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attainment and with the use of the material requisites of wellbeing"— ignoring the
fact that sociologists, psychologists, and anthropologists frequently study exactly
the same phenomena. Another English economist, Lionel Robbins, has more
recently defined economics as "the science which studies human behaviour as a
relationship between (given) ends and scarce means which have alternative uses."
This definition — that economics is the science of economizing — captures one
of the striking characteristics of the economist's way of thinking but leaves out the
macroeconomic approach to the subject, which is concerned with the economy as
Difficult as it may be to define economics, it is not difficult to indicate the
sort of questions that economists are concerned with. Among other things, they
seek to analyze the forces determining prices — not only the prices of goods and
services but the prices of the resources used to produce them. This means
discovering what it is that governs the way in which men, machines, and land are
combined in production and that determines how buyers and sellers are brought
together in a functioning market. Prices of various things must be interrelated;
how does such a "price system" or "market mechanism" hang together, and what
are the conditions necessary for its survival?
These are questions in what is called "microeconomics," the part of economics
that deals with the behaviour of such individuals as consumers, business firms,
traders, and farmers. The other major branch of economics is "macroeconomics,"
in which the focus of attention is on aggregates: the level of income in the whole
economy, the volume of total employment, the flow of total investment, and so
forth. Here the economist is concerned with the forces determining the income of
a nation or the level of total investment; he seeks to learn why full employment is
so rarely attained and what public policies should be followed to achieve higher
employment or more stability.
But these still do not exhaust the range of problems that economists consider.
There is also the important field of "development economics," which examines
the attitudes and institutions supporting economic activity as well as the process
of development itself. The economist is concerned with the factors responsible for
self-sustaining economic growth and with the extent to which these factors can be
manipulated by public policy.
Cutting across these three major divisions in economics are the specialized
fields of public finance, money and banking, international trade, labour economics,
agricultural economics, industrial organization, and others. Economists may be
asked to assess the effects of governmental measures such as taxes, minimum-
wage laws, rent controls, tariffs, changes in interest rates, changes in the government
budget, and so on.
It is social science that seeks to analyze and describe the production,
distribution, and consumption of wealth.
The major divisions of economics include microeconomics, which deals with
the behaviour of individual consumers, companies, traders, and farmers; and
macroeconomics, which focuses on aggregates such as the level of income in an
economy, the volume of total employment, and the flow of investment. Another
branch, development economics, investigates the history and changes of economic
activity and organization over a period of time, as well as their relation to other
activities and institutions. Within these three major divisions there are specialized
areas of study that attempt to answer questions on a broad spectrum of human
economic activity, including public finance, money supply and banking,
international trade, labour, industrial organization, and agriculture. The areas of
investigation in economics overlap with other social sciences, particularly political
science, but economics is primarily concerned with relations between buyer and
Construction of a system
David Ricardo's Principles of Political Economy and Taxation (1817) was,
in one sense, simply a critical commentary on the Wealth of Nations; in another
sense, it gave an entirely new twist to the developing science of political economy.
Ricardo invented the concept of the "economic model," a tightly knit logical
apparatus consisting of a few strategic variables, an apparatus that was capable of
yielding, after a bit of manipulation, results of enormous practical import. At the
heart of the Ricardian system is the notion that economic growth must sooner or
later be arrested, owing to the rising cost of growing food on a limited land area.
An essential ingredient of this argument is the Malthusian principle—enunciated
in Thomas Malthus' Essay on Population (1798)—that population tends to increase
up to the limits set by the existing supply of food, thus holding down wages. As the
labour force increases, extra food to feed the extra mouths can be produced only
by extending cultivation to less fertile soil or by applying capital and labour to
land already under cultivation (with diminishing results because of the so-called
law of diminishing returns). Although wages are held down, profits do not rise
proportionately because tenant farmers outbid each other for superior land. The
chief beneficiaries of economic progress, therefore, are the landowners.
Since the root of the trouble, according to Ricardo, is the declining yield of
wheat per unit of land, one obvious solution is to import cheap wheat from other
countries. Eager to show that Britain would benefit from specializing in
manufactured goods and exporting them in return for food, Ricardo hit upon the
"law of comparative costs" as proof. He assumed that, within countries, labour
and capital are free to move in search of the highest returns; between countries,
however, they are not. In these circumstances, Ricardo showed, the benefits of
trade are determined by a comparison of costs within each country, rather than by
a comparison of costs between countries. It pays a country to specialize in the
production of those goods that it can produce relatively more efficiently and to
import everything else; although India may be able to produce everything more
efficiently than England, India is nevertheless well advised to concentrate its
resources on textiles, in which its efficiency is relatively greater, and to import
British capital goods. The beauty of the argument is that if all countries take full
advantage of the territorial division of labour, total world output is certain to be
larger than it will be if some or all countries try to become self-sufficient. Ricardo's
law became the fountainhead of 19th-century free-trade doctrine, which would
have been enough, if he had said nothing else, to give him a place in the economists'
The influence of Ricardo's treatise was felt almost as soon as it was published,
and for over half a century the Ricardian system dominated economic thinking in
Britain. In 1848 John Stuart Mill's restatement of Ricardo's thought in his Principles
of Political Economy brought it new authority. After 1870, however, most
economists turned their backs on the range of problems that had concerned Ricardo
and began to re-examine the foundations of the theory of value; that is, they became
interested in the theory of why goods exchange at particular prices, so that for a
while they devoted almost all of their efforts to the problem of resource allocation
under conditions of perfect competition.
A few words must first be said, however, about the last of the classical
economists, Karl Marx. The first volume of Das Kapital appeared in 1867; the
second and third after his death, in 1885 and 18 94. For a generation, therefore, the
competitive market theorists jostled with the followers of Marx. By 1900 the
intellectual battle was over, and thereafter professional economists largely lost
interest in Marx. Despite the Russian Revolution, despite what amounts to official
endorsement of Marxism in one-third of the world, and despite the lingering
influence of Marx's ideas, Marxian economics has been moribund ever since Marx's
death in 1883. If Marx may be called "the last ofthe classical economists," it is
because to a large extent he found his economics not in the real world but in the
teachings of Smith and Ricardo. They had espoused a "labour theory of value,"
which holds that products exchange roughly in proportion to the labour costs
incurred in producing them. Marx worked out all the logical implications of this
theory and added to it "the theory of surplus value," which rests on the axiom that
human labour alone creates all value and hence constitutes the sole source of
profits. It is an axiom in the sense that it cannot be established in terms of the
theory itself: it must be imported from without. To say that an economist is a
Marxian economist is in effect to say that he shares the value judgment that it is
socially undesirable for some people in the community to derive their income
merely from the ownership of property. Since few professional economists in the
19th century accepted this ethical postulate and most were indeed inclined to find
some social justification for the existence of private property and the income derived
from it, Marxian economics fell on deaf ears. The Marxian system, moreover,
culminated in three great generalizations: the tendency of the rate of profit to fall,
the growing impoverishment of the working class, and the increasing severity of
business cycles, of which the first is the linchpin of all the others. Marx's exposition
ofthe "law of the declining rate of profit" is invalid; with it all of Marx's other
predictions fall to the ground. In addition, Marxian economics had little to say on
some of the practical problems that are the bread and butter of economists in any
society. This is enough to suggest why Marxian economics failed to make many
converts among academic economists. Marxists will reply that the reason is simply
that academic economists have always been "lackeys of the capitalist class." Perhaps
so, but the fact remains that Marx has had virtually no effect on modern economic
The marginal revolution was essentially the work of three men: Stanley
Jevons, an Englishman; Carl Menger, an Austrian; and Leon Walras, a Frenchman.
Their contribution was the replacement of the labour theory of value by the marginal
utility theory of value; their explanation of prices began with the behaviour of
consumers in choosing among increments of goods and services (see utility and
value). The idea of emphasizing the marginal or last unit proved in the long run to
be more significant than the introduction of utility. It was the consistent application
of marginalism that marks the true dividing line between classical theory and modern
economics. The classical political economists saw the economic problem as that
of predicting the effects of changes in the quantity of capital and labour on the rate
of growth of national output. The marginal approach, however, focussed on the
conditions under which these factors tend to be allocated with optimal results
among competing uses — optimal in the sense of maximizing consumers'
Throughout the last three decades of the 19th century, the English, Austrian,
and French contributors to the marginal revolution largely went their own way.
The Austrian school dwelt on the importance of utility as the determinant of value
and vehemently attacked the classical economists as completely outmoded. A
brilliant second-generation Austrian economist, Eugen von Bohm-Bawerk, applied
the new ideas to the determination of the rate of interest, putting his stamp for all
time on capital theory. The English school, led by Alfred Marshall, sought a
reconciliation with the doctrines of the classical writers. The classical authors,
Marshall argued, concentrated their efforts on the supply side in the market;
marginal utility theory was concerned with the demand side, but prices are
determined by both supply and demand, just as a pair of scissors cuts with both
blades. Marshall, seeking to be practical, applied his "partial equilibrium analysis"
to particular markets and industries.
The leading French marginalist was Leon Walras, who carried the approach
furthest by describing the economic system in general mathematical terms. For
each product there is a "demand function" that expresses the quantities of the
product that consumers demand as depending on its price, the prices of other
related goods, the consumers' incomes, and their tastes. For each product there is
also a "supply function" that expresses the quantities producers will supply as
depending on their costs of production, the prices of productive services, and the
level of technical knowledge. In the market, for each product there is a point of
"equilibrium"— analogous to the equilibrium of forces in classical mechanics—
at which a single price will satisfy both consumers and producers. It is not difficult
to analyze the conditions under which equilibrium is possible for a single product.
But equilibrium in one market depends on what happens in other markets (a
"market" in this sense being not a place or location but a complex of transactions
involving a single good), and this is true of every market. There are literally millions
of markets in a modern economy, and therefore "general equilibrium" involves
the simultaneous determination of partial equilibria in all markets. Walras' efforts
to describe the economy in this way led the historian of economic thought Joseph
Schumpeter to call his work "the Magna Carta of economics." Walrasian economics
is undeniably abstract, but it provides an analytical framework for incorporating
all of the elements of a complete theory of the economic system. It is not too much
to say that nearly the whole of modern economics is Walrasian economics. Certainly,
modern theories of money, of employment, of international trade, and of economic
growth are all Walrasian general equilibrium theories in a simplified form.
The years between the publication of Marshall's Principles of Economics
(1890) and the Great Crash in 1929 may be described as years of reconciliation,
consolidation, and refinement. The three national schools gradually coalesced into
a single mainstream. The theory of utility was reduced to an axiomatic system that
could be applied to the analysis of consumer behaviour under various circumstances,
such as a change in income or price. The concept of marginalism in consumption
led eventually to the idea of marginal productivity in production, and with it came
a new theory of distribution in which wages, profits, interest, and rent were all
shown to depend on the "marginal value product" of a factor. Marshall's concept
of "external economies and diseconomies" was developed by his leading pupil,
Arthur Pigou, into a far-reaching distinction between private costs and social costs,
thus laying the basis of welfare theory as a separate branch of economic inquiry.
There was a gradual development of monetary theory, which explains how the
level of all prices is determined as distinct from the determination of individual
prices, notably by the Swedish economist Knut Wicksell. In the 1930s the growing
harmony and unity of economics was rudely shattered, first by the simultaneous
publication of Edward Chamberlin's Theory of Monopolistic Competition and
Joan Robinson's Economics of Imperfect Competition in 1933 and then by the
appearance of John Maynard Keynes's General Theory of Employment, Interest
and Money in 1936.
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