Classical Economics

Contributor: Nathan Murphy. Lesson ID: 13831

Have you ever played Monopoly? Then you were NOT using classical economics! Learn how this theory arose and eventually gave way to capitalism in the 18th and 19th centuries.

categories

Economics, History, United States

subject
Government
learning style
Auditory, Visual
personality style
Beaver
Grade Level
High School (9-12)
Lesson Type
Dig Deeper

Lesson Plan - Get It!

Audio:

This is the logo for the Dutch East India Company:

Dutch East India Company logo

This company dominated trade during the 17th and 18th centuries; however, its success had absolutely nothing to do with capitalism.

In fact, the thing that made this company successful is the exact opposite of classical economics!

Mercantilism

Dutch Ships in a Bay

Image by Willem van de Velde the Younger, via Wikimedia Commons, is unavailable under the CC0 1.0 public domain dedicaiton.

Beginning during the Age of Exploration in the 16th century, European powers established colonies all over the world.

The Netherlands, a small country, for example, established massive colonies in Southeast Asia and had a substantial presence in South America and the Caribbean.

  • But who was going to manage all the trade and resources that were being harvested from these colonies?

In the Netherlands and other countries like Great Britain, the job of managing trade was given to a single company that was granted a monopoly over all the colonial holdings.

The Dutch East India Company was incredibly successful because it was granted this monopoly and pulled exotic spices from Indonesia to sell back in Europe.

Dutch East India Company monopoly

Image by Chandrani876, via Wikimedia Commons, is licensed under the CC BY-SA 4.0 license.

The British Empire's British East India Company once had a surplus of tea from India so massive that they tried to force the American colonists to only purchase tea from this company to get rid of the stockpile.

  • Why did governments grant companies monopolies like this?

Capitalism did not exist yet, and the European powers were not interested in things like competition or driving prices down. European countries were interested in reaping the benefits of controlling large pieces of land rich in resources, goods, and labor.

Therefore, the economic policy of mercantilism, which is based on trade generating wealth, was a good fit.

However, as the Industrial Revolution was occurring, some people started to call for an altogether different role of government and ways to manage the economy.

Adam Smith

Adam Smith

Adam Smith was a moral philosopher from Scotland in the 1700s. He was interested in countless topics and eventually toured Europe as a tutor to wealthy families.

While in places like France, he was heavily influenced by other emerging economists who called for less governmental regulations and fewer barriers to businesses.

Once returning home, he helped to bring the philosophical movement based on reason, known as the Enlightenment, to Scotland. He also continued to ponder the economic ideas he was exposed to in Europe.

sailing ship

As a moral philosopher in Scotland, he had been largely detached from the debate between mercantilism and any potential alternatives. However, once he returned home, he began writing his most famous book, The Wealth of Nations.

In this book, Smith unknowingly laid the groundwork for the capitalist system that would fully emerge decades later.

The most important concept in Smith's book was the idea of the invisible hand. As you watch a portion of the video below on this concept, pay attention to how the idea of the invisible hand is still relevant today.

The Essential Adam Smith: The Invisible Hand from The Fraser Institute:

The invisible hand is the economic idea that, if both parties in a purchase are given a choice whether they want to engage in the interaction, an invisible hand will guide the economy toward prosperity because people will only voluntarily make a trade if they both benefit from the transaction.

In other words...

  • if there is freedom for people to create the businesses they want
  • and people have choices about where they can go to get their goods,
  • then the competition will drive prices down and only the best and most affordable products will prevail.
  • How does this contrast with the mercantilism that was being practiced in Smith's time?

Capitalism

Mercantilism is in direct opposition to the ideas in The Wealth of Nations.

Adam Smith is the most well-known of a number of economists who founded the idea of classical economics. In the 200-plus years since these ideas first surfaced, capitalism is still centered around the very same principles.

rate of return

  • What is capitalism to you?

Classical economics is centered around ensuring that the economy:

  • is free from governmental regulation
  • is rich with competition
  • allows people to make a profit

Because of this emphasis on a free-market economy, classical economic theory calls for very little action from politicians.

In 1975, Ronald Reagan explained how to fix the economy while appearing on The Tonight Show. As you watch a portion of this interview, pay attention to how closely it follows with classical economic theory.

Ronald Reagan Interview on The Tonight Show Starring Johnny Carson - 01/03/1975 - Part 02 from Johnny Carson:

Reagan believed that, if the government would just stop regulating the economy for a few weeks, no one would miss it. And, if people were allowed to regulate themselves, everyone would benefit.

Continue on to the Got It? section to explore how classical economic theory changed the established assumptions about the economy.

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