Economic Theories

Updated 2009-09-21 11:09



The word "economics" is derived from oikonomikos, which means skilled in household management. Although the word is very old, the discipline of economics as we understand it today is a relatively recent development. Modern economic thought emerged in the 17th and 18th centuries as the western world began its transformation from an agrarian to an industrial society.


Despite the enormous differences between then and now, the economic problems with which society struggles remain the same:


How do we decide what to produce with our limited resources?
How do we ensure stable prices and full employment of our resources?
How do we provide a rising standard of living both for ourselves and for future generations?


Progress in economic thought toward answers to these questions tends to take discrete steps rather than to evolve smoothly over time. A new school of ideas suddenly emerges as changes in the economy yield fresh insights and make existing doctrines obsolete. The new school eventually becomes the consensus view, to be pushed aside by the next wave of new ideas.


This process continues today and its motivating force remains the same as that three centuries ago: to understand the economy so that we may use it wisely to achieve society's goals.

Economic Theories

Universal Economic Problems With Which Society StrugglesHow do we decide what to produce with our limited resources?; How do we ensure stable prices and full employment of our resources?; How do we provide a rising standard of living both for ourselves and future generations?
MercantilismDuring the 16-17th centuries; held prosperity of a nation is dependent upon its supply of capital, and that the global volume of trade is "unchangeable". Capital represented by amount of gold & silver held by the state and best increased through a positive trade balance (NX=X-M); ruling government should play protectionist role in the economy by encouraging exports (with subsidies) and discouraging imports (with tariffs); represented the elevation of commercial interests to the level of national policy.
PhysiocratsGroup of 18th century French philosophers, immediately preceding Classical School, who believed that agriculture was the sole source of wealth in an economy. Opposed to Mercantilism's copious trade regulations, they advocated a policy of laissez-faire policies; from Greek: literally "Government of Nature"; Francois Quesnay and Pierre Samuel Du Pont
Classical School During late 18th-mid 19th centuries, widely regarded as the first modern school of economic thought and associated with the idea that free markets can regulate themselves. Began with A Smith's W.O.N. (1776). Ricardo, Malthus, and John Stuart Mill other prominent figures.
MarginalismEmphasized that prices depend upon the level of demand, which in turn depends upon the amount of consumer satisfaction provided by individual goods or services(Consumer Utility); it provided modern tools of Demand and Supply and Consumer Utility; also a mathematical framework for using those tools. Furthermore showed that in a free market economy, factors of production -- land, labor, and capital -- receive returns equal to their contributions to production. (used to explain disparate distribution of income at the time)
Marxian EconomicsInspired by Karl Marx's mid-19th century Das Kapital (edited by Friedrich Engels), it challenged the foundations of Classical Theory. Marx believed that capitalism would destroy itself and be succeeded by a world without private property. Advocated the Labor Theory of Value; that is, all production belongs to labor because workers produce all value within society. Believed that the market system allows capitalists to exploit workers by denying them a fair share of their product. Also predicted capitalism would reduce number of workers through labor-saving machinery, thus creating a "reserve army of unemployed" who would rebel against capitalists and seize the means of production.
Institutional EconomicsRegarded individual economic behavior as part of larger social pattern influenced by current ways of living and modes of thought. Rejected Classical view that people are primarily motivated by economic self-interest. Opposed laissez-faire policies toward government's role in economy and called for government controls and social reform to bring about more equal distribution of income. Also focused on role of institutions in eliminating transaction costs.
Keynesian SchoolArgues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the government, including monetary policy (central bank; money supply and interest rates) and fiscal policy (government spending and revenue collection) to stabilize output. Analytic framework remains the core of modern macroeconomic analysis. A middle ground between laissez-faire capitalism and socialism.
MonetarismUpdates the Quantity Theory, the basis for macroeconomic analysis before Keynes. It reemphasizes the critical role of monetary growth in determining inflation.
Rational Expectations TheoryProvides a contemporary rationale for the pre-Keynesian tradition of limited government involvement in the economy. It argues that the market's ability to anticipate government policy actions limits their effectiveness.
Supply-side EconomicsRecalls the Classical School's concern with economic growth as a fundamental prerequisite for improving society's material well-being. It emphasizes the need for incentives to save and invest if the nation's economy is to grow.
Neoclassical EconomicsApproach to economics which focuses on the determination of prices, outputs, and income distributions in markets through supply and demand, often as mediated through a maximization of utility by both individuals and firms in accordance with rational choice theory. Dominates microeconomics, and together with Keynesian economics forms the neoclassical synthesis, which dominates mainstream economics today.

Historical Economists & Texts

"Wealth of Nations"Written by Adam Smith in 1776; widely regarding as beginning of Classical School. Described "invisible hand"; identified land, labor, and capital as factors of production; and emphasized production of income. Agreed with Physiocrats' laissez-faire policies, but comparisons stopped there.
David RicardoFocused on the distribution of income (as opposed to Smith's production of income). He saw conflict between landowners on one hand and labor and capital on the other. Posited that rapid growth of population and capital, pressed against a fixed supply of land, pushes up rents and holds down wages and profits.
Thomas Robert MalthusArgued population tended to outstrip production of food; contended the force of a growing population against a limited amount of land meant diminishing returns to labor which resulted in chronically low wages and prevented the raising of standards of living. Questioned automatic tendency of market economy to produce full employment. Blamed unemployment on consumer tendencies to save (Keynes revived this notion in 1930s)
John Stuart MillRounding out Classical School, he parted company with the earlier classical economists on the inevitability of the distribution of income produced by the market system. Instead pointed to distinct differences between the market's two roles: allocation of resources and distribution of income; said the Market is efficient in allocating resources but not in distributing income, therefore society must intervene.
"General Theory of Employment, Interest, and Money"Written in 1936 by British economist John Maynard Keynes in response to the worldwide Great Depression. It broke from Classical views of recessions. Instead Keynes held that falling prices and wages, by depressing people's incomes, would prevent a revival of spending.

Buzz Words

TermBuzz Word
Universal Economic Problems With Which Society StrugglesProduce? Stable Pricing? Rising Standards
Mercantilism16th-17th, Unchangeable, Bullion, Balance of Trade (X-M), Protectionism
Physiocrats18th, Agriculture, Laissez-Faire
Classical SchoolLate 18th to Mid 19th, First Modern School, Self Regulated, WON
MarginalismConsumer Utility --> Demand --> Price, S&D Models and Marginal Utility, Inputs (FOP) = Outputs
Marxian Economics19th, Das Kapital, Capitalism Implosion, Labor Theory of Value, "army of unemployed"
Institutional EconomicsSocial Patterns, no "self interest" or laissez-faire, Govt Policy, Social Reform
Keynesian SchoolInefficient, Monetary & Fiscal Policy, Middle Ground
MonetarismUpdates Quantity Theory (price and inflation positive correlation), Monetary Growth
Rational Expectations TheoryRationale for Ltd Govt interaction, Anticipation
Supply-side EconomicsEconomic Growth, Saving and Investing
"Wealth of Nations"1776, Adam Smith, Invisible Hand, Factors of Production, Laissez-Faire
David RicardoDistribution not Production, Land vs. Labor & K
Thomas Robert MalthusOutstrip, Diminishing Returns to Labor
John Stuart MillLast Classical, Resources vs. Distribution
"General Theory of Employment, Interest, and Money"136, Keynes, Recessionary Tendencies



Economic theories are constantly changing. Keynesian theory, with its emphasis on activist government policies to promote high employment, dominated economic policymaking in the early post-war period. But, starting in the late 1960s, troubling inflation and lagging productivity prodded economists to look for new solutions. From this search, Monetarism, Rational Expectations Theory, and Supply-side Economics emerged.


These theories and others will be debated and tested. Some will be accepted, some modified, and others rejected as we search to answer these basic economic questions: How do we decide what to produce with our limited resources? How do we ensure stable prices and full employment of resources? How do we provide a rising standard of living both for now and the future?