Economics is the science that studies how societies produce goods and services and how they consume them. Economic theory has influenced global finance at many important junctures throughout history and is an integral factor in our everyday lives. However, the assumptions that guide the study of economics have changed dramatically throughout history. Here we take just a brief look at the history of economic thought.
- Civilizations in the Middle East, China, and elsewhere employed sophisticated financial concepts and produced written guides of best economic practices and norms in the first millennium BCE.
- Tunisian philosopher Ibn Khaldun, writing in the 14th century, was among the first theorists to examine division of labor, profit motive, and international trade.
- In the 18th century, Scottish economist Adam Smith used the ideas of French Enlightenment writers to develop a thesis on how economies should work, and in the 19th century, Karl Marx and Thomas Malthus expanded on his work.
- Late-19th century economists Léon Walras and Alfred Marshall used statistics and mathematics to express economic concepts, such as economies of scale.
- John Maynard Keynes developed theories in the early 20th century that the Federal Reserve still uses to manage monetary policy today.
- Most modern economic theories are based on the work of Keynes and the free-market theories of Milton Friedman, which suggest more capital in the system lessens the need for government involvement.
- More recent theories, such as those of Harvard University economist Amartya Sen, argue for factoring ethics into social welfare calculations of economic efficiency.
Economics in the Ancient World
Economics in its basic form began during the Bronze Age (4000-2500 BCE) with written documents in four areas of the world: Sumer and Babylonia (3500-2500 BCE); the Indus River Valley Civilization (3300-1030 BCE), in what is today’s Afghanistan, Pakistan, and India; along the Yangtze River in China; and in Egypt’s Nile Valley, beginning around 3500 BCE. Societies in these areas developed notation systems using markings on clay tablets, papyrus, and other materials to account for crops, livestock, and land. These accounting systems, arising in tandem with written language, eventually included methods for tracking property transfers, recording debts and interest payments, calculating compound interest, and other economic tools still used today.
From the third millennium BCE onward, Egyptian scribes recorded the collection of and redistribution of land and goods. Sumerian traders developed methods to calculate compound interest over a period of months and years. The Code of Hammurabi (circa 1810–1750 BCE), the earliest work of economic synthesis, specifies norms for economic activity and provides a detailed framework for commerce, including business ethics for merchants and tradespeople.
The first millennium BCE saw the emergence of more detailed written treatises on economic thought and practice. The Greek philosopher and poet Hesiod, writing in the eighth century BCE, laid out precepts for managing a farm in his Works and Days. Athenian military leader, philosopher, and historian Xenophon built on this in Oikonomikon, a treatise on the economic management of an estate. In Politics, Aristotle (circa 350 BCE) took these ideas further still, concluding that while private ownership of property was preferred, the accumulation of wealth for its own sake was “dishonorable.”
The Guanzi essays from China (circa the fourth century BCE) laid out one of the first explanations of supply and demand pricing; the crucial roles of a well-managed money supply and a stable currency. Among key insights was the notion that it was money, not armies, that ultimately won wars.
In Western Europe during the Middle Ages, economic theory was often blended with ethics, as seen in the work of Thomas Aquinas (1225-1274) and others. Few of those writers went into the amount of detail that Ibn Khaldun (1332-1406), Tunisian historian and philosopher, did. In Al-Muqaddimah, Ibn Khaldun analyzes economic issues such as the perils of monopolies, the benefits of division of labor and the profit motive, and the rise and fall of economic empires. The importance of his work was recognized by Machiavelli and Hegel, and many of his ideas prefigure those of Adam Smith and those who followed him centuries later.
The Father of Modern Economics
Today, Scottish thinker Adam Smith is widely credited with creating the field of modern economics. However, Smith was inspired by French writers publishing in the mid-18th century, who shared his hatred of mercantilism. In fact, the first methodical study of how economies work was undertaken by the French physiocrats, notably Quesnay and Mirabeau. Smith took many of their ideas and expanded them into a thesis about how economies should work, as opposed to how they do work.
Smith believed that competition was self-regulating and governments should take no part in business through tariffs, taxes, or other means unless it was to protect free-market competition. Many economic theories today are, at least in part, a reaction to Smith's pivotal work in the field, namely his 1776 masterpiece The Wealth of Nations. In this treatise, Smith laid out several of the mechanisms of capitalist production, free markets, and value. Smith showed that individuals acting in their own self-interest could, as if guided by an "invisible hand," create social and economic stability and prosperity for all.
Even devout followers of Smith’s ideas recognize that some of his theories were either flawed or have not aged well. Smith distinguishes between “productive labor,” such as manufacturing products that can be accumulated, and “unproductive labor,” such as tasks performed by a “menial servant,” the value of which “perish[es] in the very instant of their performance.” One could argue that in today’s service-dominant economy, the excellent execution of services creates value by strengthening a brand through goodwill and in numerous other ways. His assertion that “equal quantities of labour, at all times and places, may be said to be of equal value to the labourer” ignores the psychological cost of working in hostile or exploitative environments. As an extension of this, Smith’s labor theory of value—that the value of a good can be measured by the hours of labor needed to produce it—has also largely been abandoned.
The Dismal Science: Marx and Malthus
Thomas Malthus and Karl Marx had decidedly poor reactions to Smith's treatise. Malthus was one of a group of economic thinkers of the late 18th and early 19th centuries who were grappling with the challenges of emergent capitalism following the French Revolution and the rising demands of a burgeoning middle class. Among his peers were three of the greatest economic thinkers of the age, Jean-Baptiste Say, David Ricardo, and John Stuart Mill.
Malthus predicted that growing populations would outstrip the food supply. He was proved wrong, however, because he didn't foresee technological innovations that would allow production to keep pace with a growing population. Nonetheless, his work shifted the focus of economics to the scarcity of goods, rather than the demand for them.
This increased focus on scarcity led Marx to declare that the means of production were the most important components of any economy. Marx took his ideas further and became convinced a class war was going to be sparked by the inherent instabilities he saw in capitalism. However, Marx underestimated the flexibility of capitalism. Instead of creating a clear division between two classes—owners and workers—the market economy created a mixed class wherein owners and workers held the interests of both parties. Despite his overly rigid theory, Marx accurately predicted one trend: businesses grow larger and more powerful to the degree that free-market capitalism allows.
The Marginal Revolution
As the ideas of wealth and scarcity developed in economics, economists turned their attention to more specific questions about how markets operate and how market prices are determined. English economist William Stanley Jevons (1835-1882), Austrian economist Carl Menger (1840-1921), and French economist Léon Walras (1834-1910) independently developed a new perspective in economics known as marginalism.
Their key insight was that in practice, people aren't actually faced with big-picture decisions over entire general classes of economic goods. Instead, they make their decisions around specific units of an economic good as they choose to buy, sell, or produce each additional (or marginal) unit. In doing so, people balance the scarcity of each good against the value of the use of the good at the margin.
These decisions explain, for example, why the price of an individual diamond is relatively higher than the price of an individual unit of water. Though water is a basic need to live, it is often plentiful, and though diamonds are often purely decorative, they are scarce. Marginalism quickly became, and remains, a central concept in economics.
Speaking in Numbers
Walras went on to mathematize his theory of marginal analysis and made models and theories that reflected what he found. General equilibrium theory came from his work, as did the practice of expressing economic concepts statistically and mathematically instead of just in prose. Alfred Marshall took the mathematical modeling of economies to new heights, introducing many concepts that are still not widely understood, such as economies of scale, marginal utility, and the real-cost paradigm.
It is nearly impossible to expose an economy to experimental rigor; therefore, economics is on the edge of science. Through mathematical modeling, however, some economic theory has been rendered testable. The theories developed by Walras, Marshall, and their successors would develop in the 20th century into the neoclassical school of economics—defined by mathematical modeling and assumptions of rational actors and efficient markets. Later, statistical methods were applied to economic data in the form of econometrics, giving economists the ability to propose and test hypotheses empirically and in a methodologically rigorous manner.
Keynes and Macroeconomics
John Maynard Keynes developed a new branch of economics known as Keynesian economics, or more generally as macroeconomics. Keynes styled the economists who had come before him as "classical" economists, and he believed that while their theories might apply to individual choices and goods markets, they did not adequately describe the operation of the economy as a whole.
Instead of marginal units or even specific goods markets and prices, Keynesian macroeconomics presents the economy in terms of large-scale aggregates that represent the rate of unemployment, aggregate demand, or average price-level inflation for all goods. Keynes's theory says that governments can be powerful players in the economy and save it from recession by implementing expansionary fiscal and monetary policy—manipulating government spending, taxing, and money creation—in order to manage the economy.
The Neoclassical Synthesis
By the mid-20th century, these two strands of thought—mathematical, marginalist microeconomics and Keynesian macroeconomics—would rise to near-complete dominance of the field of economics throughout the Western world. This became known as the neoclassical synthesis, which has since represented the mainstream of economic thought as taught in universities and practiced by researchers and policymakers, with other perspectives labeled as heterodox economics.
Within the neoclassical synthesis, various streams of economic thought have developed, sometimes in opposition to one another. The inherent tension between neoclassical microeconomics—which portrays free markets as efficient and beneficial—and Keynesian macroeconomics—which views markets as inherently prone to calamitous failure—has led to persistent academic and public policy disagreements, with different theories ascendant at different times.
Various economists and schools of thought have sought to refine, reinterpret, redact, and redefine both neoclassic microeconomics and Keynesian macroeconomics. Most prominent is monetarism and the Chicago School, developed by Milton Friedman, which retains neoclassical microeconomics and the Keynesian macroeconomic framework but shifts the emphasis of macroeconomics from fiscal policy (favored by Keynes) to monetary policy. Monetarism was widely espoused through the 1980s, '90s, and 2000s.
Several different streams of economic theory and research have been proposed to resolve the tension between micro- and macroeconomics by incorporating aspects or assumptions from microeconomics (such as rational expectations) into macroeconomics or by further developing microeconomics to provide micro-foundations (such as price stickiness or psychological factors) for Keynesian macroeconomics. In recent decades, this has led to the development of new theories, such as behavioral economics, and to renewed interest in heterodox theories, such as Austrian-school economics, which were previously relegated to the economic backwaters.
Classical economic theory and theory of markets, from Smith through Friedman, have rested largely on the assumption that consumers are rational actors who behave in their own best interests. Current economists such as Richard Thaler, Daniel Kahneman, Gary Becker, and the late Amos Tversky, have shown that people often do not act in their own best material interests but allow themselves to be swayed by non-material, psychological factors, and biases.
Behavioral economics has helped to popularize a number of new concepts that make economic modeling and forecasting more difficult than ever. These concepts include:
- The sunk cost fallacy: Continuing to invest in a failing project because of what has been invested so far.
- Availability heuristics: Thinking a certain consequence of an action is more likely because it comes more easily to mind than other outcomes.
- Bounded rationality: People acting without complete information when they know that more information is available.
Factoring in Social Benefit
A rising cohort of economists has emphasized the importance of factoring in inequalities in income distribution and social well-being when measuring the success of a given economic policy. Pre-eminent among them is Anthony Atkinson (1944-2017), who focused on income redistribution within a given country, and Amartya Sen, professor of economics and philosophy at Harvard University, whose work on global inequality won him the Nobel Prize for Economics in 1998. Sen’s work is also notable for reintroducing ethical behavior into his analysis. This concern ties Sen’s thinking back to the writing of the earliest economic thinkers, who saw over-accumulation of wealth by individuals or groups as ultimately harmful to society.
The Bottom Line
Economic theory grew out of societies’ need to account for resources, plan for the future, and exchange and allocate goods. Over time, these basic accounting tools grew into financial models of increasing complexity, blending the mathematics required to calculate compound interest, with ethics and moral philosophy. Economics as a system to understand and control the material world and mitigate risk emerged and evolved across the globe in a staggered fashion—the Fertile Crescent and Egypt, China and India, ancient Greece and the Arab world.
As societies grew wealthier and trade grew more complex, economic theory turned to the mathematics, statistics, and computational modeling that economists use to help guide policymakers. The business cycle, booms and busts, anti-inflation measures, and mortgage interest rates are outgrowths of economics. Understanding them helps the market and government adjust for these variables. Balancing out the mathematical modeling approach is the study of factors that are more difficult to quantify but crucial to understand—most notably, the foibles and unpredictability of human psychology.