Neo Classical School HS 419

1. Neo Classical SchoolHS 419 Lecture 6

2. Three critical questions • 1. What ends do we desire? • 2. What limited or scarce resources do we need to attain these ends ? • 3. What ends get priority and to what extend should we allocate resources to them? • The last question cannot be answered without answering the first and the second questions

3. Traditionally – the answer to the first question – ‘Utility or human welfare’ • Welfare depends on what people want which they reveal through market transactions – by what goods and services they buy or sell • This only reflects preferences for market goods and assumes that non market goods contribute little to welfare • Since human wants are insatiable – welfare is increased through ever increasing provision of goods and services as measured by their market value – hence unending economic growth is an adequate , measurable proxy for the desired end.

4. Neo Classical View • Market – leads to efficient allocation of scarce resources – pereto efficient allocation – a situation in which no other allocation of resources would make at least one person better off without making someone else worse off. • Efficiency is so important in Neo classical view that sometimes it is taken as the end in itself

5. The circular Flow Diagram

6. What does it mean? • Even today the Economy is often portrayed as a closed, isolated system in economic textbooks, similar to a clockwork or the circular flow model depicted in the Figure • Hence there are no inflows from and outflows to the environment. • The supply of natural resources and the capacity to absorb waste are therefore not perceived as limiting factors for economic development.

7. A closed system • The economy is portrayed as a closed, isolated system • Hence there are no inflows from and outflows to the environment.

8. Environment as a subset of economy

9. The Marginal Analysis • The neo-classical economics formulated precise “economic laws” regarding consumption, production and distribution based on the theory of optimisation through calculation of cost and benefit at the margin. • The consumer optimises his purchasing power by equalising the marginal utility of all commodities, purchased according to his scale of preference, derived from the last unit of money spent on them. • The producer optimises the use of the factors of production by equalising their marginal productivity to the amount paid (that is, wage equals marginal productivity of labour, rate of interest equals the marginal efficiency of capital and rent to marginal productivity of land . • A firm would produce up to the point where marginal cost equals marginal revenue.

10. There would be the tendency towards equilibrium in the market at which point demand and supply of goods, services and factors of production would be in balance through the operation of the price mechanism. • If at any time demand exceeds supply there would be the tendency for the price to go up which would result in fall in demand and increase in supply, the latter because of increase in the profit margin. • In the case of some commodities there would be equilibrium in the short run while in the case of others it would be in the long run depending on the elasticity of supply.

11. Mathematical Economic • TWO economists of the neo-classical school, namely, William Stanley Jevons of Manchester University and Leon Walras, of Lausaune University felt that the economic laws being concerned with quantities lend themselves to mathematical formulations. • They introduced mathematical systems of analysis. Walras pioneered the concept of “general equilibrium” based on simultaneous equations relating to all the transactions in the economy. The culmination of the mathematical approach to economics was P.A. Samuelson’s “Foundations of Economics” (1947), a 379-page book of mathematical formulations. • Econometrics evolved as a specialised branch of Economics but it had no empirical content. • The classical economists used the term “Political Economy”; after the 1870s the term went out of fashion and was replaced by the term “Economics”.

12. Alfred Marshall, defined Economics in wider terms. On the first page of Principles (1890) he gave the following definition: “Political Economy or Economics is the study of mankind in the ordinary business of life, it examines that part of individual and social action which is most closely connected with the attainment and the use of material requisites of well being.” • The break came in 1932 with the publication of the essay “Nature and Significance of Economics” by Prof Lionel Robbins. It re-defined Economics as the science of individual choice concerned with the optimum use of “means” which are limited for the attainment of “ends” which are unlimited. • Thus, Economics became a technical subject, cutting its umbilical knot with the social phenomena and social sciences. Its focus became narrow and highly specialised.

13. Great Depression • The greatest challenge was posed by the unprecedentedly severe and long lasting depression in the US economy from 1929 onwards. The laws of Neo-classical Economics required cut in wages to cut costs and create profits, which would stimulate business and raise the economy out of trough. But this did not happen. On the other hand cut in wages reduced demand and deepened depression. Market did not provide an automatic correction and public intervention on a massive scale in the shape of President Roosevelt’s New Deal Programme became necessary – Govt. intervention and not market !

14. Development Economics • From about the middle of the twentieth century, several countries of Asia and Africa started emerging as independent countries free from the yoke of imperialism of the Western countries. • They felt that political independence should be used for rapid economic development so that their peoples can get out of the vicious circle of poverty and enjoy better conditions of living and reduce the gap between their own living standard and that of the Western countries. • These countries came to be known as “developing” countries as compared to the “developed” countries of the West. • “Development” had to include building the infrastructure of transport, communication, education and health facilities, power generation, modernisation of agriculture, industrialisation and diversification of the economy. • Countries like India felt that such comprehensive and balanced development could not be left to the market forces of demand and supply; development had to be deliberately designed and fostered by the State. But the government has to be efficient. • A lot of economic literature emerged, and these came to be recognised as a distinct branch of Economics that is, “Economics of Development” for which academic courses were established as a part of the curriculum.

15. Eradication of poverty has been the greatest challenge before the developing countries. It was expected that if economic growth takes place, the fruits will eventually percolate to the poor. However, Micro-economics has not explained how the percolation theory works. • In several Latin American and African countries, poverty has proved intractable. Most of the decline in poverty is in China and to some extent in India. On the whole, the income level of poor countries has failed to cope up with the income level of rich countries.

16. Structural Adjustment Programme • Development Economics, however, suffered a set- back when as a part of the “Washington Consensus”, the World Bank and International Monetary Fund and later the World Trade Organisation after it was set up in 1995, started insisting that countries approaching them for assistance should strictly follow the Structural Adjustment Programme (SAP) which envisaged marketisation of the economy as against planning, liberalisation as against dirigisme or state control and regulation and privatisation as against the public sector, open economy as against autarky and fiscal discipline implying minimisation of public expenditure and “minimal state”.