Classical Economists

1. Lecture 6
Classical economics
Features
Contributions of Adam Smith,
T.R Malthus and David Ricardo

2. Classical Economists
6/25/2017 Adam Smith (1723 - 1790) 2
Adam Smith (1723 – 1790) Thomas Malthus (1766 – 1834)
David Ricardo (1772 – 1823) John Stuart Mill (1806 – 1873)

3. Adam Smith (1723 – 1790)
 Adam Smith was a Scottish Philosopher and Economist.
 Considered by many the father of economics.
 At age 14 he enrolled at Glasgow University to study moral
philosophy, and later studied moral and political science in
Oxford.
 17th century is “The Age of Enlightenment”.
 Enlightenment thinkers believed that reasoning might be
applied to all areas of human activity, and carried into the
governmental sphere, in their explorations of the individual,
society and the state.

4.  Francis Hutcheson (1694 –1746), his teacher of Moral
Philosophy, inspired Adam Smith to be passionate about
liberty, reason, and free speech.
 Aristotle (384 – 322 BC), a student of Plato who supported
private property.
 Thomas Hobbes (1588 –1679), English Philosopher, famous
for his book “Leviathan”, in which he studies the need for
governments in a society.
 John Locke, (1632 –1704), English Philosopher, considered
private property as natural right, advocated a government with
checks and balances, and had influence on the Constitution of
the United States and its Declaration of Independence.

5.  Richard Cantillon (c. 1680 – 1734), developed long run price
equilibrium, and a two sector general equilibrium, quoted by
Adam Smith in the Wealth of Nations.
 Mercantilists - The motivation to prove mercantilist theory
wrong was one of his major efforts in Wealth of Nations.
 David Hume (1711 – 1776), Scottish philosopher, historian
and economist, close friend of Adam Smith, exchanged ideas,
Adam Smith has been known to have added some of David
Hume’s work in Wealth of Nations.

6. Contributions
1. Division of Labor
2. Invisible Hand
3. The Role of Government
4. Rent of land
5. Importance of Capital
6. Money
7. Agriculture
8. Wage fund theory
9. Profits and interests
10. Economic liberty
11. Public finance
12. International trade

7. Division of Labor
 “One man draws out the wire, another straightens it, a third
cuts it, a fourth points it, a fifth grinds it at the top for
receiving the head; to make the head requires two or three
distinct operations; to put it on is a peculiar business, to
whiten the pins is another; it is even a trade by itself to put
them into paper.”
 He observed a production unit of 10 workers producing pins.
 If each of the 10 workers performed all the tasks, the daily
output would be 200 pins.
 When the production is divided into 10 different tasks, the
same workers make 48,000 pins in one day (240 times
more!).

8.  He concluded that division of labor can increase the output at
the global level. Specialization and trade, is division of labor
at the global level.

9. Invisible Hand
 “It is not from the benevolence of the butcher, the brewer, or
the baker, that we expect our dinner, but from their regard to
their own interest. We address ourselves, not to their humanity
but to their self-love, and never talk to them of our necessities
but of their advantages.”
 The Invisible Hand is the quest for profit.

10. Invisible Hand – Modern
Illustration
Representative firm
Costs
Price
Quantity Quantity
AC
MC
PLR
D
S
Market for Chinese Restaurants
profit
D1
S1

11. Consequences of Invisible Hand
1. Each firm will produce at minimum average costs. If for
some reason the price is above PLR, then firms will enter the
industry and reduce the price to minimum AC.
2. Firms have incentive to innovate to improve quality and
reduce costs, and thereby have above normal profit.
3. Firms respond to changes in consumers’ tastes without
government regulation. If the demand for some good
drops, the price will decline below PLR, profits will be below
normal, and the number of producers will decline. Similarly,
if the demand for some good rises, its price will rise above
PLR, increasing the profits above normal, which leads to
entry of new firms.

12.  It is difficult to imagine any government being able to collect
information on all the consumers’ preferences and all the
firms’ technologies, and finding the optimal output level in
each firm. It turns out that the Invisible Hand (or the desire of
firms to increase their profit) makes everybody better off.

13. The Role of Government
 Adam Smith, although argued that markets are efficient,
pointed out that sometimes there are market failures (public
goods, monopolies).
 He argued that government intervention is justified in cases
of market failure.
1. “The first duty of the sovereign, that of protecting the
society from the violence and invasion of other independent
societies”
2. “The second duty of the sovereign, that of protecting, as far
as possible, every member of the society from the injustice
or oppression of every other member of it”

14.  “The third and last duty of the sovereign or commonwealth is
that of erecting and maintaining those public institutions and
those public works, which, though they may be in the highest
degree advantageous to a great society, are, however, of such
a nature that the profit could never repay the expence to any
individual or small number of individuals, and which it
therefore cannot be expected that any individual or small
number of individuals should erect or maintain.”
 “After the public institutions and public works necessary for
the defence of the society, and for the administration of
justice, both of which have already been mentioned, the other
works and institutions of this kind are chiefly those for
facilitating the commerce of the society, and those for
promoting the instruction of the people. The institutions for
instruction are of two kinds: those for the education of youth,
and those for the instruction of people of all ages.”

15.  Adam Smith’s Contributions:
–He helped make Political Economy into an “autonomous
systematic discipline”
–The invisible hand, division of labor,
 Adam Smith has influenced many Economists
–David Ricardo
• David Ricardo became interested in Economics after
reading Wealth of Nations.
• All the other economists that followed.
 Adam Smith’s efforts arguing against Mercantilism paved way
for Britain to engage in free trade.
–Britain dropped some Mercantilist thought years after
Wealth of Nations.

16.  Adam Smith’s theories appear today in our microeconomic
and macroeconomic text books
–Some recognizable theories are: The Invisible Hand,
Division of Labor, and the concept of Lassiez-faire.
 Adam Smith did not believe in the usefulness of statistics in
economics, an approach proposed by William Petty (1623 –
1687).
 His almost 1000 pages book, the wealth of nations, could
have been much shorter and clearer had he used graphs and
math.

17. MALTHUS AND RICARDO
 The ideas of Malthus influenced many of his time
 Among them, Charles Darwin and David Ricardo
 Darwin in the development of his theory of natural selection
was greatly influenced by the observation made by Malthus
that like plants and animals, humans can overproduce
offspring if left unchecked.
 Malthus and Ricardo were above all great friends.
 They disagreed with each other on many points which in
reality where more an issue of style rather than substance.
 However they did have one very important difference of
opinion.

18.  This difference was in the fact that David Ricardo supported
the so called Says Law while Malthus did not
 We will discuss the Says Law in greater detail later on
An Essay on The Principle Of
Population
 Population level is severely limited by
subsistence
 When the means of subsistence increase,
population increases
 Population pressures stimulate increases in
productivity

19.  Increases in productivity stimulate further population
growth
 Since this productivity can never keep up with the
potential of population growth for long, there must be
strong checks on population to keep it in line with
carrying capacity
 It is through individual cost/benefit decisions regarding
sex, work, and children that population and production are
expanded or contracted
 Checks will come into operation as population exceeds
subsistence level
.

20. VII. The nature of these checks will have significant effect on
the rest of the sociocultural system—Malthus points
specifically to misery, vice, and poverty
“I think I may fairly make two postulata.
First, That food is necessary to the existence of man.
Secondly, That the passion between the sexes is necessary and
will remain nearly in its present state.

21. Malthus
Food
Population
Time
Growthrate
An Essay on The Principle Of Population
Recall that Malthus’ hypothesis could be summarized simply
by
◦ The fact that while population grows at a geometric rate,
food production grew at an arithmetic rate

22. PREVENTIVE CHECKS – reduces the birth rate
 Malthus approved of “Moral Restraint”
◦ Postpone marriage – and no sex before then!
◦ Forget about marriage! Be celibate!
 Malthus disapproved “Vice” (even though these methods also
reduced birth rate)
◦ Prostitution
◦ Birth control
◦ Homosexuality
POSITIVE CHECKS – increases the death rate
 Malthus elevated these to natural phenomena or laws -
unfortunate evils needed to limit the population
◦ Famine
◦ Misery
◦ Plague
◦ War!
 Positive checks were “punishment” for those who did not
practice “Moral Restraint” (OUCH!)

23. David Ricardo
1772-1823
 Son of Jewish immigrant stock broker
 Broke ranks with family and became a Unitarian to marry a
Quaker woman he fell in love with
 took modest stake and build into a fortune
 invested in Securities and Real Estate
 In 1779, while on vacation, read The Wealth of Nation by
Adam Smith
 Got interested in economics as a “hobby”

24.  He was elected to the House of Commons
 There he became highly respected
 He argued issues not based on the prevailing wind but on the
relevance to the structure of society
 He was said to have been the man that educated Commons.
Develop System
 Basic Assumptions:
◦ Classical Rent
◦ Population issues as presented by Malthus
◦ Wage-fund
House of Commons

25. Rent and Corn Laws
 During the Napoleonic wars (1790-1810), the English had a
diffucult time using their porst
 Thus, reduction in corn imports to England resulted in 18%
annual growth rates in the price of corn

26. Extensive and Intensive Rent
1
5
8
10
20
30 40
50
0
20
40
60
80
100
120
140
160
180
200
Z
Additional
Labor
(INTENSIVE)
Additional Land (EXTENSIVE)

27. Theory of Value
 Use Value necessary for Exchange Value
 Labor theory value only for Perfectly Competitive Markets
 Economic Forces change relative prices over time
 Short-run price changes are due to demand-supply while
Long-run price changes due to labor costs
 Any variation of the preceding is only temporarily and in all
cases Long-run price changes are due to labor cost changes

28. Distribution Theory
Marginal Product
A
D Rent B
Profits
G H
E Q N
F J
Wages M
C I P
Doses of Capital

29. Rent
Profits
wages
Doses of Capital
Currency
Distribution Theory
Marginal Product

30. Basic Assumption of the Law of
Comperative Advantages
 Each Country has a fixed endowment of resources, and all
units of each particular resource are identical (i.e.
homogenous factors).
 The factors of production are completely mobile between
alternative uses within a country factor prices identical for
alternative uses.
 Costs of production are constant horizontal supply curve.

31.  The factors of production are completely immobile
externally (i.e. across countries) factor prices can be
different across countries prior to trade.
 A labor theory of value is employed for the model. Thus
the value of the product is determine solely by the value of
its labor (a) no other input is being used, or (b) the other
inputs are measured in terms of its labor cost, or (c) the
other input/labor ratios.
 The level of technology is fixed in each country during the
period under consideration, although the technology can
differ between them.

32.  There is full employment.
 There is perfect competition.
 No government-imposed obstacles to economic activity.
 Internal and external transportation costs are zero.
 We begin with a two-country and two-commodity trade

33. Ricardian Condition of Production in
England and in Portugal
Country Wine Clothing Price under
Autarky
Portugal 80
hrs/bbl
90 hrs
per yard
1 w 8/9 c or
1 c 9/8 w
England 120
hrs/bbl
100 hrs
per yard
1 w 6/5 c or
1 c 5/6 w

34.  If the Autarky Price ratio is the pre-trade price ratios.
◦ These are based on the opportunity cost
◦ England 1 W : 1.2 C
◦ Portugal 1 W ; 8/9 C
 Who should specialize in Wine:
 Who should specialize in Clothing:
Comparative Advantage

35. Comparative Advantage
Terms of Trade between England and
Portugal
Which TOT is acceptable to which country?
TOT England Portugal
1 W : 1 C
1 W : 1.2 C
1 W : 1.4 C
1 W : .89 C
1 W : .7 C

36. Comparative Advantage
 So given the previous table:
◦ The range of the TOT would be
◦ 1 W : for ______ C high
◦ 1 W : for ______ C low

37. Say’s Law
 J.B. Say, James Mill, and David Ricardo
 Supply Creates Its Own Demand
 Thus, Glut in a market may exist but it will not exist in all
markets
 An argument against Malthus