HET Classicals 1 Smith, Hume, Cantillon ST

The Classical School (1776-1871)
Forerunners and Adam Smith

The Classical School
• Began with the publication of "Wealth of a
Nation" written by Adam Smith, ended by
coming to the stage of Neoclassical School
What was the historical background behind
The Classical School?
• The Scientific Revolution, began by Isaac
Newton, which rejected innate thinking in
favor of empirical and evidence based thinking
– No longer people accept the ancient truth
unquestioningly (for example opposition of
religion to interest is no longer accepted as truth)
• The Scientific Revolution
• The industrial revolution arose out of the past,
took centuries and included social, intellectual
and agrarian revolutions as well as “industrial”
changes
• “Scientific revolution,” the rise of “natural
law” and the separation of “knowledge” from
theology
• Role of technology and industrialization, examples include
• the building of canals and transportation system [In England
between 1750- 1820 3000 miles of navigable waterways built
(often private for profit), in 1750 to 1770 nearly 12,000 miles
of turnpikes were built]
• 1698 Thomas Savery obtained patent for steam pump for
use in Cornish mines, 1712 he made an atmospheric pump,
Newcomen’s steam engine improved by James Watt in 1769
• 1709 Abraham Darby made coke from coal, (by 1750 it
accounted of 5% of British steel)
• Role of technology and industrialization, examples include
• 1733 John Kay invented the “flying shuttle,” James Hargreaves’
“spinning jenny” was invented in 1764 and Richard Awkwright
developed the “water frame.” Samuel Crompton combined the
jenny and water frame in 1774 and was adapted for steam power
by 1790. Eli Whitney invented a mechanical gin in 1793, Edmund
Cartwright patented the power loom in 1785. Use of raw cotton
increased from 500 tons in 1700 to 2500 tons in 1770 and 25,000
tons in 1800.
• Other industries included pottery [Josiah Wedgewood], chemical
[Antoine Lavoisier (1743-1794), coal industry, railways [Richard
Trevithick(1771- 1833) locomotive in 1801]
• The Industrial Revolution(1760-1850) –
– was in its infancy in 1776, and began in England
even though they were behind France in
manufacturing and Holland in commerce.
• Why Mercantilists rules are fading as Physiocracy and
Classical School of thought come along?
– Natural growth of population due to advances in science
and economic growth
– Peasants leave the rural areas to join cities and become
part of the labor force
– Small manufacturers and artisans who are going out of
business because of competition from larger manufacturers
are joining the labor force
– Irish Famine (1740-41) led to migration of Irish People to
large cities in England to join the labor force.
What were the major tenets of The Classical
School?
• Minimal government intervention in the economy. Market forces would
guide production, exchange, and distribution.
– Government activity should be confined to providing for the national defense, and
protection of property rights, providing public education
• Self-interested economic behavior. Merchants pursue profit and consumers
buy goods to satisfy wants.
• Harmony of interests. By pursuing their own individual interests, people
served the best interests of society
• All economic resources and activities are important. According to classicists
all economic resources (capital, land, labor) and all economic activities
( agriculture, commerce, production and international trade) contribute to a
nation’s wealth
• Economics Laws- Law of comparative advantage, theory of value, Say's Law,
Theory of Rent
Whom did The Classical School benefit?
• In the long run classical school benefited everyone
because their ideas encouraged industry, trade, and
profit. This helped promote economics progress that
created welfare for large populations over time
• Merchants and industrialists achieved a new status
and dignity as the promoters of the nation’s wealth
• At the beginning of industrial capitalism the laborers
bore the heaviest share of the cost of
industrialization to hard work and low wages
How was the Classical School of thought
valid, useful, or correct in its time?
• It rationalized the practice engaged in by interpreting people.
It justified overthrowing mercantilists principles.
• They advocated less government intervention, which were
very corrupt at the time.
• There was not a large base of consumers to purchase many
of the goods produced by the capitalists therefore surplus
was reinvested which expedited industrial growth
• As labor force was being formed in cities creating a market
for agricultural products to be sold in cities by merchants.
• They also expanded markets by pursuing free international
trade
Which tenets of the Classical School
became lasting contributions?
• Gave the best analysis of the economy far better
than any other school.
• They laid the foundation of economics as a social
Science.
• Theoretical Contributors
– The law of comparative advantage
– The notion of consumer sovereignty
– The importance of capital accumulation
– The market as a mechanism to reconcile interest of
individuals with interest of society
Which tenets of the Classical School
became lasting contributions?
• Weaknesses
– no attention to economic recession/depression
– no attention to monopoly/monopsony
– no discussion of externalities and public goods
– labor is the only source of value, disregarding
utility
Richard Cantillon (about 1680-1734)
• Cantillon created something of a system of economics, he was a model

builder and used abstract methods.
• A major work was published in 1755, about 20 years after his death.
• Cantillon was a Paris banker of Irish extraction. His work in economics
demonstrated a mechanical, rationalist approach.
• His contributions include:
– The treatment of population as an integral part of the economic process
– A theory to explain the location of cities and manufacturing
– That change in velocity are equivalent to changes in the quantity of
money
– Show the paths by which changes in the quantity of money influence
price
– Explain the adjustment of prices in international trade
– Consideration of the flows among sectors of the economy
Richard Cantillon (about 1680-1734)
• He started with land as the source, “matter” of all
wealth, labor is the “form” that produces it
• He saw the economy and society as a
interconnected, mechanical process that was
constantly adjusting through individual pursuit of
profits in a series of connected markets. The concept
of the "entrepreneur" is associated with Cantillon in
this regard. It is these entrepreneurs who react to
markets and generate a loose "general equilibrium."
David Hume (1711-1776)
• Wrote "A Treaties of Human Nature", in which he propagates the
'Naturalistic Philosophy’
• He published his economic essays in Public Discourses (1752),
came closest to ideas of Adam Smith
• Theory of price-specie flow mechanism was his greatest
contribution.
– Exchange rate between currencies regulates trade- import of
a product increases the demand for money from the country
that is exporting the product, this increases the exchange rate
and increase demand.
• Elastic and Inelastic price
– Hume believed that demand for alcohol was elastic , so taxes
should be lower.
David Hume, Political Discourses (1752)
• Assumes that we live under the gold standard

• International payments are in the form of gold
• Price specie-flow mechanism –positive balance of
trade(E>I)leads to an increase in the specie within
(English) economy, which in turn leads to …
• a rise in the level of prices in this economy (with a
positive balance of trade), and…
• in effect, exports in England will decrease and imports
will increase because England prices will become
relatively higher than those of other economies.
David Hume, Political Discourses (1752)
• The opposite tendencies will prevail in an

economy with an initial negative balance of trade.
• This process will ultimately lead to self-
correction(E=I)of the trade balance in all countries
in the long-run.
• Therefore, mercantilist policy of maintaining a
positive balance of trade is self-defeating, it is
impossible to have a positive (or negative) balance
of trade in the long-run.
Quantity theory of money
• Result of specie-flow problem in last half of
1500’s
• Implies a “supply and demand for money”
• Prices are a function of the money supply
• Development of theory stretches over 300
years
• Nicholas Copernicus (1473-1543)
– 1526 Copernicus wrote Monetae Cudendae
– 1522 he offered an explanation to the Prussian Diet
on the principles for a sound currency
• “Money usually depreciates when it becomes too
abundant.”
• Not published until 1800’s, so not much influence
• Spanish experience in 16th century not cause of
Copernicus’ idea
• Martinus de Azpilcueta Navarrus (died 1586)
– 1556 Navarrus published manual on moral theology with
appendix on usury
– Question was whether financiers could morally profit
from variations in the value of money
• “Money is worth more when it is scarce than where
it is abundant”
• Where money is scarce, goods and services have low
prices
• human need is reflected in prices {Aristotle}
• Jean Bodin (1530-1596) and the Quantity theory of Money
(QTM)
– Credited for stating the QTM in 1568 in a response to Malestroit
– Navarrus and Bodin both students at University of Toulouse ,
“Multiple discovery?”
• He sees 5 causes for increase in prices:
– Abundance of gold and silver
– Monopolies
– Scarcity of goods [caused by exports and waste
– Luxury for nobility
– Debasement of coin
Adam Smith (1723-1790)
• Born in Kirkcaldy, Scotland (near Edinburgh).
• Studied at Glasgow under Hutcheson, professor of moral
philosophy and head of the Scottish Naturalist School.
• Attended Oxford for 6 years.
• 1750, took the Chair of Logic at Glasgow College.
• 1752, took the better paying job of Chair of Moral Philosophy
• 1759, Theory of Moral Sentiments
• 1776, An Inquiry into the Nature and Causes of the Wealth of
Nations
• 1790, Died.
• Was influenced by Turgot and Quesnay
• Published 'The Theory of Moral Sentiments‘
(1759)
• Published "An Inquiry into the Nature and
causes of the Wealth of a Nation" (1776)
• Was professor of logic and received the chair
of moral philosophy
• Often called “the father of economics”, because he was able to synthesize
his and previous achievements into one coherent, integrated system
explaining:
– how markets function(price determination),
– how economic growth operates,
– what policies accelerate economic growth,
– how domestic economy interacts with others (international trade),
– what is the appropriate role for the state in the economy, etc.
• Not a great theoretical economist (but advanced e.g. price theory, growth
theory, trade theory, etc)
• Biggest impact in terms of promoting and popularizing the economic policy
and economic worldview of free market capitalism with very limited
government interventionism (state as a night watchman, minimal state
role in the economy)
• Important Influences for Adam Smith
• The general intellectual climate of the time. This was the period of
Enlightenment, a period of revolution in human philosophy, in which reason and
rational thinking is replacing faith.
– Enlightenment was built upon two pillars: People’s reasoning ability and the concept of
natural order
– Through systematic reasoning, people could discover not only these natural laws but also
those governing the society
• The physiocrats, especially Quesnay and Turgot. Smith admired the physiocrats
attack on mercantilism. Adopted the idea of little government and the idea of
laissez-faire.
• Francis Hutcheson, his instructor at Glasgow who believed that people can find
the truths on their own without government intervention (The Will of God)
• David Hume, his personal friend, contributed to his intellectual development and
economic ideas
• Theory of Moral Sentiments (1759)
• It was about ethics and morality , it went through 6
editions, so it can be thought of, along with "Wealth of
a Nation", as two sides of Adam Smith's thinking about
societies.
– In the "Moral Sentiments", moral force restrains selfishness
– in "Wealth of Nations", it is competition that regulates 'self
interest', as sympathy overcomes selfishness.
– Grief and joy in others arouse the same feelings in
ourselves.
• Theory of Moral Sentiments (1759)
• Two types of Passion:
– Unsocial Passion: Hatred and Resentment
– Social Passion: Sympathy and Kindness
• Beneficence and Justice;
– Societies can live without beneficence ( although they may not be pleasant)
but cannot live without justice.
• Both "Moral Sentiment" and "Wealth of Nations" reconciled the
individual with self interest through national harmony and principle of
natural liberty if the individual and the right to justice.
• In "Moral Sentiments", sympathy and benevolence restrain selfishness
and in "Wealth of Nations", competition channels economic self
interest toward the social good.
• The Wealth of Nations (1776)
• Five books:
– 1. Production and distribution with special
reference to labor
– 2. Capital and Accumulation
– 3. Economic development and policies to aid it
– 4. Different systems of political economy
– 5. Public finance
• Main problem –causes of the national income,
forces of the economic growth and policies for
encouraging growth
• Methodology –deductive reasoning combined
with historical description
• First chapter is on the division of labor. At a pin factory,
he observed how the division of labor increases
productivity from few pins a day to a few thousand.
• Reasons why labor increases productivity:
– increased dexterity to repeating the same task over and over
again.
– time saved by not switching tasks
– if the process of production is broken up into smaller
segments, then the machinery can be built/invented to do the
tasks of the worker leading to higher productivity.
• Harmony of interests
• Hidden within the apparent chao of economic
activity is a natural order.
• There is an invisible hand that channels self-
interested behavior in such as way that the
social good emerges.
• Harmony of interests
• The key to understanding Smith’s invisible hand concept of
competition.
• The action of each producer or merchant to make profit is
restrained by the other producers or merchants who are likewise
attempting to make profits.
• Competition drives down the process of goods and in so doing the
prices of goods and in doing so reduces the profit received by each
seller.
• The pursuit of self interest, restrained by competition, thus tends to
produce Smith’s social good-maximum output and economic growth
• Harmony of interests makes intervention of the government
unnecessary and applies to international trade.
• Smith's opinion on international trade was prominently
different from the mercantilists, who believed in zero sum
gain. Whereas Smith believed in no protection and mutually
beneficial trade relationships.
• He was against export subsidies for two reasons:
– Subsidy has to be funded by taxation, which he opposed
– Subsidy causes domestic price of the good to rise, therefore
hurting consumers
• Adams Smith's Beliefs on the Role of Government
• Government should only do what people cannot do individually:
• Believed they should protect against foreign attack
• Administration of Justice
• Public work
• Enforcement of contracts
• Control over paper currency
• Control of interest rate
• Patents and Copyrights
• Laws ensuring property rights in agriculture
• Against tariff protection except to equalize domestic taxation on a product or
imported on for national security reasons
• Reconstruction of ‘invisible hand’ idea in modern terms(based on the
whole book, not only on the quotation)
• Economic agents are self-interested (not interested in social goals)
• Agents maximize their objectives (e.g. profits)
• In international trade they prefer investing home than abroad (for security
reasons) if rates of return are similar
• There is a free international trade
• Invisible hand mechanism leads to a good (or even optimal) situation for the
whole society, understood as:
– 1) the greatest possible stock of capital is accumulated (engine of economic growth)
– 2) prices of consumer goods are the lowest possible
– 3) consumers’ preferences are satisfied.
• The Economic Laws of a Competitive Economy
• Value
• Two kinds of value
– Value in use (Example: water and air) = power of a good to
satisfy human wants, total utility from consumption of this good
– Value in exchange ( Example: diamond)- value depends on
amount of labor
• Two Societies
– Simple- primitive society, only labor is used
– Advanced society- where capital is also used then capital will
add value too.
• Labor theory of value in exchange in a primitive society
• Since labor is the only resource in a primitive society, the
relative value of a good would be determined by the amount of
labor necessary to produce it
• Using Smith’s own example
– Suppose that it took 2 hours to trap a beaver an 1 hour to hunt a deer
– What is the value in exchange of a beaver?
– Answer: 2 deer or 2 hours of labor. That is, a person could either
exchange the beaver for 2 deer or could use the beaver to command 2
hours of labor services
• Value (in exchange) theory in an advanced economy
• In a society where capital investments and land
resources become important, said Smith, goods will
normally be exchanged for other good, for money, or for
at a figure high enough to cover wages, rent, and profit
• Moreover, profits will depend on the value of the capital
advanced by the employer.
• The real value of commodities can no longer be
measured by the labor contained in them
• Water-diamond paradox
• How it is possible that:
– 1. the value in exchange (price) of a diamond is so high, while its
value in use (total utility) is so low for consumers.
– 2. the value in exchange (price) of water is so low, while its value
in use (total utility) is so high.
• So, there seems to be no connection between value in
exchange and value in use
• Paradox solved at the end of 19th century: Price is related
to Marginal Utility, not Total Utility
• Market Price
• Natural price is the long-run price below which the
entrepreneurs no longer would continue to sell their goods
• Market Price is short run determined by demand and supply
• Market price will converge to natural price in the long run
competition
– If it is above the natural price, more goods will come to market,
depressing the price
– If it is above the natural price, some productive factors will be
withdrawn, the quantity of supplied will fall, and the market price will
rise toward the natural price
• Wages
• Average annual wage=wages fund/labor force
• Wages Fund: the stock of circulating capital out of which present
wages are paid. This stock consists of the savings of the capitalists
• Actual wage rates for different jobs would vary according to 5
factors:
– Agreeableness of the job, the harder the job, the higher the wage,
– Cost of acquiring the skills necessary to do the job
– Regularity of employment- the more irregular the higher pay
– Level of trust and responsibility, more responsibility, the higher the wage
– The probability of success the lower the probability, the higher the wage
• Profit
• Because every investment is exposed to risk of
loss the lowest risk of profit must be high enough
to compensate for such losses and still leave a
surplus for the entrepreneur
• The gross profit includes compensation for any
loss and the surplus
• Net profit is the surplus alone
• The Economic Laws of a Competitive
Economy
• Lending and interest
– No problem with this.
– Fails to recognize that savings may fail to be invested, or
that there may be time lags.
• The Economic Laws of a Competitive
Economy
• Foreign Trade
• Prefers domestic trade to foreign since it supports a
greater quantity of domestic labor.
• Foreign trade increases the extent of the market.
• Absolute advantage.
• Rejects several arguments for protectionism. Tends
to favor free trade.
• Rent
• Smith suggested at least four theories of rent, all
of which contradict one another.
• The origins of rent are variously held to be
– (1) demands by the landlord
– (2) monopoly
– (3)differential advantages
– (4) the bounty of nature
Smith’s Theory of Economic Development
a
Division of labor Capital accumulation
f b g
c
Increase in productivity Increase in wages fund
d h
i
Increased national output Higher wages
e
Increased wealth of the nation

Smith’s Theory of Economic Development
• Arrow a: Division of labor spurs capital accumulation
• Arrows b and c : Both division of labor and capital accumulation work
together to increase labor productivity
• Arrow d: Increase in labor productivity increase national output
• Arrow f: Increase in national output widens the market and justifies
further division of labor and capital accumulation
• Arrow g: As a result of capital accumulation the wages fund increases
• Arrow h: Increase in the wages fund increases wages
• Arrow i: Higher wages motivate further productivity growth
• Arrow e: The rise in national output increases the goods available for
consumption, which, for Smith, constitutes the wealth of a nation

HET Classicals 1 Smith, Hume, Cantillon ST

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HET Classicals 1 Smith, Hume, Cantillon ST

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The Classical School (1776-1871)

Forerunners and Adam Smith

• Cantillon created something of a system of economics, he was a model

• Assumes that we live under the gold standard

• The opposite tendencies will prevail in an

Increased wealth of the nation

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