I.

Introduction

Economics, History of, the birth of economics as a separate subject of study, independent of politics and philosophy, may be traced to the year 1776, when Adam Smith published his Inquiry into the Nature and Causes of the Wealth of Nations. There was, of course, economics before Adam Smith: the Greeks made significant contributions, and so did the medieval exponents of scholasticism. From the 15th to the 18th century an enormous pamphlet literature appeared that developed the implications of economic nationalism, a body of thought now known as “mercantilism”; for a brief period in the 18th century the French “physiocrats” developed a fairly sophisticated economic model; and several other 18th-century figures can compete with Smith for the title of “founder of economics”. Nevertheless, Adam Smith wrote the first full-scale treatise on economics and, by his magisterial influence, initiated what later generations were to call (despite Smith’s Scottish nationality) “English Classical Political Economy”.

II.

The Work of Adam Smith

The Wealth of Nations, as its title suggests, is essentially a book about economic development, and about policies that promote or hinder development. In its practical aspects, it is an attack on the protectionist doctrines of the mercantilists and a brief for free trade. But in the course of attacking “false doctrines of political economy”, Adam Smith was led to analyse the workings of a free enterprise system. In a competitive free market economy each individual, being one among many, can exert only a negligible influence on prices; each must take prices as they come and is free only to vary the quantities bought and sold at given prices; yet the sum of all individuals’ separate actions determines prices. The “invisible hand” of the market, as Smith was fond of saying, assures a social result that is independent of individual intentions; it is an instrument capable of converting “private vices” (like selfishness) into “public benefits” (like maximum production). But this is only true if competitive markets are embedded in an appropriate legal and institutional framework, an insight that Adam Smith developed at length but that was largely forgotten by later generations. Within this great tome on the theme of rich and poor nations were contained a simple theory of value (or prices), a crude theory of distribution, an even cruder theory of international trade, and a primitive theory of money; but with all their imperfections, these were the building blocks of all later classical and post-classical economics. The book’s very fecundity gave it strength because it left so much for disciples to tidy up.

III.

The Ricardian System

Principles of Political Economy and Taxation (1817) by David Ricardo was, in one sense, 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 an “economic model”, a tightly knit logical apparatus consisting of a few strategic variables that was capable of yielding, after some logical manipulation, results of enormous practical import. At the heart of the Ricardian system is the notion that economic growth must sooner or later peter out, 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 An Essay on the Principle of Population (1798) by Thomas Robert Malthus—that population constantly tends to increase up to the limits set by existing supplies of food. 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. Although wages are thereby held down, profits do not rise proportionately, because tenant farmers outbid each other for superior land. The chief beneficiaries of economic progress, therefore, are 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 Great Britain would benefit from specializing in manufactured goods and exporting them in return for food, Ricardo seized for proof on the “law of comparative costs”. He assumed that labour and capital are free to move within countries in search of the highest returns; between countries, however, they are not free to move. 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 Portugal may be able to produce everything more efficiently than Britain, Portugal is nevertheless well advised to concentrate its resources on wine production, in which its efficiency is relatively greater, and to import British textiles. 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 would be if some or all countries tried to become self-sufficient. Ricardo’s law became the fountainhead of 19th-century free trade doctrine, which would have been enough, if he had written nothing else, to give him a place in the economists’ pantheon.

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 the restatement of Ricardian thought by John Stuart Mill 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 almost exclusively interested in the theory of why goods exchange at particular prices.

IV.

Marxism

A few words must be said, however, about the last of the classical economists, Karl Marx. The first volume of Marx’s Das Kapital appeared in 1867, the second and third posthumously, in 1885 and 1894. If Marx may be called “the last of the 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 espouses Marxist economics is in effect to say that he shares the value judgement 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, Marxist economics fell on deaf ears.

Marx’s 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 defence of the “law of the declining rate of profit” was unconvincing, and with it all of his other predictions fell to the ground. In addition, Marxist economics had little to say on some of the practical problems that are the bread and butter of economists in any society. That is enough to suggest why Marxist economics failed to make many converts among academic economists. Marxists would reply that the reason is simply that academic economists are and always have been “lackeys of the capitalist class”. Perhaps so, but the fact remains that Marx had no influence on economic thought after 1870.

V.

The Marginal Revolution

The 1870s saw one of the great watersheds in the history of economics, the so-called “marginal revolution”. This revolution was essentially the work of three men: William Stanley Jevons, an Englishman; Anton Menger, an Austrian; and Léon Walras, a Frenchman. Their contribution was the replacement of the labour theory of value by the marginal utility theory of 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 marked 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 growth rate of the national output. The marginal approach, however, focused on the conditions under which these factors tend to be allocated with optimal results among competing uses—optimal in the sense of maximizing the consumer’s satisfactions.

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 Böhm-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 sides, just as a pair of scissors cuts with both blades. Marshall, seeking to be practical, applied his “partial equilibrium analysis” to particular terms and industries. Walras, the leading French marginalist, 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 analyse the conditions under which equilibrium is possible for a single product. But equilibrium in one market depends on what happens in other markets, 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’s efforts to describe the economy in this way led one 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.

VI.

Neo-Classical Economics

The years between the publication of Marshall’s Principles of Economics (1890) and the Wall Street 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 changes in income or price. The concept of marginality 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 of production. Marshall’s concept of “external economies and diseconomies” was developed by his leading pupil, Alfred 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 work of the Swedish economist Knut Wicksell and the American economist Irving Fisher. 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 in 1936 of The General Theory of Employment, Interest, and Money by John Maynard Keynes.

VII.

The Institutionalists

Long before this, however, the German Historical school and the American Institutionalist school had levelled a steady barrage of critical attacks on the orthodox mainstream. The German historical economists basically rejected the idea of an abstract economics with its supposedly universal laws; they urged the necessity of studying concrete facts in national contexts. While they gave impetus to the study of economic history, they failed to persuade their colleagues that their method was invariably superior. The American Institutionalists are more difficult to categorize. “Institutional economics”, as the term is narrowly understood, refers to a movement in American economic thought associated with such names as Thorstein Veblen, Wesley Clair Mitchell, and John R. Commons. These writers had little in common aside from their dissatisfaction with the abstract theorizing of orthodox economics, its tendency to cut itself off from the other social sciences, and its preoccupation with the automatic market mechanism. They failed to develop a coherent theoretical scheme to replace or supplement the orthodox theory. This may explain why the phrase “institutional economics” has become little more than a synonym for “descriptive economics”. The hope that institutional economics would furnish a new interdisciplinary social science proved stillborn, but the spirit of institutionalism is still alive in works such as The Affluent Society (1959) and The New Industrial State (1967) by John Kenneth Galbraith.

VIII.

Monopolistic or Imperfect Competition

Returning to the innovations of the 1930s, the theory of monopolistic or imperfect competition remains somewhat controversial to this day. The older economists had devoted all their attention to two extreme types of market structure, that of pure monopoly, in which a single seller controlled the entire market for one product, and that of pure competition, characterized by many sellers, highly informed buyers, and a single standard product. The theory of monopolistic competition gave recognition to the range of market structures that lies between these extremes, including 1) markets having many sellers with “differentiated products”, employing brand names, guarantees, and special packaging that cause consumers to regard the product of each seller as unique; 2) oligopoly, markets devoted by a few large firms; 3) monopsony, markets with a single monopolistic buyer and many sellers. The theory produced the powerful conclusion that competition industries in which each seller has a partial monopoly because of product differentiation will tend to have an excessive number of firms, all charging a higher price than they would if the industry were perfectly competitive. Since product differentiation and the associated phenomenon of advertising seems to be characteristic of most industries in developed capitalist economies, the new theory was immediately hailed as injecting a healthy dose of realism into orthodox price theory. Unfortunately, it failed to provide a satisfactory theory of price determination under conditions of oligopoly. In advanced economies many manufacturing industries are oligopolistic. The result has been to leave a somewhat undigested lump at the centre of modern price theory, a constant reminder that economists still lack an adequate explanation of the conditions under which the giant firms of rich countries conduct their affairs.

IX.

The Keynesian Revolution

The second major breakthrough of the 1930s was primarily the work of one man—John Maynard Keynes. Keynes asked questions that in some sense had never been asked before: what determines an economy’s level of national income and volume of employment. This was still a problem of supply and demand, but “demand” here means the total level of effective demand in the economy, and “supply” means the nation’s entire capacity to produce. When effective demand falls short of productive capacity, the result is unemployment and depression; when it exceeds the capacity to produce, the result is inflation. The heart of Keynesianism consists of an analysis of the determinants of effective demand. If one ignores foreign trade, effective demand consists essentially of three spending streams: consumption expenditures, investment expenditures, and government expenditures, each of which is independently determined. Keynes attempted to show that the level of effective demand so determined may well exceed or fall short of the physical capacity to produce goods and services, and that there is no automatic tendency bringing the two into line with one another. This fundamental implication of the theory came as something of a shock to exponents of the traditional economics who had been inclined to take refuge in the assumption that economic systems tend automatically to full employment. By keeping his attention focused on macroeconomic aggregates, like total consumption and total investment, and by a deliberate simplification of the relations between these economic variables, Keynes achieved a powerful model that could be applied to a wide range of practical problems. His system subsequently underwent considerable refinement and became thoroughly assimilated into the body of received doctrine. Still, it is not too much to say that Keynes is perhaps the only economist to have added something really new to economics since Walras and perhaps since Ricardo.

Keynesian economics as conceived by Keynes was entirely “static”; that is, it did not involve time as an important variable. But a disciple of Keynes, Roy Harrod, soon developed a simple macroeconomic model of a growing economy; in 1948 he published Towards a Dynamic Economics, launching an entirely new speciality, “growth theory”, which absorbed the attention of an increasing number of economists.

X.

Post-War Developments

In the half-century following World War II, economics was so totally transformed that those who studied it before the war might as well have lived in another world. First of all, there was an enormous increase in the use of mathematics, which came to permeate virtually every branch of economics. Hand in hand with the spread of mathematical economics went an increasing sophistication of empirical work under the rubric of “econometrics”, comprising a combination of economic theory, mathematical modelling, and statistical testing of economic predictions. The post-war tendencies in economic thought were best exemplified, however, not by the emergence of new techniques but by the disappearance of divisive “schools”, but the increasingly standardized professional training of economists all over the world, and by the transformation of the science from a rarefied academic exercise to an operational discipline geared to practical advice.

In retrospect, this consensus within the economics profession reached a climax somewhere in the 1970s. Since then, there has been something of a sense of crisis in economics. At any rate, the confidence of economists in their own subject has been increasingly sapped, first of all by the appearance of “stagflation”—the simultaneous presence of unemployment and inflation—which contradicted the implications of Keynesian economics, and secondly by the proliferation of dissenting schools of thought within economics, such as Radical Economics, Evolutionary Economics, Austrian Economics, Post-Keynesian Economics, Sraffian Economics, Behavioural Economics; not to mention monetarism, the New Classical Macroeconomics, Neo-Keynesian Economics, Transactional-Costs Economics, and the New Institutionalism within the inner bastion of mainstream economics. The history of economics in the last quarter of the 20th century, when it comes to be told, will be a more complicated story than that of inter-war or immediate post-war economics.