Classical theory of growth and stagnation


Classical theory of growth and stagnation

Classical economics refers to work done by a group of economists in the eighteenth and nineteenth centuries. The theories developed mainly focused on the way market economies functioned. Classical Economics study mainly concentrates on the dynamics of economic growth.[1]

The generalized classical theory on growth and stagnation is a combination of the contributions of Adam Smith, David Ricardo and Robert Malthus. The theory was put together by combining the common stands of thought, within the individual growth theories, of these renowned classical economists. To understand the generalized classical theory of growth and stagnation, let us first look into the individual theories propagated by each of the three economists in detail.

Contents

Adam Smith's theory of growth

Adam Smith
Full name Adam Smith
Born 16 June 1723
Kirkcaldy, Scotland
Died 17 July 1790(1790-07-17) (aged 67)
Edinburgh, Scotland
Era Classical economics
(Modern economics)
Region Western philosophy
School Classical economics
Main interests Political philosophy, ethics, economics
Notable ideas Classical economics,
modern free market,
division of labour,
the "invisible hand"
Signature

Adam Smith (1723–1790) was a Scottish philosopher and economist who is renowned as the author of The Wealth Of Nations (1776), one of the most influential books on market economics ever written.[2] Adam Smith was born in 1723 on an unknown date. He studied moral philosophy at the University of Glasgow and Balliol College, but eventually left the latter and made a name for himself as a traveling lecturer. He later became a professor of logic, ethics, rhetoric, jurisprudence and political economy.[3]

Introduction

Adam Smith has not received as much recognition for his theory of growth as he has for his theory of value and rent, but the fact still remains that he does provide a consistent dynamic model.

Adam Smith identified three major sources of growth:

(i) growth in the labour force and stock of capital

(ii) improvement in the efficiency with which capital is used in labour through greater division of labour and technological progress

(iii) promotion of foreign trade that widens the market and reinforces the other two sources of growth.[citation needed]

To understand the final growth process as stated by Adam Smith in this theory, we first need to look into the individual components, which have laid the foundation of the theory. These are Adam Smith's Production Function, his views on the process of growth of labour force and capital accumulation in the economy.

The production function

Adam Smith recognized only three factors of production: land, labour and capital. Considering these three factors, his production function may be expressed as

Y=ʄ(K,L,N)

where,

K represents the vapital

L denotes labour force

N stands for land

Adam Smith, in his theory, has not assumed his production function to have Diminishing marginal productivity. However, his production function is subject to increasing returns to scale (which means that, output increases more than proportionally to an equal percentage increase in all inputs)[4]. In his view, with the passage of time, the size of the market will increase, which will lead to both internal and external economies of scale, which will eventually lower down the cost of production. This process would be initiated by improvement in the production techniques and a greater degree of division of labour.

Adam Smith asserted that, division of labour, did not merely depend on only technological improvement, but also, to a great extent, the size of market, which in turn depends on the availability of capital and the restrictions placed upon both domestic and international trade. Thus, he came to the conclusion that capital accumulation is a necessary precondition to the division of labour.

Adam Smith, recognized the importance of technological development for the improvement in productivity. However, he believed that productive forces would automatically be released into the economy, in the form of innovations and that they would get adjusted to the currently available supply of capital at that point of time. This basically means that, Adam smith believed that the economy would never suffer from the want of technical know-how and that technical knowledge and that it would keep expanding as the capital stock of the country expanded.[5]

The growth of labour force

The growth of the labour force is largely dependent of the rate at which population grows in a country. According to Adam Smith, rate of population growth in the long run depends on the funds available for human sustenance. Assuming that this statement is true, it can be said that the wage rate prevailing in the market is an important determinant of the size of population. In Smiths’s opinion, “subsistence wages or Iron Law of Wages” i.e., the lowest wage upon which a worker and his family can survive is consistent with a constant population. If it so happens that the actual wages exceed the subsistence wage, population will show a tendency to increase and If the actual wages is less than the subsistence wage then population would decrease.

The supply of labour is normally expected to be in equilibrium with the demand for labour. If the demand of labour continuously rises, causing the wage rate to increase above subsistence level, this would induced the working population to multiply faster, as a result of which supply of labour would also increase, pushing the wages down. Incase, the wage rate has fallen below the level of subsistence, in time the demand for labour would restore it to the subsistence level again. In each of the above cases, any disturbance of the wage rate from its subsistence level, due to the disturbance in the equilibrium between the supply and demand for labour, would automatically set into motion a cycle, the end result of which, would lead the wage rate to equal subsistence wages.

Smith explains the demand of labour in the framework of wage fund doctrine which seeks to show that wages, depend upon the relation which exists between the supply of population and the capital available to employ workers[6]. He asserts the demand for those of live by wages (labourers), increases with the increase of revenue and stock of a country, as, an increase in revenue and stock is an increase in wealth, and the demand of labour, therefore, naturally increases with an increase in a nation’s wealth.

Since the supply of labour has a tendency to respond to the demand for it, Smith statement implies that in a growing economy, the population would be rising, in a declining economy, it would be decreasing and that in a stagnant economy, the population would be constant. Smith also throws light on the wage course of the economy. He says high wages are consistent with growing economies. By that logic, low wages would exist in delicing economies and the subsistence wages would only be present in economies which are characterized by the stationary or steady state''[5]

Capital accumulation

Capital accumulation has been assigned a strategic and calculated role in the growth process in Adam smith’s theory. According to him, growth is functionally related to the rate of investment. This mean that if a country is subject to a fixed capital stock, it is bound to suffer stagnation. Adam Smith states that, any increase in the capital stock in a country generally leads to more than a proportional increase in the output on account of constantly growing division of labour.

According to Adam Smith, the rate of investment which is an important determinant of Economic growth, is determined by the rate of savings in an economy[7] He did not believe in the possibility of any sort of leakage occurring between savings and investment, even thought the activities are performed by different sets of people. In Adam Smith’s system, savings and investment have been identified with each other and both are determined by the consideration of private profit. However he also notes that, the ability to save is constricted by income.[5]

1.Profit:

Smith’s view on rate of profit is quite precise. He states that over time when a country develops and its capital stock expands, the profit rate shows a tendency to fall. This happens because of three reasons. Firstly, the competition that builds up among the competitors in the market. Secondly, the demand for labour increases (becomes greater than the current supply) and this pushes wage rates up. Higher wages leads to a smaller profit margin for the entrepreneurs. Thirdly, a larger capital requires abundant investment opportunities which may not always exists in an economy. For these reasons, when capital stock of an economy expands, entrepreneurs will only be able to use it at a lower marginal profit ratio. In other ways, using a more modern expression, one could say that Adam Smith postulated a downward sloping marginally efficiency of capital[8] curve, which means that on every extra unit of capital employed, the return from that capital keeps on decreasing.

2.Rate of Interest:

In relation to falling rate of interest and capital accumulation Smith postulated a negatively sloped supply curve of capital implying that supply of capital increases in response to a decline of interest rate. Many have found this explanation rather unconvincing. His argument was that, rentiers, in order to maintain their standard of lving, lend more when the interest rates fall. But when the interest rate falls by a substantial amount, they discover that they cannot live on property income and they then are forced to turn into entrepreneurs themselves. This social change allows the accumulation of capital, despite a fall in the interest rates.

According to Adam Smith, capital accumulation will only stop when the rate of interest falls to a rate of profit that is sufficient only to compensate of the risk premium. In other words, when no profit can be made from investment, entrepreneurs lose their interest in investment acitivity and the economy reaches the Stationary state.

The growth process

Taking into the consideration, the production function, the process of growth of labour and the process of capital accumulation, we can now summarize the process of growth as visualized by Adam smith.

According to Smith, in a developing economy, both income level and capital stock rise. In addition to this, the rate of capital accumulation also shows a tendency to increase. This leads to increase in the capital stock in successive periods as investment keeps on increasing. Another important factor which contributes to the progress of an economy is the successive decline in the incremental capital-output ratio due to the influence of capital on the productivity of labour. These factors reinforce each other and accelerate the pace of development of the economy. This development continues until a point where the economy’s capital stock grows large enough to eliminate any chance of profits. At this stage the economy has reached its stationary state.

In Adam Smith’s system. the stationary state is distinctly different from the state of underdevelopment. Having reached the stationary state, the common characteristics of the economy becomes unchanged population, constant income, subsistence wages, complete elimination of profits, and absence of net investment. According to Smith, an economy which reaches a stationary state in its growth process has reached the highest level of propensity consistent with its present natural resources.

Adam Smith has identified the rate of profit as a vital ans strategic factor in the economic growth process. He stressed on the point that the rate of economic progress would only rise if the rate of investment rose. However, the savings and investment rates were primarily dependent on the excess of the market rate of profit over the minimum compensation for bearing risk. Since these factors depended mainly on the socio- economic framework in the country, Institutions where his solution to the problem of economic growth. Adam Smith was firmly in favour of the policy of free trade and did not approve of any sort of government intervention (Laissez-faire). He is opposed to any kind of planning for economic development.[5]

David Ricardo's theory of growth

David Ricardo
Classical economics
David Ricardo(1).jpg
Born 19 April 1772(1772-04-19)
Died 11 September 1823(1823-09-11) (aged 51)
Nationality British
Influences Smith · Bentham
Influenced Ricardian Socialists · John Stuart Mill · Marx · Sraffa · Barro
Contributions Ricardian equivalence, labour theory of value, comparative advantage, law of diminishing returns, Economic rent[9]

David Ricardo (1772–1823) was one of the greatest theoretical economists of all time. Ricardo attended school in London and Amsterdam and at the age of fourteen entered his father's business. Initially Ricardo following his dad’s business line, set up independently as a broker on the London Stock Exchange. But soon Ricardo became interested in economics in 1799 after reading the works of Adam Smith (the Wealth of Nations). He, after some initial struggle published his own book, The Principles of Political Economy and Taxation, in 1817. Two of Ricardo's most important contributions were the theory of rent and the concept of comparative advantage.

Introduction

Ricardo, like Adam Smith, was much less interested in economics growth, than he was in his theory of value and distribution. Yet we must consider his individual theory of growth in the formation of the generalized version because of the position he holds in the classical school. To understand the final growth process as stated by Ricardo in this theory, we first need to look into the individual concepts, which have laid the foundation of the theory. These are, the production function, his views on land and human resources, and the process of capital accumulation in the economy.

The production function

Ricardo’s production function, similar to that of Adam Smith, considers only three factors of production, namely Land, Labour and Capital. But distinguishing his production function from that of Smith’s, Ricardo’s production function is subject to the restriction of diminishing marginal productivity, which means that the marginal increase in total output decreases eventually when additional units of variable input factor are used, given quantity of fixed factors.

Ricardo observed that marginal productivity of all the factors invariably declines unless it Is monitored by technological progress. In Agriculture, introduction of new technology merely delays the decline in the marginal productivity of land, while, in industry, technology outweighs the tendency towards diminishing marginal, and as a result a tendency of increasing returns sets in. For the overall growth it is necessary to examine which of the two tendency prevails with respect to output of both the agriculture and industry both. Ricardo quoted “although then it is probable that, under the most favorable circumstances, the power of production is still greater than that of population, it will not long continue so; for the land being limited in quantity, and differing in quality, with every increased portion of capital employed on it there will be decreased rate of production, whilst the power of population continues always the same”[10]. Thus the views of Ricardo, differ from those of Adam Smith with respect to pace of economic development. Smith’s system which develops at an accelerate rate, but Ricardo’s system grows at a continuously declining pace. From the facts stated above, we can write Ricardo’s production function as Y = f( K, N, L, S) K, N and L signifies Capital, labour force, and land respectively (the same as Smith’s production function). The new variable S represents Technical know-how.[5]

Land and human resources

Ricardo’s views on land were precise and well defined. In his opinion land included only the original and indestructible powers of the soil. Thus, in his opinion supply of land in fixed. His theory of population growth is very similar to that of Smith’s. He distinguished ‘natural wage’ from the ‘real wage’ which is exactly the same concept of subsistence wages. In Ricardo’s opinion, if the market wage rate is above the natural wage rate, it induces population growth and vice versa. Only in the situation that both the rates are the same, i.e., market wage rate equals real wage rate, the population will show no tendency to change.

Other than this similarity, Ricardo’s views differ greatly from those of Smith’s. Firstly, Ricardo does not support the view of Adam Smith, that the growth of labour and population is proportional to the difference between the market wage rate and the subsistence (natural) wage rate. He believes that the growth force is functionally related to the difference between the rate, but he does not think that the relationship they share is equi- proportional. Secondly, Ricardo believe that there is always an upper limit to the rate of population growth.

As a rule, market wage rate generally conform to the natural wage rate, but there is still a chance that these two rates could be different from each other. Ricardo quotes that "Notwithstanding the tendency of wages to conform to their natural rate, their market rate may, in an improving society, for an indefinite period, be constantly above it; for no sooner may the impulse, which an increased capital gives to a new demand for labor, be obeyed, than another increase of capital may produce the same effect; and thus, if the increase of capital be gradual and constant, the demand for labor may give a continued stimulus to an increase of people"[11] This statement explains the process of how wages eventually conform at the natural wage level. If the demand for labour, exceeds its current supply, the market wages show a tendency to rise, which provides a stimulus to population growth. This increase in the population, eventually pushes downward to the subsistence level. Low market wages, do not allow population growth and over time the population would decline. Eventually the demand for labour would again push the wages to their natural level. Ricardo asserts that in long run equilibrium, the expansion rate of labour supply remains in balance with the expansion rate of labour demand and that the labour force changes propotinately to the change in supply of capital. In the short run,the rate of population growth may be slower than that of capital growth, and that this would cause a raise in the market wage rate, which would provide impetus to population growth. this would again lead to equilibrium between the demand and supply of labour in the long run.[5]

Capital accumulation

In Ricardo's theory of growth, Capital Accumulation play a strategic role. in his system, capital includes both fixed capital and circulating capital (the portion of an organization's investment that is continually used and replenished in ongoing operations),[12]which grows at a proportional rate to the fixed capital. It is an increase in this variety of capital which determines the increase in the demand for labour. similar to the view propagated by Adam Smith, Ricardo eliminates any possibility of leakages between the process of savings and investment, stating that "for no one accumulates, but with the view to make his accumulations profitable"[13] The rate of capital Accumulation depends on the ability to save (which intern depends on net income)and the will to save (which depends on the rate of profit). Net income, according to Ricardo, refers to the surplus over the total product required for maintaining labour's subsistence level. Disagreeing with Smith, Ricardo believes that the people's willingness to save and invest "will diminish with every diminution of profit, and will cease altogether when profits are so low as not to afford them an adequate compensation for their trouble, and the risk which they must necessarily encounter in employing their capital productively"[13]

According to Ricardo, capital accumulation, an increasing function of excess profits (which means that as profits increase, capital accumulation would increase) will entirely be given up under two circumstances. One, if surplus above subsistence level falls to zero and two, if the rate of profit falls to such a low level that it is only sufficient to compensate the risk.

The dynamic process of capital accumulation, as envisioned by Ricardo, can be summarized below. For this purpose, we shall have to analyse the behavior of 'net income' and its rate of profit. According to Ricardo, profits are determined by the surplus amount left over after the subsistence level wages are paid to labour. Thus, the rate of profit would change with a change in the subsistence level of wages. Since the subsistence level of wages has a tendency to rise over time (due to diminishing returns, the natural tendency of the rate of profit is to fall. However, the introduction of innovations might keep in check the diminishing returns and thus the share of the subsistence wages in the profit might also fall. It is in these periods that profits would rise. But, Ricardo believed that these tendencies could not last for long as ultimately diminishing returns would set in and the long run trend of profits will inevitably be downwards. In the earlier period the rate at which profits fall was quite low and their share in output tends to increase. also the rate at which capital accumulation takes place is quite high. But, in the latter period, when the share of profits begins to fall, in reinforces downward pressure on the capital accumulation, and it to slows down. Ultimately, the pressure of the growing population requires the cultivation of much inferior land where the margin for profit is almost zero. In an economy which has reached this stage, the capital accumulation stops completely and further increase in population also becomes impossible. In Ricardo's system, this is the stationary point in the growth process of an economy.[5]

The dynamic process of growth

In Ricardian economy, the economy does not advance towards the Stationary state in a sustain manner. The progress is often interrupted for short intervals when the economy enters in to state of equlibria, during which the wages stabalize and population does not grow. During these periods, the 'net income' of the economy does not fall to zero, and the rate of return on the investment is more than what is necessary to compensate the risk. because of these factors, investment is promoted, causing an increase in the demand for labour. Excess wages, above the subsistence level, promotes population growth. In this temporary phase, the rise in wages, decline the portion of profits in income, which leads to a slower rate of capital accumulation. Eventually, when the supply of labour catches up with the demand for it, the economy breaks into a new equilibrium position. The economies' previous equilibrium positions differ from this new position in at least two major aspects. One, the size of the population grows with every new equilibrium position the economy reaches, and two, the capital stock of the economy also grows larger and larger with every successive equilibrium position reached.

According to Ricardo, and economy which has reached the Stationary state, is characterized by wages at the subsistence level, maximum possible population, profits which are merely enough to compensate the risk, constant capital stock and a fixed quantity product. Ricardo did not visualize any economy reaching the stationary state any time in the near future. In Ricardo's time underdevelopment did exist. In his opinion, sparsely populated countries required a more rapid growth of capital stock. This same remedy could not be applied to countries with Dense population, as rapid increase in capital stock would promote more population growth, and this would make matter worse for the country. Ricardo, thus suggested that the only remedy for these densely populated countries was a population control, by a change in the consciousness of the working class.[5]

Malthus's theory of growth

Thomas Robert Malthus
Classical economics
Thomas Malthus.jpg
Thomas Robert Malthus
Born February 14, 1766(1766-02-14)
Surrey, England
Died December 29, 1834(1834-12-29) (aged 68)
Bath, England
Nationality British
Field demography, macroeconomics, evolutionary economics[citation needed]
Opposed William Godwin, Jean-Baptiste Say, Marquis de Condorcet, Jean-Jacques Rousseau, David Ricardo
Influences David Ricardo, Jean Charles Léonard de Sismondi
Influenced Charles Darwin, Francis Place, Garrett Hardin, John Maynard Keynes, Pierre Francois Verhulst, Alfred Russel Wallace, Karl Marx, Mao Zedong
Contributions Malthusian growth of population model

Robert Malthus (1766–1834) was an economist who was most famous his doctrine which stated that "population increases in a geometric ratio, while the means of subsistence increases in an arithmetic ratio"[14] which basically means that the population of mankind will eventually outstrip man's ability to supply himself with the necessities of life. Dubbed the "prophets of gloom and doom," his theories became associated with turning economic thought into a dismal science. He became renown for his pessimistic predictions regarding the future of humanity[15] His major contribution to economic thought came in the form of six editions to An Essay on the Principle of Population, published from 1798 to 1826.

Introduction

Unlike both Adam Smith and Ricardo, Robert malthus was more interest in the problems of Growth of the economy and population. According to him, no enquiry could be more important that that which identifies the causes differences between the potential and actual growth of a country. The concepts that would help understand Malthus'theory of growth are his views on human resources and capital accumulation, the identification of the Growth retarding factors and the interaction of sdifferent secotrs in underdeveloped areas.

Human resources and capital accumulation

According to Malthus, population growth, to a great extent, depends on the strengths of psychological and physiological forces.He also admitted that Population growth is limited by society's riches. He wrote "an increase in population cannot take place without a proportionate or nearly proportionate increase of wealth"[16]. Malthus argued that, lack of wealth is a constraint on population growth. Thus, it is clear that the natural tendency of population growth in malthusian system does not ensure that population or income will actually grow in a country

Effective demand[17] which is the quantity of a good or service that consumers are actually buying at the current market price, is the main for propelling the growth process. Malthus believes that an increase in the population does not provide a stimulus to economic growth as, it may not increase effective demand because workers often may be lacking in purchasing power due to the lack of demand of their labour. Supporting both Smith's and Ricardo's views, Malthus to thought that demand for labour depends on capital accumulation.

Malthus differed from both Smith and Ricardo on the potulate that savings always equals investment and hence, any act of savings would lead to an increase in wealth of the economy. Rejecting Say's Law of Market, which states that 'supply creates its own demand'[18], he says that savings brings about a reduction in effective demand by reducing the ability to consume of people, in turn bringing down a decline in profits and investments.

According to Malthus

Y = R + W, ...... (1)where,

Y represents National income

R denotes profit

W states the wages

We may re-write this equation as

R = Y - W......(1a)

Thus, we can deduce from the above equation that profits are equal to total output(income) minus the workers wages.

Workers getting subsistence wages are too poor to save any amount from their income. In other words, workers spend/consume the whole of their income, which we can denotes as Cw. Capitalist' earning are larger than that of what they need for their consumption. Hence, they save this excess amount of their income. According to Malthus, the total amount of the capitalist' savings are not invested, and since savings only produce income to the extent they are invested, we can substitute this in equation (1a) as,

R = (I + Cc + Cw) - Cw = I + Cc, .... (1b) where,

Cc represents the capitalists consumption

I denotes investments

Identifying equation (1) as equation (1b) helps us in forming Malthus' argument. According to him, national Income (Y) is created by investment (I) and consumption (C), which is divided into capitalist' consumption (Cc) and workers' consumption (cw). As the wages of workers equals their consumption level, profits are equal to Investment plus the capitalist' consumption. Malthus argues that abstinence to consume on the part of the capitalist only contributes to growth if the savings are then invested. In case this does not happen, the capitalist' savings would only retard growth. Nonetheless he also states that when the opportunities for profitable investment get exhausted, savings cannot get converted into investment. At this point abstinence on the part of the capitalist would only reduce the amount of effective demand in the economy, thereby reducing the possibility if growth.[5]

Growth-retarding factors

Malthus also gave light on three main factors which he thought sometimes arrest economic growth. Firstly, he refers to a backward sloping curve of effort for both Workers and managers, meaning that the incentive to do hard work was missing on account of many factors such as market size, etc.He suggested that a remedy to the problem of small size of markets was in the promotion of international trade and by improving the transport and communication at a domestic level. Secondly, inability of an economy, to structurally transform itself into an industry based economy, may lead to economic retardation. Technological progress generates employment in the industrial sector by allowing providing jobs to people from the agricultural sector. Where technology fails, income tends to fall and there is a rise in unemployment.The introduction of land reform, so as to provide the ownership of the land to the actual land tillers so as to generate an incentive to raise output, was the solution provided by Malthus, but he himself stated that this was only temporary. Thirdly, intersectoral analysis of Malthus suggested that technological progress in a country had to be rapid enough to permit large investment in the industrial sector, whereby the impact of diminishing returns to increased employment on the land can be neutralized. Often such progress could not be accomplished in industries while diminishing returns in agriculture put a break on its development. In fact, in Malthusian economy, it is the interaction of these two sectors while lead to the stationary state.[5]

Sectoral interaction in underdeveloped areas

Malthus, in terms of sectoral Interaction, explained why some economies remain underdeveloped. He asserted that in a state of Autarky[19], which means the condition of self-sufficiency (absence of trade),the two sectors of an economy (agricultural and industrial) constitute markets for each others products. therefore, due to the dependency among the two sectors, if any one sector fails to grow, it becomes exceedingly difficult for the other sector to expand. Malthus contended that the development of the industrial sector in a backward economy is limited by underdevelopment of the agricultural sector in the economy. The backwardness of the agriculture and the poverty of the peasantry do no result from the scarcity of land, but it is the limited demand for agricultural products due to inadequate development of the industrial sector which prevents the peasants and the landlords from taking up any programmes which help agricultural developed. Faced with inadequate resources and limitations of the market, farmers has no incentive for more intensive cultivation. To sum up the general view of Malthus, the limited effective demand in less developed countries prevent development in both the agricultural and industrial sectors. If a small modern industrial sector does emerge in the economy, it leads to a phenomenon called dualism. because of the high level of techniques employed in the modern sector, the employment opportunities it generates are limited and therefore, the overall impact on the economy is hardly felt. Labour intensive techniques of production in the agricultural sector does permit the absorption of most of the countries labour force, but it does not generate high enough income/wages of the labourers, and therefore it does not lead to an increase in the effective demand of the economy, nor to an increase in the rate of economic growth.[5]

The Classical's theory of growth

Introduction

We have separately viewed each of the individual growth theories propagated by Adam Smith, David Ricardo and Thomas Malthus. In each case, we have seen how each of the theories the economists have visualized the economy entering a stationary state. It can be noted that there is little agreement between them, but we find that the basic approach and framework for the classical economists is the same.

The classical economists had explained growth process in terms of rates of technological progress and the population growth. In their opinion, technological progress (depending on capital accumulation) remains in lead for some time, but eventually falls when a fall in the profit rates prevent further accumulation of capital. It is as this stage that the economy falls into a state of stagnation. The main components of the Classical Theory of growth and Stagnation are the production function, technological progress, investment, the determinants of profit, size of labour force and the wage system.

The production function

Smith, Ricardo and Malthus all postulated the identical production function, which can be written as Y = f(K, L, N, S)......... (1) which means that output depends on the stock of capital, labour force, land and the level of technology. In the generalized classical growth model ‘Land’ is taken as “the supply of known and economically useful resources” and this seems like the right thing to do as it is not the amount of cultivable land and its fertility that determines the national output but the total supply of know and usable natural resources.

Most of the other classical economists, except for Adam Smith, seems to believe that the production function is liner and homogeneous,[20] which implies that it has constant returns to scale meaning that on doubling the quantities of all the factors of production output would double[21]. Adam Smith, on the other hand, believed in increasing returns to scale on account of improved division of labour.

In case the term land is restricted to cultivable land only, the supply of which is a fixed amount, then the ask able question to be answered would be as to how the output would respond to an increased supply of labour with a fixed supply of land.

Most classical economists believed that output would not show a uniform response to the increase in the quantity of land. The referred to four different responses of output which depended on the phase of the production, that is to say, increasing marginal returns (where an increase in the variable input results in an increase in the marginal product of the variable input)[22], Diminishing returns(when additional units of an input result in a smaller increase in output)[23],dimishing average returns (where the average output increases by less from additional units of an input used)[23] and diminishing total returns.[5]

Technological progress and its constraints

Most classical economists believe that the main constraint to technological progress is Capital Accumulation. According to them, technological progress could not be assumed to be completely independent factor. In their opinion, technological progress is a capital absorbing and therefore, capital accumulation is a pre-requisite for a steady advance of technology. For this Capital Accumulation they stressed on savings and Investment as a primary factor.[5] Putting this in equation form,

S = S(I)...........(2)

Investment

Investment, in the classical model, refers to Net investment, which is the net addition to the capital stock. For the classical economists profit was the sole motivator for all productive activity, and therefore, they believe that investment activity is dependent on the profit expectations of the entrepreneurs, which is largely influenced by the rate of profit.[5] Stating the above in equation form, where R is profit and net investment, by definition, equals the increase in the capital stock, we get

I = dK = I(R).............(3)

Determinants of profit

By studying the many theories of classical economists, it is possible to identify two main factor which determine the level of profits in a system. They are, one, the supply of labour force (which is dependent on the population growth) and two, the technological progress.

The classical economists thought that population would grow over time leading to an increase in the labour force. Since supply of labour is fixed, the increase in population would lead to diminishing returns in agriculture which would increase labour costs and reduce profit margins. They did not believe that an improvement in Technology would lead to increasing returns from agriculture as they thought this to be the case specific to only industries. In their opinion, the tendency of increasing returns would offset that of diminishing returns in the case of industries. The trend of profit rate depended on the relative strengths of these two tendencies.[5] This said, however, the classicists were not optimistic of the future stating that ultimately profit rate would fall, slowing down investment activity. So we can write,

R = R(L,S)........(4)

One can see that there is a Circularity in the Arguments of the classicists. For them, Technological progress depends on Investment. Investment, in turn, depends on profits, which depends among other things, on Technological Progress. "This circularity is no accident or oversight; it is precisely what the classicists- and most later economists- have wished to stress; in economic development nothing succeeds like success, and nothing fails like failure"[24]

Size of labour force

Population Growth and the Labour supply have been explained in terms of the 'Iron Law of Wages'. They Believe that it is the size of the wage fund which decides the rate of population growth. When the wage fund grows, it leads to a temporary rise of wages levels above the subsistence level. this gives incentive to boost population growth which increases supply of labour, bringing the wage level to subsistence level again. Even now, this theory seems to provide a satisfactory description of peasent societies in Third world countries.[5]

L = L(W) ........ (5)

Wages

The wage fund, which is the amount of money available for paying wages to the labour, constitutes the working capital, and is created out of savings. Both Adam Smith and Ricardo believed that savings would automatically get converted into investment. Malthus however, was of a different opinion. He believed that in the absence of Effective demand, savings of the Capitalists do not find investment opportunities. Keeping this in mind, it can be said that the classical position is that the wage fund depends on the levels of investment and not savings in the economy.[5] So we may write,

W = W(I).......(6)

Closing the system

Now, we have seven variables and only six equations. Hence, the system is indeterminate. It can be closed by Introducing the following identity. Y = R + W......(7)

This Identity states that, total real income is the sum of profits and wages. In this determinate system, we can now clearly see the circularity which has been previously mentioned.

We can examine this circularity by breaking it down to see how the system evolves. Since the classical economics believed in a capitalist economy in which the main motivator is profit, we will start examining it from the point of profit

dR → dL → dK → dS, dW → dL → dR

The above flow chart indicates four things.

  1. It implies that any increase in profits induces investment, which thereby brings an increase in the raising of the stock of capital
  2. A growth in the capital stock allows a steady growth in the technological progress and the wage fund
  3. A growth in the wage fund accelerate population growth and with an expansion in the labour force diminishing returns to labour sets in.
  4. Thus, labour costs increase and the profit margins decline.

This, in the classical model, is the end result of development activity or in other words the Stationary state.

Merits

Two relevant insights that became evident from the Classical theory of Growth and Stagnation are as follows[5]

  1. The theory underlies that there is a strong relationship between the performance of the Agricultural sector and the industrial growth.
  2. The model points to the key variables of economic growth and the analysis of their interdependence.

Limitations

The two main limitations in the classical theory of growth and stagnation have been stated below[5]

  1. The classical economists knew the role of entrepreneurs in the process of production, yet they never assigned any important position to them in their system
  2. Contrary to what the classical economists has envisioned, Capital had become an important factor in agriculture and is now increasingly substituting land. This is prevented a fall in the rate of profits. Even in the industrial sector, growth caused by increasing returns has prevented profit rates from falling. Hence, investment activity has not slowed down. The classical economists were right to observe the technical progress was greatly dependent on savings and investment, but the relationship they share is not as rigid as the one they have assumed in their model.

Suggested readings

  1. Adelman, Irma, Theories of Economic Growth and Development(California: Standford University Press,1962)
  2. Brenner, Y.S.,Theories of Economic development and Growth (London: George Allen and Unwin Ltd., 1969)
  3. Donaldson, Loraine, Economic Development- Analysis and policy (St.Paul: West publishing company, 1984)
  4. Eltis, Walter, The Classical theory of Economic growth (London: Macmillian press, 1984)
  5. Higgins, Benjamin, Economic Development - Principles, Problems and Policies (Allahabad: Central book depot, 1966)
  6. Hoselitz,Bert. F.(ed) Theories of Economic Growth (The Free press of Glencoe,1960)

References

  1. ^ http://www.investopedia.com/terms/c/classicaleconomics.asp#axzz1Znt5MQ8Z
  2. ^ http://www.adamsmith.org/adam-smith/
  3. ^ http://rebirthofreason.com/Articles/twigg/Karl_Marx_versus_Adam_Smith.shtml
  4. ^ http://economicsconcepts.com/law_of_returns_to_scale.htm
  5. ^ a b c d e f g h i j k l m n o p q r s S K Mishra, V K Puri. Economics of Development and Planning – Theory and Practice. Himalya. ISBN 81-7866-055-5. 
  6. ^ http://www.economictheories.org/2008/11/j-s-mills-wages-fund-theory.html
  7. ^ http://www.articlesalley.com/article.detail.php/134796/19/Ethics/Business/1/Economics_By_Adam_Smith
  8. ^ http://www.economicsconcepts.com/factors_on_which_marginal_efficiency_of_capital_depends.htm
  9. ^ Miller, Roger LeRoy. Economics Today. Fifteenth Edition. Boston, MA: Pearson Education. page 559
  10. ^ Ricardo, David (1937). The Principles of Political Economy and Taxation. London. pp. 56. 
  11. ^ Ricardo, David (1937). The Principles of Political Economy and Taxation. London. pp. Chapter 5:on wages. 
  12. ^ http://www.investopedia.com/terms/c/circulating_capital.asp#axzz1aGsxTqQW
  13. ^ a b Ricardo, David (1937). The principles of Political Economy and Taxation. London. pp. 73. 
  14. ^ http://www.blupete.com/Literature/Biographies/Philosophy/Malthus1.htm
  15. ^ http://www.victorianweb.org/economics/malthus.html
  16. ^ Malthus, Robert. T. (1951). Principles of Political Economics. New York. pp. 317. 
  17. ^ http://www.businessdictionary.com/definition/effective-demand.html
  18. ^ http://ingrimayne.com/econ/Connections/Says.html
  19. ^ http://www.merriam-webster.com/dictionary/autarky
  20. ^ http://sshinoha.doshisha.ac.jp/report/regular_report/shinohara_report/Shinohara_Note_CRS_ProductFunction.pdf
  21. ^ http://economics.about.com/cs/economicsglossary/g/constant_return.htm
  22. ^ http://glossary.econguru.com/economic-term/increasing+marginal+returns
  23. ^ a b http://www.blackwellreference.com/public/tocnode?id=g9780631233176_chunk_g97814051006637_ss1-8
  24. ^ Higgins, Benjamin (1966). Economic Development- Principles, Problems, and Policies. Allahbad. pp. 92. 

Wikimedia Foundation. 2010.

Look at other dictionaries:

  • Economic growth — GDP real growth rates, 1990–1998 and 1990–2006, in selected countries …   Wikipedia

  • Dependency theory — International relations theory  • Idealism  Liberalism   …   Wikipedia

  • Islam and democracy — Part of the Politics series Democracy History · Var …   Wikipedia

  • Unified growth theory — In economics, endogenous growth theory or new growth theory was developed in the 1980s as a response to criticism of the neo classical growth model. In the exogenous neoclassical growth model the long run rate of growth is determined by… …   Wikipedia

  • distribution theory — ▪ economics Introduction       in economics, the systematic attempt to account for the sharing of the national income among the owners of the factors of production land, labour, and capital. Traditionally, economists have studied how the costs of …   Universalium

  • History of science and technology in China — Inventions …   Wikipedia

  • Mill, John Stuart: Ethics and politics — J.S.Mill Ethics and politics R.F.Khan ON LIBERTY John Stuart Mill’s mature views on ethics and politics are to be found in On Liberty (published in 1859), Utilitarianism (1861), Considerations on Representative Government (1861) and The… …   History of philosophy

  • Stagflation — is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time. cite book last = Blanchard first = Olivier title = Macroeconomics edition = 2nd ed. pages = p. G8 publisher =… …   Wikipedia

  • education — /ej oo kay sheuhn/, n. 1. the act or process of imparting or acquiring general knowledge, developing the powers of reasoning and judgment, and generally of preparing oneself or others intellectually for mature life. 2. the act or process of… …   Universalium

  • Russia — /rush euh/, n. 1. Also called Russian Empire. Russian, Rossiya. a former empire in E Europe and N and W Asia: overthrown by the Russian Revolution 1917. Cap.: St. Petersburg (1703 1917). 2. See Union of Soviet Socialist Republics. 3. See Russian… …   Universalium


Share the article and excerpts

Direct link
Do a right-click on the link above
and select “Copy Link”

We are using cookies for the best presentation of our site. Continuing to use this site, you agree with this.