible prices, Say's law, and saving-investment equality.

• Flexible Prices: The first assumption of classical economics is that prices are flexible. With flexible prices, unrestricted by government regulations or market control, markets are able to quickly and efficiently achieve equilibrium. In particular, a market is able to quickly attainment eliminate any shortage and surplus that exists, reaching a balance between the quantity demanded and quantity supplied. This is especially important for resource markets in which equilibrium means that full employment is maintained and unemployment is not a problem.


• Say's Law: The second assumption of classical economics is that the aggregate production of good and services in the economy generates enough income to exactly purchase all output. Say's law is commonly summarized by the phrase "supply creates its own demand" and is consistent with the modern circular flow model. With Say's law of markets a mismatch between aggregate demand and aggregate supply is a rare and temporary occurrence. The economy is most unlikely to experience an aggregate surplus or shortage of production.


• Saving-Investment Equality: The last assumption of classical economics is that saving by the household sector exactly matchesinvestment expenditures on capital goods by the business sector. This assumption ensures that Say's law holds because any decrease in consumption demand for output due to saving is replaced by an equal amount of investment demand. The saving-investment equality is assured by applying the notion of flexible prices to interest rates in the financial markets.

A Perfect World?

A world operating according to the principles of classical economics achieves efficiency and full employment. Not only are resources efficiently allocated, but those resources are also fully employed. This "perfect" state of the world results because flexible prices allow buyers and sellers to achieve an equilibrium balance throughout the economy.

• Efficiency: Efficiency is attained with market equilibrium and the quality between the price that buyers are willing to pay for a good and the price that sellers are willing to accept. At this automatically generated equilibrium, it is not possible to produce more or less of a particular good such that the economy generates a greater level of satisfaction. If buyers find one good that generates greater satisfaction than another, which is reflected in their willingness to pay a higher price, then sellers are enticed to allocate resources to its production.


• Full Employment: Most important for macroeconomics, full employment is attained because all markets, especially resource and labor markets, achieve equilibrium. With equilibrium, a market has neither a surplus nor a shortage. A surplus in any labor market would mean unemployment. With no surplus, there is no unemployment. The surplus (or shortage) is, of course, eliminated due to flexible prices. If a (temporary) surplus should emerge, then wages--the price of labor--decline until equilibrium balance and full employment is restored.

Perhaps the most important implications of classical economics are that efficiency and full employment are attained without government intervention. Government is not needed to direct resources to the most desired activities--markets do this automatically. Government is not needed to keep resources working--markets do this automatically.

In fact, taking this a step farther, any problems of inefficiency and unemployment that might emerge are attributable to government intervention. From a classical economics perspective, government is the problem, not the solution. Inefficiency and unemployment arise because government prevents markets from achieving equilibrium through regulations, taxes, or other forms of meddling.

A Few of the Founders

As already noted, Adam Smith formed the foundation of classical economics. A host of other economists in the 150 years after Adam Smith contributed greatly to its development. A complete list is not practical at this time, but a short synopsis of the more important players is possible.

• Jean-Baptiste Say: Say is most noted for the "supply creates its own demand" classical law bearing his name. Say was a French economist who helped to popularize the work of Adam Smith in the early 1800s. Among other contributions, Say emphasized the importance of entrepreneurship as a productive factor and was among the first to observe that value and price depend on both supply (resource cost) and demand (satisfaction).


• David Ricardo: Considered by many to be the most noted classical economist, Ricardo made a number of contributions to international trade, labor markets, and the distribution of income in the early 1800s that remain fundamental to the modern study of economics. Perhaps most important, Ricardo viewed the economy as a complex system of interrelated components and was a strong advocate of the principles laid out by both Adam Smith and Jean-Baptist Say.


• Thomas Robert Malthus: A contemporary of David Ricardo and an ordained minister, Malthus developed a theory of population growth which indicated living standards would never rise above a minimal subsistence level. The Malthusian theory of population growth contributed to the economic analysis of wages and was largely responsible for the designation of economics as the "dismal science." Malthus broke from many of his classical colleagues arguing that Say's law might not hold because effective demand would lead to unpurchased production (which was later to become a fundamental part of Keynesian economics).


• John Stuart Mill: The classical economic mantel was carried forth in the mid-1800s by John Stuart Mill, whose father James Mill was contemporary and colleague of Ricardo, Malthus, and other scholars of the preceding generation. Mills not only authored the primary economic textbook used during this era, he also made important contributions to utility analysis and consumer demand theory.


• William Stanley Jevons: Jevons made several important contributions to classical economics in a relatively short career. At the top of the list, Jevons helped to develop the mathematical formulation of marginal economic analysis that transformed classical economics into modern neoclassical economics. Jevons also pioneered work onbusiness cycles, especially a "sunspot theory" that connected sunspot activity to agricultural activity and thus to overall economic activity.


• Alfred Marshall: Marshall, perhaps one of the last of the great classical economists, extended the work of Jevons in the transition of classical to neoclassical economics. In 1890, he authored what was the standard economics textbook for decades, making him the poster boy for classical economics leading up to the Great Depression. Among his many contributions, Marshall developed the modern market diagram (Marshallian cross), the extensive use of graphical analysis used throughout economics, the distinction between short run and long run, and the concept of elasticity.

A Classical Legacy

As already noted, modern microeconomics (especially neoclassical economics) evolved from the classical economics. The basic notions of free markets, equilibrium, and efficiency provide the foundation upon which more complex and realistic analyses are pursued, analyses that take into consideration the market failures of externalities, market control, public goods, and imperfect information.

Classical economics also continues to play an important role in modern macroeconomics. Although popularly discredited by the Great Depression and the theory of Keynesian economics, classical economics persisted and reemerged in the 1980s (when the flaws of Keynesian economics emerged). The core classical notions of unrestricted markets, laissez faire, limited (or no) government intervention, and emphasis on supply rather than demand surfaced in modern macroeconomic theories, including supply-side economics and rational expectations theory.

Perhaps the most important legacy of classical economics is the aggregate market analysis, or AS-AD analysis. Representing the state-of-the-art in modern macroeconomics, AS-AD analysis combines many of features of classical economics and Keynesian economics. In particular, the long-run aggregate supply and the long-run adjustment of the AS-AD model to full employment capture the essential features of classical economics.

A Pinch Of Politics

Any study of macroeconomics, with inherent government policy implications, is inevitably intertwined with politics. Classical economics is no different.

The primary implication of classical economics, that full employment can be achieved without intervention by government, corresponds nicely with aconservative political philosophy. Conservatives stress individual freedoms, reliance on market exchanges, limits on government activity, and support of business activity, all of which match up with classical economics.

This might help to explain why the modern versions of classical economics (supply-side economics and rational expectations theory) surfaced in 1980s along with conservative politics.