Classical Theories of Economic

Development
Adam Smith
David Ricardo,
Thomas Robert Malthus
 The Classical Theories
Common view (Smith, Ricardo, Malthus)
Explained growth process in terms of technological
progress and population growth
Technological progress drives growth for some
time
Finally it weakens when the falling rate of profit
prevents further accumulation of capital
At that point the economy reaches stagnation
Growing capitalist economy would reach stationary
state
 The Classical Model
The Production Function

Y = f ( K, L, N, T)
Where, K = Stock of capital
L = Labour force
N = Natural resources e.g., land
T = Level of technology
 The Classical Model
Technology

Technological progress is not completely

autonomous
Innovation needs finance
Capital accumulation therefore a pre-requisite
for technological advancement
So, saving and investment are the primary
factors
 The Classical Model
Investment
Net addition to the stock of capital
Investment depended on profit expectations
I = dK = E(π)
 The Classical Model
Labour
Labour supply depends on population growth
Population growth rate depends on “wages fund” – the
amount of resources available for payment of wages.
So, L = L (WF), where WF is wages fund
Wages fund is a part of the working capital and
therefore depends on investment/savings,
WF = WF (I)
 The Classical Model
Profit
Supply of labour and technological progress
determine profit levels
Over time labour supply increases with increase in
population
Supply of land etc. being fixed, increased supply of
labour would lead to diminishing returns
Labour costs increase but profits decline as output
does not increase by similar extent
 The Classical Model
Profit
Adoption of new technology might be able to
counter diminishing returns, but only in the industrial
sector and not in the agricultural sector
In the 18th and the 19th centuries technological
progress was rapid enough to offset the impact of
population growth, and so profit rates did not
decline
Most of the classical economists however thought
that profits would decline and consequently
investment will fall leading to stagnation
 The Classical Model
Circular Causation

dπ dI dK dT dW dL dπ
 Increase in profits or expected profits induces investment
thereby raising the stock of capital
 Higher capital stock brings in technological progress and
growth of the wages fund
 This accelerates population growth, expands labour force
resulting in diminishing returns, given other fixed factors
 Labour costs increase and profits decline
 End result is a stationary state of a mature economy, does not
imply underdevelopment
Classical Theory

Adam Smith’s Theory of

Development
 Introduction
Adam Smith is known as the father of Economics.
Published a book named “An Enquiry into the
Nature and Causes of Wealth of Nations” in 1776.
Though he did not expound any systematic
Developement theory, still his theory can be explained
with the help of certain concepts which are as follows:
– Natural Law
– Laissez Faire
– Division of Labour
– Process of Capital Formation
– Trade Cycle
 Natural Law
He advocated the cause of freedom of action.
He regarded every person as the best judge of his
own interest who should be left to pursue it to his
own advantage.
Freedom of action brings out the best of an
individual which increases
– Society’s wealth
– Individual’s desire to earn income in the manner he likes
best.
Each individual was led by an “invisible” hand
– E.g: It is not the benevolence of Baker but to his self
interest that we get our bread.
Since every individual if left free, will seek to
maximize his own wealth, thus all individual if left
free will maximize aggregate wealth.
 Laissez- faire
It requires the state should not impose
restrictions on individual’s freedom of action.
He was a staunch free trader.
The indivisible hand – the automatic
equilibrating mechanism of the perfectly
competitive market tended to maximize
national wealth.
Price act as the mechanism of attaining the
equilibrium in the market.
 Division of Labour
It is the division of labour that results in the greatest
improvement in the productive power of labour.
The output can be raised by greater division of labour
which results in specialization.
Division of labour and specialization leads to
– An increase in the dexterity among workers
– A decrease in time necessary to produce commodities
– Invention of large number of labour machines.
Division of labour leads to more skill and efficiency
which are most needed for raising the level of output.
Worker producing one thing or part of it exchange it
with other things produced by other people.
Division of labour leads to exchange of goods,
promotes trade and widens the extent of market which
is important for economic development.
Process of Capital Accumulation
Accumulation of capital is the central point
around which his theory of economic
development revolves.
– The increase in wealth is an index of country’s
prosperity.
The only way to increase wealth is to
produce more which requires more capital
investment for which we must save more.
– Stressed the role of Parsimony which formed
the basis of capital accumulation.
 Process of Capital Accumulation
For Parsimony, we should spend less on
consumption and save more.
– Sacrifice present wants and enjoyments for the
sake of future wants and enjoyments.
– creation and use of more capital is the integral
part of economic development.
– He stressed that only capitalist and landlords are
capable of saving.
– Labour class are incapable of savings.
 Concept of “wage fund”
– Belief of the existence of Wages fund.
– Wages always tend to be equal to amount
necessary for the subsistence of workers.
If total wage fund at any time is > the subsistence level,
– The labour force will increase
– Competition for employment will increase
– Wages decrease to the subsistence level.
In such situation, some workers will find it difficult to pull
on below an unaccustomed standard of living
Unable to sustain and unable to bring up children
Working force decreases leads to competition among
capitalists increases for employing workers
Increases in wages.
In stationary conditions, wages fall to the subsistence
level.
In periods of rapid capital accumulation, wages always
tend to increase.
Depends on the rate of accumulation and the rate of
population growth.
 Trade Cycle
He is of view “Economic development is neither a smooth and simple
affairs nor it is a sudden and abrupt process.
According to him, “ growth is a gradual and cumulative process”.
During upswing,
– Savings, capital accumulation, employment, wages, income
and demand increase.
– Market expands leading to absorption of increased
production.
– Large capital accumulation needs free labour mobility and
high level of income leading to increase in demand for good.
– This leads to setting up of new industries, which is
accompanied by further increase in demand for raw
materials, employment and income
– This industrial expansion creates external economies which
lowers the cost of production.
– This leads to increase in profits which acts as an incentive
for investors to have further investment.
– So all the variables continue to increase simultaneously.
But the process of expansion does not continue for
ever.
– Rise in national output is eaten out by the growing
population.
– As more and more capital is accumulated the marginal
efficiency of capital (MEC) starts decreasing.
– Disheartens businessmen and they feel discouraged to
make fresh investment.
– National output is and the wages continue to decrease.
– The process of multiplier starts working in the backward
direction.
– A stage comes when the economy becomes stationary and
remains stagnant and growth is not possible in such a state.
Adam Smith has not suggested any way out of this
stationary state.
 Criticisms
1) Rigid Division of Society: Society only
divided between the capitalists( including
landlords) and the labourers, but has ignored
the middle class.
Unrealistic assumption of stationary state.
Unrealistic assumption of perfect competition.