ASSUMPTIONS, CLASSICAL ECONOMICS:

Classical economics, especially as directed toward macroeconomics, relies on three key

assumptions--flexible prices, Say's law, and saving-investment equality. Flexible prices
ensure that markets adjust to equilibrium and eliminate shortages and surpluses. Say's
law states that supply creates its own demand and means that enough income is
generated by production to purchase the resulting production. The saving-investment
equality ensures that any income leaked from consumption into saving is replaced by an
equal amount of investment. Although of questionable realism, these three assumptions
imply that the economy would operate at full employment.
The three key assumptions underlying the classical study of macroeconomics are flexible
prices, Say's law, and saving-investment equality. These three assumptions ensure that
the macroeconomy would continue to produce the quantity of aggregate output that fully
employs available resources. While a few resources might be temporarily unemployed,
they would be quickly reemployed as resource prices (especially wages) adjust to
equilibrium balance.

A Classical Overview

Classical economics can be traced to the pioneering work of Adam Smith (often referred
to as the father of economics). The specific event launching the modern study of
economics, as well as classical economics, was the publication by Adam Smith of An
Inquiry into the Nature and Causes of the Wealth of Nations in 1776. In this book, Smith
contended that the "wealth of a nation" was attributed to the production of goods and
services (rather than stockpiles of gold in the royal vault, which was the prevailing view
at the time). And this production was best achieved by unrestricted market exchanges
with buyers and sellers motivated by the pursuit of self interests.

The work by Smith was refined and enhanced by scores of others over the ensuing 150
years, including Jean-Baptiste Say, John Stuart Mill, David Ricardo, Thomas Robert
Malthus, and Alfred Marshall, to name just a few. Their work led to the creation of a
sophisticated body of principles and analyses that offered insight into a wide range of
economic phenomena--both microeconomic and macroeconomic. Many of these
principles remain essential to the modern microeconomic theory. And while classical
economics was largely discredited by John Maynard Keynes and advocates of Keynesian
economics from the 1930s through the 1970s (due in large part to the Great
Depression), it has reemerged (albeit with modifications) in recent decades.

Flexible Prices

The first assumption of classical economics is that prices are flexible. Price flexibility
means that markets are able to adjust quickly and efficiently to equilibrium. While this
assumption does not mean that every market in the economy is in equilibrium at all
times, any imbalance (shortage or surplus) is short lived. Moreover, the adjust to
equilibrium is accomplished automatically through the market forces of demand and
supply without the need for government action.

The most important macroeconomic dimension of this assumption applies to resource

markets, especially labor markets. The unemployment of labor, particularly involuntary
unemployment, arises if a surplus exists in labor markets. With a surplus, the quantity of
labor supplied exceeds the quantity of labor demanded--at the exist price of labor
(wages). With flexible prices, any surplus is temporary. Wages fall to eliminate the
surplus imbalance and restore equilibrium--and achieve full employment.
If, for example, aggregate demand in the economy takes a bit of a drop (perhaps due to
fewer exports of goods to other countries), then production also declines (temporarily)
and so too does the demand for labor, creating a surplus of labor and involuntarily
unemployed workers. However, flexible prices mean that wages decline to eliminate the
surplus.

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.
This notion commonly summarized by the phrase "supply creates its own demand" is
attributed to the Jean-Baptiste Say, a French economist who helped to popularize the
work of Adam Smith in the early 1800s. Say's law was a cornerstone of classical
economics, and although it was subject to intense criticism by Keynesian economists, it
remains relevant in modern times and is reflected in the circular flow model.

Say's law is occasionally misinterpreted as applying to a single good, that is, the
production of a good is ensured to be purchased by waiting buyers. That law actually
applies to aggregate, economy-wide supply and demand. A more accurate phrase is
"aggregate supply creates its own aggregate demand." This interpretation means that
the act of production adds to the overall pool of aggregate income, which is then used to
buy a corresponding value of production--although most likely not the original
production.

This law, first and foremost, directed attention to the production or supply-side of the
economy. That is, focus on production and the rest of the economy will fall in line. Say's
law further implied that extended periods of excess production and limited demand, the
sort of thing that might cause an economic downturn, were unlikely. Economic
downturns could occur, but not due to the lack of aggregate demand.

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. A potential
problem with Say's law is that not all income generated by the production of goods is
necessarily spent by the household sector on consumption demand--some income is
saved. In other words, while the production of $100 million of output generates $100
million of income, the household sector might choose to spend only $90 million, directing
the remaining $10 million to saving. If so, then supply does NOT create its own demand.
Supply falls $10 million short of creating enough demand.

If this happens, then producers reduce production and lay off workers, which causes a
drop in income and induces a decline in consumption, which then triggers further
reductions in production, employment, income, and consumption in a contractionary
downward spiral.

However, if this $10 million of saving is matched by an equal amount of investment,

then no drop off in aggregate demand occurs. Such a match between saving and
investment is assured in classical economics through flexible prices. However, in this
case price flexibility applies to interest rates. Should saving not match investment, then
interest rates adjust to restore balance. In particular, if saving exceeds investment, then
interest rates fall, which stimulates investment and curtails saving until the two are once
again equal.
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English school of economic thought that originated during the late 18th century with
Adam Smith and that reached maturity in the works of David Ricardo and John Stuart
Mill. The theories of the classical school, which dominated economic thinking in Great
Britain until about 1870, focused on economic growth and economic freedom, stressing
laissez-faire ideas and free competition.

Many of the fundamental concepts and principles of classical economics were set forth in
Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Strongly
opposed to the mercantilist theory and policy that had prevailed in Britain since the 16th
century, Smith argued that free competition and free trade, neither hampered nor
coddled by government, would best promote a nation’s economic growth. As he saw it,
the entire community benefits most when each of its members follows his or her own
self-interest. In a free-enterprise system, individuals make a profit by producing goods
that other people are willing to buy. By the same token, individuals spend money for
goods that they want or need most. Smith demonstrated how the apparent chaos of
competitive buying and selling is transmuted into an orderly system of economic
cooperation that can meet individuals’ needs and increase their wealth. He also observed
that this cooperative system occurs through the process of individual choice as opposed
to central direction.

In analyzing the workings of free enterprise, Smith introduced the rudiments of a labour
theory of value and a theory of distribution. Ricardo expanded upon both ideas in
Principles of Political Economy and Taxation (1817). In his labour theory of value,
Ricardo emphasized that the value (i.e., price) of goods produced and sold under
competitive conditions tends to be proportionate to the labour costs incurred in
producing them. Ricardo fully recognized, however, that over short periods price
depends on supply and demand. This notion became central to classical economics, as
did Ricardo’s theory of distribution, which divided national product between three social
classes: wages for labourers, profits for owners of capital, and rents for landlords. Taking
the limited growth potential of any national economy as a given, Ricardo concluded that
a particular social class could gain a larger share of the total product only at the expense
of another.

These and other Ricardian theories were restated by Mill in Principles of Political
Economy (1848), a treatise that marked the culmination of classical economics. Mill’s
work related abstract economic principles to real-world social conditions and thereby lent
new authority to economic concepts.

The teachings of the classical economists attracted much attention during the mid-19th
century. The labour theory of value, for example, was adopted by Karl Marx, who worked
out all of its logical implications and combined it with the theory of surplus value, which
was founded on the assumption that human labour alone creates all value and thus
constitutes the sole source of profits.

More significant were the effects of classical economic thought on free-trade doctrine.
The most influential was Ricardo’s principle of comparative advantage, which states that
every nation should specialize in the production of those commodities it can produce
most efficiently; everything else should be imported. This idea implies that if all nations
were to take full advantage of the territorial division of labour, total world output would
invariably be larger than it would be if nations tried to be self-sufficient. Ricardo’s
comparative-advantage principle became the cornerstone of 19th-century international-
trade theory.