Economic Theories

• Video: Wanhee’s Youtube Video

1. Classical Economics (Adam Smith, David Ricardo)

• Core Idea: Views the economy as a self-regulating machine that functions best with minimal government intervention (Laissez-faire).
• Key Figure: Adam Smith (“The Wealth of Nations,” 1776). Introduced the concept of the “Invisible Hand,” where individuals pursuing their self-interest inadvertently benefit society as a whole (e.g., a baker seeking profit provides bread).
• Mechanism: Believes prices, wages, and markets naturally adjust to reach equilibrium through supply and demand.
• Key Figure 2: David Ricardo introduced the theory of “Comparative Advantage,” suggesting countries benefit most by specializing in producing goods where they have a relative efficiency advantage and trading.
• Warning: Government interference (tariffs, price controls) disrupts this natural, efficient order.

2. Marxian Economics (Karl Marx)

• Core Idea: Contrasts sharply with Classical thought, viewing capitalism not as harmonious but as a “battlefield” characterized by exploitation.
• Key Figure: Karl Marx (writing during the Industrial Revolution).
• Concept: Based on the “Labor Theory of Value,” where the value of a product is determined by the labor required to produce it.
• Exploitation: Argues capitalists (owners) extract “Surplus Value” – the difference between the value created by workers and the wages they receive – leading to the owners’ wealth. This exploitation is seen as inherent to capitalism.
• Prediction: Believed this exploitation would create internal contradictions, leading to capitalism’s eventual collapse and replacement by socialism, then communism (Historical Materialism).

3. Game Theory (John von Neumann, John Nash)

• Core Idea: Analyzes strategic interactions where individuals’ outcomes depend on the choices made by others, like a chess game.
• Key Figures: John von Neumann, John Nash (“A Beautiful Mind”).
• Focus: How rational individuals behave in interdependent situations.
• Example: The “Prisoner’s Dilemma” illustrates how individually rational choices (betraying a partner) can lead to a collectively worse outcome than cooperation (both staying silent).
• Concept: “Nash Equilibrium” – a state where no participant can improve their outcome by unilaterally changing their strategy, given the other players’ strategies.
• Applications: Widely used to understand arms races, price wars, climate negotiations, business strategy, auctions, etc. Highlights the “tragedy of rational self-interest.”

4. Neoclassical Economics

• Core Idea: Emerged in the late 19th century, shifting focus from social classes to individual rational choices and utility maximization.
• Concept: Introduced “Marginalism” – the idea that value is determined by the marginal utility (additional satisfaction) gained from consuming one more unit of a good.
• Example: Explains the “Law of Diminishing Marginal Utility” (e.g., the decreasing satisfaction from each additional pizza slice) and the water-diamond paradox.
• View of Economy: A system driven by supply and demand, where rational individuals and firms seek to maximize utility and profit, respectively, moving towards equilibrium. Prices act as crucial signals.
• Model: Uses “Perfect Competition” as an ideal benchmark for market efficiency.

5. Keynesian Economics (John Maynard Keynes)

• Context: Developed in response to the Great Depression, challenging the idea that markets always self-correct.
• Key Figure: John Maynard Keynes (1936).
• Core Idea: Aggregate demand (total spending) is the primary driver of the economy, and government intervention is necessary during downturns.
• Problem: The “Paradox of Thrift” – during recessions, increased individual saving leads to decreased overall spending, worsening the downturn.
• Solution: Advocated for active government intervention (fiscal policy) – increasing spending (on infrastructure, etc.) or cutting taxes – to boost aggregate demand and “prime the pump.”
• Concept: “Multiplier Effect” – each dollar of government spending creates more than a dollar in overall economic activity.

6. Supply-Side Economics (Arthur Laffer)

• Context: Rose to prominence in the 1980s (associated with Reagan), reacting against Keynesian demand-side focus.
• Core Idea: Focus should be on boosting production (supply) by reducing barriers like high taxes and regulations.
• Mechanism: Tax cuts, especially for businesses and high earners, incentivize investment and work, leading to economic growth.
• Concept: “Laffer Curve” suggests that cutting high tax rates could potentially increase total tax revenue by stimulating economic activity.
• Concept 2: “Trickle-Down Economics” – benefits given to the wealthy and corporations will eventually benefit everyone through job creation and investment.
• Critique: While associated with economic booms, also linked to increased deficits and inequality; the extent to which tax cuts “pay for themselves” is heavily debated.

7. Monetarism (Milton Friedman)

• Context: Gained influence during the 1970s stagflation.
• Key Figure: Milton Friedman.
• Core Idea: Control of the money supply is key to economic stability. Argued that “inflation is always and everywhere a monetary phenomenon.”
• Mechanism: Excessive money printing devalues currency and causes inflation.
• Critique of Keynesianism: Government attempts to “fine-tune” the economy often fail due to time lags and imperfect information.
• Solution: Advocated for a stable, predictable growth rate in the money supply managed by the central bank, rather than active fiscal policy.
• Concept: “Natural Rate of Unemployment” – a baseline unemployment level exists; trying to push below it mainly causes inflation.

8. Development Economics (Amartya Sen, Muhammad Yunus)

• Core Question: Why are some countries rich and others poor?
• Focus: Goes beyond capital and labor to include institutions, culture, history, health, and education.
• Concept: “Poverty Traps” – vicious cycles where poverty perpetuates itself (e.g., poor health → low productivity → low income → poor health).
• Solutions: Emphasizes targeted interventions like microfinance (small loans), conditional cash transfers (incentivizing education/health), and improvements in health/nutrition (like iodized salt).
• Key Lesson: Sustainable development requires building strong institutions (rule of law, property rights, education systems, stable governance) alongside economic factors.

9. Austrian School (Carl Menger, Friedrich Hayek, Ludwig von Mises)

• Core Idea: Emphasizes individual action, subjective value, and skepticism towards mathematical modeling and central planning. Economics is about human action.
• Concept: “Austrian Business Cycle Theory” – blames boom-bust cycles on central bank manipulation of interest rates, leading to malinvestment.
• Critique: Argues central planning is impossible due to the “knowledge problem” (no planner can know enough).
• Mechanism: Free markets, through the price system, create “Spontaneous Order” by coordinating millions of individual plans automatically.
• Value: Strong emphasis on individual freedom and limited government.

10. Behavioral Economics (Daniel Kahneman, Amos Tversky)

• Core Idea: Integrates psychological insights into economics, challenging the assumption of perfect rationality.
• Key Figures: Daniel Kahneman, Amos Tversky.
• Findings: Humans rely on biases and heuristics (mental shortcuts), leading to predictable irrationality (e.g., loss aversion, framing effects, present bias, herd behavior).
• Concept: “Bounded Rationality” – people often “satisfice” (choose good enough) rather than optimize.
• Implication: Markets may not be perfectly efficient if participants aren’t perfectly rational.
• Application: “Nudges” – designing choices to gently guide people towards better decisions without restricting freedom.

11. New Institutional Economics (NIE) (Ronald Coase, Douglass North)

• Core Idea: Recognizes that markets are not frictionless and emphasizes the crucial role of institutions in economic performance.
• Key Figures: Ronald Coase, Douglass North.
• Concept: “Transaction Costs” (search, bargaining, enforcement costs) explain the existence of firms and other institutions, which evolve to minimize these costs.
• Concept 2: “Path Dependency” – historical development of institutions shapes and constrains current economic possibilities.
• Focus: Understanding how institutions (formal rules like laws, informal rules like culture) affect economic outcomes and development.

12. Public Choice Theory (James Buchanan, Gordon Tullock)

• Core Idea: Applies economic analysis (rational self-interest) to political actors (politicians, bureaucrats, voters).
• Key Figures: James Buchanan, Gordon Tullock.
• Finding: Political actors often act in their self-interest (seeking votes, larger budgets) rather than purely for the “public interest.”
• Concept: “Concentrated Benefits and Dispersed Costs” explains why special interests often succeed in obtaining favorable policies (like tariffs or subsidies) even if they harm the general public, as the benefits are large for a few, while costs are small for many.
• Concept 2: “Regulatory Capture” – industries can influence or “capture” the agencies meant to regulate them.
• Solutions: Proposes constitutional rules, checks and balances, and inter-jurisdictional competition to limit inefficient or self-serving government actions.