Classical Economic Theory- a summary on the founding of Economics

Classical Economic Theory- a summary on the founding of Economics

Classical Economic Theory

Last time we talked about Adam Smith, the invisible hand, and supply and demand. Adam Smith is commonly known as the founder of economics but he’s also known as the founder of Classical Economic Theory. While other people also made contributions to classical economics he is the main contributor to Classical theory.

Classical theory was being formed around the industrial revolution in Europe. Capitalism and Classical theory dealt with the questions of how every person seeks to make his own life better and gain money. But the main idea behind Classical theory is that markets and people should regulate themselves, because that is most efficient.

Classical theory moved economics away from a pursuit of a ruler’s interest and towards broader national interests. Smith in the “Wealth of Nations” (1776) saw the income of a nation as the production of the nation, not just the king’s treasury. He saw the income produced by labor, land, and capital as all sources of income. Not just the taxation the king drew from his people. But Smith also divided up the income into different forms such as wages, rent, and interest/profits. All of this was part of the movement of economics away from Personal interests and towards national interests.

There is some difficulty covering Classical Economic Theory because there’s a big discussion on what should be considered classical theory and what shouldn’t be. But I will try and cover the things most people would include under “Classical theory”.

The main things covered by Classical economics is: Economic growth, value, economic freedom, and free competition.

Economic Growth:

The three main economists in classical economic theory, Smith, Ricardo, and Malthus all developed different theories on how economic growth contributes to the welfare of the nation. They are all slightly different but provide a basic approach and framework to assess GDP growth.

The classical economists explained the growth process in terms of rates of population growth and technical progress. The main components of growth theory and stagnation are seen in the production function.

Production function:

Smith, Ricardo, and Malthus all had identical production functions which were written as Y=f(K,L,N,S). This means that GDP (Y) depends on the stock of capital (k), Labor force (L), Land (N), and technology (S). The Classical economists saw the production function as linear and homogenous. Meaning that if you were to double the amount of one of the inputs like labor, you would double the output (barring some expectations which are mentioned below).

Technological progress:

Seeing as how Classical economic theory placed a high value on technological innovation they believed that there were also practical constraints to technological progress. They believed that the constraint was capital accumulation. That technological progress is a capital absorbing process and thus accumulation is a prerequisite for the advance of technology. They stressed savings and investment as the primary factor of technological advancement and capital accumulation.


For classical economic theory founders profit was the main motivator of all investment. And the two main determinants of profits in Classical Economic Theory was the supply of labor and technological progress. They figured that the population would continue to grow over time which would lead to diminishing returns in agriculture and increase labor costs. They believed that technological advancement would provide increasing returns but only in specific industries (manufacturing and technologically heavy fields) and this did not include agriculture. They thought if the relative strength of the technology was greater than that of labor then profits would continue to grow. In their opinion, the tendency for tech to have increasing returns and labor to have decreasing returns would counteract each other. Therefore, the profits depended on the relative strength of the technology vs the labor supply’s strength.

However, Classical Economic Theory developers were not optimistic of the future and figured that profits would ultimately fall. Here there is a circularity going on leading to stagnation. Technological advancement depends on investment. Investment depends on profits. Profits depend on technological progress, among other things. Indeed, but this isn’t really an accident as they were of the opinion that we should allow dying industries to die. “This circularity is no accident or oversight; it is precisely what classicalists- and most later economists- have wished to stress; in economic development nothing succeeds like success and nothing fails like failure.”

Wages and labor force size:

One of the interesting things the Classicalists caught was how wage growth affects population. When the wage fund (money available for paying wages to labors) is above the subsistence level this provides incentive to boost population growth which increases supply of labor and brings the wage fund back down to subsistence levels. Which some economists think this is a good explanation for peasant societies and some third world countries.

Production function closing:

Once we close the production function we can see the circularity mentioned above.

GDP=profits + wages… or the real income is the sum of profits and wages. From here we examine it as a system which can be broken down by focusing on profits.

Profits -> investment/savings -> tech progress and wage growth -> labor -> profits.

What this shows is that a rise in profits increases the investment and savings which leads to technological progress and wage growth. Then proceeding, a rise in the wage fund stimulates population growth, which in turn, leads to diminishing marginal returns on labor and increasing labor costs. Finally, profit margins decline. This is the basic classical model and at the end it reaches the Stationary State.

This always seemed like a disappointing conclusion of the Classical theory of growth. As a person more interested in Marco-policy and growth this was hard to swallow at first but I’ll leave a quote from John Stuart Mill on his thoughts about a Stationary State economy

“a stationary condition of capital and population implies no stationary state of human improvement. There would be as much scope as ever for all kinds of mental culture, and moral and social progress; as much room for improving the art of living, and much more likelihood of it being improved, when minds ceased to be engrossed by the art of getting on.”

Value Theory:

Value theory developed in Classical Economic theory because the Classicalists were attempting to investigate price and market influences. In order to facilitate this process William Petty developed a distinction between “market price” (price the market place sets) and “natural price” (cost of production). Market prices are changed by many influences that, at the time, were difficult to theorize about. Whereas a natural price was much easier to theorize about and even calculate and add into models. Smith said that market prices always moved towards natural prices similar to how gravitational forces attract objects.

Generally, though classical theory of prices is given three determinants:

  1. The level of outputs at the level of Smith’s “effectual demand”
  2. Technology
  3. Wages

A quick side note: Effectual demand is what Smith say as a person’s “true demand”. When a person says “I want X” they aren’t telling us much. However, if a person were to say “I am willing to give up 10 units of Y for one unit of X” this statement tells us much more.

Monetary Theory:

Monetary Theory is filled with some controversy between banking and Currency schools. According to the banks and later, Monetarists, argued that banks can and should control the money supply. That’s because Inflation is caused by banks issuing an excessive supply of money. But according to the Currency schools the supply of money automatically adjusts to the demand and banks can only control the terms (interest) on which loans are made.

Free trade and Economic freedom:

Classical economists tended to stress the benefits of trade because it allows for increased contributions of foreign wealth and money into the home economy. Free trade was important due to the production function, if we remember. The process by which we advance technology is through savings and investment. The more foreign investment a home country has the faster the technological advancement will be. Classical Economic Theory on trade was focused on what products should the home country specialize in and what should be the ratio of exchange between the two countries. This allowed for analyzation of exchange rates, specialization of labor, and comparative advantage. Value theory helped explain the costs of labor and anything else in the market place.

However, the classical theory of trade relies upon some assumptions that aren’t entirely arcuate but worked well enough at the time to explain things.

  1. Labor is the only factor
  2. All labor is the same quality
  3. Free mobility of labor
  4. Every occupation is open to all
  5. Free competition between workers
  6. The productivity of workers is equal to the wages provided.

Classical Economic Theory is a good starting point on opening one’s eyes to economics. They were focused on explaining economic growth and concerned about specialization in the work force. They were attempting to explain “The Wealth of Nations” and they did a good job at that while providing a basic framework for analyzing prices and discussing monetary value. The real fundamental principle out of Classical economics is that the economy is self-regulating. That prices, wages, and output levels will gravitate back to an equilibrium. Which that equilibrium will eventually lead the economy is a Stationary State of no economic growth.

Disclosure: There’s lots here I didn’t cover from equilibrium prices and quantities, long run and short run graphics, how the production function shifts when certain things happen, perfect information, real wage, and lots of other stuff. But at least now you’ll have a very basic understanding of Classical Economic Theory.

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