03/11/11 at 8:30 pm
These days, people have seen much interesting reversal in the fortunes of what good and services are produced, how they are produced and how they are distributed globally. Whilst societies are much too concerned about price elasticity, recession and depression, the pillars who masterminded the entire economic system still dominate the center stage. Indeed, on the face of it, not only did they solve a problem that intrigued man for ages, but, more importantly, their theories literally opened the door to exploration of the proper allocation and use of available resources for the maximum satisfaction of human wants, otherwise known as economics.
Who are the pillars of the modern economic system and what are their contributions?
Adam Smith advanced the idea of “Absolute Advantage Theory” which refers to the ability of a party to produce a particular good at a lower absolute cost than the other. He proposed two requirements in his system: the market must be free from government intervention and competition must be in full range. He believed that producers, in order to earn profit, provide right goods and services as a consequence of market forces. Without government intervention, he further argued, a laissez faire environment is possible where competition exists to cater for organized production to suit the public. Hence, an increase in public well being is inevitable. He introduced the basis of the free market economy – competition would benefit both the producers and consumers. He concluded that the greater the competition, the greater the producers’ profit. According to him, when there is competition, the prices of commodity tend to decrease which result to more demands and thus would mean more profit.
David Ricardo is most remembered for his “Theory of Comparative Advantage” which explains how trade can create value for both parties even when one can produce all goods, with fewer resources than the other. He termed the net benefits of such an outcome as “gain from trade”. His basic definition of comparative advantage is the ability of an individual, a firm or a country to produce a particular good or service at a lower marginal cost and opportunity cost than another country. He contributed the “doctrine of fiscal equivalence” which is an economic theory that suggests that the government’s initiative to increase debt-financed government spending for the purpose of stimulating demand do not actually affect the demand due to the public’s consciousness to save excess money for the payment of future tax increases in lieu of the debt settlement. He established the “Theory of Rent” which is directly tied to the marginal productivity of the land. The basis of this theory is his analogy that population growth equals more mouth to feed, more mouth to feed equals the need for more grains and the need for more grains equals the need for more land. This led to the view that an increase in food cost, salary and profit is an advantage for the land owners while the case is otherwise for the capitalist. The “Theory of Value” which is tied directly to labor cost is another Ricardian principle. It states an direct proportion between price of goods and the natural price of labor. He claimed that labor like all other goods which are purchased and sold, or which may increased or decreased in quantity, has its natural price and market price. The natural price of labor is the price which is necessary to enable constant subsistence and perpetuation. Finally, he postulated the “Theory of Distribution” which is inextricably linked to the theories of rent and value. He pointed out that the return of the land is not constant as the amount of capital available does not equate to similar growth rate, the land suffers from diminishing returns. The maximum level of economic rent results from the marginal cultivation of the land.
Thomas Malthus had two major contributions to the modern economic system: the population theory and the theory of market gluts. The Population Theory had great in influence on both Charles Darwin and Alfred Wallace as this theory led to the formulation of the theory of natural selection. The basis of this theory is the assumption that the power of population supersedes the power of the earth to provide subsistence for man. The argument that the “passion between sexes is an inevitable phenomenon” projects dramatic growth in population which bring about shortage in food supply. However, population can be controlled either naturally or by the aid of human measures. The natural factors are disease, food shortage and death due to starvation while the human measures are infanticide, abortion, delay in marriage and strict rules on celibacy. On condition that the population is uncontrolled, agricultural production is on the increase to provide for over population and food shortage. In order to validate this theory on moral grounds he maintains the thought that suffering is a way of making human beings realize the virtues of hard work and moral behavior. He also noted that such kind of suffering due to over population is an expected outcome. On the other hand, the Theory of Market Gluts is centered on the factors of wealth and poverty, which gave light to the recognition of the key to the accumulation of capital in the distribution of income. Gluts are consequences of a decline in profits brought about by insufficient demand. The reason for such insufficiency is the disproportion in the income distribution. In view of this, saving by capitalists results to demand reduction; consumption by landlords increases demand. Therefore, a redistribution of income from landlords to capitalists precipitates crisis. In order to eliminate gluts and promote economic growth Malthus advocates redistributing income to the renter and increasing government spending. He believes that the capitalists produce more than they consume so that the landlords can consume more than they produce.
John Stuart Mill
John Stuart Mill wrote the “Principles of Political Economy”, which became the leading economic textbook for forty years after it was written. He elaborated on the ideas of David Ricardo and Adam Smith. He helped develop the ideas of economies of scale, opportunity cost and comparative advantage in trade.
Mill’s analysis is fundamentally grounded in his broader approach to economics – the view that economic activity is only a part of all activities or basically termed as “Mill’s Economics”. Firstly, Mill identified that two forces: competition and custom, govern the distribution of income, and he criticized the orthodox line of English economists for emphasizing the role of competition while almost completely neglecting the role of custom. He pointed out that the operation of competition in the market economy is comparatively young historical phenomenon and that, if we glance backward, we find that custom has traditionally played a major role in solving the economic problems surrounding the distribution of income.
Karl Marx believes that the basic determining factor of human history is Economics. He advanced the idea that exchanges of equal value for equal value is fundamental to an ideal economic system where the amount of work put into whatever is being produced is the determinant of value. He absolutely disagreed with capitalism which he described as profit motivated – a desire to produce an uneven exchange of lesser value for greater value. So his belief had a great influence on communism, where all the factors of production and all the industries are owned and managed by the state. This is also known as command economy, where private property ownership is not allowed. Economics, then, are what constitute the base of all of human life and history — generating division of labor, class struggle, and all the social institutions which are supposed to maintain the status quo. Those social institutions are a superstructure built upon the base of economics, totally dependent upon material and economic realities but nothing else. All of the institutions which are prominent in our daily lives — marriage, church, government, arts, etc. — can only be truly understood when examined in relation to economic forces.
Leon Walras’ biggest contribution in economics is the “General Equilibrium Theory” and he is also one of the founders of the “marginal revolution” by postulating the idea of marginal utility. The general equilibrium theory studies the fundamentals of supply and demand in an economy with multiple markets, with the objective of proving that all prices are at equilibrium. This theory analyzes the mechanism by which the choices of economic agents are coordinated across markets. It attempts to look at several markets simultaneously rather than a single market in isolation. On the other hand, marginal utility is defined as the additional satisfaction or benefit that a consumer derives from buying an additional unit of a commodity or service. The concept implies that the utility or benefit to a consumer of an additional; unit of a product is inversely related to the number of units of that product he already owns.
Alfred Marshall’s main argument is that the economy is an evolutionary process in which technology, market institutions and people’s preferences evolve along with people’s behavior. He introduced the idea of 3 periods namely, Market Period, Short Period and Long Period, to understand how markets adjust to changes in supply or demand over time. Market Period is the amount of time for which the stock or commodity is fixed. Meanwhile, the time in which the supply can be increased by adding labor and other inputs but not adding capital is known as Short Period. Lastly, Long Period means the amount of time taken for capital to be increased. Marshall’s basic approach to welfare economic still stands today. In his most important book, “Principles of Economics”, he was able to quantify the buyers’ sensitivity to price. He emphasized that the supply and demand determines the price output of a good: the two curves are like scissor blades that intersect at equilibrium. This concept is otherwise known as Price Elasticity of Demand. He proposed that the price is basically parallel for each unit of commodity that a consumer buys, but the value to the consumer of each additional unit declines. In line with this he illustrated the benefits of the consumer from market surplus. He termed these benefits as Consumer Surplus which is equated as the size of the benefit equals the difference between the consumer’s value of all the units and the amount paid for the units. In other words, the consumers pay less than the value of the good to themselves. Lastly, he also introduced the concept of Producer Surplus which is the amount the producer is actually paid minus the amount that he would willingly accept.
Thorstein Veblen’s greatest contribution to economics is the introduction of the concept, “conspicuous consumption”. In his widely known book, “The Theory of Leisure Class”, he defined conspicuous consumption as the consumption undertaken to make a statement to others about one’s class or accomplishments. He broadened the views of other economists regarding understanding the social and cultural causes and effects of economic changes. He advocated the identification of the causes and effects of shifting from one source of income to another.
John Meynard Keynes
John Meynard Keynes revolutionized the economists’ conceptions about economics. Keynes’ General Theory of Employment, Interest and Money, for instance, introduced the notion of aggregate demand as the sum of consumption, investment and government spending. His reason is that it is apparent that maintenance of full employment mainly depends on the support of government spending. Although his thought was not favored by economists he argued that his theory aim to stabilize wages. Moreover, his insight was that a general cut of wages tends to decrease income, consumption and aggregate demands which lead to positive contributions of lower price of labor. This theory advocated deficit spending during economic downturns to maintain full employment. Keynes believed in monetarism or the quantity theory of money. His major policy view was that the approach to uphold economic stability is to stabilize the price level, and that to reach the possibility, there is a need for the government’s central bank to lower the interest rates when prices tend to rise and raise when prices tend to fall. In his eloquent book entitled, “The Economic Consequences of the Peace”, he wrote an excellent economic analysis of reparations. This book also contains an insightful analysis of the Council of Four (Georges Clemenceau of France, Prime Minister David Lloyd George of Britain, President Woodrow Wilson of the United States, and Vittorio Orlando of Italy). Keynes was one of the advocates of the postwar system of fixed exchange rates.
Irving Fisher pioneered the construction and the use of price indexes. His own Index Number Institute computed price indexes worldwide from 1923 to 1936. He also initiated the clear distinction between real and nominal interest rates which is still the basic principle in modern economy. He pointed out that the real interest rate is equal to the nominal interest rest minus the expected inflation rate. He was also a founder or president of numerous associations and agencies including the Econometric Society and the American Economic Association. Fisher advocated a more modern quantity theory of money which functions reasonably well in assuming the consistency of economy. He formulated his theory in terms of the equation of exchange, which says that MV = PT, where M equals the stock of money; V equals velocity or the speed of money circulation in an economy; P equals the price level; and T equals the total volume of transactions. Moreover, the contemporary economic models of interest are based on Fisherian principles. For one, Fisher’s principle of money and prices conceptualized monetarism. He called interest “an index of a community’s preference for a dollar of present income over a dollar of future income.” He postulated that Interest rates result from the interaction of two forces: the time preference and the Investment Opportunity Principle (the present income investment will yield more future income investment). His Capital theory which states that the value of capital is the present value of the flow of income that the asset generates is still widely held these days. His reasoning on consumption taxes to replace conventional income taxation gave light to double taxation of savings, and clearly became an insight to understand that this double taxation biases the tax code against saving and in favor of consumption.
All points considered, the contributions of the highly praised economists in their times focused mainly on the factors of production, supply and demand and market models. From their principles we now acquire a set of economic institutions that dominates a given economy, from their theories, three major economic systems in the present day societies were born. First is capitalism where the factors of production are owned by the private individuals or corporation, second is socialism which is a bridge between capitalism and socialism, under this system, the major factors of production distribution and industries are owned and managed by the state, while the minor industries are owned by the private sector, and last is communism, which is exactly the opposite of capitalism. In the future more and more economists will be born, more theories will be formulated for the quest of economic growth.