Classical school of thought

Lecture 9
Ms. Salma Shaheen
 The Classical School of Thought
• Adam smith is the founder of classical school.
• He has been described as the father of ‘father
of political economy’.
• His work ‘Wealth of nation’ (1776) is generally
regarded as the starting point of classical
school.
• Thus the Adam smith, Jeremy Bentham,
Thomas Robert Malthus, David Ricardo, J.B.
say and J.S. Mill are all the leading economist
of classical school.
• The essential features of classical School
• The entire philosophy of classical school was based
on economic liberalism.
• The classical writers believed in personal liberty,
private property and individual initiative and
private enterprise.
• Classical features are as follows:
• 1) the classical economist believed in laissez –fair.
That government is best which governed least.
• 2) they believed in a market economy based on
free and perfect competition.
• 3) They assumed condition of full employment.
they thought that economy was self adjusting and
tend toward full employment without govt,
intervention.
• 4) They believed that individual by seeking their
own interest would serve the best interest of
society. In other words they believe on the
harmony of interests.
• 5) The classical emphasized the importance of
all economic activities especially the industry.
• 6) The classical economist provided a method of
analyzing the economy and economic laws that
operate with in them.
• 7) the classical economist looked at the
economy as a whole. That is what we call the
macroeconomic approach in modern times.
• Adam Smith (1723-1790)
• Adam smith was born in Kircadly, Scotland in
1723.
• He was educated at the universities of Glasgow
and Oxford.
• He became professor first of logic and than of
moral Philosophy at Glasgow.
• He came in France and remain in contact with
leading Physiocrats of the day.
• Physiocrats left profound influence on Adam
smith.
• In 1778, Adam smith was appointed as
commissioner of customs in Edinburgh. He held
that post for the remaining year of his life.
• He died in 1790.
• Adam smith published his Theory of Moral
Sentiments in 1759.
• After that , he concentrated his attention less on
ethical doctrines and more on jurisprudence and
political economy.
• Adam smith published his “Wealth of nation” in
1776.
• The full name of the book is ‘An enquiry into the
Nature and causes of the wealth of Nation’
• Adam smith was a first economist who deal with
economic problems in a systematic manner.
• Adam smith’s wealth of nation was a challenge to
mercantilism.
• According to smith, the wealth of nation can be
increased by adopting the principle of division of
labour.
 Chief contributions

• Built a coherent and logical theory of how the

economy works
• The elements of Smith's theory were mostly
already available in the writings of earlier
writers.
• However, in those earlier writings, good ideas
coexisted alongside numerous other bad ideas
• Somebody had to figure out which theories
were useful and which were useless and
combine the useful theories into a consistent
and persuasive overall theory that could be
used reliably to think about society.
• This is what Smith did. For this he is called the
father of economics.
Theory of Moral Sentiments
 Theory of Moral Sentiments
• This book was an argument against the views
of writers such as Hobbes and Rousseau who
argued that the pursuit of self-interest, an
important human instinct, inevitably leads to
a cruel and terrible society.
• Smith argued that we are able to imagine
what others are going through; we are able to
understand with the sufferings of others.
• We feel pain when we see the pain of others.
• We can act to reduce the pain of others in
order to reduce our own discomfort, if
nothing else.
• So, it is perfectly consistent to believe that
human beings pursue self-interest and are
generous towards others.
Passions, bias, moral rules
• Sometimes our passions cause us to do bad
things.
• We have an instinctive tendency to defend
ourselves even when we know that we did
something bad.
• This leads to a bias that prevents us from
seeing that we did something bad.
• This problem is partially corrected by the wide
acceptance of moral rules in a society.
• When the moral rules are clear cut, a misdeed
may so clearly violate a moral rule that it
might be impossible even for the perpetrator
to deny the misdeed, bias notwithstanding.
Laws
• At times, even moral rules may not be enough
to keep society together
• In that case, laws and the enforcement of
those laws would be necessary to keep society
together.
• However, unlike Hobbes and Rousseau, Smith
did not believe that, in the absence of a
structure of laws, society would inevitably fall
down to disorder.
The Wealth of Nations
 Wealth of Nations

• The causes of economic progress and the creation

of wealth was Adam Smith’s main topic of interest
– David Ricardo, by contrast, focused on how wealth is
shared among different groups in society
• According to Smith, the wealth of a nation derives
from the level of the technology in use.
• The level of technology and its rate of
improvement depend on the division of labor.
• According to smith ‘the political economy is
an inquiry into the nature and causes of
wealth of nations’
• In his book he tells that wealth of nation can
be increased by the division of labour.
• Smith discussed three reasons why a greater
division of labor may increase productivity.
– Practice makes perfect
– Less waste of time between tasks
– More mechanization
Division of labor, extent of the market, economic
progress
• The division of labor is determined by the extent of
the market.
• This creates the possibility of an ever-expanding
economy.
– For example, if the extent of the market increases—perhaps
because of an expansion of trade within the country or with
another country—there will be greater division of labor, which
will lead to improvements in the level of technology, which will
lead to greater national income, which will lead to another
increase in the extent of the market, which will lead to another
increase in the division of labor, which will lead to another
increase in the level of technology, and so on and on.
• Labour is the main source of wealth of nation.
• After saying that labour is the source of wealth,
smith makes the point that division of labour will
increase the productivity of labour and thereby the
wealth of nation.
• Division of labour refers to the specialization of
labour in different industries or different process
with in the industry.
• In his famous example of Pin making industry
• “one man draws out the wire; another
straightens it, a third cuts it, a forth points it
………..and the important business of making
pin in this manner divided it into eighteen
distinct operations.”
• If one man performed all the above
operations he will produce one pin or so in
day.
• but on the other hand division of labour was
practices then the average production of each
man was 4800 pins.
• According to him the division of labour is
limited by the size of the market.
• In those industries which produce goods for
international market, there will be great scope
for division of labour.
• Division of labour has the following advantages.
• 1) Increased output:
• Division of labour will increased the output per
worker, as he described in his example of pin
industry.
• 2) Increase in skill of labour:
• By doing the same kind of work, labour gets a great
skill in his particular line.
• 3) saving in Time:
• By practicing the same kind of work, labour get
specialization in his field, so he takes less in order to
produce the same thing.
• 4) Introduction of machinery
• It smooth the way for introduction of machinery. In
other words, division of labour is the mother of
invention.
• Smith was not aware of disadvantages of division
of labour.
1) For instance , extreme division of labour will
leads monotony of work.
2) A worker by doing the same type of work
again and again would find no pleasure in his
work.
3) Division of labour will also cause immobility
of labour. And there will be greater risk of
unemployment in times of bad trade.
Division of labor and capital
• Division of labor is enabled by capital
• In a backward, agricultural economy, people
produce, on a regular basis, the simple things
they need.
• When workers specialize in the production of
more complex goods, production may take time
• The worker can be sustained during the lengthy
production period only when capitalists can
make loans
• In this way, the accumulation of additional
capital enables additional division of labor
• Division of labour necessitates exchange. This
leads onto the discussion of money as means
of exchange and to the value.
• After discussing the problem of value and
price in his book, smith discuses the problem
of wages, profit and rent.
• Then he criticized the mercantilist and
Physiocrats.
Luxury spending not crucial
• Earlier writers had argued that the growth of
an economy depended heavily on the luxury
spending by the rich; the poor consumed just
the bare necessities and, therefore, more
would not be produced unless the rich would
buy the extra output.
• Smith argued that this idea was false.
– If the rich saved any money they would lend it to
businessmen (to earn interest).
– The businessmen would borrow the money and
spend it on capital equipment.

– Therefore, all income would be spent and all

production would be purchased.

– There was no need to encourage luxury spending.

– In fact, the more the rich saved the greater would

be the level of investment by businesses and the
faster would be the rate of growth.
Free Trade
• Smith was in favor of free trade.
• He derived his support for free trade among
nations by basing it on the obvious desirability
of trade among individuals:
– "It is the maxim of every prudent master of a
family, never to attempt to make at home what it
will cost him more to make than to buy".
• According to Smith, free trade expands the
extent of the market and, thereby, allows
greater division of labor
• Further he was a great favour of free trade, he
prefer two kinds of protectionist tariff.
1) Those tariff that protect the domestic
industry essential to the defense of the
country.
2) those who equalize the tax burden on the
particular domestic industry by imposing
tariff on import of that goods.
• Smith also suggest that free trade is to be
introduced in a country after a long period of
protectionism, it should be done gradually in
order to avoid unemployment.
• Value
• According to Smith , there are two kinds of value
i) value in use
Ii) value in exchange.
• The first one expresses the utility of some
particular object and second one refers to the
power of purchasing other goods.
• For example, nothing is more useful as water but it
has little value in exchange.
• On the other hand diamond has little value in use
but greater value in exchange.
• Smith believed that the labour is the main
source of value. According to him the value of
things depend on amount of labour employed
in the production.
• Smith make the distinction between the
natural price and market price.
• ‘when the price just cover the ordinary rate of
rent , wages and profits expended in preparing
and marketing the commodity, its sells at its
natural price.’
• ‘The market price may be below or above this,
depending upon the supply actually on the
market and the effectual demand-------- the
demand of those who are willing to pay the
natural price.’
 Theory of value
• Smith used different theories of value at
different points in the Wealth of Nations
• His discussion is at times contradictory
 Theory of value: labor
• For primitive economies sustained by hunting
and fishing, Smith adopted the Labor Theory
of Value
– This was adopted by Classical economists such as
Smith, Malthus and Ricardo.
– But even in such a case, there is no standard unit
of labor. The hardship and cleverness involved can
vary from task to task
• Some criticism of the labor theory of value:
• There is difficulty in measuring labor or cost of
production. Smith used time as his measuring
rod. But all workmen are not of equal efficiency.
So less skilled may take longer than the skilled
labor. So more labor put into more production.
• Misdirect labor can not have value. If labor is
incapable of fulfilling the purpose for which it
was intended can have no value.
• It fails to explain the value of rare things. Such as
work of art or antiques. It is the great weakness
of any theory of value, if it dose not explain the
value of all the things.
 Theory of value: unit cost
• When analyzing the industrialized economy of
the Great Britain of his time, Smith thought of the
‘natural price’ (or, long run price) of a product as
the cost of all resources used in production
• Cost includes wages (payment for labor), rent
(for land), and profit (for the capital of the
entrepreneur).
• Note: price = unit cost does not mean profits =
zero; it only means supernormal profits = zero.
• Profit is what the entrepreneur gets for risk-
taking
• As workers need to be paid even if the output is not
ready for sale, the entrepreneur is essentially a
money lender to the workers. Therefore, profit also
includes what we call interest today
• From today's point of view the classical theory of
value, which denies the influence of demand and
identifies production cost as the only influence on
prices, has some validity in the long run but is not
useful for short run analysis.
 Prices signal opportunity
• In Smith’s view of the workings of the market
system, any short-run deviation of the market
price from the long-run price would trigger
the forces of competition—by which Smith
meant profit-seeking entry and loss-avoiding
exit—which would eventually take the market
price to its long-run level.
 Wages: Iron Law of Wages
• Smith used different theories of the wage rate
at different times
• One was a form of the Iron Law of Wages
– This theory held that wages are by and large equal
to the subsistence level of wages.
– If wages exceed the level that is just enough to
keep the worker and his dependents alive, there
will be an increase in population that will drive
wages down to the subsistence level.
 -If wages fall below what the workers need to stay
alive, population will fall and wages will rise to
the subsistence level.

• This meant that any increase in total output

went not to the workers but to capitalists who
would save and invest in machinery that
would make possible further division of labor
and technological progress.
 Wages: bargaining
• The wage rate depends on the bargaining power
of workers and businesses
• Employers can plan with greater ease because
employees are numerous
• In Great Britain at Smith’s time, employers’
agreement was allowed but unions were not.
There were laws against raising wages, but none
against lowering them
• It is clear that Smith had a very complex view of
the nature of a market economy
 Rent
• Smith had multiple theories of rent, some of them
contradictory
• Smith thought of rent as a residual that is leftover
after wages and profits had been paid out of total
output.
• Wages would be reduced to the subsistence level, as
we saw before.
• Competition would gradually reduce the rate of profit
to a low level that would also be uniform across all
industries.
• Therefore, only those who earn rent income would
benefit from progress.
• Smith has given a number of explanations for
rent.
• At one place he describes it as monopoly
price. At other time, when he discusses the
commodity prices, he includes the rent of land
as an element of cost and therefore a
determinant of the product price.
• In some other context, he tells that rent is
determined by the prices.
• He considers that high or low rent is the
effect of high or low product price.
• Smith was not disposed favorably to land lord
as a class.
 Falling rate of profit
• Economic progress depends on profits
• But Smith believed that the rate of profits
would fall over time, because of competition
among capitalists
• This implied a slowing rate of growth over
time
 Profit and interest:
• Smith was of the opinion that wages and profit
moves in opposite direction.
• As more and more capital is accumulated, the
mutual competition among the owner of capital for
investment in the same trade will tend to lower its
profit.
• However smith made certain exception to the statement
that wages and profit moves in opposite direction.
• For instance in new colonies both wages and profit may be
high and in “stationary state” both wages and profit may
be low.
• According to smith, interest is the
‘compensation which the borrower pays to
the lender, for the profit which has an
opportunity of making by the use of money.’
• He believed that interest could vary with
profit.
 The Invisible Hand
• Smith's argument that the pursuit of self-
interest can lead to a socially efficient
outcome is the crowning beauty of the Wealth
of Nations.
 The Invisible Hand
• “[E]very individual … generally, indeed,
neither intends to promote the public interest,
nor knows how much he is promoting it. … he
intends only his own gain, and he is in this, as
in many other cases, led by an invisible hand
to promote an end which was no part of his
intention. …”
 The Invisible Hand
• Consumer sovereignty and business
competition are the key components of
Smith’s argument that the pursuit of individual
self interest leads to an excellent social
outcome
• Consumer sovereignty ensures that consumer
needs determine what gets produced
• Business competition ensures that prices are
driven down to unit cost
• Thus, without any government control, the
most beneficial goods get produced, and at
the lowest possible price
 Competition is key

• Smith was doubtful of businessmen

– He believed that, given the chance, businessmen
would do anything to reduce competition among
themselves and then form a group to gang up on
consumers and charge them more than the
competitive price.
• In this sense, Smith may be considered a
pioneer of the modern economic approach to
the politics of lobbying.
• Capital:
• Smith has realized the importance of role of
capital in the economic development of a nation.
• He was aware of the fact that the capital
accumulation is essential for the Industrial
development of a nation.
• In his book he mentioned that capital appears in
three forms:
– As an instrument of production.
– As a source of revenue
– As a fund maintaining the workmen.
• Further smith has classified capital into three
portions.
1) the first portion is used for immediate
consumption, , it affords no revenue or profit (e.g.
stock of food, clothes etc.)
2) The second portion is fixed capital which affords a
revenue or profit without circulating or changing
masters (e.g. machines, improvement of land etc.)
3) The third portion is circulating capital, which affords
a revenue, only by circulating or changing masters
(e.g. money, material, complete work in hands of
merchant or manufacturer which are not yet
dispose of)
• Smith believed that income which is not
consumed become the investment.
• In other words , as “an act of saving at once
become an act of investment, saving is equal
to investment”
• He did not pay much attention to the problem
of hoarding.
• We should also remember that Smith was in
the favour of labour intensive investment
during the development process.
• The role of Money
• Classical economist in general de-emphasize
the importance of money.
• It was Adam Smith who had established this
tradition.
• Infact he attacked the mercantilist mainly
because they over-emphasized the role of
money.
• According to Smith, a nation’s true wealth
consist ‘not only in its gold and silver, but in its
land, houses and consumables goods of all
different kinds’
• Money only serve as a instrument for the
circulation of the wealth and for the
measurement of value.
• Money does not add to the revenue of the
society.
• But it is the ‘great wheel of circulation’.
• It facilitate the circulation of goods and it is
the production of goods that makes up the
revenue.
• Smith believed that paper money was
preferable to gold and silver. For the paper
money required much less effort to produce.
• Laissez- fair and the harmony of Interest
• Smith believed in the natural organization of
economic order under the influence of personal
interest.
• He was greater advocate of Laissez fair---- non
intervention by govt, in business.
• According to him Govt, are wasteful, corrupt
and incompetence.
• He believed that individual was led by ‘an
invisible hand’ to do good for the society. In
other words he believed that the interest s of
the individuals coincide with the interest of
society.
• Smith advocate the free trade.
• He believed that free foreign trade would
promote greater division of labour.
• While the mercantilists believed that each
nation enriched itself at the expense of its
neighbor.
• Smith believed in an international harmony of
interests: ‘the wealth of neighboring nation,
however, though dangerous in wars and
politics , is certainly advantageous in trade…..
• As a rich man is likely to be better customer to
the industrious people in his neighborhood ,
than a poor, so is likewise a rich nation.’
• Role of Govt.
• Smith advocate the minimum role for the
state in economic affairs.
• He believed that state could perform the
following three major functions.
1) To protect society from foreign attack.
2) To establish the administration of justice within
the country.
3) To erect and maintain the public works and
institutions that private entrepreneur cannot
undertake privately.
• He justified legal control over the interest rates,
state administration of Post Office, control over
the issues of paper money by bankers, compulsory
elementary education etc.
•
• Canons of Taxation
• Smith recommended taxation to finance govt.
activities.
• He has laid down some rules for a good tax
system. They are known as canons of taxation.
1) Canon of equity:
It is bases on the principles of justice and ability
to pay. He tells that people should pay taxes
according to their respective abilities.
2) Canon of Certainty
there must be certainty about the tax which an
individual has to pay .
• Things like the time payment, the manner of
payment and the quantity to be paid should be
plain and clear to tax player. A tax should not be
arbitrary.
3) Canon of convenience:
A tax should be levied in such a manner that it is
convenient for the tax payer to pay it.
4) Canon of Economy:
Taxes should be collected at minimum cost to
the government.
• Q #1 which school of thought emphasis on
capitalism.
• Ans: physiocrates