Economic Thought (SL IB Economics)

• Understanding the evolution of economic thought over the past 400 years, helps us to understand the strengths and weaknesses of economic policies we use today
• Each period of economic revolution was created as a result of challenges societies were facing at the time e.g. classical economics was the solution to centuries of mercantilism while Marxism was the solution to capitalism and worker exploitation
• There is a strong debate around whether societies should create a new economics fit for the 21st century challenges

 

A summary of the economic schools of thought from the 18th century

• Adam Smith published his famous book on Economics in 1776: The Wealth of Nations
  • He is widely regarded as the father of Classical Economics
• Written at the start of The Industrial Revolution, it captured his thoughts on how markets could be coordinated by demand and supply
  • This book was a natural response to the previous century of government intervention in markets in Europe during a period known as mercantilism

 
Key ideas from Adam Smith in the 18th Century

Idea	Explanation
Laissez-faire ('to leave alone') economics	A philosophy which believes there should be no (or minimal) government intervention with regard to decisions about resource allocation and production
Invisible hand	The unseen free market forces of demand and supply that coordinate the best allocation of resources within society Markets are driven by consumers and producers seeking to maximise their self-interest Personal incentives, not government decisions determine the allocation of resources
Free trade	Removing the protectionist measures found in mercantilism would increase production, trade and wealth
Wealth	Production creates wealth for individuals and when individuals get wealthy, the nation gets wealthy

• During the 19th century, several key ideas emerged including classical microeconomics (utility); the concept of the margin; classical macroeconomics (Say’s law)
• During this period Karl Marx also developed his critique of classical economic thought 

Key ideas from the 19th Century

Idea	Explanation
Classical microeconomics (utility)	The idea of utility as a concept challenged what classical economists believed about how a product should be  priced Previously, prices were a function of the costs of production involved. Now prices were seen as a function of the satisfaction gained in consumption Producers should increase production for goods with high consumer utility Utility theory assumes that consumers always act rationally (yet many purchasing decisions are based on emotion)
The concept of the margin	Marginal utility is the additional utility (satisfaction) gained from the consumption of an additional product The utility gained from consuming the first unit is usually higher than the utility gained from consuming the next unit E.g. A hungry consumer gains high utility from eating their first hamburger. They are still hungry and purchase a second hamburger but gain less satisfaction from eating it than they did from the first hamburger To calculate total utility, the marginal utility of each unit consumed is added together This means that total utility keeps increasing even while marginal utility is decreasing
Classical macroeconomics (Say’s law)	Say's law of markets was developed in 1802 by the classical, laissez-faire economist Jean-Baptise Say It can be summed up with the phrase 'supply creates its own demand' By supplying goods to the market a producer generates income from sales which they can then use to purchase (demand) more products This law implies that increasing national output in an economy is vital to income generation and thus governments should focus on generating production and be less concerned with consumption

Karl Marx's Critique of Classical Economic Thought

• Free markets generated incredible wealth in the Western World
• Karl Marx, a German philosopher, identified that wealth seemed to come from worker exploitation (a natural function of profit maximisation) and that inequality was deepening in societies
  • The exploitation was seen in low wages and poor working conditions 
  • The owners of the factors of production (capitalists) generated the highest income (wages, interest, rent and profit)
  • If all someone had to offer was labour, and wages were suppressed: then inequality was bound to increase
• Marx argued that capitalism would eventually lead workers to revolt and that periods of exploitation would be followed by revolutions
  • These revolutions would require government intervention to restore stability and equality
  • Governments would need to be involved in the allocation of resources (command economy) to prevent the pattern from repeating
• Marx's ideas were incredibly influential and within a relatively short time frame resulted in more than a third of the world's population living in economies influenced by his ideas

• The first half of the 20th Century was dominated by the two World Wars and the Great Depression
• The economic ideas of the previous century no longer worked
• In this severe recession, Say's Law became obsolete as households were unable to buy goods/services due to a complete lack of income
• John Maynard Keynes, a British economist from Cambridge felt new ideas were needed
• His ideas were quickly embraced and the next 50 years saw a widespread Keynesian revolution as governments adopted Keynesian economics
  

Key ideas from Keynes in the 20th Century

Idea	Explanation
The limitations of markets	Contrary to classical theory, Keynes saw that the Great Depression had created a situation where markets did not automatically readjust to a new equilibrium Some markets remained in a long term period of disequilibrium where supply was greater than demand Market forces were not resolving the situation
The Macroeconomic role of Governments	Keynes believed that Governments needed to stimulate demand by increasing government spending This would begin to increase the flow of income in the economy which would further stimulate demand which would help markets to function again He developed the term and field of 'Macroeconomics' by explaining how aggregate demand is calculated He argued that the use of Fiscal Policy was essential to stabilise an economy during periods of recession or depression, much more so than the use of Monetary Policy

The Monetarist/New Classical Counter Revolution 

• Monetarism is an economic school of thought which emphasises the use of Monetary Policy to influence an economy
  • Monetarists believe that poor monetary policy lead to the Great Depression
  • Monetarists believe that the use of fiscal policy leads to inflation as government spending increases aggregate demand
    
• Milton Friedman was one of the leading Monetarists of the late 20th Century
  • His ideas influenced Ronald Reagan in the USA and Margaret Thatcher in the United Kingdom
  • Both Governments moved away from Keynesian economics
    
• From the early 1980s there was a resurgence in belief in classical economics and laissez-faire markets
  • Government spending reduced and the focus shifted to Supply-Side Policies
  • One prominent Supply-Side Policy that the USA and the UK embraced was the use of privatisation

• The early part of the 21st Century has seen several significant global challenges emerge
  • Climate change
  • On-going wars and displacement of populations
  • An increase of global population in the last 100 years by 7 billion people
  • The Global Financial Crisis of 2008
  • The Covid Recession of 2020
    
• Keynesian economic thought came to prominence again with the 2008 Financial Crisis as governments chose to spend their way out of trouble
  • Government spending increased to levels never seen before, continuing for more than a decade
  • This increased spending was financed by increased government borrowing
  • Increased Government borrowing creates increased tax burdens for future generations
    
• Even with Government spending extraordinarily high in many economies, expansionary Monetary Policy had to be widely used to bring stability
  
• This pattern of events prompted calls for societies to rethink Economics
  • It called for an economic philosophy to emerge that is no longer rooted in 'old thinking'
  • It called for ideas fit for a 21st Century world
    

21st Century Ideas

Idea	Explanation
The growing role of behavioural economics	A fundamental flaw in economic theory is that individuals behave rationally in markets Behavioural economics recognises this and combines elements of economics and psychology to understand how and why individuals make the economic decisions they do Understanding human behaviour creates better opportunities for firms and governments to nudge people towards better choices E.g. The use of choice architecture for online forms in many countries automatically selects organ donation as a default: individuals have to opt-out as opposed to opting-in Nudge theory is increasingly used by firms and governments across the world
Awareness of the interdependencies that exist between the economy, society and environment	The circular flow of income model has provided a basis for understanding macroeconomies since it was visualised by Frank Knight in 1933 The model has been criticised as not fit for the 21st century as it does not take into account the inputs and outputs of societies It focusses on money as opposed to well-being and planetary health Inputs are the raw materials which are increasingly used in unsustainable ways Outputs are the carbon and waste that are generated
The compelling reasons for moving toward a circular economy	A circular economy has three main principles Eliminate waste and pollution Recirculate products  Regenerate nature The increasing climate crisis provides a strong reason why economies should rush to move away from the circular flow of income model to the circular economy model