How To Turn Old-School Economic Theories Into Forward-Thinking Economic Strategies

11 mins

How To Turn Old-School Economic Theories Into Forward-Thinking Economic Strategies

Adam Smith: Classical Economics

How to spot the invisible hand

2 mins

Who was the “Father of Economics”? He went from being kidnapped aged three to founding the field of economics aged 53 – Scotsman Adam Smith was kind of a big deal. His 1776 book, The Wealth of Nations, laid the groundwork for economics (which was known as “political economy” back then). He established the school of thought known as “classical economics”.

Smith’s big idea was that individuals acting in their own self-interest would help society as a whole to generate wealth. According to Smith, people want to buy the best things they can at the lowest possible price – and in a competitive environment, that means manufacturers will try as hard as possible to reduce their costs. Production is therefore as efficient as it can be, meaning more resources for everyone. This idea is known as the invisible hand– the way in which a series of individual actions coalesce into a big movement in the right direction 🤘

The other big idea in classical economics is Say’s Law: “supply creates its own demand”. When something is sold (i.e. supplied), workers and suppliers are paid, and profits are taken. Those workers can then use their money to buy other goods – meaning demand increases for them.

Classical economics also has lots to say about international trade. David Ricardo developed the idea of comparative advantage: that free trade makes everyone better off by getting countries to focus on the things they can produce most efficiently.

In practice, this led to a laissez-faire approach: one where government intervention was the bogeyman, and where the notion of reduced demand shrinking an economy was outright rejected. But over time this thinking relaxed slightly, eventually morphing into the now-popular “neoclassical” approach.

With more of a focus on consumers than producers, neoclassical economics is all about maximizing people’s happiness and minimizing their suffering. It views the world as being made up of rational, selfish individuals who will somehow produce a good societal outcome for everyone. It’s still a pretty hands-off approach, but it understands that markets can sometimes mess up – especially in the branch known as “welfare economics”. Arthur Pigou pointed out that markets fail to value some things, like the negative effects of air pollution 😷 and that some intervention was necessary to force markets to consider these externalities.

The anti-intervention stance of classical and neoclassical economics was popular for a while, but the Great Depression put a bit of a stop to that. In the next session, we'll find out what came next...

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