1. Classical economics

Nowadays, economics distinguishes between classical and neoclassical theory. The last term is often used in a pejorative meaning as mainstream economics. The main distinctive characteristic between classical theory and neoclassical theory is said to be the "marginal revolution", in other words, the concept that optimal allocation depends on the utility/profit of the last unit of a commodity/a productive factor and not on the average of all the units. We will see in this chapter, that the concept of marginality is very present already in authors nowadays considered as classical; see for instance natural price/market price, Law of Say, David Ricardo. A marginal revolution never happened.

The distinction of Adam Smith between natural price and market price includes already implicitly the concept of marginality. The natural price is the price we get if the marginal revenue, the revenue of the last unit allocated for a specific use, is the same everywhere. In this case, there is no need to reallocate something because the marginal revenue is the same everywhere. If for instance, a farmer has the choice to sell his corn to the producer of popcorn or to a producer of biofuel, he will sell it to the one or the other until he gets the same revenue for both uses. Selling it for instance to the producer of biofuel will have the effect, that the producer of popcorn has to pay more. This tendency will last until the producer of popcorn and the producer of biofuel pay the same price for corn. That doesn't mean that the average revenue of a unit of corn is the same, but it is obvious that as long as the farmer can improve his situation through reallocation, he will do it.

selling corn to the biofuel producer: 50 / 30 / 20 / 10 => average 27.5 => revenue last unit 10
selling corn to the popcorn producer: 30 / 25 / 25 / 10 => avarage 22.5 => revenue last unit 10

If we read Jean-Baptiste Say in the original version, we will realise that he already realised the price people were willing to pay for something, depends on the quantity they have already produced.

[Actually, Jean-Baptiste Say formulated the issue in a more general and more correct way. We will see later on when discussing about Say's Law.]

If a pear costs 1 dollar and yields 1 unit of utility, however, the term utility is defined, and an apple yields as well 1 unit of utility but cost 2 dollars, people prefer the pear, that's obvious. However, if the utility that yields a pear diminishes with consumption, if for instance the 4th pear only yields a utility of 0,2 utilities then it becomes more attractive to buy apples. In buying a pear, people would have to spend 5 dollars in this case to get 1 utility, but only 2 dollars when they buy apples.

[This is more or less what we find in textbooks. Actually, the situation is different in reality. From most of the products, we consume only one unit. One bicycle, one television, one car, one refrigerator etc. In this case, the relevant issue is not the decreasing marginal utility, but the fact that commodities are competing. If a smartphone yields 20 utilities and costs 400 euros, and going on holidays equally 400 euros but yields 21 unities of utility, we prefer to go on holidays. However, if the price of the smartphone decreases to 350 euros, we pay the smartphone. In other words, the producer of the smartphone has to lower its prices, if he wants to compete with going on holidays. In other words, the falling demand curve can't be explained as it is explained in textbooks about microeconomics. The increase in the amount of units sold can't be explained, in general, by the "law" of the decreasing marginal utility. The falling demand curve is because the commodities compete.]

Finally, the concept of rent of David Ricardo includes the idea of marginality, albeit David Ricardo only applies the concept to land. It is the marginal producer of corn, in other words, the less fertile and the most far away land that given a certain demand can still produce that decides upon the price of corn. The rent of David Ricardo is the same thing as the producer surplus of Alfred Marshall. The difference is that David Ricardo applies this concept only to land. Actually, the same logic is true for any producer. It is always the less efficient producer who can, given a certain demand, can still produce, who determines the price.

To put it shortly, the marginal revolution never happened and we can suppose, that the classical author didn't invent the idea either. They just wrote it down. We can assume that because discounts are a very old sales promotion measure. If one item of something costs 1 dollar, people won't pay 10 dollars for 10 units because the last unit yields less utility. In order to sell 10 at one time, there must be a discount. This is trivial.

What we can say is that the concept of marginality is more relevant to the neoclassical theory, because the neoclassical theory is almost only about equilibrium and any kind of equilibrium in any kind of market uses the concept of marginality. Equilibrium is a state in which a reallocation of resources is not useful because nobody can improve his situation by reallocating the resources being the marginal revenue/marginal utility the same in any use.

Classical theory is more about the long run development of an economy and less about equilibrium. Therefore, the concept of marginality is more relevant to neoclassical theory.

We can as well say that modelling, especially mathematical modelling, began its triumphant advance in the era of the neoclassical authors. This is way the nowadays dominant economic theory is called the neoclassical mainstream. However, things are not as simple. .

Alfred Marshall is actually the founder of mathematical modelling, but it is Alfred Marshall as well who warns about the excessive use of modelling. That is one reason why he silently ignored Léon Walras. In the opinion of Alfred Marshall, Léon Walras not resolved with a lot of effort not existing problems.

Actually, the sinister tradition of modelling started earlier. The first representative of this methodological approach is David Ricardo. In the Ricardian theory, we have a drastic reduction of the issues addressed and the abstraction of all individual circumstances. It is not incidental that there are lot of tentatives to describe the theory of David Ricardo with a mathematical model, but not one to do that with the theory of Adam Smith or Jean-Baptiste Say. This is possible because any incidental and unpredictable circumstance are excluded in the theory of David Ricardo.

Besides the problem that very different authors are nowadays summarised under one term, classical theory, there is a second problem: The somehow eclectic canonisation of concepts. Concepts that were nothing else than a remark of two sentences in the original work, for instance, the theory of comparative costs of David Ricardo, Say's Law, the invisible hand of Adam Smith were canonised and can be found in any textbook about economics and much more relevant concepts have fallen into oblivion.

[There is actually another problem. Very often, as in the case of Say's Law, the presentation given in modern textbook doesn't fit with the original version. In the original version, Say just wanted to say that it is not a lack of money, that leads to a lack of demand, but a lack of production. If people don't produce something, they don't have the resources to buy something. From that we can't deduce that people spent all the money they have nor that the production is high enough to guarantee full employment.]

It is obvious that relevance is not the criteria for canonisation. The concept of natural price / market price, for instance, explains much better the mechanisms of a market economy than the invisible hand. The invisible hand actually explains absolutely nothing; it is just a nice expression. However, everybody knows the invisible hand, albeit most of the people don't have a clear idea what the term means, and nobody the concept of the natural price/market price.

A more stunning example is the expression creative destruction of Joseph Schumpeter. The idea that there are charismatic entrepreneurs who change the economic structure fascinates people, although this has little to do with reality. The real important concept of the Schumpeterian theory, his concept of the role of money, something that broke with the misleading traditional theory and is almost correct, was completely forgotten.

It seems that concepts expressed with an impressive term are more easily canonised. A second criteria seems to be the possibility to mathematically modelling a concept. Even if the concept was described without any kind of mathematical modelling like the pareto optimum or, a more relevant case, the Keynesian theory, we find it described nowadays mathematically modelled in textbooks. Therefore, we can assume that the methodological approach played a significant role in the canonisation.

Last but not least, canonisation is strengthened by the fact that nobody reads the original. If this were the case, if someone read the original, more people would realise that a concept was only a passing remark and/or the original meaning was different and canonisation would be more difficult.

We will focus on the next chapters on the fundamental erroneous concepts of classical theory. The most fundamental error of the classical theory is the concept of savings as not consumed income of the past. This fundamental error leads to a lot of other errors. It is crucial to understand this basic error. Otherwise, the Keynesian theory can't be understood. See the booklet downloadable from the start of this website.

If we want to mention some common characteristics that all the classical authors have in common we can mention this one.

  • Markets tend to an equilibrium. This means for instance, that volunteer unemployment is impossible.
  • All classical authors assumed savings, not consumed income of the past as a condition for investments. There is no clear distinction in this context between capital and money, although they presume that capital is needed for investments and money is only a means of payement.
  • The allocation of resources is best realised if the government doesn't intervene. The result of the market, steered by volunteer cooperation through prices, can't be improved by governmental intervention.
  • All kinds of hindrance to international trade, customer duties as well as non-tariff barriers are rejected. The same rules are to apply in national trade, are to be applied as well in international trade.
  • The price of product has to cover at least the price for the capital, the profit, the price for labour, the wage and the price for the land, the rent. (A term used in a more specific way by David Ricardo.)
  • Money is a pure veil and doesn't have any impact on the economic development.

The marginal revolution is not the distinctive difference between the classical and neoclassical theory. The difference between the classical and neoclassical theory is that the neoclassical theory is almost only about equilibrium. In the classical theory, this is an issue between many others, but the topic is never addressed directly. The concept of the natural price of Adam Smith, for instance, describes an equilibrium. In this situation, the market player has no reason to reallocate resources, but this equilibrium contrasts with the market price, which will induce the market players to reallocate the resources. The classical economy is more about growth and not about equilibrium.

Neoclassical theory is almost only about equilibrium, although they are a lot of different concepts of equilibrium. Alfred Marshall describes a partial equilibrium, only one product is considered, and that equilibrium is based on cardinal measurement of utility, in other words, the utility is measured in money. This is, at least in theory, in practise this problem is irrelevant, a problematic perspective because money itself has a different utility depending on the income. 100 dollars is not a lot for someone who earn 10, 000 dollars a month, but it is a lot of money for someone who earns only 1,000 dollars a month. This equilibrium is the most used concepts in textbook about economics because it allows to analyse the loss of consumer/producer surplus due to taxes, customer duties, external shocks and the effects of a change in the consumer preferences or changes in the production structures.

The paretian equilibrium tries to avoid this problem by an ordinal measurement of utility. In this case, the two persons involved in a change are considered separately. They have two products and they substitute one product for another while the utility of the last unit of the product they give away is less than the utility of the product they get for it. In other words, the utility of one product is measured by the utility of the other product.

Finally, we have the general equilibrium of Léon Walras. This general equilibrium resembles the natural price of Adam Smith. All the resources are allocated in an optimal way and there is no space for improvements.

The question arises why we find in economic textbooks almost only neoclassical authors. The first idea would be that there was an advance, that the neoclassical authors explain reality better than the classical authors does. This would lead to the next question. In what exactly consists the advance? This question is difficult to answer because all the discussions about equilibrium in its different forms and models play no role in public debate and contributes nothing when it comes to real problems.

We can assume that the fact that neoclassic dominates microeconomics can be explained by the abstraction from any dynamic element: change in the production structure, technological progress, change of preferences, etc. An equilibrium is defined by the fact that nothing changes. If we abstract from any dynamic element, we have a better change use mathematical modelling and to present economics as a "true science" like physics, although the output is irrelevant.

The more we focus on the dynamic of economies, the less we can use mathematical modelling. Modelling and especially mathematical modelling is only possible if the assumption of the models are stable and concerns economic models, this is not the case.

Concerning the fundamental error, the concept of savings as not consumed income of the past and all the errors that derived from this fundamental error, there is no difference between the classical and the neoclassical theory. That's the reason why Keynes didn't distinguish between classical and neoclassical theory.

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The "marginal revolution", considered the main characteristic that distinguishs classical theory from the neoclassical theory never happened, because the concept of marginality is already present in classical thinking.

Classical theory is more about economic growth and development, neoclassical theory is more about equilibrium.

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