ASSUMPTIONS, CLASSICAL ECONOMICS

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Classical economics, especially as directed toward macroeconomics, relies on three key assumptions--flexible prices, Say's law, and saving-investment equality. Flexible prices ensure that markets adjust to equilibrium and eliminate shortages and surpluses. Say's law states that supply creates its own demand and means that enough income is generated by production to purchase the resulting production. The saving -investment equality ensures that any income leaked from consumption into saving is replaced by an equal amount of investment. Although of questionable realism, these three assumptions imply that the economy would operate at full employment. The three key assumptions underlying the classical study of macroeconomics are flexible prices, Say's law, and saving-investment equality. These three assumptions ensure that the macroeconomy would continue to produce the quantity of aggregate output that fully employs available resources. While a few resources might be temporarily unemployed, they would be quickly reemployed as resource prices (especially wages) adjust to equilibrium balance.

A Classical Overview
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, as well as classical economics, was the publication by Adam Smith of An Inquiry into the Nature and Causes of the Wealth of Nations in 1776. In this book, Smith contended that the "wealth of a nation" was attributed to the production of goods and services (rather than stockpiles of gold in the royal vault, which was the prevailing view at the time). And this production was best achieved by unrestricted market exchanges with buyers and sellers motivated by the pursuit of self interests. The work by Smith was refined and enhanced by scores of others over the ensuing 150 years, including Jean-Baptiste Say, John Stuart Mill, David Ricardo, Thomas Robert Malthus, and Alfred Marshall, to name just a few. Their work led to the creation of a sophisticated body of principles and analyses that offered insight into a wide range of economic phenomena--both microeconomic and macroeconomic. Many of these principles remain essential to the modern microeconomic theory. And while classical economics was largely discredited by John Maynard Keynes and advocates of Keynesian economics from the 1930s through the 1970s (due in large part to the Great Depression), it has reemerged (albeit with modifications) in recent decades.

Flexible Prices
The first assumption of classical economics is that prices are flexible. Price flexibility means that markets are able to adjust quickly and efficiently to equilibrium. While this assumption does not mean that every market in the economy is in equilibrium at all times, any imbalance (shortage or surplus) is short lived. Moreover, the adjust to equilibrium is accomplished automatically through the market forces of demand and supply without the need for government action. The most important macroeconomic dimension of this assumption applies to resource markets, especially labor markets. The unemployment of labor, particularly involuntary unemployment, arises if a surplus exists in labor markets. With a surplus, the quantity of labor supplied exceeds the quantity of labor demanded --at the exist price of labor (wages). With flexible prices, any surplus is temporary. Wages fall to eliminate the surplus imbalance and restore equilibrium--and achieve full employment.

then interest rates adjust to restore balance. then production also declines (temporarily) and so too does the demand for labor. then interest rates fall. which causes a drop in income and induces a decline in consumption. Economic downturns could occur. the sort of thing that might cause an economic downturn. employment. If so. which is then used to buy a corresponding value of production --although most likely not the original production. In particular. If this happens. However. which then triggers further reductions in production. the production of a good is ensured to be purchased by waiting buyers. . 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. it remains relevant in modern times and is reflected in the circular flow model. Supply falls $10 million short of creating enough demand. economy-wide supply and demand. Say's law further implied that extended periods of excess production and limited demand." This interpretation means that the act of production adds to the overall pool of aggregate income. Saving-Investment Equality The last assumption of classical economics is that saving by the household sector exactly matches investment expenditures on capital goods by the business sector. flexible prices mean that wages decline to eliminate the surplus. creating a surplus of labor and involuntarily unemployed workers. which stimulates investment and curtails saving until the two are once again equal. and although it was subject to intense criticism by Keynesian economists. but not due to the lack of aggregate demand. the household sector might choose to spend only $90 million. that is. This law. if saving exceeds investment. if this $10 million of saving is matched by an equal amount of investment. for example. then no drop off in aggregate demand occurs. A more accurate phrase is "aggregate supply creates its own aggregate demand. However. and consumption in a contractionary downward spiral. That law actually applies to aggregate. A potential problem with Say's law is that not all income generated by the production of goods is necessarily spent by the household sector on consumption demand--some income is saved. directed attention to the production or supply -side of the economy. then producers reduce production and lay off workers. In other words. in this case price flexibility applies to interest rates. Such a match between saving and investment is assured in classical economics through flexible prices. while the production of $100 million of output generates $100 million of income. aggregate demand in the economy takes a bit of a drop (perhaps due to fewer exports of goods to other countries). Should saving not match investment. directing the remaining $10 million to saving. However. focus on production and the rest of the economy will fall in line. first and foremost. a French economist who helped to popularize the work of Adam Smith in the early 1800s. then supply does NOT create its own demand. This notion commonly summarized by the phrase "supply creates its own demand" is attributed to the Jean-Baptiste Say. Say's law was a cornerstone of classical economics.If. income. Say's law is occasionally misinterpreted as applying to a single good. That is. were unlikely.

neither hampered nor coddled by government. As he saw it. which divided national product between three social classes: wages for labourers.. Ricardo¶s comparative-advantage principle became the cornerstone of 19th-century internationaltrade theory. He also observed that this cooperative system occurs through the process of individual choice as opposed to central direction. individuals spend money for goods that they want or need most. which states that every nation should specialize in the production of those commodities it can produce most efficiently. . Smith argued that free competition and free trade. By the same token. Strongly opposed to the mercantilist theory and policy that had prevailed in Britain since the 16th century. More significant were the effects of classical economic thought on free-trade doctrine. Ricardo emphasized that the value (i. who worked out all of its logical implications and combined it with the theory of surplus value.amosweb. In a free-enterprise system. Ricardo expanded upon both ideas in Principles of Political Economy and Taxation (1817). In his labour theory of value.e. Mill¶s work related abstract economic principles to real-world social conditions and thereby lent new authority to economic concepts.pl?s=wpd&c=dsp&k=assumptions. focused on economic growth and economic freedom. Ricardo concluded that a particular social class could gain a larger share of the total product only at the expense of another. total world output would invariably be larger than it would be if nations tried to be self -sufficient. individuals make a profit by producing goods that other people are willing to buy.Link : http://www. The teachings of the classical economists attracted much attention during the mid -19th century. These and other Ricardian theories were restated by Mill in Principles of Political Economy (1848). for example. and rents for landlords. price) of goods produced and sold under competitive conditions tends to be proportionate to the labour costs incurred in producing them. would best promote a nation¶s economic growth. which dominated economic thinking i n Great Britain until about 1870. profits for owners of capital. that over short periods price depends on supply and demand. Smith introduced the rudiments of a labour theory of value and a theory of distribution. Smith demonstrated how the apparent chaos of competitive buying and selling is transmuted into an orderly system of economic cooperation that can meet individuals¶ needs and increase their wealth. which was founded on the assumption that human labour alone creates all value and thus constitutes the sole source of profits. Many of the fundamental concepts and principles of classical economics were set forth in Smith¶s An Inquiry into the Nature and Causes of the Wealth of Nations (1776). The labour theory of value. was adopted by Karl Marx. The most influential was Ricardo¶s principle of comparative advantage. Ricardo fully recognized. This notion became central to classical economics. everything else should be imported. In analyzing the workings of free enterprise. stressing laissez-faire ideas and free competition. the entire community benefits most when each of its members follows his or her own self-interest.%20classical%20economics English school of economic thought that originated during the late 18th century with Adam Smith and that reached maturity in the works of David Ricardo and John Stuart Mill. a treatise that marked the culmination of classical economics. as did Ricardo¶s theory of distribution.com/cgibin/awb_nav. Taking the limited growth potential of any national economy as a given. however. This idea implies that if all nations were to take full advantage of the territorial division of labour . The theories of the classical school.

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