Understanding Economic Principles

• Economy

Etymology

• "oikos" means home, household, or estate
• "nomos" means to govern or administer
• Definition: the administration of a house or estate

Definition

• The social science studies managing limited resources to meet unlimited needs

Study Object

• Encompasses issues related to the production and distribution of goods and services to meet human needs

Purpose

• Ordering and classifying economic phenomena to establish laws that determine economic needs and satisfaction (welfare)

Study Method

• Uses inductive methods (from particular to general) and deductive methods (from general to particular)

Historical Evolution of Economic Thought

Ancient Age

• Plato (427-327 BC)
  • Analyzed political and economic structure of an ideal State
  • Recognized work specialization and division as a source of efficiency and productivity, leading to social organization (City-State)
  • Viewed profit and interest as necessary evils, proposing a communist approach to rulers, where the governing class shouldn't own private property to remain free of corruption
  • Artisans should have private property rights under state administrative control
  • Notable work: The Republic
• Aristotle (384-322 BC)
  • Rejected Plato's ideal State concept, defending private property for all classes to promote economic efficiency
  • Like Plato, interested in administered economy ensuring justice and social peace
  • The interest generated from money considered an unnatural yield threatening social and economic stability
  • Recognized exchange of goods via money as a natural needs-satisfying mechanism but disapproved of accumulating wealth
  • Notable work: Nicomachean Ethics

Middle Ages

• Feudalism: the dominant form of economic organization
  • Production system in which legal ownership of land rested with kings and lords
  • Land assigned to warrior chiefs and nobles in exchange for loyalty, subleased to tenants in return for military, personal, or economic obligations
  • Feudalism in Europe lacked political, economic, and social integrity; characterized by Catholic Church doctrinal unity and the market's emergence
  • Justice: the main field of study
  • Medieval individuals were more interested in justice in exchange rather than the exchange of goods
  • Medieval thinkers condemned "usury" as a profit-generating mechanism from money use
  • Recognized "interest" as compensation for loss or delayed payment
• Thomas Aquinas (1225-1274)
  • Improved his teacher Alberto Magno's labor theory by introducing idea of human needs in setting the price of goods
  • A focus on justice led to development of a "fair price" on a normative basis
  • Sought to ensure that a good's price didn't exceed article value or was below it
  • Charging exorbitant prices or purchasing at meager prices considered unjust and illicit

Mercantilist School (15th-18th Centuries)

• Addressed problems of origin of countries' wealth and how to increase it
• Wealth wasn't determined by production but by trade and money flow (gold and silver)
• Failed to grasp comparative advantage in international trade
• Thought that gains for one country meant losses for others
• Developed protectionist measures for domestic economy and policies detrimental to neighboring countries
• State intervention in the economy advocated to maximize inflow of wealth (gold and silver) and minimize outflow
• Aimed at a continuously favorable trade balance, implementing protectionist policies that significantly expanded manufacturing
• Representatives: Jean Bautista Colbert, Antoine de Montchretien, Thomas Mun.

Physiocratic School (1756-1778)

• Emerged in 18th-century France as an opposition to mercantilism
• Argued that a country's wealth lies in best use of land
• First "school of thought" in economics, combining economics and mathematics
  • "Physiocracy" means "government of nature"
• Production means creating a surplus
• Productive industry produces more than consumed in the process
• Francis Quesnay (1694-1774)
  • Intellectual leader
  • Applied rational principles to the study of economic and social events
  • Analyzed interaction between France's socioeconomic classes as a circular flow of income and expenditure called the Economic Table
  • Could evaluate policies that favored economic growth
  • Assessed effects on economy from a key circular flow factor
  • Rejected French monarchy's mercantilist policies as prejudicial, advocating economic freedom
• Other Representatives: Jacques Turgot and Vincent Gournay (famous for saying "Laissez faire, laissez passer")

Classical School

• Appeared in late 18th century with the development of the Industrial Revolution and emergence of capitalism named Political Economy
• Advocated a free trade economy without state intervention
• Labor identified as wealth source that ultimately depends on work division and specialization
• Distinguished Use Value from Exchange Value in goods
• Increasing a nation's wealth required increasing labor and productivity
• Adam Smith (1723 – 1790)
  • Considered the father of economics after publishing "An Inquiry into the Nature and Causes of the Wealth of Nations“
  • Key contribution is the theory of value determined when people exchange goods for money or other goods
  • Can be broken down into use value (object's utility) and exchange value (purchasing power)
  • "Wealth of Nations" emphasized work division, that consists in specializing in the necessary steps to produce a good
    • Increases worker dexterity, saves time, and promotes machine invention
• David Ricardo (1772 – 1823)
  • Used deductive method to construct a system of thought founded on theory of rent, Malthus population principle, and wages
  • In classical rent theory, law of diminishing marginal returns determines agricultural rent as the difference between the yield of best land and the worst land under cultivation, with same amounts of labor and capital
  • Addressed international trade, introducing theory of comparative advantage
  • Aimed at proving that a country can benefit from importing goods it is highly efficient at producing, to specialize in other work
• Other representatives: John Stuart Mill, Thomas Malthus

Critical School of Classical Political Economy or Marxist

• Emerged as a critique of English Political Economy that advocated for capitalism conceived as societal based on conflict in society
• This situation fostered change and revolution, such as the bourgeois revolution in France, slave uprising in Rome, and peasant uprising in feudalism
• Socialists consider private ownership of means of production as one of capitalism's pillars, creating inequality
• Karl Marx (1818 – 1883)
  • Postulated labor theory of value, stating that merchandise value is based on socially necessary labor for production
  • The value has an objective property as competitive market prices fluctuate around production costs, mainly labor costs
  • Developed a wage theory explaining that workforce value can be divided into socially necessary work (survival) and surplus value
  • "Socially necessary work" determines worker's wage, while capitalist retains surplus value
• Friedrich Engels (1820 – 1895)
  • Among other books, contributed a study of families' historical development, rise and consolidation of private property, and the presence of the State

Neoclassical School

• Emerged as a reaction to socialist school and in defense of economic liberalism
• Disregarded classical issues like wealth distribution and value theory to study mechanisms that facilitate scarce resource allocation in various markets
• Optimized welfare based on the individual, not social classes
• Made extensive use of mathematics to support conclusions
• Conducted analyses by studying relationships between supply and demand rather than examining them separately
• Made extensive use of the Latin clause ceteris paribus in addition to the term homo economicus
• The distinction between positive and normative economics was established in the work of the neoclassical economists
• Representatives: Karl Menger, León Walras, Wilfredo Pareto, Alfred Marshall.

Keynesian School

• The inability of the neoclassical school to provide answers for the "Great Depression" of the 1930s in the US, led to a different approach in John Maynard Keynes' book "General Theory of Employment, Interest and Money"
• Proved so insightful that followers were called Keynesians
• John Maynard Keynes (1883 – 1946)
  • Claimed aggregate demand determines output
  • To ensure sufficient efficient demand, employment and investment must be maintained
  • Also studied markets requiring State intervention in the economy via economic policies
  • Keynesians believe workers offer labor regarding the nominal wage not the real wage creating difference between labor supply and demand
  • Classical economists assumed the labor market was always in equilibrium

Monetarist School

• Emergence of inflationary pressures in the sixties and seventies which Keynesian policies couldn't address changed academic debate
• Greater emphasis placed on money
• Basic idea of monetarist economics is to analyze total money demand and money supply as a whole
• Economic authorities have capacity and power to set the nominal money supply (regardless of price effects) as they control amount that is printed or coined and bank money creation
• People make choices about amount of real cash they wish to possess
• Monetarists assign fundamental role to money supply, rightly arguing that it is key determinant of short-term movements of a country's productivity, and long-term price level
• Milton Friedman (1912 – 2006)
  • Opposed Keynesian ideas at their peak
  • Proposed a theory of money demand based on long-term income, explaining inflation as an exclusively monetary phenomenon
  • A monetary authority's decision to increase money supply will cause prices to rise and agents adapt by increasing phenomenon
• Representatives: Milton Friedman, John B. Taylor

Division of the Economy

• Economics has developed a series of concepts to explain the behavior of companies and families
• For better understanding, the following divisions have been developed
• Positive economics
  • Seeks to understand and describe reality as it is, without inserting value judgments or moral considerations
  • Refers to facts or "what is"
• Divided into
  • Descriptive Economics
    • Aims to observe and describe economic activities.
  • Economic theory
    • A set of principles, laws, theories and models that allow describing, explaining and predicting economic phenomena
    • Supports data provided by Descriptive Economics
    • Division of Economic Theory
      • Microeconomics
        • Studies how people and businesses make decisions and interact to form prices
      • Macroeconomics
        • Studies the economy as a whole using economic aggregates such as inflation, unemployment, amount of money, and economic growth
• Normative Economics
  • Proposes the direction reality should change and methods to affect that change.
  • Deals with value judgments about state of affairs, concerning "what should be"
    • Economic policy
      • A set of guidelines whereby the State regulates and directs the country's economic activity, defining general criteria based on the overall development strategy
      • Includes key areas and relevant instruments to the domestic financial system, public expenditure, public enterprises, links to the global economy, and skills and productivity

Fundamental Economic Problems

• Society identifies its most pressing needs and which goods are appropriate to produce
• Families and businesses must organize to decide what goods are needed and in what quantities
• Production involves workers (labor), machinery (capital) and supplies
• The economy must answer how those goods will be produced
• How the produced goods are distributed in the society are determined on economic, political and moral issues
• It is important to whom goods are produced or distributed
• Any economy must address the economic issue when resolving the following three questions
  • What is to be produced: Televisions, computers, automobiles
  • How to produce it: Labor or capital
  • For whom to produce it: Infants, pregnant women, students
• Each country will have differing answers depending on political system and consequently the organization of its economic activity

Economic Systems

• Economic systems are the set of standards regarding how to organize economic activities to address the three questions raised by economic issue
• Economic activities are all those human actions to produce goods and services as wanted
  • Economic Systems
  • Market economy
    • The questions of the economic issue are resolved in the market via voluntary interaction of individuals
    • Individuals can freely choose the goods according to their needs
    • Businesses use efficient production methods
  • Centrally planned economy
    • All economic decisions are made at a central government level
    • This governing authority is in charge of addressing the three economic issues mentioned
    • Production is distributed fairly among society members
  • Mixed Economy
    • An economic system combining the above two, where the market is the main goods allocation mechanism, but the government can intervene to correct certain problems regarding in distribution
• Effectiveness
  • Meeting goals set in the business
• Efficieny
  • Refers to achieving goals with fewer resources
  • Defining characteristic is saving or reducing resources to a minimum