Early economic theory was particularly inspired by the scientific thought of the time. Classical economics viewed money and its movement in a particular way. But how did classical economics view people and the market? Let us try and understand the peculiar relationship between the market and the people.
Money is Value
Money is the prime mover in business. Money is the bearer of economic value. Money is worth something. We use it to do two things: Either we trade it for other things we want, that is, we give it to someone else in order to acquire material goods or services. Or we use it to make more money; we invest it or lend it in order to get more later.
The reason we can use it for purchases and investment is that everyone else values it, too. But that value changes. So, money is not simply a fixed amount of spending power. What then is it? How do we know what it’s worth? Indeed, why is it worth anything?
This is a transcript from the video series Redefining Reality: The Intellectual Implications of Modern Science. Watch it now, on The Great Courses Plus.
The Science of Economics
Sociologists speak of economic classes and social capital coming from financial capital. Karl Marx argues that differences in wealth is the driving factor for all of human history. Max Weber contended that we can’t understand religious differences without understanding the different approaches to the value of money.
Economics as a science began in 18th century when relations between production, consumption, scarcity, and price began to be formulated. In classical economics, the idea was that we ought to be able to model the flow of money in the marketplace on our vision of energy flowing in a physical system.
Energy is transferred in predictable ways according to relationships between objects that are subject to rigorous formulation. Similarly, we should be able to determine how wealth is transferred, according to relationships between people and objects.
Physics and Economic Theory
Energy changes form from gravitational potential, to motion, to electricity, to heat; just as wealth changes forms from labor, to money, to resources, to goods.
When we have a group of particles interacting together, they find equilibrium—a stable state that high and low ends of the spectrum converge upon. Similarly, prices find equilibrium after a number of transactions through which suppliers and consumers interact with each other. The metaphor seemed perfect.
The problem, of course, is that in physics we’re dealing with objects that have no will. The rock does not choose to fall. People, on the other hand, decide for themselves. Hence, the objection that a science of economics would be impossible. Economics could only be scientific, could only produce universal quantifiable regularities, if humans behaved in predictable ways.
Early economists objected that this image of the capricious human is an empirical matter. If we look at the functioning of the marketplace, we actually observe a well-regulated system that acts and reacts in fully predictable ways. Human choices are not random; on the contrary, we can fully understand why humans do what they do in the marketplace.
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The Birth of the Economic Man
This was the birth of homo economicus—economic man. According to this view in classical economics, when people interact in the marketplace, their intentions are transparent. They want always and only what is in their own best self-interest. If they’re buying something they want or need, they want the most of it they can get for the smallest price. If they’re selling, they want to get the highest price possible.
This desire to maximize self-interest would be pointless if people were unable to figure out: A, what is in their own best self-interest. And B, how to get what’s in their own best self-interest. Fortunately, in this view, people are unlike rocks. We are rational. When two vendors make offers, we’re able to figure out which is the most advantageous to us. We know what we want, and we always choose the option that is the most favorable.
Setting Up Equilibrium
If humans act according to this model of perfect rational self-interest, then economic interactions become mathematically representable. We can draw supply curves. We can draw demand curves. We can place them, and see where they meet, and call it equilibrium. When we see prices set below this equilibrium, what do we see? Economic forces move the price up. When we see alternative products in the market that are cheaper, what do we see? We see the equilibrium point move down and the price change.
Note the word ‘equilibrium’, which is used a lot in classical economics. It is a term from thermodynamics. Following James Clerk Maxwell, we explain the macroscopic properties of the gas by appealing to the microscopic interactions of the particles that make it up, interactions which follow the deterministic laws of physics.
In the same way, in classical economics, the macro-level fiscal phenomena derives directly from one-on-one interactions of buyers and sellers in the marketplace. What happens at the micro level, between individual producers, laborers, and consumers, is predictable since they’re all seeking only to maximize their own self-interest.
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From Micro to Macro
When we have a great number of these interactions together, the behavior of the economy in the large, at the macro-level, is also directly determinable. Maxwell used the assumption of well-regulated elastic collisions among gas particles in an inflated body to derive the large-scale ideal gas law governing the macro-level relations among thermodynamic quantities.
Classical economists used the picture of interactions guided by self-interest at the micro-level to derive laws governing the macro-level relations among fiscal quantities. Indeed, if you look at the economists’ lexicon, you find many, many thermodynamic terms. Economists speak of ‘elasticity’, ‘inflation’, ‘equilibrium’, ‘efficiency’, ‘work’. They talk about the economy heating up or cooling down. This isn’t an accident.
So, we see that classical economics is based on two primary assumptions: First, at the micro-level, all financial interactions are between people who always act rationally and who act in the own best self-interest. Second, the large-scale behavior of the economy is the result of the well-behaved small-scale interactions. It seemed as if these two presuppositions were needed if economics as a science was even possible.
Common Questions about Classical Economics
Economics as a science began in 18th century when relations between production, consumption, scarcity, and price began to be formulated.
In classical economics, the idea of homo economicus, economic man, is that when people interact in the marketplace, their intentions are transparent. They always want what is in their own best self-interest.
Classical economics is based on two primary assumptions: First, at the micro-level, all financial interactions are between people who always act rationally and who act in the own best self-interest. Second, the large-scale behavior of the economy is the result of the well-behaved small-scale interactions.