Classical economics dominated the study of economics for 150 years after it was introduced. This work not only launched the modern study of economics, it continues to provide the foundation for modern microeconomics. Classical economic principles were also adapted to macroeconomic phenomena and provided a guide for macroeconomic policy until the beginning of the Great Depression in 1929. Classical economics fell out of favor in the 1930s largely because it did not adequately explain the occurrence of high rates of unemployment during the Great Depression.

The term "classical economics" was coined in the first half of the 1800s by Karl Marx, who is considered by some as an important contributor to the development of classical economics and by others as a primary critic of this theory. The term gained new life in the early 1900s when John Maynard Keynes developed Keynesian economics as an alternative theory of macroeconomics.

Highlights of classical economics include:

• One, classical economics is based on three key assumptions--flexible prices, Say's law, and savings-investment equality.


• Two, the theoretical structure of classical economics is based on a view that the macroeconomy operates in aggregate according to the same basic economic principles that guide markets and other microeconomics phenomena.


• Three, the economic principles of classical economics indicate that aggregated markets, especially resource markets, automatically achieve equilibrium, meaning full employment',500,400)">full employment of resources is assured.


• Four, classical economics indicates that full employment is achieved and maintained without the need for government intervention and that government intervention is more likely to cause than to correct macroeconomic problems.

A Little History

Under mercantilism the ruling aristocracy directed economic activity with the primary goal of benefiting the ruling aristocracy. The merchantilist view was that the wealth of a nation was based on the wealth of the ruling aristocracy. Smith argued, quite convincingly, that the wealth of a nation was actually based on the productivity of resources, which was best achieved if the producers, consumers, and resource owners were left to their own "selfish" actions.

An efficient allocation of resources, higher living standards, and economic growth were achieved if producers sought higher profit and consumers sought greater satisfaction. Higher profit motivated producers to offer the most desired goods at the lowest expense. Greater satisfaction motivated to seek the most desired goods at the lost expense. The result is the best, more efficient use of available resources.

The classical framework developed by Adam Smith was enhanced, refined, and improved over the ensuring 150 years by a number of scholars. The basic principles were refined and applied to an assortment of topics and issues, including resource markets, international trade, economic development, and industrial activity--to name just a few. Much of this work remains relevant to the modern study of microeconomics, often termed neoclassical economics.

Economists also applied this classical framework to macroeconomic issues, especially unemployment, economic growth, and business-cycle stability. With this application a comprehensive theory of macroeconomics was developed that offered an explanation for macroeconomic phenomena and provided recommendations for government policies.

Three Key Assumptions

• Flexible Prices: The first assumption of classical economics is that prices are flexible. With flexible prices, unrestricted by government regulations or market control, markets are able to quickly and efficiently achieve equilibrium. In particular, a market is able to quickly attainment eliminate any shortage and surplus that exists, reaching a balance between the quantity demanded and quantity supplied. This is especially important for resource markets in which equilibrium means that full employment is maintained and unemployment is not a problem.


• Say's Law: The second assumption of classical economics is that the aggregate production of good and services in the economy generates enough income to exactly purchase all output. Say's law is commonly summarized by the phrase "supply creates its own demand" and is consistent with the modern circular flow model. With Say's law of markets a mismatch between aggregate demand and aggregate supply is a rare and temporary occurrence. The economy is most unlikely to experience an aggregate surplus or shortage of production.


• Saving-Investment Equality: The last assumption of classical economics is that saving by the household sector exactly matches investment expenditures on capital goods by the business sector. This assumption ensures that Say's law holds because any decrease in consumption demand for output due to saving is replaced by an equal amount of investment demand. The saving-investment equality is assured by applying the notion of flexible prices to interest rates in the financial markets.

A Perfect World?

• Efficiency: Efficiency is attained with market equilibrium and the quality between the price that buyers are willing to pay for a good and the price that sellers are willing to accept. At this automatically generated equilibrium, it is not possible to produce more or less of a particular good such that the economy generates a greater level of satisfaction. If buyers find one good that generates greater satisfaction than another, which is reflected in their willingness to pay a higher price, then sellers are enticed to allocate resources to its production.


• Full Employment: Most important for macroeconomics, full employment is attained because all markets, especially resource and labor markets, achieve equilibrium. With equilibrium, a market has neither a surplus nor a shortage. A surplus in any labor market would mean unemployment. With no surplus, there is no unemployment. The surplus (or shortage) is, of course, eliminated due to flexible prices. If a (temporary) surplus should emerge, then wages--the price of labor--decline until equilibrium balance and full employment is restored.

In fact, taking this a step farther, any problems of inefficiency and unemployment that might emerge are attributable to government intervention. From a classical economics perspective, government is the problem, not the solution. Inefficiency and unemployment arise because government prevents markets from achieving equilibrium through regulations, taxes, or other forms of meddling.

A Few of the Founders

• Jean-Baptiste Say: Say is most noted for the "supply creates its own demand" classical law bearing his name. Say was a French economist who helped to popularize the work of Adam Smith in the early 1800s. Among other contributions, Say emphasized the importance of entrepreneurship as a productive factor and was among the first to observe that value and price depend on both supply (resource cost) and demand (satisfaction).


• David Ricardo: Considered by many to be the most noted classical economist, Ricardo made a number of contributions to international trade, labor markets, and the distribution of income in the early 1800s that remain fundamental to the modern study of economics. Perhaps most important, Ricardo viewed the economy as a complex system of interrelated components and was a strong advocate of the principles laid out by both Adam Smith and Jean-Baptist Say.


• Thomas Robert Malthus: A contemporary of David Ricardo and an ordained minister, Malthus developed a theory of population growth which indicated living standards would never rise above a minimal subsistence level. The Malthusian theory of population growth contributed to the economic analysis of wages and was largely responsible for the designation of economics as the "dismal science." Malthus broke from many of his classical colleagues arguing that Say's law might not hold because effective demand would lead to unpurchased production (which was later to become a fundamental part of Keynesian economics).


• John Stuart Mill: The classical economic mantel was carried forth in the mid-1800s by John Stuart Mill, whose father James Mill was contemporary and colleague of Ricardo, Malthus, and other scholars of the preceding generation. Mills not only authored the primary economic textbook used during this era, he also made important contributions to utility analysis and consumer demand theory.


• William Stanley Jevons: Jevons made several important contributions to classical economics in a relatively short career. At the top of the list, Jevons helped to develop the mathematical formulation of marginal economic analysis that transformed classical economics into modern neoclassical economics. Jevons also pioneered work on business cycles, especially a "sunspot theory" that connected sunspot activity to agricultural activity and thus to overall economic activity.


• Alfred Marshall: Marshall, perhaps one of the last of the great classical economists, extended the work of Jevons in the transition of classical to neoclassical economics. In 1890, he authored what was the standard economics textbook for decades, making him the poster boy for classical economics leading up to the Great Depression. Among his many contributions, Marshall developed the modern market diagram (Marshallian cross), the extensive use of graphical analysis used throughout economics, the distinction between short run and long run, and the concept of elasticity.

A Classical Legacy

Classical economics also continues to play an important role in modern macroeconomics. Although popularly discredited by the Great Depression and the theory of Keynesian economics, classical economics persisted and reemerged in the 1980s (when the flaws of Keynesian economics emerged). The core classical notions of unrestricted markets, laissez faire, limited (or no) government intervention, and emphasis on supply rather than demand surfaced in modern macroeconomic theories, including supply-side economics and rational expectations theory.

Perhaps the most important legacy of classical economics is the aggregate market analysis, or AS-AD analysis. Representing the state-of-the-art in modern macroeconomics, AS-AD analysis combines many of features of classical economics and Keynesian economics. In particular, the long-run aggregate supply and the long-run adjustment of the AS-AD model to full employment capture the essential features of classical economics.

A Pinch Of Politics

The primary implication of classical economics, that full employment can be achieved without intervention by government, corresponds nicely with a conservative political philosophy. Conservatives stress individual freedoms, reliance on market exchanges, limits on government activity, and support of business activity, all of which match up with classical economics.