Evolution of Economic Thought

Economics as a discipline and body of theory goes back many centuries. Over the years, many ideas put forward have been discredited or downplayed by successors. Others have withstood the test of time, in part because they illuminate a fundamental economic process or mechanism and in part because no one has yet convincingly disproved them. Like most fields of human endeavor, brilliant minds over the course of centuries have shaped and reshaped our thinking on the workings of the marketplace. This evolution is most clearly evident in the changing views held about price central to the theory of value and the efficient allocation of resources.

Keywords General Equilibrium; Imperfect Competition; Invisible Hand; Laissez-Faire; Marginal Analysis; Utility Theory of Value

Economics > Evolution of Economic Thought

Overview

Looking back at the evolution of economic thought, one cannot help but marvel at how concepts we consider patently obvious, like supply and demand, weren't always so. In point of fact, the Laws of Supply and Demand were not formally articulated until the late nineteenth century. This does not mean, of course, that the fundamental dynamics of markets did not exist before then, or that they were unknown, but simply that they were not yet full-fledged ideas in their own right. Nor would they have been if not for the flash of insight and carefully reasoned arguments of a dozen brilliant minds: Smith, Ricardo, Cournot, Jevons, Menger, Walras, Marshall, and Keynes, chief among them. Keen observers all, each commented on the economic realities of his day. As historical documents then, each individual work mirrors the successive changes in the means and scale of production that have transformed economic life over the last two and a half centuries. Looking to the future, though, the true import of theirs and other innovative economists' work lies in the synthesis of ideas, new and old, confirmatory or contradictory, into a coherent understanding of economic forces that, when applied, will bring us and future generations good rather than ill fortune. To first appreciate the vitality of this synthesis we must go back in time thousands of years to the very beginnings of economic thought.

Further Insights

Stages of Thought

Ethical Living

Production and trade, investment and profits, poverty and wealth all, of course, predate the rise of capitalism by many, many centuries. Yet the intelligentsia of the ancient world paid scant attention to questions of supply and demand, capital accumulation and investment, and income distribution that would come to preoccupy classical and modern economics. Ethical rather than commercial considerations dominated the debate even as sea-faring Athens grew rich from trade. Some very modern-sounding business practices, what's more, were well established two thousand five hundred years ago. In Ways and Means to Increase the Revenues of Athens, the philosopher Xenophon chronicled how the supply of goods affected prices; how investment companies pro-rated earnings per share and paid out dividends, and how the sharing of risk lowered individual investor's exposure (Perrotta 2003). As long as commerce made the state more powerful philosophers countenanced it. Yet their unease was equally evident in another of Xenophon's works, Oeconomicus, where he condemns the greed and excesses of those who seek wealth for its own sake.

Aristotle thought virtue and happiness came solely from being self-reliant and leading contemplative life. In so far as wealth furthers this end, it was natural and desirable. 'Chrematistic,' or wealth-getting, is neither; those in its thrall have unlimited appetites and are never satisfied. He took even greater umbrage at the idea of any man's gain coming at the expense of other men instead of from nature. All judgment aside, 'other men' of course excluded the slaves who labored in the fields and mines of Ancient Greece and the Roman Empire, filling the granaries and supplying the metal armourers fashioned weapons from. It was after all the proceeds from both agriculture and conquest that fueled the consumption of goods that trade thrived upon.

Spiritual Salvation

Although war remained profitable for the victors and slavery morphed into serfdom, wealth still flowed primarily from the land well into the late middle ages. And Aristotelian thought suffused much of medieval philosophy. But the object now was spiritual salvation, not simply ethical living. St. Thomas Aquinas and other scholastics championed a just price, a just wage and a prohibition against usury (interest) in the belief that what is taken should be equal to what is given (Pribram, 1953). Economic practices beyond the Christian pale were worse than unnatural; they were sinful. And it would take the Black Death, the rise of town and the growing political influence of the commercial bourgeoisie, the Renaissance and the Protestant Revolution to convince people otherwise.

Mercantilism

But convinced they were. Echoing classical philosophers, Mercantilists from the sixteenth through the eighteenth century believed the power of the state paramount. At issue was the central question of how to finance the upkeep of very costly standing armies and naval fleets to fend off predatory neighbors. To defend the realm and further its interests, national governments, they argued, had to harness their national economies so that gold and silver flowed into their treasuries. The surest route to achieving a favorable trade surplus was to export more bullion-earning goods than one imports. Towards that end, sizable tariffs should be levied on foreign-made luxury items, the moral virtues of thrift extolled to all, and, when all else failed, sales and excises taxes imposed. Since high quality export products sold better and at higher prices, furthermore, governments should regulate manufacturing and require industry to reinvest the lion's share of profits. They should also forbid colonies from manufacturing goods; forcing them to import them from the mother country in exchange for cheap raw materials.

Agriculture

Ironically, it would take a courtier at the epicenter of absolute monarchy, Versailles, to challenge the Mercantilist agenda by advocating a laissez-faire approach in its stead. Louis Quesnay, a physician attending King Louis XV of France and contributor to Diderot's Encyclopedia, called for an end to all government control of the economy. But Quesnay was no anarchist; he believed natural law would subsequently assert itself and the true productive capacity of the economy come to the fore (Pressman 1999). That, crucially, was not manufacturing, not trade in goods, but agriculture. For only there does the innate fecundity of the land create genuine surpluses; in the two other spheres of the economy — manufacturing and land ownership — all earned income is spent in full.

Outputs in other words equal inputs, so there is no net gain. Echoing Aristotle and Thomas Aquinas, the land then was the source of all national wealth. To prove this, Quesnay quantified the flow of funds between the three spheres in a rudimentary economic model, a first, in his Tableau économique of 1758. The proceeds, importantly, could be divvied up among landlords, church and state only after enough was put aside to finance future production. Not all of the ideas like this elementary notion of capital put forth by Quesnay and his colleagues were as original: Their belief in a 'bon prix' or fair price differed little from Aquinas' 'just' price. And some of their ideas contradicted others: Though militantly opposed to government intervention, for example, they nonetheless wanted royal officials to set interest rates.

Classical Economics

Smith & the Invisible Hand

Political Economics is said to have come into its own as a discipline with the publication of Adam Smith's An Inquiry into the Nature and Causes of the Wealth of Nations in 1776. He draws praise to this day for recognizing the competitive marketplace as the preeminent engine of economic growth. It was, in truth, a brilliant insight convincingly articulated. As was his observation about the agency of the self-interest driving human behavior in the furtherance of economic order and ever greater prosperity. No great admirer of selfishness, the Scotsman nonetheless conceded its ubiquity and, crucially, argued that competition can transform this 'private vice' into a 'public virtue.' Everyone, he observed, typically considered his or her economic needs foremost and acts accordingly. Yet, serendipitously, out of this anarchy a robust if unintentional economic order materializes, one seemingly guided, as Smith famously put it, by an 'invisible' hand.

What distinguishes Smith's work from predecessors' is the scope of his inquiry and the systematic nature of his conclusions. Drawing on his and the observations of other Eighteenth-Century philosopher-economists, Smith examined (Pressman, 1999):

• The central role played by prices in ensuring the efficient allocation of scarce resources;
• The way wealth was distributed;
• The productivity gains achievable through the division of labor;
• The perniciousness of monopolies;
• The advantages of international free trade over mercantilism.

He seconded Roger Cantillon's earlier idea that every price has two components: A natural based on cost-of-production and a market determined by supply and demand (Groenewegen, 2002). The former suffices to pay the rents, wages and interest incurred during production, no more, no less. In the long run, competition exerts a centripetal force on market prices drawing them ever closer to their natural level. Any difference between the two in the short-run, Smith observed, attracts or dissuades producers from entering a market. As such, price exerts tremendous influence, acting as an autonomous mechanism to allocate resources most efficiently. It acts as a proxy of that 'invisible hand' when it comes to the distribution of income as well: Landowner, laborer and investor earn that portion of an item's natural price commensurate with the value each one contributed to its production.

In a cruel irony, the very drive to better themselves eroded laborers' share, for by affording a higher standard of living, more of their children survived to adulthood and the ranks of the unemployed that producers cannot afford to hire. This demographic predicament, Smith reasoned destined workers in the long-run to earn just enough to live and reproduce. No matter how dour the outlook became, the individual worker would continue to strive for a better life, which is why Smith believed a greater division of labor would be welcomed for the attendant increases in production and wealth it would bring. To realize such gains, sufficient funds, or 'stock,' had first to be secured to afford the necessary machinery and additional workers. Future wealth would come from reinvesting profits in manufacturing, not agriculture as Quesnay believed. Monopolies not governments, what's more, were a more endemic threat to the efficient functioning of a laissez-faire marketplace because they skewered prices, thwarting competition. Mercantilism did much the same in Smith's view and was thus equally as pernicious.

David Ricardo & Comparative Advantage

Smith forever changed the line of inquiry future economic theorists would take. It would, however, be left to David Ricardo to formalize some of his seminal ideas about income distribution, free trade and economic growth. In his Principles of Political Economy and Taxation of 1817, Ricardo proposed a theory to explain each of the constituents parts of national income alluded to by Smith: Rent, wages and profits. Agricultural production, or rather the lack there of, figured prominently in Ricardo's differential theory of rent; citing Malthus's belief that famine is the natural consequence of unrestrained population growth. Ricardo reasoned that less and less fertile land would have to be cultivated at greater and greater expense, increasing in the process the value of the higher yielding acreage. Landowners were thus destined to receive more and more national income at others' expense (Pressman, 1999).

Scarcity though was hardly ever a problem with readily reproducible, manufactured goods; supply and demand therefore affected prices temporarily at best and mattered little compared to costs-of-production. Ricardo viewed the latter solely in terms of the quantity of labor expended directly and indirectly in making something. This labor theory of value inspired Ricardo to equate a worker's pay with the 'natural' price of the item he or she produced. Like Smith, then, Ricardo too believed laborers could only expect to earn a subsistence wage. As to profits, since higher than usual returns attract new competitors who push market prices down, over time a uniform profit rate will prevail across multiple industries. His ingenious argument in support of free trade between nations, the theory of comparative advantage, is Ricardo's most enduring contribution to economic thought. Unlike Smith, he considered the cost differential between producing countries far less important than the differential within countries. In purely economic terms, importing goods from a more efficient foreign producer, he reasoned, is preferable to purchasing them from a less efficient domestic one. No matter how noble the sentiment, economic self-sufficiency could not match what a country stood to gain by funneling all its investments into ultra-efficient export industries.

Neoclassical Economics

Cournot & the Demand Curve

Successors readily accepted the basic tenants of classical economics, most notably the preeminent importance of competition and the autonomous workings of the marketplace. They grew increasingly dissatisfied, though, with its theory of value. Missing in Smith and Ricardo's ideas, they felt, was an adequate explanation of pricing's role in the efficient allocation of resources. Simply put, the labor theory of value made no mention of demand per se much less of the fact that it varied proportionately with increasing or decreasing prices. The mathematician cum economic theorist who drew the very first demand curve was Antoine Augustin Cournot. Studying the French wine market, he observed that if there were more customers than goods, a bottle's price invariably rose. Conversely, if there were more goods than customers, it dropped (Pressman, 1999). Decisions on the size of firm's production runs, he therefore reasoned, are best made one additional 'unit' at a time. Via this marginal analysis, Cournot examined the pricing behavior of monopolies: They stood to earn the most profits whenever their marginal revenues equaled their marginal costs. In marketplaces made up of many smaller producers, though, no one firm can control prices by withholding goods from the market; there 'perfect competition' existed.

Utility Theory of Value

But what exactly was demand? Why did people buy one thing and not another? Hitherto the focus of inquiry had been national economies, markets and the firm. Mid-to late nineteenth century theorists realized demand arose from consumer choice. Separately, three economists — Jevons, Menger, and Clark — concluded that what truly mattered here was the benefit the individual consumer thought the purchase would derive. That almost everyone regularly made these calculated, rational decisions convinced them of the existence of a utility theory of value. Now, not only was this a subjective valuation but also, crucially, a private exercise in diminishing marginal analysis where the more of something one has, they observed, the more sated one becomes. Jevons went on to show how the utility of the goods paid for by their wages counterbalanced laborers' dislike of the inconvenience and unpleasantness of work, its 'disutility.' Surrounded by material plenty, consumers, Menger argued, rationally select some goods but not others, according to their needs and wants. These very personal preferences affect purchase decisions which collectively amount to market demand; a key constituent of any price.

Price Fluctuation

A much more expansive view about pricing came from another supporter of marginal utility theory and subjective valuation was taken by Léon Walras. A mark up or down in one item, he maintained, rippled through the entire economy, potentially altering the price of every other item. A spectacular claim, but one that simply took prevailing ideas to their logical conclusion. For, just as every price and every market balances and rebalances opposing forces, so too does the economy as a whole. Walras, what's more, marshaled some very sophisticated mathematics to support his notion of general equilibrium. Examining the behavior of individual markets in isolation instead, Alfred Marshall formalized the Laws of Supply and Demand: The higher the price the greater the quantity of goods produced; the lower the price the greater the quantity of goods consumed. He also observed how the upward or downward movement in the price in some goods affected sales volumes more than in others: The larger the impact, the greater what he called an item's price elasticity of the demand; the smaller the impact the greater its price inelasticity.

Modern Economics

Inflation

With the mechanics of pricing now widely considered known, economist began to ask new questions, some related, others not. Inflation, the dysfunctional side of pricing, became one focal point of inquiry. The problem was caused by an overly abundant money supply, according to Fisher. To prove his assertion, he worked out a formula, the equation of exchange that showed how the quantity of goods produced multiplied by their prices had match as the amount of currency in circulation multiplied by the number of times each coin or bill was used per year. This became the central plank of latter-day Monetarists' doctrine that calls for only very small, fixed year-to-year increments in money supply. A very different kind of monetary policy was advocated by Wicksell: since most business investment was financed through credit, interest rate fluctuations were much more likely to directly affect an economy. He is also remembered today for showing the important role economies-of-scale play in a firm's cost structure.

Keynes & Aggregate Demand

Given its legion of supporters and critics, the most far-reaching theoretical doctrine in modern economics, though, has been John Maynard Keynes's The General Theory and Employment, Interest and Money. Here, he challenged that prevailing notion that supply creates its own demand. If that is so, Keyes countered, every one should have a job. (Pressman, 1999). Production and employment, he further argued, were largely determined by aggregate demand, a concept that revolutionized economics. Prior to Keynes, economists analyzed demand in terms of households, firms and markets, not of the economy as a whole. Macroeconomics — the study of how national economies function — effectively began with Keynes. And his central thesis, that aggregate demand in turn is a function of consumer spending and business investment, has figured prominently in debates over both monetary and fiscal policy ever since.

Robinson & Imperfect Competition

A colleague of Keynes, Joan Robinson, meanwhile, challenged the prevailing microeconomic theory about market competition. Orthodoxy held a market was occupied by a sole supplier and therefore uncompetitive or by many small ones and purely competitive. But what happens, she asked, when larger firms compete against each other? Her real-world observations led her to conclude the result is often imperfect competition. That's because firms resort periodically to sales to rid themselves of unshipped inventory. In such instances, their marginal revenue declines. Or they could simply produce and sell fewer goods, giving competitors an opening. The outcome in either case is underutilized capacity.

Conclusion

Compared to what went before, contemporary Economics seems riven by schisms: There are post-Keynesians, neo-Keynesians, New Keynesians, new classicals, monetarists, rational expectations theorists, real business cycle theorists, and supply-siders (Walker, 2002). History is like a glacier covering all but the highest peaks, however, in that it subsumes minor doctrinal disputes, so that, somewhat misleadingly, the past by contrast seems relatively free of controversy. And in the case of a general history of what are in fact at times opaque concepts, the illusion is even greater. There are a number of economic thinkers that the limits of time and space prevented any mention of. And the ideas of those that were can be and are gone into much greater detail. Rest assured, though, that past generations were equally as argumentative, and appropriately so. Economics is an observational, not an experimental science. The proof of a theory here thus rests in how well it empirically withstands the counter-arguments hurled at it: That, and the test of time.

Terms & Concepts

Differential Theory of Rent: The value of fertile land increased disproportionately as less and less fertile land was brought under cultivation to feed a growing population.

Distribution Theory: National income is divided into rents, wages and profits and any change in one comes at the expense of another.

Division of Labor: Specialization and compartmentalization of the firm's workforce to achieve significant productivity gains.

Elasticity of Demand: The degree to which a change in price alters a product's sales.

General Equilibrium: The notion that all economic activity is interrelated and any change in one market has a knock-on effect in every other market.

General Theory of Employment, Interest and Money: The 20th century work by Keynes that pioneered the ideas and techniques of macroeconomic analysis by its study of aggregate demand.

Imperfect Competition: Exists when large firms rely on discount pricing or smaller production runs to maintain their current revenue levels, undermining the marketplace's efficient allocation of resources.

Labor Theory of Value: The wages of workers producing an item constituted its price.

Laissez-Faire: The doctrine that governments should not interfere with the workings of the marketplace.

Marginal Analysis: The impact one additional unit of input is found to have on output as it applies to revenues, costs and utility.

Mercantilism: A 16th and 17th century doctrine calling for the government to enact economic policies that actively favor exports over imports in the belief that a trade surplus alone ensures national security.

Theory of Comparative Advantage: An argument in support of free trade that contends a country is economically better off concentrating on its investments in export industries where it out competes rival countries rather than in domestic industries where it does not.

Theory of Value: In classical economics, the process whereby prices are set and resources allocated most efficiently.

Utility Theory of Value: As rational actors, individuals make economic decisions based on their wants and needs.

Bibliography

Daniela, Z. (2013). "New" and "old" in economic neoliberalism. Annals of the University Of Oradea, Economic Science Series, 22(1), 572-578. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90545749&site=ehost-live

Groenewegen, P. (2002). Part I: Chapter 3: New light on the origins of modern economics. In Eighteenth century economics (pp. 76-96). Abingdon: Taylor & Francis Ltd. Retrieved November 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17445763&site=ehost-live

Harrison, P. (1997). A history of an intellectual arbitrage: The evolution of financial economics. History of Political Economy, 29(4), 172-187. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=858942&site=ehost-live

Jovanovic, F. (2008). The construction of the canonical history of financial economics. History of Political Economy, 40(2), 213-242. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=32432484&site=ehost-live

Perrotta, C. (2003). The legacy of the past: Ancient economic thought on wealth and development. European Journal of the History of Economic Thought, 10(2), 177. Retrieved November 28, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=10182339&site=ehost-live

Polanyi-Levitt, K. (2012). The power of ideas: Keynes, Hayek, and Polanyi. International Journal of Political Economy, 41(4), 5-15. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87675162&site=ehost-live

Pressman, S. (1999). François Quesnay (1694-1774). In Fifty major economists (pp. 13-17). Abingdon: Taylor & Francis Ltd. Retrieved December 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17020621&site=ehost-live

Pressman, S. (1999). Adam Smith (1723-90). In Fifty major economists (pp. 20-26). Abingdon: Taylor & Francis Ltd. Retrieved December 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17020628&site=ehost-live

Pressman, S. (1999). David Ricardo (1772-1823). In Fifty major economists (pp. 35-40). Abingdon: Taylor & Francis Ltd. Retrieved December 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17020645&site=ehost-live

Pressman, S. (1999). Antoine Augustin Cournot (1801-77). In Fifty major economists (pp. 40-44). Abingdon: Taylor & Francis Ltd. Retrieved December 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17020647&site=ehost-live

Pressman, S. (1999). John Maynard Keynes (1883-1946). In Fifty major economists (pp. 99-105). Abingdon: Taylor & Francis Ltd. Retrieved December 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17020677&site=ehost-live

Pribram, K. (1953). Patterns of economic reasoning. American Economic Review, 43(2), 243. Retrieved December 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=8706921&site=ehost-live

Walker, D. (2002). Chapter 1: The relevance for present economic theory of economic theory written in the past. Competing economic theories (pp. 15-32). Abingdon: Taylor & Francis Ltd. Retrieved November 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17150109&site=ehost-live

Suggested Reading

Groenewegen, P. (2002). Part I: Chapter 3: New light on the origins of modern economics. In Eighteenth century economics (pp. 76-96). Abingdon: Taylor & Francis Ltd. Retrieved November 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17445763&site=ehost-live

Heilbroner, R. (1980). Modern economics as a chapter in the history of economic thought. Challenge, 22(6), 20. Retrieved November 28, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=6115718&site=ehost-live

Pressman, S. (1999). Alfred Marshall (1842-1924). In Fifty major economists (pp. 64-69). Abingdon: Taylor & Francis Ltd. Retrieved December 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17020658&site=ehost-live

Pressman, S. (1999). Joan Robinson (1903-83). In Fifty major economists (pp. 128-132). Abingdon: Taylor & Francis Ltd. Retrieved December 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17020694&site=ehost-live

Pressman, S. (1999). Léon Walras (1834-1910) In Fifty major economists (pp. 53-57). Abingdon: Taylor & Francis Ltd. Retrieved December 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17020651&site=ehost-live

Thoben, H. (1982). Mechanistic and organistic analogies in economics reconsidered. Kyklos, 35(2), 292. Retrieved December 1, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=4439362&site=ehost-live