Economics is the science that concerns itself with economies; that is, it studies how societies produce goods and services as well as how they consume them. It has influenced global finance at many important junctions throughout history and is a vital part of 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 modern economic thought. What we present is just a narrow snapshot, which focuses primarily on Western European and American strands of thought.
KEY TAKEAWAYS
Economics is the science of how goods and services are produced and consumed.
Adam Smith used the ideas of French writers to create a thesis on how economies should work, while Karl Marx and Thomas Malthus expanded on his work—focusing on how scarcity drives economies.
Leon Walras and Alfred Marshall used statistics and mathematics to express economic concepts, such as economies of scale.
John Maynard Keynes' economic theories are still used today by the Federal Reserve to manage monetary policy.
Most modern economic theories are based on the work of Milton Friedman, which suggests more capital in the system lessens the need for government involvement.
The Father of Economics
Economic thought goes as far back as the ancient Greeks and is known to have been an important topic in the ancient Middle East. Today, Scottish thinker Adam Smith is widely credited for creating the field of economics. However, he was inspired by French writers who shared his hatred of mercantilism. In fact, the first methodical study of how economies work was undertaken by these French physiocrats. 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 book, 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.
The Dismal Science: Marx and Malthus
Karl Marx and Thomas Malthus had decidedly poor reactions to Smith's treatise. Malthus predicted that growing populations would outstrip the food supply.1 He was proven wrong, however, as 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 things, rather than the demand for them.
This increased focus on scarcity led Karl Marx to declare the means of production were the most important components in any economy. Marx took his ideas further and became convinced a class war was going to be initiated by the inherent instabilities he saw in capitalism.2 However, Marx underestimated the flexibility of capitalism. Instead of creating a clear owner and worker class, investing created a mixed class where owners and workers hold the interests of both parties. Despite his overly rigid theory, Marx did accurately predicted one trend: businesses grew larger and more powerful, to the degree that free-market capitalism allowed.
The Marginal Revolution
As the ideas of wealth and scarcity developed in economics, economists turned their attention to asking more specific questions about how markets operate and how market prices are determined. English economist William Stanley Jevons, Austrian economist Carl Menger, and French economist Leon Walras independently developed a new perspective in economics known as marginalism.345 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. 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 there. General equilibrium theory came from his work, as did the tendency to express 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 fully understood, such as economies of scale, marginal utility, and the real-cost paradigm.6
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.
Keynes and Macroeconomics
John Maynard Keynes developed a new branch of economics known as Keynesian economics, or more generally as macroeconomics.7 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 policy makers, with other perspectives labeled as heterodox economics.8
Within the neoclassical synthesis, various streams of economic thought have developed, sometimes in opposition to one another. Largely due to the inherent tension between neoclassical microeconomics, which portrays free markets as mostly efficient and beneficial, and Keynesian macroeconomics, which views markets as inherently prone to calamitous failure that threatens society, this has led to persistent academic and public policy disagreements, with various 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. This approach became especially popular through the 1980's '90's, and '00's.9
Several different streams of economic theory and research have tried 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 in order 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 previously relegated to the economic backwaters, such as Austrian economics.
The Bottom Line
Theoretical economics uses the language of mathematics, statistics, and computational modeling to test pure concepts that, in turn, help economists understand the truths of practical economics and shape them into governmental policy. The business cycle, boom and bust cycles, and anti-inflation measures are outgrowths of economics; understanding them helps the market