Module I

Importance of History of Economic Thought

Pre-Classical School
Classical School
The Marginalist School
Development of Macroeconomics
The Institutional School

INTRODUCTION

The History of Economic Thought is the study of the philosophies of different thinkers
and theories in the subject matter of economics from the ancient world to the present.
Economic thought helps to understand economics and provides introduction to the part
of intellectual history.

Economic thought deals with the origin and development of economic ideas and
their interrelation. It involves different opinions and ideologies on economics subject.
It involves many different schools of economic thought. Studying the history of
economic thought is very important because one cannot possess knowledge about
economics until one knows its history.

MEANING AND DEFINITION

Economic thought can be regarded as a collection of highly subjective, and personal
economic ideas of great economists. History of economic thought may also include
opinions of the different schools of economic thought. It is the sum-total of all opinions
concerning economic discipline.

According to H.L Bhatia history of economic thought includes the doctrines and
generalisations of various thinkers which deal with economic phenomena of our life.
It went through a lot of evolution with specific contributions from various thinkers that
had great impact upon the future of economic thought.

Prof. Haney has defined the subject in the following words: "The subject, the History
of Economic thought, may be defined as a critical account of the development of
economic ideas, searching into their origins, interrelations and manifestations.
History of Economic thought is different from Economic History and History of
Economics.

While History of Economic thought deals with the development of economic ideas;
Economic History is the study of the economic development of a nation or country. On
the other hand, History of economics deals with the science of economics. Economics
as a science, that is, as a body of systematised knowledge, is only of recent origin. It is
roughly two hundred years old. It is only after the publication of the "Wealth of
Nations" by Adam Smith in 1776 that we have come to study economics as a science.
That is why Adam Smith is regarded as the 'Father of Political Economy." That is, the
latter part of the 18th century may be taken as the starting point. But the History of
economic thought is broader than the history of the science. Economic ideas have been
there ever since the birth of mankind. We find economic ideas even in the writings of
the ancient Hebrews, Indians, Greeks, Romans and during the Middle Ages. Prof. Bell
describes economic thought as

NATURE & IMPORTANCE OF HISTORY OF ECONOMIC THOUGHT

History of economic thought is sometimes regarded as the old ideas of dead authors.
There is some truth in this statement. However, there are many ways of looking at the
subject of history of economic thought.

It has been rightly pointed out that a history of economic thought is a critical account
of the development of economic ideas, searching into their origin, inter-relations,
manifestations, and effects. History of economic thought is concerned with the history
of economic ideas which are placed in order on the basis of origin. Since human beings
have always thought about economic problems for their day-to-day existence,
economic thought can be regarded as old as the history of mankind.

There are two main views on the importance of the study of the history of economic
thought. One group of economists asserts that there is no need to study the history of
economic thought, especially the history of economic thought before the 18th century.
They regard the ‘history of economic thought as the ‘history of errors.’ They believe
that no useful purpose can be served by the study of the absurd (illogical) opinions and
doctrines that have long been exploded. This is however, is not a correct view. For even
the study of error would enable us to avoid it in future.
Another set of economists believed that one cannot, moreover, be said to possess a
knowledge of any doctrine or to understand it until one knows something about its
history.

A study of history of economic thought is important for the following reasons.

1. Through the study of the history of economic thought, we realise that there is a
certain unity in economic thought and this unity connects us with ancient times.
We can see that there is continuity in the evolution of economic thought.

2. Inspite of tremendous improvement in the science of economics, even today the

nature and scope of of economics is under dispute. The study of economic thought
will help us in understanding the origin of economics. So there is great value in
studying the history of economic thought.

3. Economic ideas have been instrumental in shaping the economic policies of

different countries.

4. Through a study of economic thought we realise that most of the economic ideas
are relative by time, place, and circumstances. Economic ideas are rooted in
economic practice. Many economic ideas in the past had their roots in institutional
arrangements. Aristotle justified slavery because slavery was an accepted social
fact of the greek civilisation.

5. A study of economic thought provides a broad basis for comparison of different

ideas. It will enable a person to have well-balanced and reasonable judgement. As
he is familiar with most of the old theories. He will not be confused easily be new
ideas. He will have the necessary background to form a correct judgement.

6. The student will realise that economics is one thing and economists are another.
There may be controversies among economists. But these controversies will not
last long. They will die and there may be synthesis of different conflicting theories
with will result in the evolution of economic laws.

7. A study of thought helps us to know the achievements, the failures, the capabilities
and the limitations of different theoreticians and of different theories.

8. The study of the subject helps us to avoid the mistakes committed by earlier
economic thinkers.
9. The study of history of economic thought will enable us to know the person
responsible for the formulation of certain important principles.

10. A study of thought broadens the horizon of our knowledge and perspective. Such
a study provides a crucial insight into our ability to analyse problems.

11. It is possible to know, by a study of history of economic thought, the chronological

growth of different economic theories. We can know the origin of various theories
in economics by a thorough study of history of thought. In this process, it is also
possible to know the differences of opinion and philosophy in the development of
theories in economics.

12. Economic thought provides the readers with a broad basis of comparison between
different theories and also between different authors.
 PRE-CLASSICAL SCHOOL

1. ANCIENT ECONOMIC THOUGHT

a. HEBREW ECONOMIC THOUGHT

b. GREEK ECONOMIC THOUGHT
c. ROMAN ECONOMIC THOUGHT
d. MEDIEVAL ECONOMIC THOUGHT

2. MERCANTILISM
3. PHYSIOCRACY

1. ANCIENT ECONOMIC THOUGHT

The ancient economic thought is not based on any systematic paradigm. In ancient
times, economic thought was not organised. It was scattered lying here and there in an
unorganised manner. Economic thought during this period was mixed with ethics and
philosophy. The economic thought of ancient times was not scientific.
The economic thought of the ancient period can be discussed under different schools
of thought, such as, Hebrew school of thought, Greek school of thought, Roman school
of thought and the Medieval economic thought. These are briefly discussed below.

a. Hebrew Economic Thought (2500 B.C. - 150 B.C.)

The Old Testament of the Bible discusses the Hebrew economic ideas. The Hebrew
economic thought is based on metaphysical and ethical considerations. During the
Hebrew period, agriculture was given the most important place in society. There were
two classes of people: the privileged and the under-privileged. The royal families used
to lead a life of enjoyment. There was also the existence of a slave class. Land was the
important form of property. For most of the people, agriculture was the primary
occupation. Trade and commerce were not developed. In the Hebrew period, the family
system was patriarchal in nature (a social system that gives power and control to men
rather than women). The Hebrew society was based on the concept of justice.
Corruption was punishable, whereas honesty was rewarded. There was discouragement
of speculative activities. Money facilitated exchange in the market. The Hebrew
women were experts in weaving and spinning. There was no tax system in the Hebrew
society. No interest was allowed for loans, and trade and commerce were regulated by
laws. The people were advised to lead a life of idealism by giving up corrupt practices
and dishonesty.

b. Greek Economic Thought (427-322 B.C.)

The Greek economic thought considered economics as the science of home
management, and secondly, also as the art of wealth-getting and wealth-spending.
However, economics was not treated as an independent discipline. The Greek
economic thought was developed mainly by the three writers: Plato, Aristotle and
Xenophon.

i. Plato (427-347 B.C.)

Plato's ideas on economics arose in his book, The Republic. Plato advocated the
importance of division of labour (division of labour, the separation of a work
process into a number of tasks, with each task performed by a separate person or
group of persons) in economic activity. The division of labour arose from the natural
differences in human beings. Plato's interest was mainly in the development of the
economy and of output. He was also interested in the increase of efficiency. Plato
also advocated for the increasing amount of specialisation in production. Exchange
and trade were an integral part of the social organisation during the time of Plato.
Money was not only a medium of exchange, but it was also a standard of value.
Money facilitated trade and commerce. According to Plato, specialisation is the root
of all economic progress. Plato considered slavery as a permanent and necessary
institution in the history of mankind. But he wanted good treatment to the salves.

ii. Aristotle (384-322 B.C.)

The most important contribution of Aristotle to the development of economic thought
was his ideas on the meaning and nature of economics. According to him,
Oeconomicus aims at the management of the household economy and Chrematisptics
is concerned with wealth-generation and spending. He was in favour of the household
economy as it was a natural one. Aristotle's books, Politics and Ethics, contain his
economic thinking. He was also a supporter of the slavery system. Aristotle
considered value-in-use and value-in-exchange (value in use refers to utility or use
that you get from using something. On the other hand, value in exchange refers to the
utility or use you get from exchanging something for something else). He was the
economist who made such a distinction for economic analysis. Aristotle was against
the payment of a high rate of interest (usury). Money was a medium of exchange and
 a unit of account. He also thought that money can act as a store of value. Aristotle
was in favour of private property, and he was against the joint use of property. He
condemned monopoly. He was against the payment of high rate of interest because it
is unnatural, and it leads to an unnatural accumulation. Aristotle wanted the
maximisation of average wealth, given the constraining natural law. Aristotle's major
contribution was the conceptualisation of economics in the form of microeconomic
household management.

iii. Xenophon (440-355 B.C.)

The main economic ideas of Xenophon are contained in his book Cyropaedia. This
book contains a good discussion on the division of labour. He has also discussed
about the management of the domestic economy. He was in favour of agriculture. He
was of the view that mines can be an important source of wealth for the development
of a nation. He urged for the organisation of joint-stock companies. According to
Xenophon, merchants and shipowners were considered highly valuable citizens
because they brought wealth to the city.

c. Roman Economic Thought

The Roman economic thought was not original. It was mainly derived from the Greek
economic thought. It was against money- making. It had a high regard for agriculture.
The Roman thinkers were in favour of cultivation of small plots of land. Large-scale
farming was not favoured by the Roman thinkers. The Roman writer, Pliny, was in
favour of using gold as money. However, there was a marked change in attitude
regarding slavery during the Roman period. The slaves were considered inefficient.
There were many Roman such as Cicero, Seneca, Pliny, Cato and Verro.

Cicero was in a favour of wholesale trade and agriculture, but he was opposed to
interest (usury). Seneca considered money as the root of all evils. He also recognised
the importance of utility for the determination of exchange value of a commodity. He
also had faith in the division of labour. Cato thought agriculture to be the most
important profession. Pliny wrote on the use of money and its importance in the
development of a nation. He condemned interest. He wrote about the superiority of
gold as a medium of exchange. Columella was in favour of small-scale farming and
pointed out the superiority of free labour over the slave labour. According to him, the
utilisation of slave labour was responsible for the decline of Roman agriculture. Verro
was an industrial economist. He said that the labourers should be given incentives for
the growth of industrial production. He was in favour of the use of hired labour instead
of using the slave labour because the slave labour was less productive.

d. Medieval Economic Thought

The Medieval writers are moralists. The Medieval thought was based on moral
questions of right and wrong, justice and natural law. The most important single writer
who was responsible for the development of Medieval thought was St. Thomas
Aquinas.

i. St. Thomas Aquinas (1225-1274)

According to Aquinas, value is nothing but the just price. The price should include the
cost of production, risk and carriage charges. Aquinas also supported the division of
labour in society. He said that all occupations were valuable, and agriculture alone is
not superior. Aquinas condemned high rate of interest (usury). But he was in favour
of providing compensation for damages and delay to the lenders. Interest was regarded
as a sinful and unnatural payment. Although internal and international trade were
developing during the period of Aquinas, still be considered trade as something
unnatural. Aquinas was in favour of private property. But he felt that property should
be honestly acquired and be used for the common social benefit. According to
Aquinas, a state has to perform many important functions such as the maintenance and
building of roads, providing a good system of coinage, weights and measures and for
eliminating poverty, apart from maintaining the regular law and order situation. It is
pointed out that the Medieval concept of just price was the beginning for the
development of labour theory of value. (The labour theory of value is an economic
concept that states that the value of a commodity is based on the amount of labour
required to produce it. The concept was popularised by classical economists like Adam
Smith and David Ricardo and has been adapted over time by other economists such
as Karl Marx). It was indeed a great Medieval contribution.
2. MERCANTALISM

Mercantilism is a system of commercial capitalism or merchant capitalism which was

introduced in different parts of the world during the period 1500-1750. The term
Mercantilism' was coined by Adam Smith. The mercantilists thought that the wealth of
a nation could be increased by trade.

Mercantilism had different meanings and connotations in different countries. In

Germany, mercantilism was called Cameralism; in France, it was called Colbertism
and in England, the system was called Mercantilism. It is a set of doctrines
advocating the accumulation of gold and silver, favourable foreign trade balance,
increase in state power and the prosperity of the nation.

The fundamental aim of the mercantilist was to make his country strong. The
mercantilists believed that the wealth of a nation consisted in the amount of gold
and silver possessed by it. So, they suggested ways and means of increasing the
stock of gold and silver in a country. So, the mercantilists attached a lot of importance
to bullion (physical gold and silver of high purity in the form of coins) and S.J. Steuart.

If a country has mines, it can get gold and silver. And it can accumulate those precious
metal by imposing restrictions on the export of gold. But if a country has no mines, it
can get gold and silver only as a result of trade. Trade must be conducted and
regulated in such a way that gold may come into the country. In order that a
country may have more bullion, there must be a "favourable balance of trade."
In other words, there should be an excess of exports over imports. "It was thus a
primary principle of the typical mercantilist to maximise exports while minimising
imports.

Basic Principles and Policies of Mercantilism

There are many basic principles and policies of Mercantilism. The following are,
however, the broad ones:

1. The desire that the state must be made very strong.

2. Money is wealth and capital. There should be accumulation of money in the form
of gold, silver and precious metals, which can determine the strength of a nation.
3. Foreign trade must be encouraged so that a country can have favourable balance
of trade through the earning of export surplus. Every country should try to export
 more and import less. This is a way of getting the inflow of gold and silver by a
nation.
4. All exporting industries are to be encouraged and imports are to be discouraged.
5. A country should give more importance to the development of manufacture and
trade.
6. There would be a strong government for giving protection to the merchants and
for maintaining law and order situation.
7. A country should have its own ships for the purpose of trade.
8. The wages should be low so that the production cost and the prices can be kept
low. These will help the growth of export.
9. Population growth should be encouraged. People are the real wealth of the
country.
10. Mercantilism favoured a multiple tax system.

Economic Ideas of Mercantilism

1. Foreign Trade: Mercantilist writers were in favour of having a favourable

balance of trade which could be earned by exporting more than import. The
surplus in the balance of payments which was emphasised by the mercantilist
writers, was the excess of exports, both visible and invisible, over imports. This
surplus will come to the domestic country in the form of gold inflow.

a. The mercantilists were eager to earn money and wealth through foreign trade.
Foreign trade was a means to acquire more and more money in the form of
gold and silver from the foreign countries.
b. Foreign trade is the means to purchase cheaper raw materials from the
international market.
c. Foreign trade is also a means for selling out the domestic output in the form
of export.
d. Foreign trade surplus was regarded as an index of economic welfare.
e. The inflow of bullion may also reduce the rate of interest. This is very
essential for increasing investment, output and employment.
f. The mercantilists believed that a country can be great only at the cost of
others. They were interested in making their own country relatively stronger
than the neighbouring countries.

2. Role of Money: Money was considered to be the most important source of

strength to the nation. The mercantilists were of the view that money, usually in
the form of precious metals or treasure, had played an important role in
 determining the economic well-being of a nation. Therefore, the mercantilists paid
a lot of attention to the accumulation of precious metals. Hence their emphasis on
the ways and means of increasing the stock of precious metals by maximising
exports and minimising imports.

3. Nationalism: Mercantilists emphasised on the national strength and prosperity.

The mercantilists regarded the state as the supreme power for controlling the
activities of the people. State was the master and its citizens, the servants. The
mercantilists believed that state intervention was necessary to solve the problems
of the society. They believed that for securing success in wars a strong nation was
required. As a result, they suggested the policy of protection. The state policies
were shaped according to this idea. Special acts were passed to encourage exports
and the development of industries.

4. Population: Mercantilists favoured a large and rapidly increasing population for

making the nation militarily strong and for increasing its productive capacity. They
believed that an increasing population meant both an increase in potential number
of soldiers and an increase in the number of productive workers. They believed
that cheap and abundant supply of labour would keep the cost of production low.
According to Davenant, “people are the real strength of a country”.

5. Natural Resources: The mercantilists wanted to utilise all the natural resources to
the maximum extent so as to produce more, export more and import less. They also
attached importance to agriculture in order to solve the food problem.

6. Wages and Rent: The mercantilists discussed the problems of production only.
So, they did not give much importance to the problems of distribution, especially
to wages and rent.

7. Taxation: The views of the mercantilists on taxation were interesting because they
were more scientific and ahead of their time. Broadly speaking the mercantilists
favoured a multiple tax system based on the principle of “each should pay
according to the benefits received from the state”.

8. Factors of Production: Mercantilists recognised three important factors of

production, namely, land, labour and capital. Here we can quote Sir William
Petty’s saying, “Labour is the father and active principle of wealth as land is the
mother”. The Mercantilists emphasised the cultivation of agricultural waste lands
 so that food production might increase, and the country might become self-
sufficient, and imports might be reduced.

9. Interest: No unanimity existed among the mercantilist writers on the subject of

interest. Sir Thomas Mun, a famous mercantilist writer favoured interest taking for
the loans on the ground that lending helped the poor and young merchants. Thomas
Mun and his followers said that the rate of interest would be high or low depending
upon the industrial conditions of the country.

10. Commercial Regulation: Mercantilists believed that commercial regulations

were essential for maximising social welfare. Commercial laws were passed to
restrict the import of food materials. But no regulation was applied to the import
of raw materials because they were required for the industrial development of the
country. The state supported the export industries and shipping which would secure
a favourable balance of trade.

Critical Appraisal

1) They wrongly thought that wealth consists in gold and silver and other precious
metals. They thought that wealth was the same thing as money or bullion.
2) The mercantilists regarded wealth as an end in itself.
3) The mercantilists advocated the attainment of favourable balance of trade at the
cost of other countries. Their policy was self-centred.
4) The mercantilists were narrow nationalists. Their policy was against cosmopolitan
internationalism.
5) They wrongly considered that foreign trade is the most desirable occupation. Adam
Smith showed that all occupations are equally desirable and important.
6) Mercantilism was based on the policy of exploitation of colonies. It was the
beginning of colonialism.
7) They lacked broad-mindedness and advocated certain narrow policy measures for
their temporary gain.
8) The most misleading doctrine of the mercantilists was that ‘a country can get rich
only at the expense of other countries.’

Because of the above criticisms, mercantilism could not continue for a long time. The
criticism against mercantilism reached its climax towards the end of the 18th century
when Adam Smith published his book “The Wealth of Nations”.
3. PHYSIOCRACY

The system of physiocracy developed in France in the middle of the eighteenth

century. Adam Smith considered physiocracy as a school of agriculture. The term
physiocracy means ‘Rule of Nature’. Economic thinkers who contributed to the
growth and development of physiocracy have been designated as physiocrats. Their
publication covered the period from 1756 to 1778. Physiocrats have been regarded as
ancestors of the ‘French Revolution.’ Physiocrats developed the doctrine that
agriculture was the sole source of all wealth, the only productive occupation.
Though the physiocrats wrote only for a relatively short period, their ideas had a
profound influence on the economic thought. That is why they are regarded as the
founders of the science of political economy. Physiocracy may be defined as a reaction
against Mercantilism and its concepts. The physiocratic school was more systematic as
compared to mercantilism. It was well-organized and orderly. The school was founded
by Francois Quesnay. Francois Quesnay (1694-1774) and Turgot (1727-1781) might
be considered as the chief representatives of the physiocrats.

Comparison between mercantilism and physiocracy

Mercantilism Physiocracy
Mercantilism was in favour of trade and Physiocracy was in favour of agriculture.
commerce.
Industry is productive and agriculture isAgriculture is productive and industry is
unproductive. unproductive.
Supported state intervention. Stood for laissez faire.
Mercantilism introduced protection. Physiocracy was in favour of free trade.
Mercantilism made a lasting contribution Physiocracy made a lasting contribution
to the theories of money and trade. to general equilibrium analysis and to the
scientific development of economics.
Mercantilism was in favour of Physiocracy was in favour of liberty.
restrictions.
Mercantilism depended on surplus to be Physiocracy was also depended on
reaped from foreign trade and commerce. surplus for economic growth to be reaped
from agriculture as net product.
Mercantilists’ ideas were loose and The ideas of the physiocrats were more
scattered. systematic and organised.
Mercantilism did not believe in nature. Physiocracy had complete faith in nature.
Basic Principles and Policies of Physiocracy

The following are the fundamental principles and policies of physiocracy:

o Agriculture is the only productive occupation.

o Industry and trade are unproductive occupations.
o Agriculture produces net product (surplus)
o There is a natural order which makes life happy.
o There is harmony among all classes of people.
o The individual should get maximum liberty.
o State action should be limited to the minimum.
o Trade is a necessary evil, and there should be free trade.
o Value depends on utility.
o The wage level is at subsistence.
o Real wealth lies in tangible and consumable goods.
o Private initiative must be encouraged.
o Distribution of products is very crucial.
o Money is a medium of exchange.
o Rent is a perfectly legitimate income of landlords.
o Real wealth lies in tangible and consumable goods.
o Rent is a perfectly legitimate income of landlords.
o There should be a single and direct tax on land, as it is the only productive
source.
o Private property is essential.
o There is the possibility of overpopulation on land.

Main Ideas and Theoretical Concepts of Physiocrats

1. Natural Order

According to the physiocrats, the natural order is an ideal order given by God. Natural
order was quite different from the positive order made by man. In other words, the
society which was governed by the laws of nature was an ideal society and the society
which was governed by positive laws made by government was an imperfect society.
The moral and religious philosophy of physiocrats was reflected in their concept of
natural order. They believed in God.
There are two types of natural laws. natural physical laws and natural moral laws.
Physical laws govern physical universe. Natural moral laws are the laws of human
actions. They are laws which govern human behaviour. It is the rule of justice, to be
followed by individuals while dealing among themselves. According to physiocrats,
natural order was an ideal order of things created by God for the maximization of
human happiness. The man-made social orders were artificial in nature. So, the
physiocrats wanted the people to do away with artificial man- made rules.

The natural order implied that only under conditions of freedom, man can enjoy the
maximum happiness and derive maximum advantage in economic matters. It followed
there should be minimum interference of government in economic affairs. According
to this doctrine, the only function of government is to protect life, liberty and property.
In other words, they advocated laissez faire.

2. The Net Product

The mercantilists have maintained that the source of wealth lay in foreign trade and
that it consisted of precious metals. The physiocrats differed from the mercantilists on
both these ideas. Physiocrats considered agriculture as the only source of wealth. To
the physiocrats the only productive wealth was agriculture. To them the other
occupations, other than agriculture were unproductive. In agriculture nature labours
along with man. By the gift of nature (fertility) agriculture produces more than what
the farmers consumes. This surplus production in the agriculture sector is called as
“Net product”. This surplus is obtained by subtracting the input (the amount of wealth
destroyed in the production of new wealth) from the amount of new wealth produced.
This surplus is used to nourish the other classes of people. It means that agriculture not
only satisfied the needs of those engaged in it, but also of others engaged in trade,
manufacture, and other professions. Physiocrats considered commerce and
manufacture as unproductive. The physiocrats believed that agriculture alone was
productive.

3. Individualism and Laissez Faire

The Physiocrats, especially Turgot, believed that self-interest was the motivating
reason for each segment of the economy to play its role. With each individual
determines what goods he wanted and what work would provide him with what he
wanted out of life. The trade restrictions place an unnatural barrier to achieving one’s
goals.
4. The circulation of wealth

Based upon the concept of Net Product, the physiocrats advanced the theory of
circulation of wealth. That is distribution of net product. Physiocrats were the first to
attempt to analyse the problem of distribution. The credit for putting the idea in a
systematic manner goes to Francois Quesnay. He skilfully and graphically analysed the
concept of circulation of wealth. By attempting an analysis of this phenomenon, a
synthesis of production and distribution was attained. This laid the foundations for a
number of future fields of study in economies. The ideas regarding the circulation flow
of wealth have been given by Quesnay in 1758 in the form of table called the Tableau
Economique. The Tableau Economique is a graphical representation of the way in
which the circulation of wealth takes place.

5. Private Property

There is a strong legal support for the ownership of private property. Private property
becomes a critical component of the workings of the Tableau.

6. Diminishing Returns

Turgot was one of the first to recognize that “successive applications of the variable
input will cause the product to grow, first at an increasing rate, later at a diminishing
rate until it reaches a maximum”. This means that the productivity gains required to
increase national wealth had an ultimate limit, and, therefore, wealth was not infinite.

7. Investment Capital

Both Quesnay and Turgot, Baron recognized that capital was needed by farmers to start
the production process, and both were proponents of using some of each year’s profits
to increase productivity. Capital was also needed to sustain the laborers while they
produced their product.

8. On Taxation

Physiocrats put forward a simple system of taxation. They advocated a single tax
system, namely the land tax, which should be paid by the proprietary class directly to
the govt. Some taxes were required for meeting the expense of the state 'for the
maintenance of security, spread of education and establishment of public works. The
only source which could be tapped was the net product and the only class who could
pay taxes were the landed proprietors. So, they advocated a single tax on land. This
single tax was direct and hence cannot be evaded.

9. On Value

Physiocrats had taken little interest in the theory of value. According to Turgot value
depended upon utility. They also differentiated value in use and value in exchange. But
they treated price and value as one and the same thing. Value according to physiocrats
was not fixed but changed from time to time depending upon demand.

10. On Trade

Trade and commerce were considered as unproductive. According to them trade did
not produce any real wealth. Hence all commodity transition were waste of time and
energy.

11. Functions of the state

They suggested a state with minimum of civil laws. To them the best state was the one
in which there were the least number of laws. They advocated a state with minimum
of legislation and maximum of authority. The function of the physiocratic state was (a)
to preserve natural order (b) To defend private property (c) To spread universal
education (d) To undertake programs of public work.

Critical Appraisal

• Their views on interest, value and wages were not clear.

• They were wrong in considering agriculture alone as the productive occupation
because commerce and industry are equally important and productive as
agriculture.
• They believed in individual freedom. They did not want restriction of any type
in the life of individuals.
• The physiocrats advocated complete freedom of trade and industry. But absolute
freedom of trade and industry are not advisable. If we follow the laissez-faire
doctrine, there will be little scope for social action.
• The aim of physiocrats was to develop agriculture. They regarded land as the
only source of wealth. For them land alone yielded a surplus. It followed that the
landowner alone should bear the burden of taxation.
 CLASSICAL SCHOOL

The Classical School

Adam Smith is the founder of the classical school. He has been described as the "Father
of Political Economy." His work "Wealth of Nations" (1776) is generally regarded as
the starting point of classical school. Adam Smith, Jeremy Bentham, Thomas
Robert Malthus, David Ricardo, J. B. Say and J. S. Mill are the leading economists
of the classical school. Of them, Smith, Ricardo and J. S. Mill formed the classical
trinity. The classical system rested on four main pillars-the Malthusian Population
doctrine, the Wages-Fund Theory, the Ricardian Theory of Rent and the Labour Theory
of Value.

The Essential Features of Classical School

The entire philosophy of the classical school was based on economic liberalism. The
classical writers believed in personal liberty, private property and individual initiative
and private enterprise. Classical ideas were liberal in contrast to mercantilist
restrictions of trade and industry.

We shall summarise now some of the basic features of the classical school.

1. The classical economists believed in laissez-faire. It implied a minimum role

for government in economic matters. That government is best which governs
least.
2. They believed in a market economy based on free and perfect competition.
Production, exchange and distribution would be guided by market forces.
3. They assumed conditions of full employment. (It is this assumption that came
in for a lot of criticism in the hands of J. M. Keynes). They thought that the
economy was self-adjusting and would tend towards full employment without
government intervention. (full employment means all available labour are
being used in the most efficient way possible)
4. They believed that the individual by seeking his own interests would serve the
best interests of society.
5. The classical economists emphasized the importance of all economic activities,
especially industry. The mercantilists believed that wealth was derived from
commerce. The physiocrats had seen in agriculture the source of all wealth. The
 classical economists added industry to commerce and agriculture and regarded
all of them as productive.
6. The classical economists were the first set of economists who paid a good deal
of attention to the problems of economic growth and development.
7. The classical economists looked at the economy as a whole. This is what we
call the macro economic approach in modern times.
8. Lastly, the classical economists believed in J. B. Say's Law of Markets which
said that supply creates its own demand. On that basis, they felt that general
over-production and hence unemployment impossible.

ADAM SMITH (1723-1790)

Adam Smith was born in Scotland in 1723. Although Adam Smith was a bachelor,
he is regarded as the father of economic science. The greatness of Adam Smith lies
in his effort to systematically and analytically present the facts of economics. He
introduced economics as a separate discipline. He unified the scattered ideas and
loose theories of his time.

Smith's book, ‘An Inquiry into the Nature and Causes of the Wealth of
Nations’, which was published in 1776, is not just an ordinary book. It contained
the thinking of the whole era. There is nothing in this book which can be called
purely original. All the ideas presented in this book are already known. Smith
simply presented the ideas in a more systematic and analytical manner.

We have already noted that Adam Smith's "Wealth of Nations" was a challenge to
mercantilism. According to Adam Smith, the wealth of a nation can be increased
by adopting the principle of division of labour and division of labour is limited by
the size of the market. The size of market will depend upon the volume of
international trade. But the mercantilist policy of protection and their efforts at
maximizing exports and minimizing imports resulted in the shrinkage of
international trade. So, he advocated free trade policy so as to increase international
trade.
His Main Teachings

1. Division of Labour

Adam Smith, first of all, emphasizes the importance of labour as the source of the
wealth of a nation. After saying that labour is the source of wealth, Adam Smith
makes the point that division of labour will increase the productivity of labour and
thereby the wealth of a nation. Division of labour refers to the specialization of
labour in different industries or different processes within the same industry.

According to Adam Smith, "Division of labour is limited mainly by the size of the
market." That is, only if there is a wide demand for a good, it will be produced on
a large scale and there will be a lot of scope for the application of division of labour.
In those industries which produce goods for international market, there will be
great scope for division of labour. The scope for the application of division of
labour also depends upon the nature of the good. For example, the scope for
division of labour is not as great in agriculture as in the case of manufacturing
industry. Division of labour has the following advantages:

a. Increased output: Division of labour will increase the output per worker.
b. Increase in the skill of workers: By doing the same kind of work
constantly, the worker gets a great skill in his particular line. Practice makes
a man perfect.
c. Saving in time: A man can work continuously on a single operation. He
need not spend time in changing tools or in passing from one process to
another.
d. Introduction of machinery: It prepares the way for introduction of
machinery. It will result in the invention of a great number of machines. In
other words, division of labour is the mother of invention.
2. Value

According to Smith, there are two kinds of value (1) value in-use and (a) value-in
exchange. The first one expresses the utility of some particular object and the
second one refers to the power of purchasing other goods. For example, nothing is
more useful than water, but it has little value-in-exchange. On the other hand,
diamond has little value-in-use, but it has great value in exchange. The
determination of value (value-in-exchange) has been one of the central problems
in economics. Adam Smith believed that labour was the real source of value.
According to him, the value of a thing depended on the amount of labour used in
its production. In fact, he attacked mercantilists mainly because emphasized the
role of money in an economy. According to Adam Smith, a nation's true wealth
consists "not only in its gold and silver only, but in its lands, houses, and
consumable goods of different kinds." Money only serves as an instrument for the
measurement of value.

3. Role of Government: Laissez-faire

Smith advocated a minimum role for the state in economic affairs. He considered
non-intervention by government in economic matters as a wise policy. In his view,
governments are "always" and without any exception, the greatest spendthrifts in
the society.

Adam Smith said that the State could perform only the following three major
functions: (1) To protect society from foreign attack, (f) To establish the
administration of justice within the country. and (iii) To maintain the public works
and institutions that private entrepreneurs cannot undertake privately.

We shall, however, note that non-intervention for Adam Smith was a general
principle and not an absolute rule. He justified legal control over interest rates, state
administration of Post office. control over the issue of paper money by bankers,
compulsory elementary education and so on.
4. Canons of Taxation

Adam Smith recommended taxation to finance government activities. He has laid

down some rules for a good tax system. Even today they are valid. They are known
as the canons of taxation. They are the canons of equity, certainty, convenience
and economy.

a. Canon of Equity: It is based on the principles of justice and ability to pay.

It tells that people should pay taxes according to their respective abilities.
b. Canon of Certainty: There must be certainty about the tax which an
individual has to pay. Things like the time of payment, the manner of
payment and the quantity to be paid should be plain and clear to the
taxpayers.
c. Canon of Convenience: A tax should be levied in such a manner or at such
a time that it is convenient for the taxpayer to pay it. For example, the Indian
farmer may be asked to pay the land revenue after the harvest is over.
d. Canon of Economy: Taxes should be collected at minimum cost to the
government.

Even today the above canons of taxation are regarded as good working principles
for planning a sound tax structure.

5. Theory of Distribution

a. Wage: According to Smith, wage is determined by the bargaining power of

employers and wage earners. Employers, being limited in number, can easily
organise themselves to form associations whereas the organisation of labour
is not possible. The employers consistently try not to raise wages of labour
above the actual rate. Hence, wages depend on the bargaining strength of
both the parties. Since bargaining strength is on the side of employers, the
labour gets only as much wage as will be sufficient to support him and his
family. This is the subsistence level.
b. Rent: Smith indicates that rent is a surplus. If the price of the produce of
land is greater than the cost of production, there will be a surplus. This
surplus is rent. If the price is not greater than the cost, there will be no rent.
The price commanded by the produce will depend on the demand for it.
c. Profit: Smith tried to prove that profit is equivalent to the total return on
capital and interest is a constituent element in profit.
 d. Interest- A part of profit is paid as interest to the capitalist. Interest arises
when the capitalist does not himself employ his capital but lends it. Interest
is the price paid by the borrower to the capitalists.

6. Invisible Hand Theory

It is a term coined by Adam Smith in his 1776 book ‘An Inquiry into the Nature
and Causes of the Wealth of Nations’. The theory of the Invisible Hand states that
if each consumer is allowed to choose freely what to buy and each producer is
allowed to choose freely what to sell and how to produce it, the market will settle
on a prices and distribution that are beneficial to all the individual members of a
community, and hence to the community as a whole. The reason for this is that
self-interest drives actors to beneficial behaviour. Efficient methods of production
are adopted to maximize profits. Low prices are charged to maximize revenue.
Investors invest in those industries most urgently needed to maximize returns and
withdraw capital from those less efficient in creating value. All these effects take
place dynamically and automatic.

7. Capital and Free Trade

Capital-Smith had realised the importance of the role of capital in the economic
development of a nation. He treated capital as an important source of national
wealth. Besides division of labour and money, capital plays a great role in
production. He was aware of the fact that capital accumulation is essential for the
industrial development of a nation.

Smith advocated free trade. Free trade means that trade as among countries is not
subject to restrictions. Smith was opposed to the mercantilist theory of balance of
trade. Smith did not accept the mercantilist view that foreign trade is advantageous
because it acquires gold and silver. According to him, gold and silver, just like
other commodities and in the natural course of trade, will come to any country as
other commodities do. Therefore, he does not agree that the export of gold and
silver should be restricted. According to him, the only advantage from foreign trade
is that it carries out surplus commodities and brings in commodities which are in
demand.
CRITICISMS

1. We find that Adam Smith did not give anything new to the development of
economic thought as the concept of division of labour is as old as Plato and
Xenophon.
2. His approach is essentially materialistic. His concept of wealth is extremely
narrow.
3. There is undue emphasis on individualism.
4. Smith’s theory of distribution in incomplete.
5. It is in the context of laissez fair, self-interest, invisible hand that Smith’s
theory of development is supposed to operate. In developing countries, the
state has come to dominate the development process.
6. Smith does not discuss rate of interest separately- It is included in profit.
THOMAS ROBERT MALTHUS (1766-1834)

Thomas Robert Malthus was born in 1766. Malthus is famous for his theory of
Population. As we know Mercantilists had always regarded a large population as
advantageous. They never entertained any fear of overpopulation. A discussion on the
subject led to the publication of the first edition of the An Essay on the Principle of
Population in 1798.

The Malthusian theory of population discusses the relationship between population and
supply of food. In simple words, the theory states that population increases at a
faster rate than food supply. Malthusian theory of population is based on the
following two fundamental assumptions-

• Food is necessary for the existence of man.

• Passion between the sexes is natural and will remain nearly in its present
state.

On the basis of the above two assumptions, Malthus stated that “the power of
population is indefinitely greater than the power in the earth to produce subsistence
for men.” Population, when unchecked, increases in a geometric ratio (i.e., at the
rate of 2,4,8,16…) while the supply of food increases only in an arithmetic ratio
(i.e., at the rate of 2,4,6,8, 10 etc.) Malthus believed that the population of the
country, when unchecked, would double itself in every twenty-five years. But food
supply will not increase as fast as population on account of the influence of the law
of diminishing returns on land. He further said that if population will increase at a
fast rate, there will not be enough food for all. Because the population outgrows
food supply. The growth of population has to be checked. This can be done by the
application of some checks by nature or by man himself or by both.

In the first edition Malthus has spoken of two kinds of checks on population
growth-
1. Preventive Checks: Those checks which are applied by men for checking
population growth are called preventive checks. Preventive checks are major
checks to control birth rate. Malthus suggested that those who cannot afford
the upbringing of children should either postpone marriage or never marry.

2. Positive Checks: War, famine, starvation, and diseases are the positive
checks on population. They increase the death rate. If population is not
 checked by the preventive methods, then it will be checked by natural
phenomenon such as famine, starvation and death. Thus, Malthus presents a
dark and pessimistic picture about the future of mankind.

CRITICISM

1. Population does not grow as Malthus has suggested. His ratios have been proved
wrong by history. Malthus believed that once in every twenty-five years,
population would double itself. There is no historical proof for this.

2. It is true that in many countries population has increased at a rapid rate. But food
supply has also increased, and people have not died of hunger in those countries.

3. The Malthusian theory is based on the Law of Diminishing Returns. Malthus has
overlooked the possibility of scientific improvement in agriculture.

4. This is an age of international trade and commerce. If a country does not grow
enough food grains for itself, it can import food grains from other countries.

DAVID RICARDO (1772-1823)

In the classical school of economics, Ricardo is considered one of the greatest theorists.
Adam Smith is known as the founder of the classical school and David Ricardo is the
last representative of the classical school of economics. Ricardo has a very significant
place in the history of Economic thought. Ricardo was born in 1772 in England.
Ricardo is known for his work “On Principle of Political Economy” which was
published in 1810.

Economic Ideas

1. Value

Ricardian theory of value is essentially a labour theory of value. First of all, like
Adam Smith, Ricardo has recognized two forms of value: (i) value-in-use, and (ii)
value-in-exchange. Then he points out that for a commodity to have value-in-
exchange, it must have utility. But he asserts that utility cannot be the measure of
exchangeable value. According to Ricardo, the value of commodities depends upon
two things, (i) Scarcity and (ii) the quantity of labour required to obtain them.
Ricardo agreed with Adam Smith that the value of most things depended on the
amount of labour required to produce them. But there was another group of things,
whose supply cannot be increased by labour. The exchange value of such non-
reproducible commodities depended upon their scarcity. Rare statues, and pictures
(works of art), scarce books and coins belong to this category.

2. RICARDIAN THEORY OF RENT

Ricardo’s whole theory of distribution is very closely related with land as a

factor of production and rent is the income which goes to it. According to
Ricardo, “rent is that portion of produce of the earth which is paid to the landlord
for the use of original and indestructible power of the soil.”

Assumptions

1) Rent arises because of difference in the fertility of land. All lands are not
of equal fertility. Only those lands which are more fertile than others will
get rent.
2) Land is subject to the law of diminishing returns.
3) Land is a free gift of nature.
4) Cost of production is same.
5) Land has only one use to grow crops (only for cultivation)

Reasons for Existence of Rent:

According to Ricardo rent arises for two main reasons:

1) Scarcity of land as a factor and

2) Differences in the fertility of the soil.

Differential rent

According to Ricardo, rent of land arises because of different plots of land have
different degree of productive power, some lands are more fertile than others.
Sot there are different grades of land. The difference between the produce of the
superior lands and that of the inferior land is differential rent.
Here, AD, DG and GJ are three separate plots of land of the same size, but of
different in fertility. The total produce of AD is ABCD, that of DG is DEFG and
that of GJ is GHIJ. The first and second plots of land generate a surplus showed
by the shaded area, which represents the rent of the first two plots of land. Since
the third plot GJ has no surplus, it is marginal land or no-rent land.

It has been stated that rent arises due to a difference in the fertility levels of land.
Besides fertility, rent may also arise on account of situational advantage. Some
lands enjoy situational advantage. For example, if land is nearer to the market
place the produce of that land reaches the market easily so there will be no
transport cost. Thus, the producer saves transport cost in such a case. Even if all
lands are equally fertile, lands possessing situational advantage command some
superiority over other lands. Thus, rent arises on account of differences in
fertility and in situation.

While discussing the relationship between rent and price, Ricardo has stated that
rent does not enter price. Rent is high because the price (of corn) is high. Price
is high not because rent is high. Ricardo has concluded that rent does not enter
price because according to him, there are some no-rent lands. But still their
produce has a price on the market and rent does not enter price here because of
the marginal lands do not get any rent at all.
3. Wages

After explaining the rent, Ricardo proceeds to discuss the determination of

wages. Wages are the price of labour. Like all other commodities, labour has its
natural price (subsistence wage) and market price. According to him, the
natural price of labour is that price, which is necessary to enable the labourers to
subsist their race without either increase or decline. Thus, the natural price of
labour is subsistence wage which depends on the price of food, necessaries and
conveniences of life required by the labour and his family. If the price of food
and necessities rise, wages will rise and when the price of food and necessities
fall, wages will fall. The market rate of wages is determined by the forces of
demand and supply. If there is an abundant supply of labour, market price of
labour will be low and if there is scarcity of labour, market price of labour will
rise.

4. Profits: Ricardo has not given a clear-cut theory of profit. He has treated profit
and interest as one thing. Ricardo has not given a complete discussion of the
sources from which profit arise and has not analysed the various components of
profit. According to him, “profit consists of interest and entrepreneur’s gain.”
He treats profit as the income received by the entrepreneurs. Ricardo firmly
believed that wages increased at the expenses of profit, whenever there was an
increase in wages profit would fall and vice versa.

5. International Trade: Comparative Cost Theory

In the matter of international trade, Ricardo was the true follower of Adam Smith
especially concerning free trade, he seemed to have a more refined perspective
than Adam Smith.

The theory of comparative cost is the major contribution of Ricardo to the theory
of foreign trade. Adam Smith’s theory of trade was based on difference in
absolute cost. But Ricardo developed the theory of comparative cost.

Assumptions of the Theory:

The principle of comparative cost is based on several assumptions:

a) Trade takes place between two countries only, say A and B.

 b) They are trading with only two commodities, say, jute and cotton.
c) The cost of production of these two goods in both the countries is
expressed in terms of labour only.
d) There is no transport cost.

He suggested that each country should specialise in the production of those

goods where its comparative advantage was greatest.

This can be explained by using the division of labour as an example. If A is ten

times more efficient than B as a surgeon and twice as efficient as a road sweeper,
then A should devote all his efforts to surgery and leave all the roads sweeping
to B.

Ricardo developed his theory by comparing two countries, England, and

Portugal, and two commodities, wine, and cloth. Table 1 shows that Portugal
was more efficient in the production of both goods, but Ricardo argued that both
countries could benefit if they specialised where their advantage was
comparatively high and then traded.

Portugal’s labour costs were lower than England’s in both cloth and wine, but
the comparative advantage was greater in wine. Ricardo showed that both
countries would benefit if England specialised in cloth and Portugal in wine and
if after specialisation, a unit of wine is exchanged for a unit of cloth.

Criticisms of the Theory:

1) It is much more complicated in the real world in deciding in which goods

countries have a comparative cost advantage. This is so because there are
a large number of goods and many countries.
2) The theory ignores the effects of transport costs.
3) The classical writers have applied their principle in case of trade with two
countries only and with two commodities only. So, the principle has a
limited scope of application in practice.
4) Ricardo’s theory assumes the operation of the law of constant cost. Hence,
it cannot be applied in the case of increasing or decreasing costs.
 MARGINALIST SCHOOL

Introduction

The Marginal Revolution' took place in the latter half of the nineteenth century. The
marginalist school developed in many countries at the same time. Different people
worked independently of each other at first. Hermann Heinrich Gossen in Germany,
Stanley Jevons in England, Carl Menger in Austria and Leon Walras at
Lausanne, Switzerland are generally regarded as the founders of the Marginalist
school. The term "Marginal Revolution" is applied to the writings of the above
economists because they made fundamental changes in economic analysis. And they
started looking at some of the important economic problems from a new angle different
from that of the classical economists.

Marginal economics has been used to analyse the single firm and its behaviour,
consumer behaviour, the market for a single product and the formation of
individual prices. Marginalism dominated Western economic thought for nearly a
century until it was challenged by Keynesian in 1936. Keynesian economics, however,
shifted the enquiry from micro-economics to macro-economics, where the problems of
the economy as a whole are analysed.

Essential Ideas of Marginalist School

1. The approach of the marginalist school is micro-economic rather than macro-

economic. The marginalist school does not deal with the aggregate economy. It
deals with decision making of individual buyers and sellers, price of single
commodity, the output of single firm and so on.
2. The marginalist school has adopted the abstract and deductive method of
classical economists.
3. The marginal utility analysis is based on the assumption of Competition. There
will be a large number of buyers and sellers and no one buyer or seller can
influence the market decisions by his actions.
4. While the classical school considered cost of production, i.e., supply as the
determinant of value, the marginalist school considered demand to be important
element in the determination of value.
 5. The marginalist approach assumes of rational behaviour on the part of
individuals. He marginalists assume that men act in a rational manner.
6. The marginalist school believes the economic forces generally tend towards
equilibrium.
7. They supported laissez faire policy.
8. They thought maximum social welfare could be attained by market forces such
as competition and there should not be any governmental inference with natural
economic laws.

GOSSEN (1810-1852)

Herman Heinrich Gossen is one of the most tragic figures in the history of economics.
He published his book "Development of the Laws of Exchange Among Men" in
1854. He hoped that his book would revolutionize the science of economics. But his
ideas were never popular during his lifetime. One main reason for that was his
treatment of the subject was highly mathematical. But Jevons and Menger praised the
efforts made by Gossen in the development of marginal utility theory.

Gossen has given certain laws of human enjoyment. Of them, the first two laws are
very important.

Gossen's First Law: It states that the marginal utility of a good for a person diminishes
with every increase in the stock that he already has. In other words, it states that, as
consumption increases, the marginal utility derived from each additional unit declines.
In modern times, this law is known as the Law of Diminishing Marginal Utility.

Gossen's Second Law: The second law tells that each man will spend his money on
different commodities in such a way that the last rupee spent on each commodity yield
him equal marginal utility in order to get maximum satisfaction. In modern terms,
Gossen's second law is known as the Law of Equi-marginal Utility.

Gossen’s views on value are based on the above two laws.

WILLIAM STANLEY JEVONS (1832-1882)

Jevons was one of the founders of the marginal utility school. Jevons' main contribution
to economic theory is to be found in his "Theory of Political Economy” (1871). Javons
was interested not merely in theory but also in the problems of applied economics. He
also made an attempt to construct a theory on trade cycles. His theory is known as ‘sun-
spot’ theory. Jevons failed in his attempt to provide a satisfactory explanation of the
trade cycle. And the sun-spot theory today is only of historic interest.

Utility

Jevon’s fame rests mainly on his contribution to the development of the marginal utility
theory. According to Jevons, "Value depends entirely upon utility." He considered this
a great innovation and revolutionary idea because the classical economists believed
that the value depended upon the amount of labour used in the production of a good.
Jevons rejected the labour theory of value which dominated economic thought for a
long time. He believed that labour once spent has no influence on the future value of
any article.

After saying that 'value depends entirely upon utility, ' Jevons explains the term 'utility'.
He describes utility as the quality possessed by an object of producing pleasure or
preventing pain. Like Gossen, Jevons concluded that final degree of utility (marginal
utility) varies with the quantity of commodity, and ultimately decreases as the quantity
increases. The final degree of utility is the fundamental concept in Jevons’ theory of
exchange and distribution.

(In modern times we call this ‘final degree of utility’ as ‘marginal utility’. We should
remember that none of the founders of marginalist school used the term ‘marginal
utility’. It was Marshall who used the expression)
CARL MENGER (1840-1921)

Carl Menger was the founder of the Austrian school. He published his book "Principles
of Economics" in 1871. Menger’s book established his fame as the author of the
‘Marginal Revolution’ of the Austrian school. According to Eric Roll method, money
and pure theory are the main contributions of Carl Menger.

Method

Menger advocated deductive method in economic analysis. Menger emphasized that

economic method must rest on an individualist foundation. He argued that without
understanding the behaviour of individuals, we can never understand the total
economic process. Like Jevons, he put the individual into the centre of the picture.

Money

After describing the inconveniences of barter, Menger explains how money acts as a
universal medium of exchange. Money facilitates the quantification of subjective
values. The values of goods can be expressed through money. Menger has given one
of the best explanations of the function of money in the process of exchange and in the
formation of price.

Pure Theory: Theory of Value

Menger's subjective theory of value is one of his lasting contributions to economic

thought. Menger starts with wants and means. He defines utility in a relative sense.

Classification of Goods

Menger classified goods into goods of the first order, and of the second, third and
higher orders. Goods of the first order are those which can be used for the immediate
satisfaction of our wants (e.g., bread). Goods of the second order (e.g., flour) are used
for the production of the goods of the first order which directly satisfy our wants. Goods
of the third order (e.g., wheat) are used for the production of goods of the second order.
It goes on like that. Menger makes use of this classification of goods to establish the
relationship between the value of the goods of the first order and the value of the
production goods of all kinds.
Menger further classified goods into: (i) economic goods, and (ii) non-economic goods.
Economic goods are those goods whose supply is inadequate in relation to our wants.
So, we are compelled to economize them. In the case of non-economic goods, that is,
those goods whose supply exceeds our need, there is no need to economize them.

According to Menger, “Value arises from the limitation of goods in relation to wants”.
Only economic goods possess value. Free goods do not possess value. Menger’s theory
of value is subjective in character. According to Menger "Value is a judgment of the
mind”. A commodity may have great value to one individual, little or no value to
another. Its value depends on the requirements of different individuals and the amount
available to each of them. Menger emphasises that value has nothing to do with cost of
production or labour.

LEON WALRAS (1834-1910)

Leon Walras was one of the three founders of the marginal utility school. He was a
Frenchman. Walras, the noted economist who was the author of the term 'rarete’ which
more or less means marginal utility. The economic ideas of Leon Walras are found in
his book ‘Elements Pure Economics' which was published in 1874.

Method

Walras used mathematical method. In fact, Walras is considered the founder of

mathematical-utility school in economics. Walras felt that non-mathematic persons had
no future in theoretical economics. They would only make bad economists. On account
of his mathematical approach, Walras cannot be easily understood by all. That is why
he has been described as an economist's economist.

Walras developed marginal utility theory independently of Jevons and Menger. Like
Jevons and Menger, he bases exchange value on utility. He says that value depends
upon marginal utility. He uses the term 'rarete' to mean marginal utility. He defines
rarete as "the intensity of the last want satisfied." Walras believed that there was a direct
relation between demand and price. And he thought that there was no such direct
relationship between supply and price.
General Equilibrium

Walras developed a system of equations to describe the behaviour consumers, firms,

and markets in a general equilibrium framework.

On the basis of his marginal utility theory, Walras has developed the concept of general
exchange equilibrium. While Jevons dealt with the problem of exchange equations for
only two commodities, Walras formulated equations to deal with the problem of
exchange values of any number of commodities. Under conditions of competition,
equilibrium will be achieved when the price is such that supply and demand are equal.
Walras develops in stages the concept of general equilibrium. He takes first exchange
of two commodities, then exchange of several commodities.

He also deals with the theory of production. Then he explains how equilibrium takes
place through a series of equations. The general equilibrium analysis of Walras is based
on the following assumptions: (1) There is free competition, and (ii) consumers' tastes,
technology, and factors of production (land, labour, etc.) remain constant.

The general equilibrium theory of Walras tells that a change in one part of the economy
lead to changes throughout the economic system just as a stone thrown into a pond
causes widening circles of ripples.
 DEVELOPMET OF MACROECONOMICS

Macro Economics

The word ‘macro’ was derived from the Greek word ‘makros’ which means ‘large’
Macroeconomics is the study of aggregate economic behaviour. John Maynard
Keynes is known as the father of macroeconomics. Macroeconomics analyses the
aggregate economic variables and phenomena like national income, general
employment, economic growth, inflation, international trade etc.

Macro Economics is concerned with the analyse of the behaviour of the economic
system in totally. Thus, Macroeconomics studies how the large aggregates such as total
employment national product or national income or an economy and the general price
level are determined. Macroeconomics is therefore a study of aggregate.

Unlike microeconomics—which studies how individual economic actors, such as

consumers and firms, make decisions—macroeconomics concerns itself with the
aggregate outcomes of those decisions. For that reason, in addition to using the tools
of microeconomics, such as supply-and-demand analysis, macro-economists also
utilize aggregate measures such as gross domestic product (GDP), unemployment
rates, and the consumer price index (CPI) (price change of the basket of goods and
services experienced by the consumers) to study the large-scale consequences of
micro-level decisions.

Early history and the classical school

Until the 1930s most economic analysis was focused on microeconomic phenomena
and concentrated primarily on the study of individual consumers, firms, and industries.
The classical school of economic thought, which derived its main principles from
Adam Smith’s theory of self-regulating markets, was the dominant philosophy.
Accordingly, such economists believed that economy-wide events such as rising
unemployment and recessions are like natural phenomena and cannot be avoided. If
left undisturbed, market forces would eventually correct such problems; moreover, any
intervention by the government in the operation of free markets would be ineffective
at best and destructive at worst.
Keynesianism

The classical view of macroeconomics, which was popularized in the 19th century as
laissez-faire, was shattered by the Great Depression, which began in the United States
in 1929 and soon spread to the rest of the industrialized Western world. The sheer scale
of the catastrophe, which lasted almost a decade and left a quarter of the U.S. workforce
without jobs, threatening the economic and political stability of many countries, was
sufficient to cause a paradigm shift in mainstream macroeconomic thinking, including
a re-evaluation of the belief that markets are self-correcting.

The theoretical foundations for that change were laid in 1935–36, when the British
economist John Maynard Keynes published his monumental work. The General
Theory of Employment, Interest, and Money. This book considered as the greatest
book of the 20th century, and it is considered as 'Bible of Macroeconomics ' that also
this book laid the foundation of Macroeconomics.

The Great Depression actually indicate the after collapse of the classical system which
is largely based on the says Law of Market. Says law of market States the "supply
create its own Demand". According to this classical believes that every supply of output
creates an equivalent demand for output, so that there can never be a problem of general
over production.

All the economic idea of classical economics failed in Great Depression of 1930s.
Keynes argued that most of the adverse effects of the Great Depression could have
been avoided had governments acted to counter the depression by boosting spending
through fiscal policy. Keynes viewed the economy as something that the government
should actively manage. Economists such as Paul Samuelson, Franco Modigliani,
James Tobin, Robert Solow, and many others adopted and expanded upon Keynes’s
ideas, and as a result the Keynesian school of economics was born.

In contrast to the hands-off approach of classical economists, the Keynesians argued

that governments have a duty to combat recessions. At times of economic crisis, the
economy is crippled because there is almost no demand for anything. As businesses’
sales decline, they begin laying off more workers, which causes a further reduction in
income and demand, resulting in a prolonged recessionary cycle. Keynesians argued
that, because it controls tax revenues, the government has the means to generate
demand simply by increasing spending on goods and services during such times of
hardship.
 THE INSTITUTIONAL SCHOOL

Introduction

Institutional Economics is essentially an American product. It is a twentieth century

phenomenon. The leader of the Institutionalist school was Thorstein Veblen (1857-
1929). Other important members of the school were John R. Commons (1862-1945)
and Wesley Clair Mitchell (1874-1948). The Institutionalist school had a lot of
influence on government policies in the United States.

Social background of the school

In the 19th century, American capitalism achieved a powerful industrial system,

increased in national income and so on. But condition of working class was bad. They
have no job security and shortage of houses. The economic and political power was
concentrated in the hands of big business. And political corruption was not uncommon.
Thus, American society was characterised by big business. Economists who are not
satisfied with the existing economic doctrine introduced institutionalism which is
attracted by the concept of German historical school.

The Essential Ideas of the Institutionalist School

1. The Institutionalist school emphasized the role of institutions in economic life.

We have to note that an institution is not merely an organisation or establishment
like a school or bank. The term Institution includes customs, social habits, laws,
ways of living and modes of thinking. Thus, slavery is an institution. Belief in
slavery is also an institution. Celebration of certain days as festival days is also
an institution. We may say that communism was an institution in Russia and
anti-communism is an institution in America. According to the institutional
school, economic life is regulated by economic institutions. Naturally the
institutionalists interested in analysing and reforming the institutions of credit,
monopoly, distribution of national income and so on.

2. They believed that group social behaviour is more important to the analysis of
economic problems than the individual behaviour emphasized by the marginalist
economists.
 3. They believe that the economy must be studied as a whole. It is in contrast to the
approach of the marginalist school.

4. Economic laws are not of universal application. They are relative to time and
place.

5. They reject the classical assumption of harmony of interests. They recognize

clash of interests and class conflicts.

6. They believe that market economy cannot ensure social welfare. They advocate
liberal democratic reforms to reduce inequalities of income and wealth.

7. They advocate inductive method rather than deductive approach.

THORSTEIN VEBLEN (1857-1929)

Thorstein Veblen is regarded as the founder of "Institutional Economics." Many

regards Veblen’s work as an outstanding American contribution to political economy.
He was the son of Norwegian immigrants, and he was born on a farm in Wisconsin.
He received a doctorate in philosophy from the Yale University. Veblen's first and most
popular book "The Theory of the Leisure Class" was published in 1899. It explains
the crux of most of his thoughts. Veblen wanted to apply Darwin’s evolutionism to the
contemporary economic life of a person. According to him, the industrial system
needed men to become diligent, efficient, and cooperative, however, those who were
the top leaders of the business world were only worried about making money and
exhibiting their wealth; their viewpoint was survivalist.

He was the author of terms such as "leisure class" and "conspicuous consumption”.
Veblen was not satisfied with the methods and doctrines of the classical economists
and marginalists as explanations of contemporary economic institutions and
phenomena.

The main idea of Veblen is that the institutional condition and determine man's survival
and development. Institutions are of many types. They may be customs or habits,
property and so on.
Economic Ideas of Veblen

1. Institutional Socialism: Thorstein Veblen's critique of traditional static

economic theory laid the foundation for institutional economics. Beyond his role
as an economist, Veblen was also a sociologist who held differing views from
his contemporaries. He disagreed with them by emphasizing the deep integration
of social structures within the economy. Rather than separating economics from
the social sciences, Veblen focused on the close connections between the
economy and social and cultural aspects. Institutional economics typically saw
economic institutions as significant drivers of cultural development.

2. Institutional socialism: Thorstein Veblen's critique of traditional static

economic theory laid the foundation for institutional economics. Beyond
his role as an economist, Veblen was also a sociologist who held differing
views from his contemporaries. He disagreed with them by emphasizing
the deep integration of social structures within the economy. Rather than
separating economics from the social sciences, Veblen focused on the close
connections between the economy and social and cultural aspects.
Institutional economics typically saw economic institutions as significant
drivers of cultural development.

3. The Theory of Leisure Class: Veblen’s institutionalism rest on ‘class conflict’

which is expressed in his theory of leisure class. Veblen begins with the
assumption that initially property and technological methods were the most
important institutions of capitalism. In the beginning, technological information
was open to all classes. But as industries developed, production exceeded over
requirements and a surplus appeared. Certain classes or groups of the society
managed to take away this surplus and started to live in leisure. They are referred
to as the ‘leisure class.’ The leisure class was interested only in money making
and living in comfort. On the other hand, there is the productive class which
consist of those who work and produce. Ultimately, this will lead to conflicts
between the two classes in the society, which may lead to business crises.

4. Conspicuous Consumption: In his most famous work, The Theory of the

Leisure Class, Veblen writes critically of the leisure class for its role in fostering
wasteful consumption, or conspicuous waste. In this first work Veblen coined
the term conspicuous consumption, which he defined as spending more money
 on goods than they are worth. He claimed that there was a direct relationship
between a person’s material possessions and their status in society.

Conspicuous consumption is an economic concept. It is defined as the

purchasing of goods that are of higher quality or quantity than functionally
necessary for the purpose of displaying wealth and prestige. Simply buying a
lavish item or things of unnecessarily high quality does not necessarily qualify
as conspicuous consumption. Rather, it is the "showing off" of the lavish,
expensive item for attention that makes it conspicuous consumption.

J. R. COMMONS (1862-1945)

John Rogers Commons was a leading member of the institutionalist school. While
Veblen concentrated on the sociological aspects of the society, Commons contributed
to the study of the legal aspects of institutions.

John R. Commons was born in Indiana in 1862. He never took his doctorate degree.
He was not always successful as lecturer. He changed many jobs. Finally, he settled in
the teaching profession when he got a job at the University of Wisconsin in 1904.

In 1934, Commons published ‘Institutional Economics’, which laid out his view that
institutions were made up of collective actions that, along with conflict of interests,
defined the economy. Collective action ranges all the way from unorganized custom to
the many organized going concerns, such as the family, the corporation, the trade
association, the trade union, the reserve system, the state.

Commons emphasized the legal foundations of an economy, seeing laws of the State
or other institutions as playing a fundamental part in economic theory. In economics
everything is based on relationships, and thus laws are necessary to ensure each
relationship functions properly:

Commons was a great social reformer. He helped in the drafting of many programmes
of reform and social legislation. He wrote a Civil Service Law, and drafted Wisconsin's
Unemployment Reserve Act. He did not believe in the harmony of class interests. He
noticed clash of interests in the society. He advocated an increasing role of government
in resolving the conflicting interests among many different groups. Commons
emphasized the dependence of men and the need for co-operation.
In his "Legal Foundations of Capitalism", Commons emphasized the role of courts in
the social arrangements. He classified transactions into three types: (i) bargaining
transaction, (i) rationing transaction, and (ii) managerial transaction. He criticized the
economists for paying too much of attention to the first type and for neglecting the
other two. A bargaining transaction is a market transaction between individuals of
equal status. A rationing transaction transfers ownership and modifies property rights.
It is based on an authoritative relationship. Examples for rationing transactions are the
tax burden fixed by government and wages fixed for individuals by trade unions. A
managerial transaction is also of an authoritative type. Example for this is a company
manager commanding the services of a worker. Commons thought that a study of all
the transactions was essential for a proper analysis of economic problems.

Commons was a great supporter of trade union movement. He thought it was necessary
to the collective bargaining power of workers. Today most of Common’s ideas on
social reform are generally accepted. In short, Commons made his institutional
economics a tool for social reform.