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Policonomics » Article > History of Economic Thought - A

Mar 29

Chicago school

From the University of Chicago, and opposing Keynesianism, a number of contributions and doctrinal attitudes of authors can be identified, which turn back to neoclassical economics, are in favour of laissez faire and monetarism. Created around the 1940s, its main precursor is Milton Friedman, along with Frank H. Knight and Friedrich A. von Hayek, the latter acting as a liaison with the Austrian School.

The common view of the Chicago School focuses on the idea that governmental interventions should be at its minimum required, being deregulation the most desirable path. Another characteristic theory of the Chicago School is that the reduction or eradication of all types of regulation on business activities is beneficial for the economy as a whole. They support monetary policies when required by the economic environment, as they assume these to be more reliable and effective than fiscal policies.

The Chicago School based their assumptions on the concept of rational expectations. Milton Friedman defended that the price levels in a certain economy are always determined by the amount of money moving in circulation. According to the Chicago School, by acting and allocating resources in a rational way, people drive economic growth, while at the same time controlling price levels.

Mar 29

Lope Gallego

Indifference curves

Indifference curves are lines in a coordinate system for which each of its points express a particular combination of a number of goods or bundles of goods that the consumer is indifferent to consume. This is, the consumer will have no preference between two bundles located in the same indifference curve, since they all provide the same degree of utility. The indifference curves, as we move away from the origin of coordinates, imply higher consumption and, therefore, increasing levels of utility.

An indifference map is a combination of indifference curves, which allows understanding how changes in the quantity or the type of goods may change consumption patterns.

Francis Y. Edgeworth, developed the mathematics concerning the drawing of indifference curves in his book “Mathematical Psychics: an Essay on the Application of Mathematics to the Moral Sciences”, 1881, from earlier works by William Stanley Jevons. However, Vilfredo Pareto was the first economist to draw indifference maps as we know them nowadays, in his book “Manual of Political Economy”, published in 1906.

The first example of indifference map showed in the adjacent graph is the most common representation. It shows four convex indifference curves (red), showing each curve what amount of a good or bundle of goods x₁ the consumer has to give up in order to be able to consume more goods, or bundles of goods, x₂. This relation gives us the marginal rate of substitution (MRS) between these goods, which is the slope of the curve in each of its points.

Our second example is an indifference map with four parallel lines (green). This is the case for goods or bundles of goods, y₁ and y₂, which are perfect substitutes, since the lines are parallel and MRS = 1, that is the slope has an angle of 45º with each axis. It can also be the case for goods or bundles of goods that are perfect substitutes but in different proportions. In that case, the slope will be different and the MRS can be defined as a fraction, such as 1/2 ,1/3 , and so on. For perfect substitutes, the MRS will remain constant.

Our third example shows an indifference map with four indifference curves (blue) that represent perfect complementary goods, z₁ and z₂. This is, there will not be an increase on the consumer’s utility unless both goods increase in the required proportion. The best example of complementary goods are shoes, since the consumer’s utility will not increase when he or she gets a new right shoe without getting a new left shoe. Notice that the elbows are collinear, and the line crossing them defines the proportion in which each good needs to increase in order to have an increase in the utility. In this case the horizontal fragment of each indifference curve has a MRS = 0 and the vertical fractions a MRS = ∞.

These explanations of indifference curves can also be applied to production. In that case, the MRS turns into marginal rate of technical substitution and marginal rate of transformation.
Video – Indifference curves:

Mar 29

Lope Gallego

Neoclassical school of economics

This school of thought, which appeared around 1870 in what is known as the marginal revolution, can be considered a development of the classical school of economics’ main ideas. Supporting the concept of marginalism, and being more scientific in its work than its predecessors, the neoclassical school left aside classical economics’ matters such as wealth distribution and value theory, to study thoroughly the mechanisms that allow the allocation of scarce resources in different markets. This is, understanding how agents, such as consumers and producers, will try to maximize its objective function, utility and production, considering some given constraints, such as budget and input constraints. Indeed, it was the neoclassical school that initiated the study of optimisation problems including utility maximisation and, its dual problem, cost minimisation.

Although the boundaries of this school are quite diffuse, a number of common characteristics can be found in its adherents’ work. They will work supporting methodological individualism, and extensively using mathematics in order to support their conclusions. There will usually appear analysis studying the relations between both supply and demand, instead of studying them separately. They will use throughout their studies the Latin phrase ceteris paribus, as well as the term homo economicus. Finally, it was in the work of neoclassical economists that a distinction between positive economics and normative economics started to shape.

As the neoclassical school includes many renowned doctrines and schools, a mention to some of these schools is in order. The Austrian school included one of the most important marginalist economist, Carl Menger, as well as other renowned neoclassical economists such as Eugen von Böhm-Bawerk, Ludwig H. E. von Mises and Friedrich A. von Hayek. The Lausanne school included economists such as Léon Walras and Vilfredo Pareto. Finally, the Cambridge school included Alfred Marshall, considered the “father of modern economics”, as well as Arthur C. Pigou and Francis Ysidro Edgeworth.

Mar 27

Lope Gallego

Edgeworth box

In 1881, Francis Y. Edgeworth came up with a way of representing, using the same axis, indifference curves and the corresponding contract curve in his book “Mathematical Psychics: an Essay on the Application of Mathematics to the Moral Sciences”. However, the representation given, using as an example the work being done by Friday and wages being paid by Robinson Crusoe, was not the one we commonly know nowadays.

It was Vilfredo Pareto, in his book “Manual of Political Economy”, 1906, who developed Edgeworth’s ideas into a more understandable and simpler diagram, which today we call the Edgeworth box.

This diagram is widely used in welfare economics, game theory or general equilibrium theory, to name a few. It is easy to draw and can be easily explained. In the adjacent image, we can see two examples of an Edgeworth box, and how it is drawn.

The first example is mainly used for welfare economics and distribution matters. As we see, this “box” is formed using two sets of typical indifference maps, which in this case represent the indifference curves of agents A (green) and B (red), who must choose quantities of goods x and y. When the indifference map of agent B is rotated, and put on top of the map of agent A, the box is formed. When indifference curves are tangent to each other, which is the case in this example, a contract curve (blue) can be drawn using these tangency points.

Our second example is mainly used to explain Ricardian trade theory graphically. In this case, we draw the production-possibility frontier for countries 1 (green) and 2 (red). When we rotate the diagram of country 2, we end up with an Edgeworth box, which here will help understand how great the gains of international trade are and therefore helps illustrate how trade is not a sum zero game.

Video – Edgeworth box:

Mar 27

Lope Gallego

Malthusian population theory

Thomas Robert Malthus stated this theory, which indicated that the population would increase geometrically, while food production would only increase in arithmetical proportion, thus creating the conditions for a shortage in the long term that would require an adjustment lowering the birth rate.

Nowadays, we call Malthusianism a doctrine, strongly influenced by the theory explained above, which recommends that the world’s population should stop increasing since resources and the available capacity of the biosphere are insufficient to meet future needs. This doctrine promotes birth control, primarily through measures of delayed marriage and of contraceptive character.

Mar 27

Lope Gallego

Anne-Robert-Jacques Turgot

Turgot Turgot was a French abbot (1727-1781), Baron de l’Aulne, who after leaving the clergy became an economist and stateman, and author of the book “Reflections on the Formation and Distribution of Wealth” published in 1776. One of the great Physiocrats, and student of François Quesnay, was the first to clearly formulate the law of diminishing returns. Turgot was an early supporter of trade and economic liberalization, this being the main reason of his great influence on Adam Smith.

Mar 22

Lope Gallego

Cambridge school

Name given to British economist Alfred Marshall and his followers, who were also part of the neoclassical school of economics, such as Arthur C. Pigou and Francis Y. Edgeworth, which fully assimilated the concepts and methods of marginalism.

They are also considered to be part of the Cambridge school, although in other terms not relating to neoclassical economics, the group of economists which in one way or another collaborated with J. M. Keynes in the thirties and forties, partly in connection with the problems of war. These include Post-Keynesian economists Joan Robinson and Nicholas Kaldor, extending the group to the Neo-Keynesians John R. Hicks, Paul A. Samuelson and James Tobin.

Mar 22

Lope Gallego

Arthur Cecil Pigou

Arthur Cecil Pigou Pigou was a British economist (1877-1959), disciple of Alfred Marshall, whom he succeeded as a professor at Cambridge. Pigou is remembered above all as a precursor of welfare economics, for his books “Wealth and Welfare”, 1912, and “The Economics of Welfare”, 1920, in which he used measures of national income and its distribution in order to understand how wealth and welfare are related. He is also remembered for making a distinction between different degrees of price discrimination.

Being part of the Cambridge school, Pigou used common tools derived from neoclassical economics, such as marginalism, amongst others.

Mar 22

Lope Gallego

Bullionism

Bullionism is the name given to the essential features of economic thought in the first mercantilist era, during the XVI century. According to this economic doctrine, the State acted directly, through laws and regulations on precious metals in order to make them enter the country and prevent them from leaving. The volume of gold and silver stock was considered at the time as an expression of the wealth of a country.

Mar 22

Lope Gallego

Tableau Économique

Tableau economique First circulatory diagram explaining how a national economy works. It was a contribution to economics by French physician and economist François Quesnay. Contrary to the prevailing mercantilist thought at the time, which saw in the possession of gold, silver and other precious metals the wealth of a country, Quesnay argued that real wealth came from production.

However, his Tableau was drawn considering agriculture as the only source of wealth, which gave his findings limited use, since industrial activity was gaining importance.