EVOLUTION OF ECONOMIC THOUGHT
Dr. J.S. AMARNATH, Ph. D.
DEPATMENT OF AGRICULTURAL ECONOMICS
TAMIL NADU AGRICULTURAL UNIVERSITY
AGRICULTURAL COLLEGE AND RESEARCH INSTITUTE, MADURAI
LEC.NO. TOPIC PAGE. NO.
I. APPROACHES TO THE STUDY OF HISTORY OF
II. ANCIENT AND MEDIEVAL ECONOMIC THOUGHT 8
III. THE PHYSIOCRATS 12
IV. MERCANTILISM 16
V. FORERUNNERS OF CLASSICAL POLITICAL ECONOMY 20
VI. ADAM SMITH 25
VII. DAVID RICARDO 29
VIII. THOMAS ROBERT MALTHUS 33
IX. HISTORICAL CRITICS 37
X. SOCIALISTIC ECONOMIC THOUGHT 46
XI. KARL MARX 52
XII. ORIGINS OF FORMAL MICRO ECONOMIC ANALYSIS 58
XIII. NEOCLASSICAL SCHOOL 63
XIV. WALRAS 68
XV. WELFARE ECONOMICS 72
XVI. J.M. KEYNES 77
XVII. INDIAN ECONOMIC THOUGHT 95
XVIII. ECONOMIC DEVELOPMENT THEORIES 101
XIX. GLOBALISATION 111
XX. INTERNATIONAL INSTITUTIONS 129
XXI. STRUCTURAL ADJUSTMENT PROGRAMMES 162
APPROACHES TO THE STUDY OF HISTORY OF ECONOMIC THOUGHT
History of economic thought deals with the origin and development of economic ideas. It provides a
historical amount of how people viewed and understood the economic facts and tendencies. It also deals
with history of attempts to understand the orderly working of the market economy. As structure of the
economics changes over time, theorists used different analytical methods and tools.
HISTORY OF ECONOMIC THOUGHT AND ECNOMIC HISTORY
Economic history concerns itself with the history of commerce, manufacture and other economic
phenomena dealing objectively with the ways in which men get their living or it is the chronological study
of objective economic phenomena. On the other hand, history of economic thought deals with the ideas
men have concerning economic facts and forces or it deals with history of objective ideas regarding the
There also exists a close relationship between history of economic thought and economic history.
Men’s economic ideas are largely influenced or determined by the economic conditions in which he lives.
But this relationship is reciprocal. The history of economic thought then is an essential part of general
history, both explaining it and being explained by it.
HISTORY OF ECONOMIC THOUGHT AND HISTORY OF ECONOMIC ANALYSIS
Schumpeter made a distinction between history of economic thought and history of economic
analysis. History of economic thought is the history of sum total of all opinions and desires concerning
economic subjects especially concerning public policy bearing upon these subjects that, at any give time
and place, float in public mind. It is an attempt to
a. Trace out the historical change of attitudes
b. Display the close association that exists with in the attitudes of the public mind
c. From the general attitude or spirit in which they approach their problems.
History of economic analysis or economic science is the history of intellectual efforts that men have
made to understand the economic phenomena or it is the history of the analytic or scientific aspects of
economic thought. Historians of economic thought because of his interest in changing attitudes towards
public policy cannot speak of progress or regress in economics. On the other hand, the historian of
economic analysis, who is primary concerned with increasing command of economic facts and interested in
development of analytical ideas, can say whether there is scientific progress in economics or not.
METHODOLOGICAL APPROACHES TO ECONOMICS THOUGHT
The Relativist approach
Each economic theory is a true reflection of the conditions in which it is born. Their view is that the
economic ideas are influenced by personal attitudes and motives of the thinkers on one hand and by the
social, economic and political conditions in which the thinker lives on the other hand. These ideas cannot
be understood until seen in their respective historical background. Stark says that economic theories simply
reflect the contemporary conditions and Roger says economic theory should be judged form its policy
implications designed to solve practical problems.
The Absolutist approach
History of economics exhibits a progression of thought form error to truth. It is related to the
scientific progress or to the development of analytical methods and tools for having a better understanding
of economic phenomena. Schumpeter, Mark Blaug, Robert B. Ekelund and Robert F. Hebert held absolutist
positions. Adam Smith had a faint idea of independent decisions of buyers and sellers coordinated through
market mechanism. It took a century for economists like Walrus and Marshall to show a fundamental
relationship between demand and price or between supply and price.
Relativists recognized the historical aspect and absolutists considered the analytical aspect.
Absolutions wanted to see how the science of economics has progressed, or how far it succeeded in
understanding the working of economic system. Relativists pointed out that ideas are fused with attitudinal
bases and affected by the socio- economic conditions.
Therefore the task of historian of economic thought is to
a. to fully recognize the historical significance of political and ideological influences
b. to separate economic theory from these influences
c. to put economic theory to scientific tests of validity
INFLUENCES ON ECONOMIC THOUGHT
No economic idea has emerged in a vacuum; that the motives and circumstances played a crucial
role in determining the nature of economic history.
1. Philosophical basis
Laws of nature rule materialist views that matter exist independent of mind and mental as well as
physical worlds. Men are naturally equal and act in similar manner. Based on this, English classical or
materialistic economics developed with individualistic and laissez – faire tendencies, which believed in
natural law and opposed to man – made institutions.
Idealist regards man or mind as independent of matter and not as product of matter. Believed that
men are the creator of his own destiny and could be improved through institutions. Institutional Economists
who advocated the achievement of socio-economic ideals by direct social planning and control were
influenced by philosophy of idealism.
2. Method of analysis
Classical political economists employed in deductive or abstract method of analysis. Historical
economists interested in inductive- historical research. Marshall and Austrians combined deduction and
induction in economic analysis.
3. Political bias
Theories have been formulated to achieve political objectives like general welfare, population
optimum, right or just or equitable distribution of taxation. All economic terms like principle, productivity,
equilibrium, balance and adjustment are discussed in double meaning of what is and what ought to be.
4. Metaphysical formation
Doctrines of economics are based on metaphysical assumptions and describe ideology of each
period. Such statement neither gives scientific intent or factual information. It reflects attitude of mind,
certain political sympathies or moral values and has power to influence public opinion and human conduct
in piratical life. Concepts of natural harmony and greatest good of greatest number are based on
metaphysical concepts. In actual life, it provides slogans for a particular class of society and implies
policies benefiting that class.
Physiocratic theory of ‘net product’ describes surplus produce over peasant’s consumption is due to
exclusive productivity of land. Similarly classical concepts of value and neoclassical concept of utility are
5. Existing theories
New advances in economic science depend on existing theories. No economic theory appeared in
isolation and there exists a degree of continuity in evolution of economic science. Adam Smith’s wealth of
nations came against mercantilism. Marx critique of capitalism grew out of classical political economy.
Similarly, neo-classical paradigm appeared as a result of failure of classical paradigm. Similarly Keynesian
paradigm emerged when classical mid neo-classical solution failed to show contemporary problems.
6. Socio – economic environment
It deals with casual relation between economic theory and practice. Economic structure, institutional
arrangements, relation between social classes and groups determine economic thinking of a particular
7. Practical problems
Practical problems of a particular period have gone a long way in influencing the economic thinking
of that period. In first half of 19th century, macroeconomic problem of economic growth preoccupied the
classical political economists’ .In second half of 19th century, micro economic problem of optimum
allocation of scarce resources dominated the neoclassical era. Macroeconomic problem of employment led
to Keynesian revolution in 20th century
IMPORTANCE OF HISTORY OF ECONOMIC THOUGHT
Schumpeter pointed out three gains from the study of history
1. Pedagogical advantage
Any study without historical background lacks direction and meaning.
2. New ideas
From history of science, we derive inspirations and widen our intellectual horizons. We also learn
many useful lessons of life facility and fertility controversies, wasted efforts and blind alleys and about
spells of arrested growth. We learn what succeeds and why.
3. Insight into the ways of the human mind
It provides insights into how men were able to analyze the economic problems over time. It displays
logic in concrete, logic in action and logic to vision and to purpose.
Haley presents the following agreements for the study of history of economic thought.
1. Continuity in economic thought
The study revealed that there exists continuity in economic thinking of men form the ancient times
to this day. Economic ideas of a particular age are not product of that very age but roots lie in the literature
of earlier times.
2. Understanding the nature and origin of economics
Economics concerned with man’s efforts to earn his livelihood in association with his fellow beings.
In this effort, political motives, ethical ideas, acetic judgments and other influences affect man. Thus all
social sciences are interrelated and economic is an inseparable part of the group of social sciences.
3. The Relativist attitude
Men not judge economic ideas with dogmatic absolutism and declare them good or bad. On the
contrary, he adopts a realistic attitude that economic ideas are to be examined in the light of times and
conditions in which they originate.
4. Broad basis for comparison
The study provides a basis for comparison. After the study, the student feels his judgment
broadened, and have a well – balanced and reasonable conservatism or a wise progressivism.
5. Objective point of view
Economic as a science is a body of laws or generalizations, which does not belong to one economist
not to any specific time or place but the result of the efforts of so many economists living in different
periods and conditions. Therefore the task of economic scientist is to separate economics from the
economist and study it objectively.
ANCIENT AND MEDIEVAL ECONOMIC THOUGHT
ANCIENT ECONOMIC THOUGHT
Nature and Significance
During ancient period, wants were few and simple. Food, clothing and shelter were their essential
wants. The community owned property. Barter was the rule. There was no much economic activity and
society was custom bound and tradition oriented. No independent economic theories were found and for
example, usury prohibited not on economical grounds but on ethical grounds. Early thinkers did not realize
the dignity of labor. Production was carried on mainly for consumption and they lived as self – sufficient
units. Significance is that study is rewarding because it gives the readers the origin of science, its
development and environment under which the science developed.
1. THE HEBREW ECONOMIC THOUGHT (2500 B.C.)
Economic philosophy is simple. Economic, political, ethical and philosophical ideas were
intertwined. Common man life was regulated by code of conduct of priestly class. Their philosophy was
characterized by lack of individualism and materialism and static ideals dominated.
1. Usury (interest)
Hebrew prophets thought it is unethical to charge high interest rate on loans borrowed by the poor.
2. Commerce and just price
To safeguard the interests of the poor, laws were passed against adulteration and false weights and
measures. Legislation was there to curb monopoly and export of food articles was forbidden. Hoarding of
food grains was not permitted and ceiling put on profit margin of retailers
3. Labor Realized the dignity of labors especially agriculture and payment was made in kind.
4. Agriculture and industry: Agriculture was the main occupation of Hebrews and held in high esteem.
Commerce and crafts were not in held high esteem.
5. The seventh year
Hebrews observed seventh year or sabbatical year. They left the land fallow in seventh year after
tilling for six years to conserve the soil fertility. Likewise, they extended this institution of seventh year to
slaves and loans.
6. The Jubilee year
Land sold to someone revert to its owner in 50th year. They were interested in good life, just state
and happy man. Word economics is of Greek origin and meant management of household.
Plato (427 – 347 B.C) and Aristotle (384-322 B.C) were the two great thinkers of ancient
I. Plato (427-347 B.C)
Main achievement is division of labor and origin of city – state is found in Republic and laws.
Origin of city – state and division of labor
Inequalities in human beings resulted in division of labor, which is the basis of social organization.
City – state is built on division of labor. Adam smith said specialization results in improvement in
productivity, advantageous to practicing people and explained it as cause of wealth of nations.
The Ideal State has constant number of citizens with 5040 citizens because it is administratively
convenient. Since it is divisible by all numbers up to 10, they know each other. Ruler is an ideal one with 2
classes of rules or guardians and auxiliaries and latter, the artisans. Members of the ruling class, if pass the
examination became the philosopher kings or otherwise, remain auxiliaries (soldiers). Plato believed in rule
by elite and suggested a communistic way of life, for this elite group. Elites should not have any private
property and family.
Money, interest and trade
Supported aristocratic class and didn’t question slavery. He considered money as a symbol devised
for the purpose of facilitating exchange. Citizens should not possess gold and silver and only should have
money. Foreign trade is controlled and retail trade is forbidden.
II. Aristotle (384 – 322 B.C)
Aristotle laid down the foundations of science of economics but justified slavery. He was the first
analytical economist. State, family and village originate in bare needs of life. Aristotle, in his book
‘Politics’ attacked communistic elements of Plato and supported the institution of family and private
property and justified slavery. Rulers are classified into military class, statesman, magistrates and priests.
Aristotle’s private property is superior to Plato’s communal property based on five grounds of progress,
peace, pleasure, practice and philanthropy.
1. The scope of economics means management of the household and divided into 2 parts of
a. Economy proper which deals with management of household and deals with development of city –
state from village and household
b. Science of supply, which is concerned with art of acquisition and deals with exchange through with
needs of the household, are met.
Distinguished natural exchange at satisfaction of men’s natural wants and unnatural as the exchange
for monetary gain. Thus he distinguished value – in use and value in exchange.
Distinguished money as measure of value and store of value and he condemned interest.
II. THE ROMAN THOUGHT
Roman economic ideas were borrowed from Greece. Roman philosophers regarded money lending
as a big crime. Seneca said money is the root of most evils. Pliny has condemned gold. In agriculture, they
favored small farm.
Roman law is the richest legacy of Rome to the world and plays an important role in the history of
economic analysis. Roman law dealt with institution of private property, which is absolute, and contracts
including the right of the individual to dispose the property. Law was divorced from religion. Corporate
assets were separated from owners of the corporation. Contribution was also made on price, money and
MEDIEVAL ECONOMIC THOUGHT
Middle ages were described as a feudal system. People enjoyed status according to ranks. Medieval
life was commercial and cooperative in character. There were merchant guilds and craft guilds for mutual
benefit and protection of members and for regulation of trade. Actual volume of trade is small.
The church, the Bible and Aristotle exercised influence on the economic thought.
1. Taught the universal brotherhood of man and slavery as a sinful institution
2. Life in this world is a preparation for another and so aim is salvation
3. Taught dignity of labor.
Just price and prohibition of usury were the 2 economic ideas of middle ages.
St. Thomas Aquinas (1225 – 1274)
Economic ideas find in his book Summa Theologica and based on Bible and Aristotle.
Private property is shared and regulated by sabbatical and Jubilee year. Property is private in possession
and common in use. Advocated charity and permitted theft in extreme cases.
Trade justified moderate profit on grounds of support and charity.
A fair-minded person determines just price and in exchange, it is to the common advantage of buyer and
seller. There was price regulation of many commodities.
Usury prohibited especially for consumption. Interest allowed if lender is suffered damage, lost an
opportunity to gain, borrower failed to repay and lastly if risk is involved.
Physiocracy means ‘Rule of Nature’ and physiocrats developed economic theory in France in
eighteenth century. Though they wrote for short period, their ideas had profound influence on economic
thought. Quesney was the founder of Physiocratic School.
The factor which gave rise to Physiocracy
1. Neglect of agriculture and governmental regulation of industry was taking place in France.
2. Tax system was corrupt, in efficient and unjust. Nobles and clergy, who owned two-thirds of land
exempted from direct taxation.
3. Unnecessary wars and luxurious life made government bankrupt.
4. Nobles exploited French peasants as land owners took large share of the produce, heavy taxes of
government, and market was also restricted because mercantilist policies in favor of manufactured
5. Economic situation in Britain was favorable as compared to France since agricultural revolution was
taking place in England.
6. Economic thinking indicated the importance of individual and liberty.
Main ideas of physiocrats
1. Natural order
Physiocracy described as a ‘Science of the natural order’. Society is governed by laws of nature is
an ideal society. They believed god and considered the natural order the work of god. Natural order will
increase the happiness of mankind. Prosperity, severity and liberty formed the basis of social order. They
are not interested in the concept of equality. They believed in interdependence of classes and financial
dependence upon nature. Government has minimum functions and restricted to protecting life and property.
They advocated laissez – faire. Individual interests are identical with the society.
2. Laissez- faire
This concept is opposed to government restrictions. Government functions are limited to protecting
life, liberty and property and there is lot of scope for individual efforts.
3. Net product
This considered agriculture as the productive occupation as it produced a surplus, a net product
above the costs of production. Industry, trade and profession were useful but sterile as it reproduced the
value consumed in the form of raw materials and subsistence for workers. Labor engaged in agriculture is
productive and in all occupations, is unproductive. God gave fruits of earth and man brought products of
4. The circulation of wealth
Flow of income through society is found in Quesnay’s Tableau Economique (The Economic Table),
which is a graphic representation of the way in which circulation of wealth takes place. Physiocratic system
of division of society into three classes of productive class comprising farmers who pay rent to land lords,
proprietary class including landlord and king and sterile class engaged in non – agricultural occupations of
merchants, artisans, and domestic servants.
Value of production = 5 million francs
Farmers requirement for maintenance = 2 million francs
Manufacturers purchase from sterile class = 1 million francs
Pass to landowners and government in form of = 2 million francs
Rent and taxes (and spend one million for food and one million for manufacture)
Sterile class uses 2 million francs for buying necessaries of life and raw materials for industries
from agriculturists and hence it returns to productive class. The cycle is complete.
The problem of value was not treated in a systematic way. When manufactured goods are
exchanged, only equivalents were exchanged and no profit could arise
They believed in private property. Aim is to bring lands under cultivation, dispose wealth in interest
of society, workers not exploited, tenants are protected and bear burden of taxation.
INFLUENCE OF PHYSIOCRATS ON APPLIED ECONOMICS
1. Trade: Physiocrats viewed exchange as unproductive. Mercantilists’ advocated favorable balance
of trade and physiocrats favored free trade. Foreign trade produced no wealth and countries get
goods from other countries, which it cannot itself, produce and so foreign trade is considered as a
necessary evil. They believed in free trade as with free competition, best possible price is secured
which lead to increased wealth and maintain population in agriculture.
2. Function of the state
Physiocrats wanted minimum of legislation with a maximum of authority. Duty of the state is to
preserve natural order, to protect private property and foundation of that order.
Physiocrats advocated a single tax system. One third of net product was to be paid in taxes. They
favored direct taxation.
Representatives of physiocratic school
1. Quesnay (1694- 1774)
Natural order, net product, circulation of wealth and single tax system are his ideas in article on
farmers (1756), grains (1757) and the Tableau Economique (1753-1958).
2. Turgot (1727-1781)
Advocate of laissez – faire in Reflexions (1769). Individuals know his interest is best. Emphasized
agricultural productivity and did not regard property as private institution.
He regarded value as foundation of science of economics. He laid foundation of marginal school as
value increases with scarcity and diminishes with plenty. Viewed production means giving new form to
matter. He didn’t believe in Iron law of wages like wages equal to his subsistence but wage is a share of
product, which is due to the workers as co-partners.
Critical estimate of physiocrats
Pre-occupied with gold Laid emphasis on real wealth
in form of raw produce
Maximum exports and minimum
imports for favorable balance of
Foreign trade as a necessary
Believed regulation of trade and
Freedom of trade and industry.
Physiocrats ignored commerce and industry, which is equally productive as agriculture. Production
as creation of utilities is not understood. Regarded manufacture as unproductive, which is erroneous.
Erroneous classification of labor into productive and unproductive labor whether labors resulted in
production of material or immaterial goods. There was absence of any reference to value. Regarded land as
only source of wealth as it yielded a net product. So landed proprietors bear taxation, which is against
agricultural class. Faculty in theory of distribution as rent is a free gift of nature but rent is because of
1. Put economics on scientific basis and regarded as founders of political economy.
2. Economic development is promoted by transforming traditional to large-scale agriculture.
3. Realized capital formation in economic development.
4. Advocated single tax an agriculture
5. Circulation of wealth among different classes
6. Government does minimum function of life, liberty and property.
7. Opposed all obstacles to economic development in advocating laissez-faire
Meaning of physiocracy for under developed countries.
1. Emphasis on agriculture for economic development is applicable for India but industrial
development should take place side by side.
2. For mobilization of resources, direct as well as indirect taxation is required as against the
physiocratic view of agriculture alone.
3. Believed in competition and opposed monopoly in all its forms. Competition would result in best set
4. Not giving importance to external relations may be correct when country is self – sufficient but
India reached self-sufficiency now only.
5. Physiocrats recommended increase of agricultural output and net product and not increase of
6. Free trade is not possible now because even developing countries have to be given protection and
developed nations also put high tariff.
7. Physiocrats advocated minimum functions to the state and favored laissez faire. But Government
interference is needed for economic development.
Wealth of a nation is increased by trade and followed by European statesmen from 15th century until
the second half of eighteenth century. Also called as Bullionism, Colbertism (France) and Kameralism
(Germany). War and exchange economy necessitated mercantilism. Fundamental aim of mercantilists is to
make country strong by increasing the wealth of his country through storing gold and silver.
Aim of the mercantilist is to maximize export and minimize import. Trade was the most important
occupation followed by industry and manufacture and agriculture was the least important of all since it
brought no money. Mercantilist gave importance to national advantage. Their contributions lie in role of the
state, money, rate of interest, population and balance of trade
Role of the state
State regulation of economic activity is done like imposing import duties, levying tax concessions
for exports and fixed wages and prices to increase production.
Role of the money
They felt that adequate supply of gold and silver in form of bullion is essential for the safety of the
nation. They regarded accumulation of precious metals as a sign of wealth and are aware of distinction
between money and wealth.
Rate of interest
Mercantilist advocated low rate of interest on economic grounds. Interest is low only if money
supply was adequate through accumulation of precious metals. They opposed to any policy that caused
falling prices and considered rising prices lesser evil than falling prices.
Balance of Trade
Mercantilists believed state intervention for favorable balance of trade and followed a policy of
discrimination, regulation and protection in trade matters. Commodities with high labor content relative to
value are preferred in exports. Raw materials, minerals, machines trade and workers emigration is
considered as wasteful. Ideal is Zero imports and exports are only in exchange for previous metals.
Mercantilist popularized increased population, which led to increased sailors, soldiers and
1. Thomas Mun (1571-1641)
Wrote book ‘England’s Treasure by Foreign Trade’ (1664). He suggested achieving balance of trade
and for which he
i. Recommended cultivation of waste lands to reduce imports of hemp flax and tobacco
ii. Restrain on domestic consumption of foreign goods
iii. Export requires attention to commodity prices. If necessities, it should be charged high.
iv. Value of export increased by confining to her own ships
v. Frugal use of natural wealth is suggested so that more is left for export
vi. Fishing in adjacent seas
vii. England should be a distributing centre to increase shipping and trade.
viii. Encouraged trade with far off countries
ix. Money begets trade and trade increases money
x. Velvets and silk exported free
xi. Individual must endeavor to make the most of our own efforts
He praised industry and condemned idleness and luxury.
2. Antonio Serra (1580-1650)
Mercantilist’s preference of industry to agriculture because
i. Industry is safer than agriculture
ii. Industry is subjected to law of increasing returns
iii. Industry has a share market
iv. Industry is more profitable than agriculture.
3. Philip Von Hornick (1638-1712)
Might of a country depend on accumulation of gold and silver.
i. Country’s soil should be used to maximum extent for mining gold and silver.
ii. Commodities worked up in the country
iii. Population encouraged
iv. Gold and silver are not allowed out of country
v. People content with domestic products
vi. Import payment should be in kind and not in gold and silver
vii. Import is not allowed if sufficient supply is available in home.
MERCANTILISM IN ACTION
Mercantilism ruled three centuries in England and in Europe and it is a policy of power. In England,
Corn Laws were in force until 1846. It encouraged corn imports above a given domestic price and allowed
exports when domestic prices dropped beyond a certain level. This resulted in conflict among landlords,
corn merchants, consumers and the state. In France, Colbertism was followed which imposed detailed
control on manufacture and imposed national uniformity of finished products. In Germany, Cameralism
An appraisal of mercantilism
i. Emphasis on gold and silver
ii. Over estimated commerce and under estimated agriculture
iii. Favorable balance of trade necessitated a benefit in long run
iv. What was gain for one nation was loss for another.
Mercantilism is an economic policy and state making on economic side. Adam Smith’s idea of
mercantilists is ‘little better than nonsense’. Adam Smith believed that wealth of nation is increased by
division of labor, which is limited by size of market. Adam smith advocated free trade and it is absurd to
believe that export exceed import in all countries as believed by mercantilists.
England, France, Germany and Spain became strong nation by following a policy of mercantilism.
Mercantilist developed macro- economic approach to problems of society. Maximizing exports emphasized
not only for accumulating gold and silver but also for employment. Trade depended on money. An
increase in money supply resulted in low rate of interest, which induces to save and finally determines
output level and employment. Money is only a medium of exchange but a store of value.
Knut Wicksell developed interest theory based on mercantilist ideas. Keynes approved 2
mercantilist ideas of more money for business expansion and more money for lowering the interest.
Mercantilists have over emphasized trade and under estimated agriculture unlike physiocracy who
emphasized agriculture. Mercantilists’ theory of international trade was that favorable balance of trade was
faculty and not always benefi cial to economic development of a nation. Mercantilism enabled
transformation from commercial capitalism to industrial capitalism and mercantilism is a phase in the
history of economic policy.
Decline of mercantilism
1. With Adam Smith, policy of plenty replaced the policy of power.
2. Development of banking both domestic and international reduced the importance of bullion
3. In market economy, real estates, factories and machinery were important items of wealth than gold
4. Economic growth during industrial revolution made possible for the society to rely on competitive
forces and laissez faire rather than promoting and regulating monopolies.
5. Country become richer not by impoverishing its neighbor but by mastering the forces of nature.
6. Regulations protecting the quality of goods became a barrier to progress.
Mercantilism of eighteenth century is followed by laissez faire policy of nineteenth century.
Twentieth century view is that government must assist and encourage industry and commerce. This policy
of state encouragement and assistance to industry is neo-mercantilism. Thus neo-mercantilism
envisaged assistance, support, defense of state control rather than regulation and control.
After First World War, America, France, Germany and England followed typical mercantilist
policies with emphasis on gold accumulation, or imposing high tariffs, fixed import quotas and formulated
many exchange restrictions. It depended upon effective social planning of economic life through
centralized dictatorship or democratic form of regimentation.
Meaning of mercantilism for under developed countries
1. In these countries, State plays a key role in process of economic growth.
2. Mercantilists considered non-agricultural sectors of foreign trade and manufacturing as strategic to
economic growth of a nation with state regulation and assistance. But for under developed countries
like India depend directly or indirectly on agriculture and if agriculture fails, our plan fails.
3. Recognized role of money in economic development but underestimated role of real factors. They
failed to explain when money push up prices rather than increase employment. More money lead to
4. Capital deficiency is corrected by foreign exchange. So most countries follow the mercantilist
policy of maximizing exports and minimizing imports and financial assistance to export and
restriction on import. This mercantilist policy resulted in balance of payment problem for poor
FORERUNNERS OF CLASSICAL POLITICAL ECONOMY
Smith’s emphasis of self-interest is originated from Mandeville’s Fable of the Bees. Mandeville
emphasized the multiplicity of wants and large numbers of individuals find their private interest in laboring
for the good of others and united together compose one body. He also expressed the division of labor using
production of watches and first used words divided and dividend in this connection.
Hutcheson considered moral sense to be the most important. His thought was utilitarian in trend
and proposed greatest happiness of greatest number as a standard. He distinguished utility and value.
Wealth differentiated from utility and limitation of supply makes a scarcity value. He justified interest on
the ground that money invested in things naturally productive.
Hume gave prominence to labor, changes or transitions, evidences of historical spirit and
interrelation of economic and social facts. Everything in world is purchased by labor. Money is the
representative of labor and commodities and its increase in supply may benefit the industry during interval
between acquisition and resulting rise in prices. Interest depends on profits of industry.
Josiah Trucker laid emphasis on significance of labor. He believed in advantages of a large
population and favored tax on celibacy. Advocated free trade policy and self-interest coincide with public
interest if given free play.
Hume and Tucker inaugurated cosmopolitanism in commercial policy.
Adam Ferguson gave ideas on taxation, value and utility. Goods are valued not according to real
use but in proportion to land, labor and skill required to produce them.
From physiocrats, Adam Smith derived
1. Natural rights idea
2. Beneficent providence
3. Idea of laissez fire derived from doctrine of self-interest and reaction against government
4. Principle of self-interest as the fundamental force in society
5. Idea of cosmopolitanism.
Naturalist school of philosophy (Aristotle, Plato) influenced Adam Smith. Mercantilist shaped his ideas
and prominent among them were Petty, Locke, Hume, North, Stewart and Cantillon. Petty, Cantillon and
Stewart influenced Adam Smith’s ideas on value. Hume, Locke and Stewart influenced his ideas on money.
His ideas on public finance by Petty and Stewart and trade ideas were influenced by North and wages ideas
Physiocrats believed in natural laws, which govern the human society. He opposed government
interference and supported laissez-faire. Physiocrats are against the mercantilist regulatory system and
Adam Smith has praise for them. But Adam Smith did not approve agriculture as the only productive
John Locke was traditional Mercantilist in his economics. Locke turned his attention to money and
developed a theory of money in his 1692Considerations. Locke introduced concept of “money as
convention” and notably the concept of “velocity”.
Locke saw that the lowering of interest by legal means might very well lead to a collapse in trade
because it would not reflect the “natural scarcity” of money. If money collapsed, then there would be,
alternatively, a collapse in output or prices. The collapse in prices would lead to relatively cheap English
goods and relatively expensive foreign ones “both which will keep us poor” (Locke, 1692).
Locke’s ideas on value inconsistent. In his 1690 Treatises, he proposes a quite explicit labor theory
of value. In his 1692 Consequences, Locke adheres to a demand-based theory of value. John Law (1705)
did much to clarify the confusion between them.
Finally, Locke also proposed a theory of property in his 1690 Treatises. The right to property,
Locke claims, is derived from the labor of those who work it. More specifically, he perceives that as
“labor” is naturally “owned” by the person in whom it is embodied and Locke’s “natural labor theory of
John Locke is considered one of the most significant philosophers of his era mainly for his critique
of Thomas Hobbes’ defense of absolutism in Leviathan (1651) and the development of social contract
theory. Locke believed that people contracted into society which was bound to protect their rights of
property. He defined property broadly to include people’s lives and liberties, as well as their wealth. When
people combined their labour with their surroundings, then that created property rights.
Locke was arguing that not only should the government cease interference with people’s property
(or their “lives, liberties and estates”) but also that it should positively work to ensure their protection. His
views on price and money was that the “price of any commodity rises or falls, by the proportion of the
number of buyers and sellers,” a rule which “holds universally in all things that are to be bought and sold.”
Dudley North argued that the results of mercantile policy would be undesirable.
He argued that the assumption of needing a favourable trade balance was wrong. Trade, he argued, benefits
both sides, it promotes specialisation, the division of labour and produces an increase in wealth for
everyone. Regulation of trade interfered with these benefits by reducing the flow of wealth.
North shows that wealth may exist independently of gold or silver, its source being human industry,
applied either to the cultivation of the soil or to manufactures. It is a mistake to suppose that stagnation of
trade arises from want of money; it must arise either from a glut of the home market, or from a disturbance
of foreign commerce, or from diminished consumption caused by poverty. The export of money in the
course of traffic, instead of diminishing, increases the national wealth, trade being only an exchange of
superfluities. Nations are related to the world just in the same way as cities to the state or as families to the
city. North emphasizes more than his predecessors the value of the home trade.
With respect to the interest of capital, he maintains that it depends, like the price of any commodity,
on the proportion of supply and demand, and that a low rate is a result of the relative increase of capital,
and cannot be brought about by arbitrary regulations.
Prices must determine themselves, and cannot be fixed by law; and all forcible interference with
them does harm instead of good. No people can become rich by state regulations, only by peace, industry,
freedom and unimpeded economic activity. It will be seen how closely North’s view of things approach to
that embodied some eighty years, later in Adam Smith’s great work. North is named by Wilhelm Roscher as
one of that great triumvirate which in the 17th century raised the English school of economists to the
foremost place in Europe, the other members of the group being Locke and Petty.
Bernard Mandeville, or Bernard de Mandeville
Fable of the Bees
In The Grumbling HiveMandeville describes a bee community thriving until many of the bees
decide to seek honesty and virtue. Without their desire for personal gain the colony loses the hive, thus
implying that without private vices there exists no public benefit.
Mandeville’s philosophy gave great offence at the time, and has always been stigmatized as false,
cynical and degrading. His main thesis is that the actions of men cannot be divided into lower and higher.
The higher life of man is a mere fiction introduced by philosophers and rulers to simplify government and
the relations of society. In fact, virtue (which he defined as “every performance by which man, contrary to
the impulse of nature, should endeavour the benefit of others, or the conquest of his own passions, out of
a rational ambition of being good”) is actually detrimental to the state in its commercial and intellectual
progress. This is because it is the vices (i.e., the self-regarding actions of men) which alone, by means of
inventions and the circulation of capital (economics) in connection with luxurious living, stimulate society
into action and progress.
Private vice, public benefit
Mandeville arrives at a very contemporaneously vile conclusion: vice as a necessary condition for
economic prosperity. His viewpoint is more severe when juxtaposed to Adam Smith’s. Both Smith and
Mandeville believed that individuals’ collective actions bring about a public benefit. However, what sets
his philosophy apart from Smith’s is his catalyst to that public benefit. Smith believed in a virtuous self-
interest which results in invisible cooperation. For the most part, Smith saw no need for a guide to garner
that public benefit. On the other hand, Mandeville believed it was vicious greed which led to invisible
cooperation if properly channeled. Mandeville’s qualification of proper channeling further parts his
philosophy from Smith’s laissez-faire attitude. Essentially, Mandeville called for politicians to ensure that
the passions of man would result in a public benefit. It was his stated belief in the Fable of the Bees that
"Private Vices by the dextrous Management of a skilful Politician may be turned into Publick Benefits”
In the Fable he shows a society possessed of all the virtues “blest with content and honesty,” falling
into apathy and utterly paralyzed. The absence of self-love (cf. Hobbes) is the death of progress. The so-
called higher virtues are mere hypocrisy, and arise from the selfish desire to be superior to the brutes. “The
moral virtues are the political offspring which flattery begot upon pride.” Similarly he arrives at the
greatparadox that “private vices are public benefits.”
Among other things, Mandeville argues that the basest and vilest behaviors produce positive
economic effects. A libertine, for example, is a vicious character, and yet his spending will employ tailors,
servants, perfumers, cooks, and opportunist female and/or male prostitutes. These persons, in turn, will
employ bakers, carpenters, and the like. Therefore, the rapaciousness and violence of the base passions of
the libertine benefit society in general. Similar satirical arguments were made by the Restoration and
The Division of Labour
Mandeville was an early describer of the Division of labour, and Adam Smith makes use of some of his
examples.7 Mandeville says:
But if one will wholly apply himself to the making of Bows and Arrows, whilst another provides Food, a
third builds Huts, a fourth makes Garments, and a fifth Utensils, they not only become useful to one
another, but the Callings and Employments themselves will in the same Number of Years receive much
greater Improvements, than if all had been promiscuously follow’d by every one of the Five…
Founder of classical school and described as ‘father of political economy’. His work is ‘An inquiry
into the Nature and causes of the wealth of nations’ (1776).
Essential features of classical school
1. Laissez – faire with minimum role of government.
2. Believed in market economy based on free and perfect competition.
3. Assumed conditions of full employment
4. Believed in harmony of interests of individual with society.
5. Emphasized the importance of economic activities especially industry and added industry to
commerce and agriculture
6. Economic laws were of universal application
7. Paid attention to problems of economic growth and development
8. Adopted micro – economic approach
9. Believed in J.B. Say’s laws of markets which said that supply creates its own demand.
Wealth of Nations was a challenge to mercantilism and wealth is increased by adopting ‘division of
labor’ which is dependent on size of market. Size of market depends on volume of international trade. He
advocated free trade as a mercantilist policy of maximizing export and minimizing import, which would
result in shrinkage of international trade.
1. Division of labor
Labor is the source of wealth and division of labor increases the productivity of labor and thereby
wealth of nation. It refers to the specialization of labor in different industries and limited mainly by the size
of the market.
1. Increased output
2. Increased dexterity (Skill)of worker
3. Saving in time
4. Introduction of machinery
1. Monotony of work
2. Immobility of labor
Differentiated 2 kinds of value namely value in use (water) and value in exchange (diamond). He
proposed labor theory of value wherein labor is the measure of the exchange value of all commodities. He
distinguished natural price and market price. Natural price covers rent, wages and profits. Market price
depends on supply and effectives demand which is the demand of those who willing to pay at natural price.
When market price increases than natural supply, supply will increase and price brought down.
1. All work are not of equal efficiency and less skilled may take longer
2. Misdirected labor cannot have value
3. Failed to explain value of rare things like art or antiques
4. Ignored influence of demand.
Suggested subsistence, as the natural level of wages and observed market level might be higher than
subsistence level. He has taken into account demand and supply of labor in wage determination. He has
developed the principle of equal advantage to explain wage differences like
1. Agreeableness of the employment
2. Cost of learning the skill
3. Constancy of employment
4. Trust reposed in workman
5. Probability of success
He describes as a monopoly price or determinant of product price or effect of high or low product
price. Believed that interests of society coincided with interests of landlords and rents arise only when
society was progressing.
5. Profits and interest
Wages and profits move in opposite direction. As capital is accumulated, competition for
investment will lower the profit. Interest varies with profit.
Capital accumulation is essential for industrial development of a nation. Capital appear in three
1. As an instrument of production
2. As a fund maintaining the workmen
3. As a source of revenue.
He classified capital as for immediate consumption, fixed and circulating capital. Division of labor
was limited by size of capital stock. He emphasized saving in capital accumulation. He favored labor –
intensive investment especially in agriculture.
7. Role of money
Money is for circulation of wealth and measurement of value rather than adding revenue to society.
Smith preferred paper money than gold and silver. Banking saves labor of providing gold by providing
8. Laissez – faire and the harmony of interests
Individual is led by an invisible hand to do well for the society and believed that interest of
individuals coincided with interests of the society. Advocated free trade and believed in international
harmony of interest. Businessman sacrifices the interest of others to promote their own.
9. Role of Government
Minimum role is provided for government to protect society from foreign attack, administration of
justice and erect and maintain public works. Justified legal control over interest rates, administration of post
office, issue of paper money by bankers and compulsory education. Favored tariff to protect domestic
industry and by imposing tariff on imports.
Based on principle of cannon of equity (principles of justice and ability to pay), canon of certainty,
canon of convenience (after harvest) and canon of economy (minimum cost to government).
Influence of physiocrats on Adam Smith
1. On naturalism, optimism and liberalism ideas of Smith
2. Laissez faire policy
3. Classification of labor into productive and unproductive and materialistic interpretation of wealth.
4. Free trade
Wealth of nations is a most successful book on economics. He developed price system or value
1. Essentially materialistic
2. Undue emphasis of individualism with much of economic man
3. Theory of distribution is sketchy and incomplete.
4. Emphasis of production from producer to consumer
5. Realized the importance of capital accumulation in economic development and Adam Smith’s labor
theory of value was the foundation for Marx’s theory of surplus value.
DAVID RICARDO (1772-1823)
Adam Smith is the founder of the classical school and David Ricardo is the leader of the school. His
work is “On the principles of political economy and Taxation (1810)”.
Social back ground
Industrial revolution took place with population growth, rise in price, poverty and land rents were
increasing. Corn Laws generated controversy. Landowners interested in high price for corn and
consequently high rents. Manufacturing classes interested in repeal of Corn Laws as it could lead to fall in
price of corn, fall in wages and cheap labor available.
1. Ricardian is an analytical genius and deductive thinker.
2. Believer in laissez- faire
3. Considered money as a veil and interested in analyzing economic problems in money – less world.
4. Approached the problem of value from cost of production side and accepted more or less the labor
theory of value.
5. Incorporated pessimistic value of Malthus with respect to population and food supply.
6. Ricardian rent is based on law of diminishing returns.
On the scope of political economy
Adam Smith and Malthus developed ‘An inquiry into nature and causes of wealth’. Ricardo
developed an inquiry into laws, which determine division of produce of the industry among classes.
Produce of earth is divided into rent, profit and wages and such that law which regulates this distribution is
the principle of political economy. Emphasis is shifted from production to distribution.
Developed labor theory of value and concerned with relative values. He recognized value – in – use
and value – in – exchange. Value of a commodity is dependent on scarcity and quantity of labor required
obtaining them. Scarcity is applied to rare statues and pictures, scarce books and coins. Ricardo made
distinction between natural and market price. Short – run price depends on supply and demand and long-run
price depends on cost of production.
RICARDIAN THEORY OF RENT
Landowners asked for higher protection in the name of general welfare. Businessman and
manufactures spoke against high tariff on grain imports and requested for repeal of Corn Laws. Ricardo
demonstrated that all classes except the landlords injured by the increase in the price of corn. Improvement
in agriculture and import of cheap grain reduces the rising rents.
Rent is the portion of produce of the earth, which is paid to the landlord for the use of the original
and indestructible powers of the soil.
1. Rent is peculiar to land alone. It arises because of inelastic supply and differing fertility.
2. Land has source original and indestructible powers.
3. Land is subjected to law of diminishing returns.
4. There is perfect competition
When second grade lands are under cultivation, the first grade lands yield surplus over and above the
cultivation expresses which is called rent. Rent also may arise on account of situational advantage.
Relationship between rent and price
Rent is high because price is high and price is high not because rent is high.
Criticisms of Ricardian rent
1. According to Ricardo, best lands are cultivated first and for which, there is no proof
2. Objective is also for original and undesirable power of the soil. There are no original powers of the
soil and powers are not indestructible as fertility is decreased by continuous cultivation.
3. For a single firm, rent enters price.
4. Ricardian theory is based on perfect composition but in real world, imperfect competition is the
5. Rent is not for land alone but for labor and capital as well. Marshall explained the concept of quasi
rent with reference to machines. Transfer earnings are the rent with reference to a particular
6. Over emphasized the law of diminishing returns and hold well, if technology is kept constant.
1. Physiocrats, Adam Smith and Ricardo considered rent as a surplus. Physiocrats and Adam Smith
regarded rent as gift of nature and Ricardo argued rent for its niggardliness.
2. Adam Smith saw harmony of interests between landlords and the rest of society. Ricardo saw conflict
As population increases, the increased demand for food raises its price. Lands of inferior quality
brought into cultivation. Rent raises and wages also raises to give labor their minimum of subsistence.
Profits also fall and with population increase, all classes except the landlords are injured by increase in the
price of corn. Believed in improvement in agriculture and import of cheap grains prevent rising rents and
falling profits. So he opposed the Corn Laws. Rent did not enter into price has serious implications that
even if high tax is imposed on rents, it could not raise the price of corn.
Labor has its natural price to meet subsidence level of labor and market price dependent on demand
and supply. In long run, workers receive wages at minimum subsistence level called as Iron law of wages.
When market price of labor rises above natural price, there is expansion in families of workers, population
increases and wages will come down below natural price.
Wages and profits move in opposite direction. Interests of worker and employer always opposed
and, interest of landlord to that of consumer and manufacturer is always opposed and advocated non-
interventionism or laissez – faire.
Explained why market price of gold was rising and attributed the printing of bank notes was the
main cause for it. He believed that the gold standard as a check on over-issue of currency to curb inflation.
But he advocated economy is use of gold and silver.
The theory of comparative cost
Adam Smiths’ theory of trade is based on difference in absolute costs. Every country would buy in
cheapest market. Ricardo developed the theory of comparative cost that a country specializes in promotion
of commodity that has a great comparative advantage and export. Import for those commodities, which has
highest comparative cost.
Wine cloth (Units of labor)
Portugal 80 90
England 120 100
Portugal has absolute advantage for both the commodities
Comparative advantage in terms of Opportunity cost
Portugal 8/9 9/8
England 12/10 10/12
Portugal specializes in wine and import cloth. England specializes cloth and import wine.
1. Capital and labor did not flow between countries. Otherwise both wine and cloth produced in Portugal
2. Assumed law of constant costs rather than increasing costs as output expanded. Otherwise, it is not
possible to carry specialization to fullest extent.
It is based on labor theory of value and based on assumption of full employment.
Theory of stationary state
In first stage, population is small and best lands are used for producing food, rent is small, income
is shared between profits and wages. Everybody except the landlord is happy. In next stage, profit is high
and capitalists accumulate more capital, which lead to more demand for laborers. Wages rises above
subsistence level leading to increase in population. Society forced to cultivate lands of inferior quality,
which lead to diminishing returns and increased rents. Wages and profits fail. In third stage, rents rise
further. Wages and profits fall. This process goes on until population is so large, rents are so high, and
wages at subsistence level and profit is low so those capitalists do not wish to accumulate more capital.
Society reached the stationary state at this point. Since profits are low, there is no further capital
accumulation. Since wages are at subsistence level, population will not grow
He analyzed production, growth and distribution of income. Adam Smith regarded stationary state
as a dim and distant prospect and Ricardo considered it as a real possibility. Ricardo regarded as
1. He has abstract reasoning and master of deduction in economics
2. Contribution to theory of value and distribution
3. Separated economics from other branches.
4. Laid down the foundation stone of socialism with his theory of value.
Keynes criticized Ricardo for the assumption of full employment based on J.B. Say’s law of markets,
which ruled out general over-production. Jervons viewed Ricardo as able but wrong-headed man. In spite
of these criticisms, Ricardo’s teachings dominated political economy for nearly a century.
THOMAS ROBERT MALTHUS (1766-1834)
1. An essay on the principle of population (1978)
2. Principles of political Economy (1820)
3. Theory of market gluts – Inadequacy of aggregate demand
Unemployment, poverty and disease became serious problems. Landlords were described as an
exploiting class. He attributed poverty and misery not to evil human institutions but to the fecundity of
human race. Abolition of war would remove remedies of over – population. Godwin’s egalitarian,
consumerist society would mean more food for masses and increases population.
THE MALTHUSIAN THEORY OF POPULATION
Malthusian theory discusses the relationship between population and food supply. It is based on the
law of diminishing returns.
1. Food is necessary for human existence
2. Passion between sexes is necessary and will remain nearly in its present state.
Power of population is indefinitely greater than the power in the earth to produce subsistence for
men. Population increases in a geometric ratio (2, 4, 6, 8, and 10…). Population if unchecked would
double in twenty-five years. But food supply increases in arithmetic ratio (1, 2, and 3…) and less than
population due to law of diminishing returns of land. Population outgrows food supply and suggested
preventive and positive checks by nature.
Preventive checks are the moral restraint (never marry), postponement of marriage which causes
birth rate to fall. He has approved vices like prostitution and birth control to reduce birth rate but
condemned contraception. War, famine and disease impose positive checks, which increase the death rate.
If population were not checked by 2 methods, there would not be food supply leading to famine, starvation
and death. He presented a dark and pessimistic feature of mankind. He condemned contraception because
it is an improper act to conceal the consequences of irregular gratification. He also not approved birth
control methods but it is required for developed countries like India.
India has high birth rate typical of agrarian economies and low death rates characteristic of
industrial economics. Until economic development cures this and also if there is voluntary limitation of
families, Malthusian checks of famine and disease may operate. India should westernize not only death rate
but also birth rate. Poor are responsible for poverty and misery because they fail to restrict their numbers.
Government should not provide relief to poor by means of ‘Poor laws’ because more children survive and
1. Malthusian belief that once in twenty – five years, the population would double is proved wrong by
history since in some countries, population actually declined.
2. In some countries, population increased at a rapid rate and also, food supply. Standard of living is
much higher than a century ago
3. Malthusian theory is based on law of diminishing returns and he overlooked the possibility of
scientific improvement in agriculture
4. Scope of international trade and commerce is ignored since India import during shortage.
5. Relationship between population and food supply is a problem of not numbers but wealth and its
efficient production and equitable distribution.
6. Addition to population is harmful is not correct since every man is a labor, large numbers, great
wealth, strength and power.
Malthusian theory is relevant to underdeveloped countries like India and China where problem of over
– population is a danger. Malthus is a prophet rather than a historian and an economist rather than a
Optimum theory of population
It looks population protection not as a question of numbers but from production and efficiency.
Every country has optimum or ideal population where its output is highest. Optimum population is that
population which combined with other available resources or means of production yield the maximum
returns. When a country is reached optimum population, it gives maximum income per head. Optimum
population is not fixed. It may have different optimum levels at different times.
Neo- Malthusianism (Francis Place)
Neo – Malthusian favored birth control measures as celibacy involved suffering even than want of
food and late marriages make people immoral by encouraging prostitution and increasing the number of
The Malthusian Theory of Gluts
Less known but made important contribution to economic theory. Ricardo was interested in theory
of distribution of product in equilibrium conditions. Malthus discussed volume of output day by day in real
world. Level of output at any time depended upon effective demand. Effective demand is a demand, which
is high enough to ensure a continual supply or continual production. This is a demand, which enabled the
producer to cover cost plus profit. Argued in favor of unproductive consumption to maintain and increase
effective demand. Wages of workers is so low that they cannot demand many goods. Mode of living and
habits of capitalists don’t give then room for unproductive spending and so argued for unproductive
Adam Smith and Ricardo were in favor of saving and capital accumulation. Malthus was against it
because it leads to reduction of unproductive consumption and in turn checks the wealth progress. He is not
against saving as such but suggested a proper balance between saving and consumption. Among
unproductive consumers, Malthus included landlords, menial servants, statesmen, judges and lawyers,
physicians, surgeons and clergyman. Unless a large body of unproductive consumers maintained, there
would be periodic over – production, glut in the market and stagnation. He pointed crises in the form of
trade cycle because of the inherent defects of capitalist system.
Adam Smith and J.B. Say viewed rent as monopoly return and Ricardo viewed it as due to
niggardliness. Malthus viewed it as a bounty of nature
1. There will be shortage of fertile land
2. This necessitated cultivation of lands of inferior quality
3. Produce in each case is sold at natural or necessary price.
Price of poorest quality land is equal to cost of production and land with superior fertility, get rent.
Thus Malthus anticipated the Ricardian theory of rent.
He defined value as the amount of labor plus profits. It is the power to command other goods
Contribution of Malthus to economic thought
1. He is the first to study principle of population and founder of modern demography.
2. Darwin struggle for existence is the doctrine of Malthus applied with manifold force to the whole
3. He is the founder of historical economics as he collected lot of historical and statistical data to
illustrate his theory
4. Introduced a dynamic factor into economics that is population was always changing
5. Forerunner of under consumption theories of trade cycle.
6. Malthus is a pre-Keynesian since like Keynes he believed that employment level is depended on
level of aggregate effective demand. But he doubted the classical assumption of full employment
equilibrium based on J.B. Say’s ‘Law of markets’ But he is superior than that of Ricardo’s abstract
Classical System includes
a. Social and political philosophy – Doctrine of laissez – faire
b. Method of analysis – abstract – deductive method
c. a box of tools – economic generalizations.
During 19th century, classical economic system attacked by historical critics, who criticized deductive
method and endorsed inductive or historical method. They placed nation at the center of their thought.
Germany is the homeland. Socialistic critics emphasized class rather than individual (classical) or national
(historical economists) and emphasized the ameliorating conditions of the proletariat. France was the
homeland. Both movements appeared in England
I GERMAN HISTORICAL SCHOOL
1. Older school was primarily concerned with criticism of deductive method and represented by
Roscher, Hildebrand and Knies.
2. In Younger school apart from criticism, made contributions to economics. Dominated by Gustav
Critical ideas of historical school
1. Belief of classical writers that universality of their doctrines is not fulfilled. Historians pointed out that
economic laws are relative and not absolute and cannot be applied everywhere and at all times. Economic
laws can be applied in relation to stage of economic development. Free trade is useful to advanced
countries while protection benefits poor countries.
2. The psychological assumptions of classicists were crude and inadequate. Classicists guided by self-
interest but historians included variety of motives the vanity, love, pity, glory, pleasure, duty, benevolence
and custom. The concept of economic man ignores all motives except the self-interest abandoned by
3. This school made indiscriminate use of deductive or abstract method.
Positive ideas of the historical school
Classical economists concentrated on economic problems that could be explained by simple
mechanized principles. Price fluctuations, interest rate, wages and rent are explained by mechanical
interplay of free individuals guided by their self- interest and competition with each other for individual
gains. Wage theory doesn’t tell about different classes of workers, well being in different historical periods
or about legal and political conditions. Historical school approached from organic point of view and
explained the variety of economic phenomena historically.
Organic approach is based on 2 doctrines
1. Man’s economic activity studied in connection with his environment.
2. To understand present economic life, men must lave some knowledge of successive stages of
economic development in the past.
List wrote National system of political economy (1841). He was against classical cosmopolitanism
and individualism and his advocacy of projectionist system of national unity was directly based on history
and experience. Country would prosper when it is strong and has free movement of goods within the nation.
History is against individualism.
List has criticized the individualistic approach of classical. Between every individual and humanity,
there exists history of nations. With free exchange and universal unity among nations, exploitation of poor
by rich and strong occurs.
The stage theory of economic development
List distinguished five stages of (a) savage (b) pastoral (c) agriculture (d) agricultural –
manufacturing (e) agricultural – manufacturing – commercial. Last stage was normal with strong wavy,
control over colonies, development of art and sciences, political power and independence.
The theory of productive forces
Wealth of nation lays not in exchange values but increase in productive forces that ensures greater
exchange of values in feature. He preferred development of producer good industries than consumer good
industries. Classical economists believed that economic development takes place in a natural manner but
class emphasized planning for the purpose.
The theory of protection
1. The aim is to provide protection to the countries with potential powers for economic growth such as
vast resources, efficient labor and large population exists.
2. Protection is justified when industrial development of the nation is hampered by the competition of
powerful industrial nation like Germany protected against English competition.
3. Protection should not be applied to agriculture because protection of industry indirectly benefits
agriculture by ensuring market for raw materials and food.
His work was “Principles of political economy”. Explained and introduced historical method in
economic science. He has made economic generalizations through comparative investigation of national
Reflected the deductive method of classical economists and expressed faith in historical method. He
has never mentioned any methodological rule to guide such historical approach to economics. He has
advanced stage theory to distinguish three stages of economic evolution namely phase of natural economy,
phase of money economy and phase of credit economy.
KNIES published “Political Economy from the standpoint of the historical method” Questioned not only
the natural law of classical political economists but also the existence of historical laws of economic
development of nations as believed by his predecessors. Economic theory is relative and not absolute,
applicable to specific historical circumstances and not every where and at all times.
He is the leader of younger historical school. He has made ethnological, historical survey of
psychological and environmental conditions influencing the economic behavior of people and determining
the historical laws of economic development. He has considered both deductive and inductive methods as
necessary for economic investigation. Economic theory neglecting the historical facts of economic life
should be discarded altogether. It should included abstract theories like origin of economic institutions,
their present behavior and psychology of social classes.
II HISTORICAL MOVEMENT IN ENGLAND
Jones (1790-1855) in his “Essay on the Distribution of wealth and on the Sources of Taxation”
attacked classical economists on historical grounds. He attacked Ricardo’s hasty generalizations. He
wanted to substitute abstract deductive method by an empirical method. On constructive side, he also
distinguished between farmer and peasant rent. Farmer or economic rent is the concern of economic
theorists while the peasant rent is the product of bargaining between landlords and laborers.
Criticized the classical political economy because
i. Separated the economic aspect of society from its intellectual, moral and political aspects
ii. it developed viciously abstract concepts
iii. made use of deductive method
iv. conclusions were absolute
Land systems (1870) and Essay in Moral and Political philosophy (1879), Leslie criticized concepts
of classical economists like desire of money, wage fund, private interest as abstract and confusing. He
has also criticized the classical economists for ignoring the theory of consumption.
Wrote economic studies (1880)
i. It claimed to be universally applicable but it is practically useless in countries because the
institutional setup varies from country to country.
ii. It advocates the principle of laissez – faire but, in actual practice, government like to interfere.
iii. It assumptions are verified and resulting theories are too abstract to be of practical use.
Toynbee exposed the darker and uglier aspects of industrial revolution
The impact of the historical economics
Aimed to formulate economic generalizations through historical processes and in this aim, they
failed miserably. Nowhere the historians succeeded in recreating the political economy on a purely socio-
historical basis. Historical economists ideas had considerable impact on modern economics especially U.S.
and started criticizing laissez – faire and had inclination towards social policy. In England, historical ideas
of Ingram, Leslie, Bagehot and Toynbee had defined and positive impact on economic theory.
III THE AUSTRIAN SCHOOL
Manger, Wieser and Bohm – Bawerk are the founders of the Austrian school.
i. Wieser accepted utility theory of value of Menger and further developed resource
allocation and factor pricing.
ii. Capital and interest developed by Bohm – Bawerk
iii. All the three writers upheld the theory of imputation i.e., producer goods derive their
value from the consumer goods they produce
iv. Criticized the historical method and abstract method of analysis
v. Preferred verbal and non-mathematical exposition of economic theory to mathematical
vi. Because of non-mathematical approach, Austrians regarded economic functions as
discontinuous functions expressible as sets of stair step rather than as smooth curves.
Menger initiated marginal revolution and founder of Austrian school. Wrote Principles of
Economics (1871), in which he developed the subjective theory of value.
The theory of goods
Good has four qualities i) it most have human need ii) good have properties of satisfying the need
iii) Man recognize the want – satisfying capacity of the thing iv) Good possess the technical ability directed
need satisfaction. Goods ranked according to the immediacy of need satisfaction. First order is in which
human desires are satisfied directly and indirectly is higher order goods. Bread is first, flour is second and
wheat is third.
Two distinctive features are
i. Goods of higher order (cotton spinners) cannot produce goods of lower order (cloth) without cooperation
of complimentary goods (raw cotton).
ii. Conversion of higher order to lower order needs time.
Classification of goods is objectionable because same good utilized for domestic purpose (lower
order) becomes higher order when used in smelting industry.
The subjective theory of value
Valuation arises due to scarcity of goods and related only to economic goods. Value is a subjective
phenomenon and valued based on satisfaction of human needs.
I II III IV V VI VII VIII IX X
10 9 8 7 6 5 4 3 2 1
9 8 7 6 5 4 3 2 1 0
8 7 6 5 4 3 2 1 0
7 6 5 4 3 2 1 0
6 5 4 3 2 1 0
5 4 3 2 1 0
4 3 2 1 0
3 2 1 0
2 1 0
Number in any column shows diminishing rate of satisfaction from consumption of units of a good.
Consumer maximizes his satisfaction by spending money on different goods in such a way satisfaction are
equal at the margin. If a consumer has Rs. 21 and unit price of all goods is Rs.1, than consumer maximizes
satisfaction by spending Rs.6 on I , Rs.5 on II, Rs. 4 on III, Rs.3 on IV, Rs.2 on V, Rs.1 on VI. This is equi
Value of a good is determined by least important want satisfaction. If individual uses six units of
good I, then satisfaction from sixth unit (i.e. 5) is the least important want satisfaction. Assuming all goods
homogeneous, 5 will be the value of each unit. Manger explained the price determination is case of isolated
exchange. Drawback is that he restricted the analysis to isolated exchange and he neglected the discussion
The theory of Imputation
Value of a good of higher order is imputed from the lower order. Value of a unit of a factor of
production will be equal to its marginal product based on satisfaction.
His chief work is ‘The origin and principal Laws of Economic value (1884)’, ‘Natural value (1889)’
and ‘Theory of social economics (1914)’.
The theory of Alternative cost and Imputation
Cost of a good is the other good, which might have been produced by the same resource. It
productive agent X produce 2 goods A and B and marginal utility of B is greater than A, then according to
the principle of maximum benefit, X will be employed in producing B rather than A . Cost means of
production used in production of more than one product e.g. labor and capital. Specific means of production
specific to particular product especially the land and the cost is rent.
He criticized the Manger’s loss principle that the value of a unit of factor is determined by the loss
of product if factor is withdrawn. Suppose the most efficient combination of 3 factors produces 10 units of
product and if one factor is with drawn, remaining 2 factors produce 6 units of output. Value of removed
unit is 4 units. Similarly other 2 have value of 4 each leading to 12 units which is overvalued.
Wieser replaced the loss principle by his principle of Productive Contribution. Value is determined
by the contribution to its production. He explained this with three equations representing three industries
and three unknowns representing three productive inputs. Solving this, he is able to get productive
combination of various inputs. He is able to determine the factor prices without entering into marginal
productivity of factor. Marginal utility product theory of distribution is marginal physical product(MPP) of
that factor multiplied by marginal utility of that product. Manger dealt with utility side of value while Wiser
dealt both utility and cost.
Marshall Value of a good is determined by the cost of production principle (Supply function) and
on the other hand, by final utility principle (Demand function). Austrians viewed that cost of a commodity
is determined by foregone utilities of other commodities, which could have been produced by the same
resources. Thus the utility and utility alone determine value. Social Economists propounded his
theory of welfare. Free market economy is socially unjust because competitive capitalism leads to unequal
wealth distribution accentuate unemployment. So Weiser recommended the establishment and growth of
State required playing active role in promoting social welfare by protecting the weak and defending
the nation by maintaining a system of police and law. He favored neither absolute competitive capitalism
nor absolute socialism but a sort of middle path like a mixed economy.
BOHM – BAWERK
He is famous for his analysis of capital and interest.
The theory of value
He has introduced the concept of marginal pairs in explaining the price determination in market.
One marginal pair included successful seller and buyer and the other included unsuccessful seller and
Buyers Buyers valuation of
Sellers valuation of
B1 300 100 S1
B2 280 110 S2
B3 260 150 S3
B4 240 170 S4
B5 successful buyer 220 200 S5 successful seller
210 215 S6 unsuccessful
B7 200 250 S7
B8 180 260 S8
There are 10 buyers and 8 sellers. Strength of buyers’ decreases from B1 to B10 and sellers increases
from S1 to S8. If bid is 210, there will be six buyers and only 5 sellers. If bid rises to 215, the buyers will be
5 and sellers will be 6. Price is fixed between 210 and 205. Marginal point of buyers and sellers is equal to
intersection of ‘D’ and ‘S’ curves.
The theory of capital or circulating capital or wage fund theory
Land and labor are the primary or original factors while capital is the secondary or produced factor.
Original factors of production are goods of highest order and consumption goods are goods of first order.
Social capital refer to intermediate products and also called as productive capital. This is important in
theory of production. Private capital refers to production and consumption goods and also subsistence
advanced by entrepreneurs. It is important in theory of distribution.
Capitalistic production or round – about method of production is more productive and involve the
sacrifice of time. Assumptions are
i. Involves diminishing rate of return
ii. Extension of production period requites capital
iii. Increased capital used to extend the period of production.
More the capital, the older the average wage of the capital stock. Capital means circulating capital
and used to support labor in productive process.
Average period of production (?) denotes capital stock = K/ Nw
Where N =Number of workers; W = Wage rate and Nw =rate at which K is consumed
If input is continuously applied during production process
? = ½ t where t is the absolute length of production starting from t = 0 and then
? = ½ + = K/Nw
Assumptions are inputs are not applied uniformly over the whole period of production. Made with an
assumption of homogeneous labor input and input earns simple interest.
The theory of interest
Bohm – Bawerk claimed mastery over element of time and developed the theory of interest. His
theory has 2 parts of why interest is paid? Or why there is a positive rate of interest? Bohm answer is that
people prefer present goods rather than future goods of save quality and quantity. Three reasons of
superiority of present over future are discussed below.
1. Different circumstances of want and provision in present and future.
a. In conditions of disorder, people prefer present goods because of immediate necessity.
b. In case of people looking for higher income and better conditions in future, people also prefer
present goods because there is going to be increased goods in future because of higher future income. In
latter case, people prefer present goods. He failed to examine strong cases in which people have opposite
time preference like professional athletes who expect drop in their earnings, save now.
2. Irrational underestimate of future for three temperamental reasons
a. Defective imagination b. limited will power c. future uncertainties
3. Technical superiority of present over future goods
Increase in productivity of capital is achieved by adopting round about method but it has been
criticized on grounds that this has meaning only when people have subjective preference of present over
future goods. The first two reasons explain demand for consumption loan and third reason explains demand
for production loan. All the three reasons explain that the rate of interest exists in both stationary and
Determination of rate of interest
1. The economy consist of capitalists and workers
2. Labor is utilized uniformly
3. All productive functions are identical
4. Physical and value productivity are proportional
In equilibrium, workers paid according to marginal productivity of labor discounted to the present.
Total wages exhaust the subsistence fund. The marginal product of extending the period of production,
which is economically permissible, determines rate of interest subject to available subsistence fund (or) rate
of interest adjusts the length of production period. When rate of interest is zero, capitalists have unlimited
demand for subsistence and strong desire to lengthen the period of production. As a result of scarcity of
subsistence found, interest rate rise until the whole supply of subsistence goods exhausted in lengthening
the production period.
Equilibrium is stable when i) all labor employed ii) all capital utilized iii) period of production is chosen
that minimizes rate of interest consistent with given wage rate. There is a unique wage level at which all
above 3 conditions of stable equilibrium fulfilled. If wage level increases, the production period increases,
existing capital is in sufficient to employ all labor and as a result wages fall. Conversely, if wage level
decreases, production period decreases, capital is surplus and wages increases. Given the labor and supply
of subsistence fund, Bohm – Bawerk’s theory determines simultaneously the optimum period of
production, equilibrium interest rate and wage rate for the economy as a whole.
Bohm – Bawerk summarized the basic relation of system as that the interest rate in a given economy
rise in reverse ratio to subsistence fund and in direct ratio to working population and degree of productivity.
Wicksell gave a mathematical treatment to Bohm – Bawerk’s interest theory.
SOCIALISTIC ECONOMIC THOUGHT
Socialism is protest against the injustice and inefficiency of capitalism. They opposed laissez-faire
and advocated state intervention. They believed in class conflict.
Forms of socialism
1. State socialism
Government owns certain sectors of the economy for overall social objectives rather than for profit.
Government of India adopted socialistic pattern of society or democratic socialism and its features
1. Follow mixed economy
2. Role of public sector expanded
3. Commanding heights of economy is controlled by State like banking nationalization and wholesale
trade in food grains.
4. Planned economy
5. Reduction of inequalities of income and wealth.
After 2 decades of planning, land reform legislation, progressive taxation policies, there is wealth
concentration in hands of few persons. 10 per cent of cultivators own more than 50 percent and one percent
own nearly one-fifth because we erect a socialistic superstructure on capitalist base.
2. Utopian Socialism
This was the prominent social philosophy. Saint – Simon, Charles Fourier and Robert Owen are
founders. This developed when workers are weak, have no vote and trade unionism was not developed.
They considered competitive system of capitalist society as unjust and irrational. Also, they have not
approved class struggle.
They worked out schemes of perfect social arrangement and appealed to workers to adopt them.
They appealed capitalists to cooperate with them and provide finance to implement their programs. They
set up model co-operative communities. Advocated associations with limited membership and known as
3. Christian Socialism
This was developed in England and Germany after 1848. Charles Kingley was the leading advocate.
They spoke of Bible, religion and god’s message to offer solace to suffering masses. They appealed rich to
use their property as a trust for the benefit of everybody. They didn’t believe in violence and class struggle.
They advocated education for workers, factory reforms and co-operation. Gandhi’s ideas of trusteeship are
similar to Christian socialists.
Pradhan is the leading advocate. According to him, Government is coercive and should be
abolished. State and its institutions corrupt essential goodness of human nature. Collective ownership
replaces private property. There should be mutual understanding, cooperation, and complete liberty.
5. Marxian Socialism
It was referred as scientific socialism based on labor theory of value and materialistic interpretation
of history. The struggle between capitalists and workers lead to revolution. Capitalist system was
overthrown and dictatorship of proletariat was setup. Public ownership of means of production was
followed. Private property was allowed only for consumer goods. Planned economy, elimination of private
property and price system has secondary role. “From each according to his ability, to each according to
his work” was the slogan.
It is the next higher stage of society. “From each according to his ability to each according to his
need “was the slogan. He wanted to end money because they considered this as an intervention by
capitalist class for exploitation of workers. In ultimate stage, there won’t be class conflict and no
communism. So called communistic countries (Russia, China) are the only socialistic societies.
7. Revisionism or Fabian Socialism
This was developed in England and didn’t approve class struggle, revolution and violence. They are
for reduction of inequalities of income and wealth and believed in gradual change by education, persuasion
and parliamentary reform. Not for total abolition of capitalist institutions but on ownership and
management of public utilities by public authorities and called as gas and water socialism.
Trade unionism and promoted by George Sorel (1847-1922). It didn’t believe in parliamentary
reforms. Strikes resorted to promote revolutionary spirit among workers; overthrow capitalism and industry
come under the control of workers. It advocated private property abolition.
9. Guild socialism
Cole was a great economist of this school (1889-1959). It believed in gradual change and reform.
State is needed to promote the interest of citizens by having economic policies. Control of industry is by the
workers and wanted every worker to be a partner in the firm. This called as ‘industrial democracy’. Society
is divided into producers and consumers. Guild is the national association of workers and Government is
the national association of consumers. Consumers and producers form partnership of equals.
10. Utopian socialists
Saint – Simon, Charles Fourier and Robert Owen were the founders and Proudhon and Louis Blank
were included. They had no knowledge of proletariat, appealed to the whole of society and dreamed
fantastic dreams of new society. They appealed to morality. According to Marx, from a scientific
standpoint, the appeal to morality and justice does not help an inch further. Utopian socialists did not have a
philosophy of history and Marxian socialism is a necessary product of historical development.
SAINT – SIMON (1760-1825)
His writings are Industry (1817), Organizer (1819), Industrial system (1821) and Questions on
Industries (1823). He was the father of utopian socialism and advocated industrialization. Considered
idleness as a sin and work is worship for him. For industrial growth, competition and self-interest are the
motive forces. Saint-Simon had a collectivist view according to which classes are principal agents of
Role of Government
Society is organized for promoting industry. Role of Government is to direct and not to command
people; to promote welfare of members and not to increase power. Industrial parliament has three chambers
looking after invention, review and execution. Invention clamber has artists and engineers who plan public
works. Review chamber consists of scientists who review projects and control education. Execution
chamber consists of leaders who carry the project and control the budgets. It is an example of a centrally
planned economy run by an educated elite. He felt class of interests between workers and wanted to be
dealt in a humane way.
He has opposed private property because it made rich idle and advocated collective ownership of
property. Government has a limited role and run by voluntary subscriptions. Science, fine arts and
professions contribute to the prosperity of France rather than Prince, Nobles, Bishops, Marshals and idle
landowners. As a socialist, Saint Simon believed in social change, equality of opportunity, new social order
with no room for idler, believed in greatest good of greatest numbers that is giving workers the
responsibility in administration and transforming private property. He has applied property to landed
property and not movable property (capital). This is the most diluted socialism.
Saint – Simonians are the followers of Saint-Simon and important among them were Augustus
Comte (1718-1857), Saint – Arnand Bazard (1791-1832) and Barthemy Enfantin (1798-1864). He has
criticized private property from the point of distribution, production and wealth and from justice and utility.
Private property made property owners idle and it is the source of exploitation. He has advocated collective
system instead of people property. To each according to his capacity was their slogan. Doctrine of saint –
Simonians is a mixture of realism and utopianism. He has encouraged large-scale industry, institution of
credit and profit sharing.
Founder of socialistic economics and wrote the Commercial Wealth (1803) and The New Principles
of Political Economy (1819). With method of economics, he rejected the abstract method of Ricardo,
emphasized historical school and a balanced use of induction and deduction. Aim of economics is
distribution or welfare side of wealth as against wealth of Adam Smith.
Attack on the practical conclusions
1. Over production: Classical economists believed that general expansion of production caused no
inconvenience in the system because the spontaneous mechanism corrected the production errors of
the entrepreneur. Sismondi said that automatic mechanism was full of social suffering and
2. Machinery: Classical writers considered machinery introduction as beneficial while Sismondi said
that immediate effect of machinery is unemployment of labor and reduction of wages. Machinery
increased employment only in long run and Sismondi considered with short period.
3. Competition: He has criticized classical assumption of competition is beneficial to people only
when producers increase production in response to an increase in demand. Otherwise, it lowers the
price, cost and finally wages.
4. Harmony of interests: Society has a clash of interests between capitalists and proletariat. Suffering
of worker is due to separation of property and labor.
5. Crisis: There is unequal revenue distribution between two classes of society. Industries producing
necessaries of life decay and industries producing luxury goods flourish but slow. Expansion of new
industry fails to offset decay of old industry and there is crisis.
Commerce is the root of all corruption. Cooperative communities called Phalanxes or Phalansteres
could solve social problems. Each Phalanx comprises 300 families with 1800 members and has nine square
miles of land. He gave importance to agriculture and handicrafts with co-operative enterprise. He has
described advantage of common kitchen and apartments. It is like a grant hotel with proper surroundings.
He has emphasized production, distribution and dignity of labor. Over work made labor unpleasant. He
classified labor into necessary, useful and agreeable. The first 2 received the highest reward. Surplus was
distributed between labor, capital and talent at five – twelfths, four – twelfths and three – twelfths
respectively. Phalanxes resemble china but Fourier opposed large – scale production and emphasized
voluntary cooperation. China focused on large scale production and centralized planning
He was the most famous utopian socialist. An improved environment resting on improved education
provides path to progress. Greatest happiness occurs only by serving the society as against classical that
self-interest promoted the general interest. Private property, religion and marriage act as barriers in creation
of ideal communal order. He demanded abolition of profit, speculation and money like communistic.
Villages of Co-Operation
He has established communistic settlements of parallelograms or villages of co-operation and
wanted to do away with capitalism. Allowed fixed interest rate on capital (Fourier allowed profit on
National equitable labor exchange
He has opposed money and profits. Founded National equitable labor exchange as a market where
goods exchanged on basis of notes representing labor time.
He is the founder of state socialism and published ‘organization of work’ in 1839. He has dependent
on state for implementation of ideal programs and regarded as advocate of proletarian socialism. Advocated
social or national workshops where men in similar industries co-operate and such workshops were financed
by the state. Advocated producers’ associations, received fixed rate of interest and drove capitalists out of
business. Aim was to abolish individualism, competition and private property. He was in favor of large-
scale enterprise. Competition was the root cause of all economic and social evils. Competition means
continuous fall in wages, which brings poverty, and in term brings crimes.
Advocate of anarchism and champion of individual liberty and justice. Anarchism does not mean
disorder but only absence of master.
Attack on Government
Government was biased towards the richest and most educated class as against the more numerous
and poorest class. Property was theft since it earned income in form of rent, interest and profit. Property
owners robbed the labor of their due share in production.
Bank of exchange
He has favored abolition of gold standard and advocated bank of exchange. Paper money issued
proportional to gross output of subscribers and negotiable among themselves. Banks buy from members at
50 and 100 per cent of cost of production. Provide free credit to workers with a small commission. He has
emphasized social or collective production.
An estimate of utopian socialism
1. It is an unscientific socialism. It is not based on scientific economic theory. It is ethical in character,
bourgeois in its origin.
2. Raised the question of distributive justice. Reduction of inequalities through abolition of private
property and advocated state intervention.
3. Robert Owen is a pioneer of co-operative movement. They lacked historical sense as they failed to
appreciate private property, marriage and religion.
KARL MARX (1818-1883)
Founder of scientific socialism and aim was to demonstrate socialism as a necessary product of
historical development. Marx and Engels wrote Communist Manifesto (1848), which has essential ideas
on communism. He Wrote “The Poverty of Philosophy” which was an attack of Proudhon book “The
Philosophy of Poverty”. Published The Critique of Political Economy in 1859 and Das Capital was the
It was dialectical materialism, which is a Hegelian philosophy with modification. Change is a
development and takes place in stages. An initial situation is thesis followed by antithesis and third
situation of synthesis. Change is a continuous process. Dialectical process is explained by certain rules.
1. Unity of opposites: Capitalists and workers temporarily co-exist in a capitalistic society.
2. Negation of negation: Explains mechanism of change and fells that no system is permanent.
Feudalism gave place for capitalism and capitalism in turn to socialism.
3. Change of quantity into quality: When capitalists exploit the working masses, there will be a
qualitative change and labor revolt against existing order. For Hegel, human mind was important
and Marx gave the materialistic interpretation and said that changes in the material world influenced
the mind and thoughts.
Materialistic Interpretation of History
Classical economists discussed rent, wages and profit under capitalism, which is a permanent one.
For Marx, capitalism is a transient phases in evolution of society. Classical economists viewed economic
laws are natural law. For Marx, it are relative laws and valid for particular stage of economic development.
Emphasis is on historical evolution of social, political and economic institutions. Mode of production in
material life determines the general character of the social, political and spiritual processes of life.
Underlying all social changes, there is a continuing development. The existing institutions outline their
usefulness and become replaced by another set suited to higher stage of economic development. This is
materialistic interpretation of history.
All history is the history of class struggles while classicists believed in harmony of interests. In
ancient time, it is the struggle between master and slaves. In feudalism, it is the struggle between lord and
serf and in Capitalism; it is between bourgeois and proletariat. As exploitation of workers by low wages,
long work hours and women employment increases, society is polarized into capitalists and proletariat. The
condition has become ripe for over throw of capitalism by united proletariat. Therefore capitalism creates
conditions for its destruction and socialism will be the new order.
Marx the economist
This describes how economic theory is turned into historical analysis like his work on “Theories of
Marxian and classicism
1. Marxian surplus value was developed from Ricardian labor theory of value
2. Marxian surplus value was similar to net product developed by Quesnay
3. Marxian theory of unemployment with “Industrial Reserve Army” was based on Ricardian
4. Falling profit was similar to classicists.
5. Conflict between wage and profits was discussed by Ricardo
6. Marx’s abstract, deductive method was essentially Ricardian.
Marxian Economic Analysis
1. Labor was the source of all value
2. Labor was paid in wages its own value, which was the amount of labor required to rear, train and
maintain the laborer
3. Surplus value: Capitalists employs workers for more hours than necessary to maintain him and
here he was able to secure a surplus value which was in form of profit.
4. Capitalists interested in increase of surplus value
5. Capitalists increase the surplus value by capital accumulation. Marx classifies the capital into
variable (labor) and constant (machinery)
6. Employment of constant capital increases total production but causes technological unemployment
and creates industrial reserve army of unemployed, which makes. Capitalists tried to keep down
wages. Variable capital alone was the source of value.
Recognized the importance of machinery in industrial production but displaces labor and creates
technological unemployment. So wages are at subsistence land.
Falling rote of profit
In long run, there is increase in organic composition of capital or increase in constant capital in
relation to variable capital.
O = ———–
Increase in constant capital takes place because of the desire of capitalist to accumulate more and
more capital and also to keep wages low. Fro capitalists, is results in a falling rate of profit.
Concentration of capital is in large-scale production, small-scale capitalists thrown out of business and
society was polarized into 2 classes of capitalists and proletariat.
Marx believed that cyclical fluctuations were in form of prosperity and depression inherent in
capitalist system. Average period of trade cycle was ten years. Trade cycle was a under – consumption
theory. Aim of the capitalist was introduction of machinery to increase productive powers of society and at
the same time, interested in surplus value. This implied that there were large sections without purchasing
power, which resulted in a crisis.
Mechanization, misery of laborer, decline in rate of profit, crises and concentration of capital
intensified the class struggle. Laborers unite to make revolutionary action and capitalists concerned with
falling rate of profit, tried to exploit labor as mach as possible. Expropriators are expropriated and a new
society is born.
Marxian theory of value
This is essentially the labor theory of value. Skilled work was a multiple of unskilled average labor.
Value of product was measured in units of simple average labor. Marx used the labor theory of value as the
basis of exploitation.
Marxian theory of surplus value
Simple commodity production of C -M-C, in which producer sells the commodity for money and
with that money, he buys commodities of other producers for consumption purposes. In capitalistic
production of M-C-M, money is used to buy other commodities including labor and power. Commodities
are turned into other commodities, which are sold for a great sum of money so that capitalist makes a profit
of M-M and this profit is surplus value.
Rate of exploitation is Surplus Value (or) Worker work for capitalist
Variable capital. Worker work for himself.
Capitalist increases the surplus value by increasing the number of working hours, reducing the
number of hours for workers sustenance and by employing women and children.
Criticism of Marxism
1. Marx’s materialistic interpretation of history is inadequate and over-sided. In shaping history, other
factors apart from economic forces play important role.
2. Generalization of history as a history of class struggle is only partially true because classes refused
3. Labor theory of value is outmoded because utility, demand and supply plays important role in
determination of value. Even if value depends on cost of production, all costs cannot be reduced to
labor and also labor is not homogeneous. Time element was not taken into account.
4. No proof that labor always creates surplus value. If labor theory of value is overthrown, theory of
surplus value falls to ground.
5. No historical proof for Marxian theory of Industrial reserve army.
It brings historical, social, political and economic events into a single grand scheme
1. Mode of production
2. Dialectics of mode of production
3. Various form of mode of production in the historical evolution of society.
1. Mode of production
. Means of production refers to total material conditions for production and this along with labor form
forces of production.
2. Dialectics of mode of production
Society develops in accordance with the dialectical principle. Three laws govern it.
1. Laws of unity – Productive forces and production relations are linked by an inner unity.
Mode of Production
Forces of production (organization, skill of
labor, techniques, geographical conditions)
Relations of Production
Ownership of means of production
Labour Means of production
Objects of labor
(Things to which
human labor applied
like raw materials of
timber, coal, iron,
Means of labor (things
used by man to act upon
objects of labor Included
Instruments of labor
and also industrial
2. Law of correspondence – Production relations tends to correspond with productive forces. Change
in production force induces adjustment in production relation.
3. Law of conflict – Production relations and production forces are in conflict.
Productive forces are most mobile while relations are more stable. Hence contradiction between 2
becomes acute leading to conflict. History is a record of class straggle.
3. Forms of mode of production or socio-economic formations
Production relations form the economic basis of society, while political and legal views and
ideology, and appropriate institutions make up its superstructure. These two components along with
productive forces were the key components of any socio-economic formation or particular type of mode of
Critical Appraisal of Marxian Philosophy
1. Cause of historical changes was not carried on to its logical extent. His argument was based on
theological ground and built on economic structure of society which itself changes.
2. No logical connection between Marx’s dialectical and historical materialism
3. Ignores reality because not only economic factor plays important role in historical change.
4. Historical materialism says that manner in which a man earns his living influence one’s thinking
was false because
a. Bread was not the sole end of human life
b. Person earning their living in same manner will not think alike
5. Socio-economic development does not take place in stages.
6. Marx’s theory of history neither explains the past correctly, nor predicts the future accurately.
The theory of prices or the transformation problem
Principle of equal profitability states that under competitive conditions, the rate of profit equal in all
employment. This invalidates 2 propositions of the theory of value that is i) relative prices correspond to
relative labor values (labor theory of value) ii) surplus value is a function of variable capital alone (theory
of surplus value). Marx solved the problem by transforming the values into prices of production. The
transformation was made possible by setting the total surplus value (?s) equal to total profits (?).
The theory of development
Laws of motion causing a capitalistic society to grow and then to fall are
i. Decreasing wage rate, extending working hour and increasing labor productivity increases
capital accumulation and technological progress.
ii. Competition forces capitalists to cheapen their products by inducing capital intensive technology
and by increasing the labor productivity. In the competition, small industries thrown out and
concentration of capital is with big capitalists.
iii. Growing misery of working class is due to an industrial reserve among of unemployed.
iv. Falling rate of profit r = ? /q +1
Where r = rate of profit
? = Constant rate of surplus value
q = increased capital per man or organic composition of capital.
With capital accumulation, capitalists try to get maximum production with minimum costs through
the use of capital intensive technology.
The theory of Business cycles
He has never attempted a specific theory of business cycles. Three crises pointed out (i)
Disproportionality that works without a plan and so there is disproportionate growth of various branches
of economy. (ii) Declining rate of profit (iii) Under consumption tendency to accumulate, expand capital
and produce surplus value, which increased production and consumption lags behind.
All products are divided into producer goods and consumer goods. Products are divided into three
value components of constant capital, variable capital and surplus value.
Imperialism refers to foreign policy of an advanced capitalist country that aims at political and economics
control over backward areas. This is to ensure that home country is an outlet for ideal savings and surplus
manufactured goods in exchange of necessary raw materials. A policy of monopoly capitalism and export
of capital is practiced.
Marx and the underdeveloped countries
1. Theory of surplus value says that economies with lower organic composition of capital or high
variable capital reap high surplus value, which was unproved for India.
2. With regard to theory of under consumption, in developed countries, it is the problem of high
production potential and in developing countries, it is the problem of low output level due to low
3. In case of theory of industrial reserve army, in developing economy, it is a problem of demography
rather than technological.
ORIGINS OF FORMAL MICRO ECONOMIC ANALYSIS-
JEVONS, COURNOT AND DUPIT
He has applied marginal principle to economic theory and viewed economic problems in
neoclassical manner as problems of valuation and optimal allocation.
On logic and scientific method
He has advocated hypothetical- deductive method and wanted economic science as certain like
physical science. Interested in pure theory but did not ignore statistical methods.
The utility theory of value and exchange
Economics is concerned with ordinal estimates. Utility is a subjective phenomenon and aim was to
maximize utility. He has formulated law of diminishing marginal utility and equi-marginal utility. It
resolved the age-old water-diamond paradox. Diamond is highly valued because of scarcity. Equation of
exchange requires that in equilibrium, ratios at which 2 commodities exchanged must be inversely
proportional to final degrees of utility.
——— = ——— Where x and y are two commodities.
Contract curve is obtained by joining the points of tangency of 2 sets of indifference curves. Final contract
between traders A and B takes place on this curve.
The theory of labor supply
Utility of labor
Marginal Utility A
O amount of output
C disutility of labor
Labor has utility because it was rewarding in terms of wages. It has disutility become it is painful
exertion of mind and body. Labor is supplied as long as utility is more than disutility and supplied up to
point where utility and disutility equal. Labor supply that produce OA units of output will be the
equilibrium labor supply because utility equals disutility of labor (AB=AC).
Theory of capital and interest
Capital means wages fund and regarded it a matter consuming time. A time lag separates labor
employment in production and final commodity production. Capital was required to maintain labor during
time lag. Amount of investment capital was determined by amount of capital invested multiplied by the
average time. Production process involved construction of durable goods by investing capital and
utilization of durable goods, which represents disinvestment of capital.
Capital or labor
OB represents continuous investment through time, BC represents continuous disinvestment through time
and AB is the greatest amount of capital invested. The area OBC shows amount of investment capital and
that is equal to ½ AB.OC.
Empirical Studies and Economic Policy
Jevons contributed to the science of Statistics in ‘A serious fall in the value of Gold (1863)’. Here
he examined methodological problems in construction of price index namely the problem of weighing,
choosing between arithmetic and geometric mean, problem of elimination of commodity with abnormal
O A C Time
movements and the problem of selection of sample commodity. Other statistical investigation was coal
question, which stated that rapid development of British industries would mean demand for coal in a
geometric progression. Jevons sunspot of trade cycle states that rhythmic changes in temperature as a result
of solar activity bring changes in agricultural production and affect general economic activity. Jevons called
for a systematic study of economic policy instead of the single rule of laissez-faire.
His analysis was sketchy and incomplete. It was for the latter economists like Walrus, Wicksteel,
Marshall, and Bohm-Bawerk to elaborate these ideas and examine their implications.
Jules Dupuit (18 May 1804 – 5 September 1866) was a French civil engineer and economist.
Engineering questions led to his interest in economics, a subject in which he was self-taught. His 1844
article was concerned with deciding the optimum toll for a bridge. It was here that he introduced his curve
of diminishing marginal utility. As the quantity of a good consumed rises, the marginal utility of the good
declines for the user. So the lower the toll (lower marginal utility), the more people who would use the
bridge (higher consumption). Conversely as the quantity rises (people allowed on the bridge), the
willingness of a person to pay for that good (the price) declines.
Thus, the concept of diminishing marginal utility should translate itself into a downward-sloping demand
function. In this way he identified the demand curve as the marginal utility curve. This was the first time an
economist had put forward a theory of demand derived from marginal utility. Although not the first time
that the demand curve had been drawn, it was the first time that it had been proved rather than asserted.
Dupuit, however, did not include a supply curve in his theory.
Dupuit went on to define “relative utility” as the area under the demand/marginal utility curve above the
price and used it as a measure of the welfare effects of different prices — concluding that public welfare is
maximized when the price (or bridge toll) is zero. This was later known as Marshall’s “consumer surplus”.
Dupuit’s reputation as an economist does not rest on his advocacy of laissez-faire economics (he wrote
“Commercial Freedom” in 1861) but on frequent contributions to periodicals. Wanting to evaluate the net
economic benefit of public services, Dupuit analysed capacities for economic development, and attempted
to construct a framework for utility theory and measuring the prosperity derived with public works. He also
wrote on monopoly and price discrimination.
Dupuit also considered the groundwater flow equation, which governs the flow of groundwater. He
assumed that the equation could be simplified for analytical solutions by assuming that groundwater is
hydrostatic and flows horizontally. This assumption is regularly used today, and is known by
hydrogeologists as the Dupuit assumption.
He has extensively used mathematics in economics. He was a pioneer in showing relationship
between small increments in commodities and those in price.
He assumed monopoly as his starting point. D= F(P) where quantity demanded is a function of
price. Maximum total value is obtained by multiplying QD with price. Taken another monopoly firm (more
specifically monopolistic, the less perfect condition of monopoly), the case of duopoly and attempted a
determinate solution. Concluded that price will be lowered and price lie between monopoly price and pure
competition price. With joint demand of copper and zinc (to produce brass) assuming no other use for two
raw materials and each supplied by a monopoly, concluded that price will be higher (as a result of increased
units costs) but hardly determinate. Criticism is that if two monopolies are sellers, price will be unstable
possibly falling to zero if supply increased infinitely.
Cournot competition is an economic model used to describe an industry structure in which companies
compete on the amount of output they will produce, which they decide on independently of each other and
at the same time. It is named after Antoine Augustin Cournot (1801-1877) after he observed competition in
a spring water duopoly. It has the following features:
? There is more than one firm and all firms produce a homogeneous product, i.e. there is no product
? Firms do not cooperate, i.e. there is no collusion;
? Firms have market power, i.e. each firm’s output decision affects the good’s price;
? The number of firms is fixed;
? Firms compete in quantities, and choose quantities simultaneously;
? The firms are economically rational and act strategically, usually seeking to maximize profit given
their competitors’ decisions.
An essential assumption of this model is the “Cournot conjecture” that each firm aims to maximize profits,
based on the expectation that its own output decision will not have an effect on the decisions of its rivals.
Price is a commonly known decreasing function of total output. All firms know N, the total number of firms
in the market, and take the output of the others as given. Each firm has a cost function ci(qi). Normally the
cost functions are treated as common knowledge. The cost functions may be the same or different among
firms. The market price is set at a level such that demand equals the total quantity produced by all firms.
Each firm takes the quantity set by its competitors as a given, evaluates its residual demand, and then
behaves as a monopoly.
Cournot duopoly equilibrium
This section presents an analysis of the model with 2 firms and constant marginal cost.
p1 = firm 1 price, p2 = firm 2 price
q1 = firm 1 quantity, q2 = firm 2 quantity
c = marginal cost, identical for both firms
Equilibrium prices will be:
p1 = p2 = P(q1 + q2)
This implies that firm 1’s profit is given by ?1 = q1(P(q1 + q2) ? c)
? Output is greater with Cournot duopoly than monopoly, but lower than perfect competition.
? Price is lower with Cournot duopoly than monopoly, but not as low as with perfect competition.
? According to this model the firms have an incentive to form a cartel, effectively turning the Cournot
model into a Monopoly. Cartels are usually illegal, so firms might instead tacitly collude using self-
imposing strategies to reduce output which, ceteris paribus will raise the price and thus increase
profits for all firms involved.
Important feature was introduction of marginal analysis. Classical was concerned with increasing
the wealth of a nation with limited land and unlimited labor, which was a dynamic system. Neoclassical
was concerned with short run problem of allocation of given resources with maximum benefit, which was a
An action will be performed only if it adds benefits more than the effort made on it. Necessary
condition is based on equimarginal principle which states that a resource allocated among competing uses
in such a may it yields same marginal return in all cases.
Sufficient condition was based on law of diminishing returns, which says that process of allocating a unit of
resource to one use producing diminishing results.
Production MPP = MIC
Consumption MV= MC
Mathematically necessary condition is dy/dx=0 and sufficient condition is negative d2y/dx2
Theory of value and distribution
Classical economists separated the theory of distribution from theory of value. Price of commodities
in product market is determined by natural prices of three factors of production namely land, labor and
capital. Rent was the differentiated surplus over and above marginal unit of cultivation. Wages were
explained by long run substitutive theory and profit was the residual element that is total product less rent
1. Theory of distribution is a part of theory. Value of factors is derived from value of their products.
2. Classical economists emphasized cost of production or supply aspect of valuation. Neoclassical
emphasized utility or demand side while Marshall emphasized the role of time element. In short
period, supply is inelastic and price is influenced by demand. In long run, supply changes and
3. Classical economists viewed demand determines commodity prices, neoclassical viewed price
of commodities determines price of factors of
production and Walrus said that both are mutually and simultaneously
Individual Collective agents like classes
Linked to natural science Scarcity is an eternal problem
Objective Subjective because it is a problem of
ALFRED MARSHALL (1842-1924)
Masterpiece is Principles of Economics, which appeared in 1890 and sought a
synthesis of utility theory of Austrian Economists and cost of production theory of
Nature and scope of economics welfare
Economics is study of mankind in ordinary business of life. Examine that part of individual and
social actions for attainment of material requisites of well being. Economics is not a body of concrete truth
but an engine for discovery of concrete truth. Economic laws are statements of tendencies. He has followed
diagrammatic approach to illustrate theories.
Marginal utility and demand
Marginal utility of a thing diminishes with every increase in amount of it a person already has.
1. Refers to given moment in time
2. No changes in habits and tastes
3. All units of good are homogenous.
Also, amount demanded increases with fall in price and decreases with increases in price. Law of equi-
marginal utility explains that consumer spent his money on different goods in such a way that their
marginal utilities are proportionate to their prices. Marginal utility is measured by money and economics is
the most exact of social sciences.
Consumer’s surplus is the difference between potential price and actual price. The excess of a price,
which a person would be willing to pay for a thing rather than go without the thing over that which is
actually does pay, is the economic measure of this surplus satisfaction. It became the basis of welfare
Elasticity of demand = % change in Quantity demanded
% Change in price.
This gives rate of change of demand. This is helpful in studying problem of value under monopoly.
Monopolist fixes high price for commodities with inelastic demand rather than elastic demand.
Supply and cost of production.
Supply increases when price increases. Supply curve slopes upward to right. Distinguished real cost
and expenses of production.
Marshalian theory of value and time element
Classical said cost of production or supply determines value. Marginal school said demand was
based on marginal utility, determined value. Marshall said both demand (Marginal utility) and supply (real
cost) at margin determine value, which is dual theory of value
Classified value into four kinds
1. Market value 2. Short – period value 3. Long period value 4. Secular value
Market value: Supply is fixed and it is vertical straight line and price depends on demand e.g. fish.
Short period value: Demand and Supply determine price. Only the variable inputs increases or decreases.
Long period value: Supply or cost of production determines price where plant size is changed
Secular value: population, tastes, capital and organization cause Secular changes.
Prime costs are variable and supplementary costs are fixed.
External economies Internal economies
Economies possible to an industry Economies possible to a single firm
or group of firms’ localization of due to economy of skill, machinery
industry. Develop hereditary skill, and materials e.g. federations, cartels
subsidiary and specialized industry. and co-operative organization.
Representative firm: Supply price of commodity depend on cost of representative firm It has fairy long
life, fair success, managed with normal ability and has normal access to economies of external and internal
and it represents an average firm.
Law of diminishing returns
An increase in capital and labor applied in cultivation of land causes in general a less than
proportionate increase is amount of produce raised unless it happens to coincide with an improvement in art
of agriculture. Agriculture has diminishing returns while manufacturing industry has increasing returns
Quasi rent is the income derived from machines and other appliances for production made by man. Supply
is inelastic in short run and quasi rent disappears in long run. Rent is the income from a factor whose supply
is permanently inelastic. It is fixed both in short and long run.
Wages depend on demand and supply. Demand is a derived demand, which depend on demand by
consumers for final products. Supply increases when marginal labor productivity and wages decreases.
Interest explained by abstinence theory of interest of Nassau senior. Marshall preferred the term waiting
which is sacrifice of present pleasure for future.
Marshall’s contribution to monetary economics
1. Money is a function of demand and supply
2. Made distinction between real and money rate of interest
3. Purchasing power parity which explains rate of exchange between countries with mutually
4. Index no is complied by chain method.
5. Symmetalism: Government is ready to buy or sell wedded pair of bars for a fixed amount of
currency. Symmetalism method by which bar of silver say 2000g is wedded to a bar of gold l00g.
6. Explained how increase in supply of money reflected in prices.
Conclusion: Devoted his life to make subject as a separate science, standing on its own foundations with
high standards of scientific accuracy as physical or biological sciences.
1. Clear distinction between long and short period
2. Doctrine consumer’s surplus.
3. Doctrine of quasi-rent
4. Expansion and refinement of rent concept
INDIFFERENCE CURVE ANALYSIS
The analysis is developed by English Economist Edgeworth (1845-1926) and Italian Economist,
Pareto (1848-1923) to analyze consumer demand, which is, alternative to Marshalian utility analysis of
Utility Indifference curve
1. Cardinal approach Ordinal Approach
2. One commodity is consumed Individual consumes 2 or more goods. Each
indifference curve represents satisfaction level. It
is impossible to measure satisfaction. Only say
one IC represents high or low satisfaction level.
Consumer is indifferent between different
combinations as long as he remains on IC curve.
Shape of IC: It Slopes downward from left to right; IC convex to origin; No IC cut each other.
Consumer’s equilibrium is studied through IC with following assumptions of 1. Scale of consumer
preference remained same 2. Consumer spends entire amount on one good or other 3. He is one of many
buyers 4. Homogenous goods 5. Rational consumer. Equilibrium is attained where price line is tangent to
Indifference curve. Price line shows opportunities to consumer available in market and Indifference curve
shows his tastes.
Income, Substitution and price effect
Income effect is produced with income changes but price remains constant. So consumer is better or
worse off. Substitution effect is with price change but consumers’ money income also changes and so he is
neither better nor worse off. He buys more goods for which the price has fallen. Price effect gives price
change but money income remains constant and result is change of real income. Substitution also takes
place. Price effect is a combination of income effect on one hand and substitution effect on other
1. Based on unrealistic assumption like assumption of perfect composition which is unrealistic
2. IC analysis assumed absence of institutional price controls, which is important during war and in
3. Rationalizes human behavior too much
4. Old wine in new bottle. Marginal rate of substitution is nothing but translation of marginal utility.
Other neo-classical economists are Knut Wicksell, J.B. Clark, Irving Fisher and Taussig.
Walras is a great mathematical economist. His greatest contribution is general equilibrium method
in contrast with ceteris paribus method of Marshall’s partial equilibrium analysis. Both are concerned with
equilibrium price and quantity determined by intersection of demand and supply. Marshall related Qd or Qs
with price of that good. Price of goods or substitutes and other factors enter into ceteris paribus assumption.
This is partial equilibrium method because he ignored the interrelation of different markets.
Walras economic system is a unified system in which all markets are interlinked and prices in
different markets are determined simultaneously. According to general equilibrium approach, economic
system as a whole is in equilibrium and valuation problem is solved only when all demands in economy
become equal to all supplies in economy simultaneously. Marshall wanted to write for ordinary
businessmen while Walras was interested in convincing his professional colleagues and mathematical
analysis came to importance.
The Walrasian General Equilibrium System
1. The consumer goods ‘m’ in number (A,B,C)
2. The productive services ‘n’ in number of Land, Labor ,Capital (T,P,Q)
3. The price of consumer goods (Pa, Pb, Pc)
4. The price of productive services (Pt,Pp,Pq)
5. Initial quantities of productive services possessed by the individuals qt, qp,qq
6. Quantities demanded and supplied
Ot, Op,Oq of services offered (if positive) or demanded (if negative)
da, db, dc consumer goods demanded.
Based on following 2 parameters
1. Technical coefficients of production ‘mn’ in number
at, ap, aq ; bt, bp, bq and ct, cp, cq.
Technical co efficient of production refers to quantities of ‘n’ productive services of land, labour,
capital (T, P, and Q) required to produce ‘m’ finished products (A, B, C) i.e. n column of m rows.
2. Utility functions mn in number r = Ø (q) – marginal utility function
Individual in order to be in equilibrium satisfy the following 2 conditions of exchange
1. Budget equation requires that total expenditure equal to total receipts
Ot Pt + Op Pp + Oq Pq + …… = da Pa+ db Pb + dc Pc + ….
2. Principle of equi-marginal utility requires that marginal utility of various goods and services are
proportional to their prices.
We have M equations for productive services of each individual and m-1 equation for consumer goods.
Thus there are n+m-1 equations for n unknown individual supply functions for productive services and m
unknown individual demand functions for consumer goods. When we add individual ‘D’ ad ‘S’ fns, we get
four sets of equations defining the general market equilibrium
1. Equation representing the market supply for productive services (n in number)
2. Equation representing the market demand for finished goods (m in number)
3. Equation representing market clearing conditions for factor markets (n in number)
4. Equation representing equality of unit cost and prices for finished goods (m in number)
Unknown quantities of productive services offered (n), quantities of finished goods demanded (m), ‘P’
of productive services (n), ‘P’ of finished goods (m-1) Total number of unknowns 2 m+ 2m-1. Thus
number of equations exactly equal number of unknowns and general equilibrium is possible.
The existence of a unique solution
Walrus equilibrium provides a unique and positive solution since number of unknowns equal to
equations. But mathematically shown that this equality is neither a sufficient not a necessary condition for
existence of unique solution.
1. You can have a system of 2 equations with 2 unknowns for which no solution in terms of real
q2 + p2 =0
q2 – p2 =1
solves for q = ?½ and p = z ?½ where z satisfies q2= -1
2. It is not a necessary condition because a single equation with two unknowns q2+p2=0, a unique
meaningful solution exists where q = 0 and p =0
3. Again in 2 equations with one unknown, a unique positive solution exists q=3
q3-3q = 18
Wald demonstrated Walrasian system providing a unique non-negative solution if the assumptions are
1. Supplies of productive resources are positive
2. Technological co-efficient of production are zero or positive
3. At least one productive service enters production of each commodity
4. Demand function for every commodity is positive, continuous and monotonically decreasing
The theory of Tatonnement and Question of stability
Walras then explained how equilibrium is established empirically in market by mechanism of
competition. This is the problem of economic dynamics and Walras discussed in theory of Tatonnement.
This is the process of trial and error by which a system with disequilibrium moves towards equilibrium,
which is explained with concept of excess demand, which is the difference between QD and QS.
When QD > QS, E.D. is positive
QD < QS, E.D. is negative disequilibrium
QD = QS, E.D. is zero – equilibrium
The theory of tatonnenment provides solution to the problem of determinacy and the problem of
stability is attached when
1. Negatively sloping ‘D’ curve intersects positively sloping ‘S’ curve
2. Negatively sloping ‘D’ curve intersects negative sloping ‘S’ but steeper ‘S’ curve.
The theory of capital and Interest
He distinguished fixed capital, which is not used immediately, and circulating capital, which is used
?= p – (u+v) P where
P = price of capital good
? =Net value of capital good
p = Annual gross value of capital good
v = Insurance
Rate of interest i= p+(u-v)P P
————— or P = —————
Two unknowns cannot be determined in one equation. Problem of determinacy is not a problem in
His theory is simple ad empty in substance because
i. Not analyzed trace nature of ‘D’ and ‘S’. Supply of capital was not related to price alone.
ii. Time preference was important influencing saving but Walrus ignored.
iii. Didn’t say why capital goods were demanded and failed to relate marginal productivity
iv. No theory on capital accumulation
The theory of money
Recognized four types of circulating capital namely stocks of consumption goods and cash balances
held by consumers; Inventions of goods and cash balances held by entrepreneurs; Price of four kinds of
circulating capital is related to price of its service
? = pi
? =Price of service
p = price of money
i = Rate of interest
At equilibrium, money rate of interest equals to real rates of interest i = ?. It is significant because it is
logically integrated into general equilibrium system
On applied economics and social economics
He believed in close relationship between pure and applied theory. Pure economics provides logical
proof for proposition. He felt that applied economics points to the disturbing causes in achieving the goal in
accordance with the guiding principle. He believed that perfect competition is not always beneficial. He
advocated state intervention for monetary stability, to provide public services for justice and education, to
control natural monopoly.
Social economics describes general social conditions and particularly personal position. Income
form personal goes to individual while land and rent goes to state. Walrus strikes a balance between
individualism and communism.
CHAPTER – XV
Pigou is the father of welfare economics. In views of Reader, welfare economics is the branch of
economic science that attempts to establish and apply criteria of propriety to economic policies. Oscar
Lange says welfare economics is concerned with conditions, which determine total economic welfare of a
Leading questions about welfare economics
Is economy functioning well? Is society’s system of distribution is good? What should be done
about improving total welfare? What government intervention is needed to promote economic welfare?
Welfare in evolution
Adam Smith considered index of welfare as larger per capita output as a result of larger production.
Bentham considered greatest happiness of greatest number as goal of happiness. Marshall considered
Consumer’s surplus as an engine of economics analysis ad not a program of social welfare.
J.A. HOBSTON (1858 – 1940)
His idea of welfare economic is found in BookWork and wealth. He advocated moderate radical
reform to promote economic welfare and advocated government intervention.
He has rejected classical economist’s assumption of
1. Perfect competition
2. Harmony of interest
3. Laissez-faire policy
He has developed under consumption theory of trade cycle. Under consumption and over saving
results in over investment leading to over production and glut on market. Inability of capitalist economy to
keep economy fully employed lead to imperialism. It should find new economies as market for goods and
sold in home market.
Reducing inequalities of income attains economic welfare. If there is proper distribution of income
in society, then home market is capable of infinite expansion and there is no over – production and no need
for exploiting colonies by following policy of imperialism. Income was redistributed through trade union
action to raise wages and pension He has suggested state intervention for regulation of industry and
taxation on monopoly gains, high rent and interest. Revenue was used for provision of social services like
health and education and to undertake public works program.
He was the father of welfare economics. His ideas on welfare economics were found in his
Economics of welfare (1920). He has attempted to provide theoretical basis for social reform to promote
welfare. Extended law of diminishing utility to money and assumed marginal utility of money diminishes
as more and money acquired. Pigou rejected classical economists’ assumption of harmony of interests. He
has not believed in societal welfare as a sum of welfare of individuals. Pigou rejected the idea of classicists
and distinguished between social and marginal private costs and benefits. Private marginal cost is the cost
of producing additional unit and social marginal cost is the expense or damage to society as consequence of
producing that commodity.
Social cost is greater than private costs
1. Alcoholic drinks sales against policing required
2. Environmental pollution.
Social benefit is greater than private benefit
2. Pollination by Bees.
Problems of society arise out of people’s attitude to future. People prefer present satisfaction to future
satisfaction. Therefore government avoids tax on saving to encourage savings. Hobston attacked over –
saving while Pigou increases saving to promote economic growth. Pigou assumed interpersonal comparison
of utilities, which is impossible.
New Welfare Economics
It is not possible to make interpersonal comparison of utility since utility is not measurable. He
made the use of concept of social optimum or Pareto Optimum, which is reached when one cannot make
some one better off without mating some one else worse off.
1. Applied to unambiguous cases. If government policy harm some and benefit some, then this not
2. If adopted, it leads to status – quoism and non-intervention by Government.
He pointed out weaknesses of Pigou’s approach as
1. Pigou correlated economic and general welfare
2. Made interpersonal utility comparisons
3. Identified sum of consumer surpluses with real value of national dividend.
Hicks introduced compensation and reorganization principle. Changes in tax structure are the
reorganization principle, which helped some and affected some. Compensation principle is that society’s
economic welfare increased if people gained form reorganization compensates those who lost.
Social welfare function is to explain ideas of welfare economics. Social welfare function is the
method by which social scale of preferences derived from individual scale of preferences, which done
either voluntarily or by dictator in centrally planned economy.
WELFARE ECONOMICS – SOME MORE INSIGHTS
Objective of welfare economics is evaluation of social desirability of alternative economic states.
Different resource allocation and different distribution of rewards for economic activity characterize each
state. Welfare of a society depends in broad sense upon the satisfaction level of all its consumers. Welfare
comparisons are simple if aggregate utilities of individuals are captured in a single utility function. This is
not possible since interpersonal comparisons of utilities are not possible.
Pareto optimality and the efficiency of perfect competition
Pareto optimality was attained if production and distribution can’t be reorganized to increase utility
of one or more individuals without decreasing utility of others. Pareto – non-optimal is if some one’s utility
is increased without harming anyone else. But welfare is increased, if one person’s position improves with
no change in position of others.
Pareto conditions achieved under perfect competition
i. Second order conditions satisfied for each consumer and producer
ii. No consumer is satiated
iii. No external effects in either production or consumption.
Pareto optimality for consumption
A distribution of consumption goods are pareto – optimal if every possible reallocation of goods
that increases utility of one or more consumers result in utility reduction for at least one other consumer.
Pareto optimality is achieved if each consumer’s utility is highest given the utility level of all other
consumers. Pareto optimality for consumption is attained when rate of commodity substitution of
consumers is equal. Pareto optimality for production is attained when rate of technical substitution of
producers is equal. Pareto optimality in general is attained when
1. RCS for all consumers and RPT for all producers equal for every pair of produced goods.
2.RCS for all consumers and RTS for all producers equal for every pair of primary goods.
3. RCS between factors and commodities equal the corresponding marginal products. Thus the
Pareto optimal state is described as the state that it is not possible to increase the utility of one or more
consumers without diminishing utility of others by discontinuing production of one or more goods.
Social welfare functions
It is the ordinal index of society’s welfare and function of utility levels of all individuals. Not
unique and its form depend upon value of judgment of persons for whom it is a desirable welfare function.
W = W (U1, U2 … Un)
Where Un is the level of utility index of with individual.
A welfare optimum is completely determined as a result of introduction of value judgments in form
of social welfare function. The resulting allocation is Pareto – optimal.
RCS is same for both consumers and equal corresponding RPT. The rate at which consumers substitute
leisure for commodities equals marginal productivity of labor. This proves Pareto optimality if second –
order conditions are satisfied.
Social preference and indifference
This is to create social analog to individual indifference curve. Economists derived contour lines on
commodity space, which represent alternative combinations of aggregate quantities of commodities along
which society as a whole indifferent. In a two – person society, social welfare function is W = W (U1, U2).
Find Scitovsky contours corresponding to all distributions of utility (U1, U2) for which W (V1, V2) = W0.
Least ordinate corresponding to any value of q1 represents minimum amount of q2 to ensure welfare level
W0. Envelope B of Scitovsky contour is locus of minimum combinations of q1 and q2 necessary to ensure
welfare level W0 which is Bergson contour.
Arrow possibility theorem
Arrow investigated formulation of social preferences. He describes individual and social
preferences in terms of rankings of alternative states by relation are at least, as we liked as. Arrow stated 5
axioms, which he believed social preference structures must satisfy to be minimally acceptable.
Complete ordering: Social preferences are completely ordered by relation is at least as well liked as
socially as and satisfy conditions of completeness, relativity and transitivity.
Responsiveness to individual preferences
If individual rankings change so one or more individuals revise A to a higher rank and no one lower
A in a rank. Also, this axiom is violated.
Social preference not imposed independently of individual preferences. If no individual prefers B to
A and at least one individual prefers A to B, society must prefer A to B.
Social preference not reflects preferences of any single individual. Society prefers A to B if ith
individual prefers A to B.
Independence of irrelevant alternatives
Most preferred state in a set of alternatives independent of existence of other alternatives. If society
prefers A to B to C and if C is no longer available, then it must not true that society prefers B to A.
Keynes analysis was aggregative analysis and he was inventor of macroeconomics method.
Employment = output = Income
Aggregate supply function Aggregate demand function
Size of income Propensity to consume Marginal efficiency Rate of interest
Prospective yield Supply price Quantity of Liquidity
Future expectations and so marginal efficiency
of capital and investment expenditure fluctuates
Transaction Precautionary Speculative
Motive motive motive
The General theory of employment, Interest and money is the most scientist and revolutionary
THEORY OF EMPLOYMENT
1. Employment = Output = Income. As employment increases, output and income increases
2. Volume of employment depends on effective demand which was determined by aggregate supply
function (representing cost of entrepreneurs) and aggregate demand function (representing receipts
of entrepreneurs). Aggregate ‘S’ function was taken as given in short period.
3. Aggregate ‘D’ function was governed by consumption and investment expenditure
4. Consumption expenditure.
5. Investment expenditure
6. Marginal efficiency of capital
7. Rate of interest
The General Theory of Employment, Interest and Money
Keynes was the first to develop systematic theory of employment and classical and neoclassical
economists neglected the problem of unemployment. Unemployment was due to deficiency of effective
demand and believed as short-run problem and employment = output=income. Effective Demand means
desire plus ability and willingness to buy i.e. actual expenditure. Effective demand depends on aggregate
‘D’ and ‘S’ function. Aggregate demand function represents different amount of money which
entrepreneurs expect to get from sale of output at varying expenditure levels. Planned or intended
expenditure at different income level. It comprises of consumption and investment demand
C= f(Y). As income increases, consumption expenditure also increases.
Aggregate ‘S’ function represents different amounts of money which entrepreneurs get from output
sale at varying employment levels. It represents different income levels (output and employment) which
entrepreneurs supply at different levels of expenditure (C+I). SS (45 line) is aggregate ‘S’ Schedule which
indicate given level of total expenditure (C+I) equal total income offered. Intersection of aggregate ‘D’ and
‘S’ function determine effective demand. E is effective demand and Oyo is equilibrium level of income and
expenditure at this level, Y=C+I.
1. Y = C=I does not indicate full employment level. So less than full employment occurs and ‘I’
generally inadequate to fill gap between, income and consumption.
2. Aggregate ‘S’ function can’t be manipulated and so is not of practical importance. Therefore theory
of employment is theory of aggregate demand.
Consumption function or the psychological law of consumption
C = f (y)
© SS (Y=c+1)
C+I (Agg.demand )
450 Y0 INCOME
O Y0 Income
The psychological law of consumption
1. When aggregate income increases, aggregate consumption also increases but by a somewhat smaller
2. Increment of income is divided in some ratio between ‘S’ and ‘C’
3. Both saving and consumption increases as a result of increase in income.
Three technical attributes
1. Marginal propensity to consumer (MPC) = ?C/?Y. This gives slope of ‘C’ curve. MPC of Poor is
greater than MPC of rich.
2. Marginal propensity to save (MPS) is complement of MPC so that MPC + MPS =1 It is ?S/?Y
S = Y –C
?S = ?Y – ?C
?S 1- ?C
—– = ———-
MPS = 1-MPC
3. Average propensity to consumer (APC) = C/Y (or) consumption level at a given income level.
MPC is positive but less that unity.