Schools of Economic Thought


1. Mercantilism 

The economic system of trade between 16th to 18th century. They believed that the amount of wealth in the world was static and so national strength could be maximized by limiting imports and maximizing exports. So, basically, they stood against the theory of free trade. Mercantilism included a national policy aimed at accumulating monetary reserves through positive balance of trade.

2. Classical School

Flourished between late 18th to the early-mid 19th century. Classical economists believe that prices, wages and rates are flexible and markets always clear. Wealth of nations main message was that wealth of nation is not determined by the gold in monarchs coffers but by national income. National income, in turn, depends on the labour of inhabitants & use of accumulated capital. The earlier belief that agriculture was the chief determinant of economic health was also rejected in favour of the above-mentioned parameters. They favoured free trade. The main idea was to market work best when left alone or laissez-faire. They looked at economics through the lens of production than consumption. After Smith, three main contenders emerged as successors to his work i.e. Jean-Baptiste Say, Robert Malthus and David Ricardo.

Jean helped popularize Smith’s work in France. However, he did not agree with Smith’s labour theory of value that the value of a commodity is determined by the number of labour hours and effort invested in its production. He argued that the value should be determined by the valued customer derives from its consumption. He suggested that supply creates its own demand – Say’s Law of markets. By this, he meant that any person in order to full fill his/her demand for certain goods will have to work or supply his/her own services in order to full fill his/her own demand for the goods he/she requires. Thus, if we see from the perspective of that individual then the demand which he/she makes for a certain product equals the supply of his/her services leading to the supply of certain other or maybe same product. Thus according to him, demand is supply when seen from the other angle. He further differentiated between the use of value and exchange value but unfortunately wrongly concluded that all exchange transactions must involve the exchange of equal values. Thus he came close but could not become the leader of marginal utility theory.

Thomas Malthus argued that the growth in population would eventually decrease the ability of people in the world to feed themselves.

Ricardo turned the first draft of Smith’s ideas into coherent & rigorous theory & so classical economics is also called Ricardian or British economics. He also gave the theory of comparative advantage where he suggested the win-win situation which can be created by free trade.

Karl Marx built his ideas on Ricardian theories and so Marxian economics comes under the classical regime.

Post-1870s, the classical school split into Neoclassical and Austrian School.

3. Neo-Classical School

The classical component of this school is based on the sense that they also believe that the competition leads to an efficient allocation of resources and regulates economic activity that establishes equilibrium through the operation of market forces. It is neo in the sense that it places greater emphasis on mathematical techniques as  against the analytical used in classical viewpoint. 1871 was marked the launch of Marginalist revolution that derived theories based on marginal utilities, cost or revenues. As opposed to the classical theory which focuses on the production of goods and services, this school focuses on how individual players operate in the economy and emphasizes the exchange of goods and services in its analysis. Therefore Neoclassical school is also sometimes called as the marginal school. The marginal revolution was brought through the works of three economists, William Stanley Jevons (British), Carl Menger (Austrian and founder of Austrian School) and Leon Walras (French), who independently put new theories and discarded the Ricardian theory. The theory was then refined by the 19th and 20th-century theories of Alfred Marshall (true founder of neoclassical school), Vilfredo Pareto, John Clark and Irving Fischer. Neoclassical economics assumes that people have rational expectations and strive to maximize their utility. This school also assumes that people behave independently on the basis of all the information they attain. A major part of microeconomics today is neo-classical economics. Alongside the Keynesian economics, it forms the neo-classical synthesis which dominates the current mainstream economics.

4. Austrian School

It originated in the late 19th and early 20th century. The Austrian school of economic thoughts began with the work of Carl Menger. His well-known followers included Eugen von Bohm-Bawerk, Ludwig von Mises and Friedrich A. Hayek. The school believes that the attempts to mathematically model an economy is futile due to the complexity of subjective human choices that determine the prices and other mechanisms. They are strong supporters of a laissez-faire approach. The economic theory of the Austrian school, therefore, is grounded in verbal logic and stays away from mathematics. The school seek to understand the economy by examining the effect of individual choice on the world (methodological individualism); this differs from other schools of thought which have focused on aggregate variables, equilibrium and societal groups rather than individuals. They also believed in the non-neutrality of money. Thus there are considerable differences with other schools but it provides unique insights into some of the most complex economic issues. Their theoretical contributions include the subjective theory of value, marginalism in price theory etc which has become the part of mainstream economics.

5. Institutional School

These economists did not question the Classical and Neoclassical theories but rather questioned if any theory was possible at all. They did not believe any economic theory could hold across time and in different social and institutional environments. Institutional economics focuses on understanding the role of human-made institutions and the effect of formal and informal constraints it applies to the economic behaviour and shaping economic relations and society. Generally in economics assumes stable preferences, rationality and equilibrium but institutional economics focuses on learning, bounded rationality and evolution. Economic activities take place in the context of the restraints of society, both formal and informal, that encourage and limit the activities of those agents. Institutional economics thus takes into account these restraints that institutions lay on members of society, and thus hopes to better understand the economic activities that take place then.

The old institutional economics rejected the mainstream economics esp. neoclassical economics. On the other hand, new institutional economics integrated the later developments of neoclassical economics into the analysis from the later 20th century to make the assumptions of neoclassical economics more realistic. Similarly, behavioural economics is another part of an institutional school which looks into the effect of psychology and cognition in economic decision making. With researchers from this school of thought being awarded renowned Nobel, like Ronal Coase 1991, Douglass North 1993, Oliver Williamson 2009, the influence of this school is increasing.

6. Keynesian

It arose from the analysis of the Great Depression in the 1930s. Unlike the previous schools of thought which were moving in the direction of the bottom-up approach, this school uses the top-down approach. Keynesian economists believe that free markets are volatile and not always self-correcting, thus they were supporters of government intervention alike the previous schools of thought. They believe that aggregate demand is the primary factor that drives economic activity and short term fluctuations. Keynesians were more concerned about employment than inflation, unlike previous schools which focused more on inflation and considered unemployment as a result of government intervention. They further believed that prices and wages are sticky and so government intervention is needed. So on one side, the classicists focus on solving long term problems believing that the market itself will solve the short term fluctuations, the Keynesians focus on short term problems and believe that in long term we all are dead.

7. New Classical

Keynesians were puzzled by the outbreak of stagflation in the 1970s because they had established the Philips curve relationship between inflation and unemployment. Thus was born the new classical school. The Neoclassicism used to rule the microeconomics, being able to explain prices, wages, markets while the Keynesians were able to explain the macroeconomics, GDP, inflation, unemployment. But now a need for feeling to combine these two theories to make one unified theory to explain both the domains. Robert Lucas (Chicago school) came up with the Lucas critique which questioned the Keynesian aggregate consumption functions and attempted at incorporating microeconomic foundation to macroeconomics. For this, he was awarded the Nobel prize in 1995. It borrows its assumptions from the neoclassical school (i.e. all agents maximize their utility based on rational expectations and at any time the prices and wages adjust to having an economy at full employment) to build upon further. One of the most famous new classical models is the real business cycle model (RBC).

8. New Keynesian

It was developed partly as a result of Keynesian criticism and development of New classical school. New Keynesians agreed to incorporate microeconomic foundations into macro economics as per the New Classical’s but unlike them, they believed the presence of wages and prices are stickiness and market failures thereby the need for government intervention. This school is also known as New neoclassical synthesis. The theoretical foundation provided by them forms the basis of much of the contemporary mainstream economics.

9. Post-Keynesian School

This term was first used to refer the school of economic thought by Richner and Kreger in 1975. They believed in maintaining the Keynes theory and considered neo-Keynesian’s and new Keynesian’s have misinterpreted the principals of Keynesian schools. Contrary to the new Keynesian economists they did not believe in prices or wages stickiness resulting to market failures. They also rejected the IS LM model of John hicks, which plays an important role in neo classical economics.

10. Monetarist

It is a school of thought that focuses on the role of government in controlling the amount of money in circulation. It is based on the works of Nobel Laureate Milton Friedman who earlier accepted the Keynesian models but later criticised it for Keynesians solutions of fiscal interventions. They believe that it is money supply that is the most significant parameter to determine the economic growth and fluctuations in business cycles. The foundation of monetarism is in the Quantity theory of money which says that the money supply multiplied by velocity equals nominal expenditures. It however assumes that the money velocity is stable, which is controversial. They were supporters of laissez faire and also on the boundations of centrals banks power to conduct monetary policy. They also believed in long run monetary neutrality, short run monetary non neutrality, constant money growth rule and interest rate flexibility.

image source: people.cedarville.edu


A good timeline to read -  click here 


11. References

1.       Capitalism & Commerce, Dr. Edward W. Younkins, Montreal, February 12, 2006, No. 166
2.       www.investopedia.com, visited on October 13, 2018
3.       www.wikipedia.com visited on October 13, 2018
4.       Encyclopaedia Britannica
5.       IMF
6.       Pavel’s thought wave
7.       Exploring economics, Andreas Dimmelmeier and Frederik Heussner, December 18th, 2006 (updated: July 30th, 2018), Patron and academic review: Prof. Dr. Wolfram Elsner
8.       Methodological position(s) of institutional economics, Dragan Petrovic, Zoran Stefanovic, Economics and Organization, Vol 6, 2009, pp.105-114
9.       MBN (Market Business News)
10. http://www.hetwebsite.net/het/fonseca/notes/schoolsofthought.pdf, visited on October 14th, 2018

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