Early Modern Economic Theory and the Rise of Classical Economics

Classical Capitalism

In the eighteenth century, critics of mercantilism began to arise, such as David Hume, the physiocrats of France, and finally the classical economists Adam Smith and David Ricardo. Hume drew attention to the fact that as bullion accumulates in a nation, its value decreases relative to other goods, while as bullion is exported, the value rises relative to other goods. The physiocrats argued that a nation's wealth lies in agricultural production (that is productive work) rather than governmental wealth. Quesnay, for example, held that agriculture, rather than commerce and industry, were the true sources of wealth. Turgot stressed the importance of self-interest in an economy and how trade barriers undercut this. However, the physiocrats did not look to other sources of productive work outside agriculture.

Adam Smith's Wealth of Nations, still represents the most influential work in economic theory. Smith, while accepting the physiocratic stress on an end to market regulation and the importance of productive labor, rejected agriculture as the sole source of this wealth. Labor of all kinds is more valuable than land. In Smith's understanding, a free market has a natural regulatory pattern: 

1. If a product shortage occurs, for instance, its price rises, creating a profit margin that creates an incentive for others to enter production, eventually curing the shortage. 
2. If too many producers enter the market, the increased competition among manufacturers and increased supply would lower the price of the product to its production cost, the "natural price."
3. Even as profits are zeroed out at the "natural price," there would be incentives to produce goods and services, as all costs of production, including compensation for the owner's labor, are also built into the price of the goods. 
4. If prices dip below a zero profit, producers would drop out of the market; if they were above a zero profit, producers would enter the market.
   (taken from Wikipedia)

As a result, Smith opposed mercantilist regulations of markets, though he held that governments should do things to assist the economy, such as maintain a system of national roads and promote national defense. Later theorists, Thomas Malthus and David Ricardo, expanded Smith's market understanding, though Smith's own views may better explain modern markets in some ways. Rev. Malthus formulated the principle of overpopulation which held that uncontrolled population growth occurs geometrically, while food production increases only arithmetically:

The power of population is so superior to the power of the earth to produce subsistence for man, that premature death must in some shape or other visit the human race. The vices of mankind are active and able ministers of depopulation. They are the precursors in the great army of destruction, and often finish the dreadful work themselves. But should they fail in this war of extermination, sickly seasons, epidemics, pestilence, and plague advance in terrific array, and sweep off their thousands and tens of thousands. Should success be still incomplete, gigantic inevitable famine stalks in the rear, and with one mighty blow levels the population with the food of the world.

As a result, demographics became an element in economic thinking. Ricardo, building on this line of reasoning, proposed a number of important ideas, including:

1. Comparative advantage: a country which can produce a good more efficiently can gain a market advantage by specializing in this good's production.
2. Theory of rents: Rent is charged only when various grades of land are available; rent is charged progressively higher on the higher grades. 
3. Natural price: Overtime, prices reflect the cost of production because this includes the cost of supporting the laborer. As real wages increase, real profits decrease since the cost of production must be spilt between profits and wages. Therefore, wages naturally tend toward a subsistence level since profits must be maximized.

Addison, "The Royal Exchange" (ER 480-483)

1. Why does Addison see trade in the exchange as a form of economic ambassadorship?

2. How does he idealize the process of trade and exchange?

3. How does he believe that England has profited over time and continues to profit from trade? How does this counter the older mercantile viewpoint?

Franklin, "Industry and the Way of the World" (ER 483-490)

1. What economic value does Franklin assign the habits of frugality and industry?

2. Describe Franklin's plan for a moral calculus of self-examination. What does he learn while trying to follow this pattern?
3. How does Father Abraham see idleness, pride, and folly as taxes?
4. What values does he assign to industry?

Key Themes

• Self-reliance, industry
• The public appearance of frugality and hard work
• Frank plainness
• Verbal modesty
• Individual self-examination in his 13 virtues
• A life of public service and improvement
• Empiricism
• Freedom of conscience
• Proverbial wisdom
• Lack of passion; clear self-control

Hume, "Of Luxury" (ER 491-496)

1. Why does Hume believe that industry leads to refinements in culture and social manners? Do you agree?
2. What positive benefit does he claim results from consumption of commodities?
3. What impact does this have on law, police, government, and general human behavior?
4. How does he defend mutual riches, esp. the example of Rome? Why does it lead to political equality and freedom? Do you agree?

Quesnay, "The Physiocratic Formula" (ER 496-502)

1. Why does he think a government of checks and balances will undercut national interest?
2. What are the economic advantages to land, property, and ownership? How does this compare with Smith's views?
3. What advice does he have on taxes, national revenue, agricultural workforce, and economic trade?
4. What concerns should national policy have with foreign trade as compared to freedom of domestic trade?
5. What other economic concerns should a state have?

Turgot, "Economic Liberty" (ER 502-505)

1. Why should the government stay out of market regulations?
2. How do mercantilist policies end up harming domestic producers?

Smith, "The Wealth of Nations"

According to Smith, how does self-interest lie behind division of labor and cooperation?

1. How does parsimony and capital accumulate in order to be invested in industry?
2. How does "the invisible hand" use a person's self-interest?
3. How do mercantilist policies disturb natural economic regulations?
4. What responsibilities does a sovereign government have in regard to economics?
5. How does vanity drive industry and shame of poverty?

Ricardo, "Iron Law of Wages  " (Handout)

1. Why does Ricardo argue for a relationship between profits and wages?
2. Why does he believe the prosperity of the laborers overtime results in a fall in profits and wages?
3. Why, then, does he think the poor laws have the reverse effect of what they were intended for? Do you agree?