FREE ESSAY ON LAISSEZ FAIRE

LAISSEZ FAIRE

laissez-faire 
Classical Laissez-faire Economics The earliest organized school of economic thought is
known as Classical. The father of this school is Adam Smith. Smith used the concept of
the invisible hand to describe the role of the market in the allocation of resources. In
the market, the interaction of demand and supply determines how much of a good will be
produced and the price that is charged for that good. Absent any explicit guidance
mechanism, the invisible hand guides participants in the market towards an outcome that
efficiently allocates resources to the production of goods that society desires. Other
important classical economists include David Ricardo who introduced and developed the
concepts of comparative advantage and the benefits of an open economy that participates
in international trade. J.B. Says presented what is today known as Say's Law: supply
creates its own demand. Say's law captures the essence of the classical school of
thought. The statement that supply creates its own demand implies that by producing goods
and services, firms create the jobs and incomes capable of buying those goods and
services. With economic foundations based on the role of markets, a theory generally free
of outside intervention, and emphasizing the role of production in determining income and
economic output, the classical school of thought has several important implications: ?
The government should play a minimal role in determining the condition of the economy.
The government does have an important place in areas such as providing a legal framework,
preventing abuses of the market, and to sustain national defense. However, extensive
government intervention will hinder the efficient operation of the market in the
determination of prices of goods and services and the allocation of resources towards
their production. ? The normal economic state of the economy is at full employment. This
implies that all workers that desire jobs will have them, and those who are unemployed
voluntarily choose to be so. ? The government has a minimal role over the course of the
business cycle, and left alone the economy will gravitate toward full employment. In the
long run, unemployment is not an important public policy concern as the unemployment
present will be voluntary. ? Economic analysis should emphasize the study of markets and
how they effectively operate. An Early Theory of Value One of the most important
questions early classical economists attempted to answer was how the value or price of a
good is determined. Smith described how the interaction of supply and demand in the
market determined a good's price. Smith needed to go further and explain why two goods
with identical demands would have different prices. According to Smith, the prices of
goods are determined by what it costs to produce them. Since the majority input used in
production during the eighteenth century was labor, Smith developed a labor-based theory
of prices. The price of a good reflects the amount of labor used in its creation. One
good's price is higher than another's because of the extra labor used in its production.
However, in Smith's model the price of a good is independent of the amount produced,
resulting in a horizontal supply curve. From this base, Ricardo introduced the idea of
diminishing returns in the factors of production. Diminishing returns in labor implies
that as additional workers are used in production, the incremental output from each added
worker is less than the output gained from hiring the previous worker. The quality of
workers does not contribute to diminishing returns; rather, factors outside the
individual worker's control yield this result. Ricardo used the example of agriculture.
Initially the best, most productive lands were farmed. But as the population grew,
marginal lands were harvested, bringing down the yield per acre. As a result, additional
labor would be needed to produce an extra bushel of grain. Due to diminishing returns,
the price of a good increases as the quantity produced increases, resulting in an
upward-sloping supply curve. Taking Ricardo's law of diminishing returns one step further
was Thomas Malthus. Malthus considered the increase in population that was occurring over
time in comparison to the fixed supply of land. With diminishing returns prominent as
increasing amounts of land are required to feed the growing population, there would
eventually be a shortage of food. Agricultural output per acre would expand at a
diminishing rate as increasingly marginal land was used to feed more and more people.
Eventually, Malthus predicted, famine and starvation would result. So far, Malthus's
predictions have not been realized on a global scale. Although starvation does occur, it
is a result of local conditions. At the present time, world food production is sufficient
to accommodate the world's people. Population growth accompanied by famine has not been a
problem due to the technological changes that have made workers and land more productive.
The use of increasing amounts of fertilizers and better capital has easily offset any
diminishing returns due to the use of lower quality land. In many cases, prices of goods
have fallen in the long-run as output has expanded. To complete the theory of price
determination, Alfred Marshall looked at the margin. Along the producer's supply curve,
higher prices are required to increase the quantity supplied. The supply curve shows the
increasing cost of making an additional (marginal) unit of the good; its upward slope
reflects increasing marginal costs. While along the consumer's demand curve, lower prices
are required to induce the consumer to buy that additional unit of the good produced. The
downward slope of the demand curve reflects decreasing marginal usefulness. By combining
demand and supply, Marshall showed how the two curves simultaneously determined price. A
Great Depression A course in macroeconomics teaches the student the role of the
government in dealing with business cycles. If economic thought had stopped with the
classical economists, there would be no need for a course in macroeconomics. As
mentioned, the classical economists believed that there was only a minimal role for the
government in the economy. The natural economic condition was at full employment, and the
government should not interfere with the efficient operation of markets which yield that
outcome. Economic recessions, even depressions, were temporary in nature. Left alone, the
economy would return to a level consistent with potential output. And so the world of
economic thought went until the Great Depression of the 1930s. For many industrialized
nations, output plummeted and unemployment rates soared during the 1930s. In the United
States, unemployment reached 25% and output dropped by over 30% from the level reached in
1929. The classical argument that falling prices and interest rates would restore
economic prosperity never occurred (1). The economy remained stuck. With high
unemployment, there was not enough consumer income to stimulate consumption and aggregate
demand. With falling demand for output, business investment sank. High tariffs prevented
an export-driven growth stimulus (2). (1) Flexible and falling prices, wages, and
interest rates could offset an economic slowdown in several ways. In a business downturn,
a decrease in labor demand and layoffs lead to a decrease in wages. Lower wages reduce
the relative price of employing labor relative to capital and create an offsetting
increase in the demand for labor. If prices fall further than wages, then purchasing
power increases. Furthermore, with falling prices, the value of wealth holdings also
increases - both effects contribute to increased consumption, offsetting the initial
decrease in aggregate demand that caused the economic downturn in the first place. Lower
interest rates improve the return on investment, resulting in an increase in business
investment and an increase in aggregate demand. (2) Several important factors combined to
make the 1930s a decade of extreme economic depression. ? During the 1920s, corporate,
bank, and individual participation and speculation in the stock markets was very high.
Investors, including banks, could buy stocks on margin, paying only a small percentage
(for example, 10%) of the stock's street value. This allowed for a tremendous amount of
leveraging and exposure in equity assets with only a moderate cash outlay. In addition,
banks could use customer deposits to buy stocks, further driving up share prices and
increasing the potential fall in prices. And prices did fall. From October 1929 to the
early 1930s, many stock prices lost over 90% of their value. For many Americans, their
savings and wealth evaporated almost overnight. ? As a result of the business downturn,
demand for goods and services plummeted, U.S. corporations responded by lobbying Congress
for increased protection from the import of foreign-made goods. Congress complied. Led by
Congressmen Smoot and Hawley, tariffs averaging 60% were placed on imported goods. Since
a tariff acts as a tax, this led to a corresponding increase in the price of these goods
to the American consumer. Foreign countries immediately reciprocated, shutting off
markets for U.S. exports. Global trade contracted, leading to a further deterioration of
the economy. ? With the economic downturn, incomes and tax payments declined. Believing a
balanced budget was of primary importance, President Hoover raised income and corporate
taxes, further decreasing disposable incomes and jobs. Stunned by the magnitude and
duration of the Depression, classical economists went into a funk. The traditional
classical solution to the business cycle - allow prices, wages, and interest rates to
adjust and wait it out, was not working. Wages, prices, and interest rates did fall, and
yet output continued to sink further, while the unemployment rate soared well beyond any
level justified as voluntary. The traditional catalysts for economic growth, consumption,
investment, and international trade were in a catatonic state. Massive unemployment,
coupled with a devastating loss in wealth, left consumption moribund. Businesses had no
reason to invest in expanding productive capacity when demand for their goods and
services had fallen off a cliff. Finally, the Smoot-Hawley tariffs led to a substantial
contraction in foreign trade activity and potential export markets in countries that were
doing better economically. This left only one sector of aggregate demand with the
potential to resurrect the economy: government spending. John Keynes pointed out the
obvious - when traditional methods of economic stimulus fail, use the government as a
last resort and use it forcefully. Keynes was an economist educated by classical
scholars. He took their theory a step further and exposed the shortcoming, establishing
his own ideas on the classical foundation and leaving his own school of economic thought
and policy. Keynes pointed out several problems with classical theory. An important point
was that wages tended to be sticky and would not fall as much as prices during economic
downturns. The result is an increase in real wages (w/p) and a decrease in the demand for
labor as the real cost of labor inputs increases. Keynes also developed the idea that
during periods of economic weakness investment tends to be relatively interest-inelastic,
or investment is relatively unresponsive to changes in the interest rate. Thus, a
decrease in the rate of interest will have little or no stimulative impact on the
investment component of aggregate demand. ____________________________________________ My
conclusion is simple. In addition to their strong moral base in personal freedom,
capitalism and competitive markets work to deliver substantial economic progress;
communism, socialism, even large bureaucratic welfare state third ways do not work. They
sap individual incentive, initiative, and creativity and ultimately cannot deliver
sufficiently rising standards of living to meet the expectations of their citizens for
better material lives for themselves and their progeny. Episodic economic downturns or
other perceived market failures create great opportunity for misplaced permanent
expansion of government's role in the economy. Clearly, we have learned that government
has a number of important roles to play in our economy and that we must remain vigilant
to make sure that it plays only those necessary roles in the least intrusive manner
possible. A consistent rules-based monetary policy, the lowest possible level and rates
of taxation, less command and control in favor of more flexible market-oriented incentive
regulation, slower growth of government spending including entitlement reform, and
expanded open rules-based trade are surely the lessons of economic history and would
surely be Adam Smith's wise prescription today. The theme of this year's NABE conference
is Winners and Losers of the 21st Century. Surely a large part of the answer to that
implicit question is those who can stay closest to the limited government capitalist
model in the face not only of the natural tendency of the government's role in the
economy to grow, but also the incredible impending demographic pressures that will
greatly reinforce this tendency. The calls for capital controls, greatly expanded taxes
and spending, vast new regulation, extensive industrial policy, and dangerous
protectionism threaten our economic progress and personal liberty. Such calls by pundits
and decriers of capitalism are frequent and occasionally frenetic, both inside and
outside the economics profession. Of course, as economies evolve and conditions change
(e.g., due to changing demography), the role of government based on the sound market
principles enunciated above may reasonably ebb and flow. But capitalism once again needs
its defenders, teachers, exemplars, and champions. The alternative models have proven
historically, intellectually, and practically bankrupt. We would all be better off if the
decriers of capitalism remained permanently discontented. ____________________________