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The Classical Background

The Classical Background. “Classical Economics” 1776-1870s: Adam Smith, David Ricardo, J. S. Mill Concerned with issues of long run growth and of maintaining growth Consequences of growth for distribution of income

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The Classical Background

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  1. The Classical Background • “Classical Economics” 1776-1870s: Adam Smith, David Ricardo, J. S. Mill • Concerned with issues of long run growth and of maintaining growth • Consequences of growth for distribution of income • Policy concern with removing barriers to growth created by unwise government legislation

  2. Major Components of Classical Economics • Theory of exchange value based on labour time or cost of production. • Water diamond paradox; use values not comparable. • Theory of Natural and Market Price and adjustment to Natural Price • Wage Fund Theory of Labour Demand • Population theory of labour supply and the subsistence wage

  3. Major Components of Classical Economics • Theory of Rent and diminishing returns in agriculture • Ricardo’s corn model of falling rate of profit and eventual stationary state • Say’s Law • Tendency to equilibrium at full employment • Monetary factors as disturbing causes • Theory of gains from trade • Comparative advantage • Terms of trade

  4. Challenges to Classicism:Internal Weaknesses • Theory of exchange value • Problems of cost side theories • J. S. Mill—cost of production of the most costly portion • Wage Fund Theory • J. S. Mill’s “recantation” of the wage fund theory • New Issues • Economies of scale and growth of industry • Business Cycles

  5. Challenges to Classicism:German Historicism • Reaction against the non-historical nature of Ricardian economics • Different principles apply to different times and places • Evolutionary and theories of economic stages • Organic analogies • Importance of institutions, law, and ethics

  6. German Historicism • National policy and role of the state • Historicism a major influence in Germany, America, and to a lesser extent in England • Historicism was a major influence from 1860-1880s • Economic History, empirical studies, social reform

  7. Challenges to Classicism:Marxism • Marx used the labour theory of value to argue that profit came from the exploitation of labour • Labour was paid less than the value of its output • Elements of Classical economics used to cast a very negative light on capitalism • Marxism became influential in the 1880s, Socialist parties, labour unrest

  8. Challenges to Classicism:Romanticism • The “romantic” critics of economics included Carlye and Ruskin • Saw economics as concerned only with material ends and not with anything “higher” or more spiritual--a narrow economic man • Concerned only with market valuations • Carlye and Mill and the “dismal science”

  9. New Techniques: Forerunners of the Marginal Revolution • Marginalist ideas and analysis were being developed in Europe well before 1870 and the Marginal Revolution • Daniel Bernoulli (1700-1782) • Diminishing MU of income and the analysis of expected utility • William Gossen (1810-1854) • Gossen’s “First Law”: law of satiable wants. Implies diminishing MU • Gossen’s “Second Law” conditions for a utility maximum

  10. Forerunners of the Marginal Revolution: Dupuit • Jules Dupuit (1804-1866) • Measurement of the utility of public works • Different people have different valuations of a good • Willingness to pay and consumer’s surplus • Setting of tolls to finance public utilities

  11. Dupuit P Consumer’s surplus P Willingness to pay Q Q Toll T x Q = cost of project CS = benefit CS T Q Q

  12. Forerunners of the Marginal Revolution: Cournot • Augustin Cournot (1801-1877) • Early pioneer of the mathematical approach • Law of demand expressed as a general mathematical function: D=F(P) • D varies inversely with P • Continuous function • Analysis of monopoly, marginal revenue and profit maximization

  13. Cournot • Cournot’s analysis of duopoly • Each firm sets an output given the output of the other • Reaction functions leading to an equilibrium • Cournot equilibrium is where each firm is doing the best it can given the other firm’s output • Example of two mineral springs with zero production costs • Market demand function P=100-Y where Y is total output of both firms • Profit for firm 1 = PxQ1 • or Q1(100-Q1-Q2) • Profit for firm 2 = Q2(100-Q1-Q2)

  14. Cournot P 100 50 MR D 50 100 Monopoly solution: Q1=50; P=50; Profit=250 If second firm enters and takes Q1 as given It will produce where it max Q2(100-50-Q2) Which is at Q2=25. Given Q2=25 firm 1 will adjust in order to max Q1(100-Q1-25)= 37.5 These reactions continue until an equilibrium is reached

  15. Cournot Reaction functions and Cournot equilibrium Q2 100 Q1 given Q2 50 Cournot equilibrium 33.3 Q2 given Q1 33.3 50 100 Q1

  16. Reasons for the Marginal Revolution • Decay of Classical economics • New techniques of marginal analysis • An answer to Romanticism • Utility maximization can accommodate ends other than purely material ones • An answer to Historicism • Menger and the “Methodenstreit” • An answer to Marx • Marginal productivity theory • Analogy to physics and use of calculus

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