Classical Theory of Economics

by Fraser Sherman - Updated August 23, 2018
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The classical theory of economics exists because of Adam Smith. This 18th-century Englishman developed the basics of classic economics, asking and answering questions such as "What are the basic principles of capitalism?" Smith's core idea was that players in the economy act out of self-interest and that this actually produces the best outcome for everyone. Smith's theories were the beginning of the modern discipline of economics. Despite being followed and challenged by neoclassical economics and then Keynesian theories, Smith's ideas are still influential.

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  • The classical theory of economics is that self-interest benefits everyone. Businesses profit from selling goods and services to people who need them. Competition for goods or customers naturally determines the "right" price.

What Is the Classical Model of the Economy?

As defined by Smith and his fellow classical economists, such as David Ricardo and John Stuart Mill, the economy is a self-regulating system. It doesn't need the king or a board of trade to decide what prices should be or what products are for sale. It doesn't rely on generosity or compassion to operate; it produces good results because good results are in everyone's self-interest. As Smith saw it, the interactions of all the buyers and sellers create a spontaneous order, an "invisible hand" that shapes the economy.

Ironically, it was 19th-century philosopher Karl Marx who coined the term "classical economics." The irony is that Marx had little use for the capitalism Smith and Ricardo embraced; he's the author of "The Communist Manifesto," one of the most influential criticisms of the 19th-century economic order.

How the Invisible Hand Works

Suppose John Jones and Jane Smith are both furniture makers. They want to earn a living by their craft. Their suppliers want to make money by selling oak or hickory to Jones and Smith to create furniture. The buyers want furniture without having to make it themselves. Everyone gets what they want.

How do Smith and Jones know the right price for their goods? It depends on what they need to support themselves and what furniture buyers are willing to pay them. If the makers ask for more than the buyers want to pay, Smith and Jones won't sell any furniture. They'll have to drop their price. That in turn requires either accepting a lower income or making furniture for less. In Smith's thinking, this wasn't unfair. There's no coercion involved, just the power of the free market in action.

If Smith and Jones have different business strategies – Smith makes better quality furniture but asks a higher price – that complicates things. They may both succeed by catering to different buyers. If Smith's furniture is too expensive or Jones's quality is too poor, one of them may go out of business. Alternatively, they may reboot their business approach to fit with what the market wants.

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If the demand increases, Smith and Jones may be able to increase their prices, or another business might open, soaking up some of the extra demand. The marketplace in classic economics theory doesn't follow a fixed, predictable path. It's dynamic, shifting as the invisible hand of competition and self-interest steers events in new directions. While some people may lose out, the invisible hand gives the greatest number of people the most satisfaction.

The classical economist Ricardo suggested the same principles worked with international trade. If one country makes the best wine and another makes the best cloth, it makes more sense to trade wine for cloth than for both nations to make wine and cloth.

What Is Laissez-Faire Economics?

If the invisible hand manages things, do we need government to step in? Classical economics is associated with laissez-faire economics, which is the idea that the economy works best when government has minimal or no control over it. The term, coined by a French merchant, fits with a lot of Smith's thinking but not all of it.

Smith didn't want government setting prices or tariffs; free trade was always the best path. However, he also thought that businesses had a vested interest in rigging the game against free trade: "To widen the market and to narrow the competition, is always the interest of the dealers." Setting up a monopoly or a trade guild to restrict competition benefited the sellers and dealers because it would "enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, and absurd tax upon the rest of their fellow-citizens."

In Smith's view, government had an important role in keeping the market open to free trade and competition. When it worked against that end by regulating which companies could do business, for example, it shielded merchants and manufacturers from competition. That is great for businesses and bad for consumers.

Poverty Worried Adam Smith

In a laissez-faire, free market economy, some people are bound to lose out. Some economists see this as a matter of personal failure. The invisible hand is completely fair, so if someone ends up poor, it's his own fault for not being a strong enough competitor. Adam Smith himself didn't see it that way.

In Smith's eyes, poverty was unjust: “they who feed, clothe, and lodge the whole body of the people, should have such a share of the produce of their own labor as to be themselves tolerably well fed, clothed, and lodged.” Economic inequality wasn't as big a problem if even the poor had a decent lifestyle. Smith did worry that as the rich got richer, people would glorify them and have contempt for the poor. That was bad for the poor and had a corrupting effect on society.

The Neoclassical Theory of Economics

Few theories last forever without someone revising them, and classical economics is no exception. By the end of the 19th century, neoclassical theories had taken over. Neoclassical economics didn't reject Smith, Ricardo and other classicists; instead, it built on them.

Part of the change was the increased use of scientific analysis and precise metrics since the 1700s. Neoclassical economics tries to study the economy scientifically. A neoclassical economist doesn't simply observe the market and draw conclusions; they form a hypothesis about how the economy works and then find evidence to prove it. The goal is to derive general rules and principles about how businesses and consumers behave. Neoclassical economists assume that using mathematical models to study the economy generate the most reliable results.

Neoclassical economics covers lots of different schools of thought. Most neoclassicists assume that economic agents are rational; they look at a transaction and buy, negotiate or don't buy depending on what makes rational sense to them. The logical goal for businesses is to sell products that maximize their profits. The logical goal for consumers is to buy whatever product gives them the most benefit. Out of those two opposing goals emerge the neoclassical laws of supply and demand.

However, where classical economics focused on the objective benefits consumers gain, neoclassical economics considers the subjective ones. For example, suppose a consumer has to choose between Car A and Car B. Car B needs fewer repairs and has better gas mileage, but Car A is a status symbol that will make the buyer much happier. That makes buying Car A a perfectly rational decision.

Marginalism is another part of neoclassical economics. This approach looks at the costs and behavior of buying or making extra items. If your company is making five widgets a week, the cost of ramping up to 10 might be considerable; if you're making 100,000, adding another five widgets is probably a trivial expense. The marginal costs and the decisions that result are different.

Neoclassical theories also offer a different view of poverty than classical economics did. Rather than seeing poverty as only the result of individual failures, neoclassical economists think some poverty results from market failures over which individuals have no control. The Great Depression of the 1930s, for example, left many people ruined. It wasn't a personal failure but a systemic one.

Neoclassical economics lost ground to Keynesian theories in the 20th century but enjoyed a resurgence late in the century.

Enter the Keynesians

Named for John Maynard Keynes, the school of Keynesian economic theory marks a much sharper break with Adam Smith than neoclassical thinking did.

In classical and neoclassical thinking, the growth of demand inevitably pushes free markets toward full employment. Even if businesses are doing poorly, full employment is possible; wages just have to drop low enough that businesses can afford workers.

Keynes disagreed. If goods aren't selling, he reasoned, businesses won't hire anyone to make them. That leads to unemployment, which is a major cause of poverty. It's not that the workers aren't capable of competing in the market, it's that there's nothing for which to compete. Self-interested business decisions don't automatically create a healthy economy or grow the economic pie.

That gives government an important role. In Keynesian thinking, investment in business leads to more employment. Government can boost investment with targeted public spending and by setting the right tax rates. Keynesian theories became popular in the 1930s when governments actively worked to counter the impact of the Depression. They've also had some success dealing with the 21st century's financial crises.

Then Came New Classical Economics

The 1970s was a harsh time for the American economy. It was suffering under what was sometimes called stagflation – an economy where demand was stagnant, yet inflation was rising. The two were not supposed to happen together. Keynesian economists had trouble explaining why it did.

That led to the development of new classical economics, yet another take on Adam Smith's thinking. New classicists argued that some people will voluntarily drop out and stop working, something Keynesian theories ignored. If you exclude the drop outs, then the free market does indeed move toward full employment. The new classical school also argued that government policies can't change anything because players in the market take them into account.

Suppose, for example, the government increases the money supply, and wages and prices go up. That might initially encourage firms to hire more people and encourage drop outs to get back into the workplace. Because inflation also reduces buying power, however, nothing has really changed. As soon as workers and businesses realize their higher income doesn't mean anything, they'll revert back to the previous status.

The one thing that can produce change is an unexpected shock. This can be anything from a financial crash to something positive, like a sudden demand for a particular product or service. When change strikes out of the blue, workers or businesses often have to readjust their plans and move in a completely different direction. This, however, isn't something the government can arrange. The results of an unexpected shock are unpredictable, so there's no way government can use it to steer the economy in a different direction.

Where We're at Now

The different schools of economics since the classical school have all built on Smith's work, but they've taken it in different directions and recommended different policies. That may reflect the fact that different generations face different problems. The Depression and the stagflation economy of the 1970s were different crises, which inspired economists to see different solutions. In the 21st century, governments employ variations of both the Keynesian and the new classical approach to keep the economy on an even keel.

About the Author

Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs.

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