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. Keynesian Critique Keynesian economics was developed by John Maynard Keynes in 1936 during the depths of the Great Depression. Keynes promoted his new theory of macroeconomics it part by showing where the existing classical economics went wrong, especially why it was unable to explain the length and severity of the Great Depression. A discussion of each of the three assumptions of classical economics provides a bit of insight. Flexible Prices: First up is the classical proposition that wages and prices are flexible. Keynes argued that prices are really inflexible, especially in the downward direct. This inflexibility or rigidity of prices results because sellers, both output produces and resource owners, are unwilling or unable to accept lower prices. Inflexible prices thus prevent markets from eliminating shortages and surpluses. In particular, rigid wages allow a surplus of labor (that is, involuntary unemployment) to persist. Say's Law: Keynes was perhaps most critical of Say's law that supply creates its own demand. Keynes questioned whether or not supply does in fact create demand. While, in principle, revenue generated by production ultimately ends up as household income, this does not happen instantaneously. In the meantime, households can only spend the income that they actually have. If they have less income, then they spend less, less is sold, less is produced, and less revenue is generated. Saving-Investment Equality: The assumed equality between saving and investment was also criticized by Keynes. The lack of flexible prices might also prevent equilibrium in financial markets. Should interest rates not adjust, then saving might not match investment. Moreover, the attainment of equilibrium might actually require negative interest rates. Keynes suggested that interest rates were not the only or even most important factors affecting saving and investment. Factors such as a dismal outlook on the economy might reduce investment well below saving at any positive interest rate. A such, a disequilibrium in which saving exceeds investment means aggregate demand falls short of aggregate production and is just the sort of thing that would create a sustained depression. These three critiques suggest why, contrary to the expectations of classical economics, high unemployment rates persisted during the Great Depression. Aggregate demand fell short of production, probably due to a lack of investment expenditures. Resource owners had less income and thus reduced their expenditures. Unemployment increased and the surplus of resources persisted because resource prices did not decline to restore balance. Check Out These Related Terms...      | Keynesian economics | classical economics | classical aggregate supply curve | Keynesian aggregate supply curve | flexible prices | Say's law | Or For A Little Background...      | macroeconomics | full employment | efficiency | laissez faire | free enterprise | government functions | capitalism | pure market economy | business cycles | macroeconomic theories | macroeconomic sectors | macroeconomic markets | invisible hand | market equilibrium | unemployment | political views | conservative | circular flow | competitive market | equilibrium | scarcity | saving | investment | And For Further Study...      | aggregate market analysis | scientific method | utilitarianism | long-run aggregate supply | short-run production analysis | consumer demand theory | perfect competition | natural unemployment | elasticity | marginal analysis | Marshallian cross | dismal science | Recommended Citation:      ASSUMPTIONS, CLASSICAL ECONOMICS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2025. 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