Adam Smith
Adam Smith (1723 - 1790) was the son of a Scottish judge. He was educated at Glasgow and Oxford, later a teacher and tutor, then a writer and finally Commissioner of Customs. He was probably the first academic economist in England. The Theory of Moral Sentiments 1759 shows a strong moral philosophy in inquiring into human nature. Smith had a firm belief in the natural order ("Naturalism") inherited from Greek and Roman Stoics, as well as from Bacon, Hobbes, Locke and the Physiocrats. Naturalism relies on a belief in the natural order rather than on the contrivances of human regulation, and thus proposes that human regulation and laws should be in harmony with natural law.

In An Inquiry into the Nature and Causes of the Wealth of Nations (1776) Smith defined a full theory of the economic mechanism based on the works of earlier English economists and the Physiocrats. The Wealth of Nations is divided into five books dealing with a) production, distribution and exchange, b) capital, c) economic policies adopted by nations, d) previous systems of political economy, and e) public finance. Here, Smith speaks to and on behalf of industrial capitalists, and portrays the pursuit of profit and trade as being no longer selfish or undignified. He emphasises the natural order throughout and that each individual in pursuing his own advantage is 'led by an invisible hand to promote an end which was no part of his intention'. Individuals must appeal to others' self-interest and not to their sympathy when seeking a livelihood, thus the exchange of goods that others want will provide both a livelihood for the supplier and also the goods that others consume. Thus, the common effort is directed by the invisible hand to provide what society needs. The same principle is held to apply in foreign trade, hence Smith adopts the laissez-faire policy of the Physiocrats based on an analysis of all economic activity.

Government intervention in the economy, the granting of privileges, protection of home industry, trade treaties, apprenticeship regulation and so on, are held by Smith to stifle the operation of the invisible hand. He therefore favours minimalist government, arguing that the government should cater for the requirements of national defence, administration and justice, manage the currency, and provide those institutions and works that are not maintained by private firms for lack of adequate profit. The government should be impartial and protect society against the establishment of privilege for powerful interest groups and the ruling classes.

Smith's treatment of the theory of value is regarded as confused. His classic example compares the use value and exchange value of water and diamonds (the former has high use value and low exchange value, while the latter has high exchange value and low use value). There is a contradiction within his theory of value since he says exchange value arises from either labour input, or from the amount of labour that the product can be exchanged for. But these two sources can determine different exchange values, for example, in different times and places, gold can take different amounts of labour to produce and purchase differing amounts of labour. Smith therefore confined his labour theory of value to a primitive society where all commodities are owned by their producers and are exchanged according to their labour input (the beaver and deer example). But in an advanced society this relationship breaks down. For example, stocks used as capital must be sold at a profit and, for an entrepreneur, a profit on stock can only arise where exchange value exceeds the cost of labour used to transform that stock into a finished product.

Among Smith's other important ideas are the following:

• that the division of labour improves efficiency and output but is limited by the size of the market
• that money allows an easy comparison of exchange values between all goods (while barter does not)
• that comparative advantage in foreign trade determines the division of labour internationally.
• the 'natural price' equals the value of the three inputs of labour wages and rent, while the 'market price' is determined by supply and demand. These two prices tend towards equality due to competition.
• A surplus arises due to value added to materials by workmen (similar to the Physiocrats "produit net" except Smith says that value can be added in industry as well as in agriculture). Thus surplus is not a gift of nature, it is a result of value added by labour.
• Interest was the compensation paid to the lender for the profit that the borrower would make by the use of the lender's money. Hence, rate of interest is determined by level of profits. Stock capital could not be accumulated without saving and interest is the reward for such sacrifice.

Smith has difficulty maintaining the labour theory of value since he admits that labour isn't the sole source of the surplus. Stock capital is that part of an individual's wealth that is used not for his own consumption but for further production to bring profit. The use of capital in a production process produces greater value than labour could produce on its own. Hence capital contributes to value and should be rewarded for its contribution. Therefore there is no exploitation of labour by capital. (Since capitalists take profit on renting out capital, capital is de facto a source of value added). Marx later used the surplus value theory to allege the exploitation of workers by capitalists, since he held that capitalists pay workers less than the value they produced.

David Ricardo
Ricardo is probably the greatest representative of classical political economy. A Scottish Jew, he had a non-academic background, becoming a stockbroker then a politician. The Principles of Political Economy and Taxation first written in 1817, was a definitive, condensed, scientifically intense, hypothetical not historical work, largely without philosophy. Ricardo also wrote a large number of essays. He defined the principle problem of political economy as the distribution of wealth, rather than taking a Malthusian focus on the production of wealth.

Ricardo extended the labour theory of value, arguing that the relative values of products depend on the relative amounts of labour input. He clarified Smith's confusion by showing that the past and present amount of labour alone creates value in both pre-capitalist and capitalist economies, in other words that capital is nothing but stored up labour. An implication of this stance is that land is not a source of value.

According to Ricardo, part of the value created by the labourer is appropriated by the capitalist, and part by the labourer in the form of wages. The value of labour is determined by the labour value of the subsistence requirements of the labourer. Immediately, therefore, Ricardo faces the problem that the wages paid to the labourer do not equal the value of the commodities which he produces for the capitalist. Thus exchange values cannot be determined by the amount of labour input as postulated by the labour theory of value. Ricardo evades this theoretical problem by arguing that the value of labour is itself variable. He thus establishes a labour theory of value for commodities, then makes it inoperative for the value of labour (he would later acknowledge this mistake).

Ricardo's theory of differential rent is based on the law of diminishing returns. Food requirements are satisfied by employment of the lowest fertility land at the margin. The produce of this land must sell at the same price as all other food, though the land is less productive than other more fertile land. On this marginal land the price of output will equal the cost of output. Thus rent must be zero on the least fertile land. Thus rents differ according to fertility, rent is a pure surplus, it does not determine exchange value, and it therefore satisfies Ricardo's labour theory of value. This is however an unsatisfactory theory , because it implies that value of labour input and price are the same.

Ricardo accepted Say's Law, believing that capital cannot accumulate over the amount that can be used. He rejected Smith's view (that profitability tends to decline because a greater accumulation of capital increases its supply and therefore diminishes number of profitable opportunities). Ricardo argued that profitability only declined where wages rose, and that profitability will decline if food becomes more expensive because wages will then rise. However, manufactured goods will not become more expensive because productivity in manufacturing increases over time. On the other hand, food will become more expensive over time as population grows, thus less fertile land will be employed and rents will rise.

Ricardo held that the interest of the landlord is against that of the capitalist and the labourer. This is because, as rents increase, landlords become wealthier while the cost of subsistence increases and capitalists' profitability falls (as they are forced to pay higher wages in order to meet the higher substance costs).

In The High Price of Bullion 1809, Ricardo argued that the over-issue of paper money caused inflation since the Suspension of Payments at the Bank of England in 1797. He proposed a basic Quantity Theory of Money and argued for a reduction in the note issue, and for keeping a stock of gold against the note issue (but only for large denominations of note). Ricardo was simultaneously in favour of fiat money and the withdrawal of gold coins from circulation. His proposals were adopted by the Bullion Committee and enacted in the resumption of payments in 1821 and in the Bank Charter Act of 1824.

Ricardo argued that if there is 'too much' money in circulation, prices will rise, imports will increase and money will flow abroad. (We can argue vice versa for a shortage of money.) Now, assuming a paper currency, the required flows of money cannot occur unless bank notes can be exchanged for foreign currency. Thus banking policy must mimic a gold currency when regulating the size of the note issue (this is the 'currency principle') and bullion becomes of central importance to a country's economy (this is a bullionist idea).

Ricardo believed that the general level of interest rates depended upon the profitability with which borrowed money can be employed. "Whenever a great deal can be made by the use of money, a great deal can be given for the use of it" (Principles of Political Economy and Taxation).

Thomas Robert Malthus
Malthus was pro-capitalist, but pessimistic on the outcome of the capitalist system. He was also pro-landed aristocracy, and defended unproductive labour.

Malthus established a theory of population in his Essay on the Principle of Population as it Affects the Future Improvement of Society (1798). Since population grows at a geometric rate, it exceeds the arithmetic growth rate of agricultural output. As the fertility of new land is generally decreasing, the only means of limiting population growth involved misery or vice. Following this theme, in 1803, Malthus proposed that the population is limited by the means of subsistence and that it can only increase where the means of subsistence increase. Checks on population growth can be either positive (affecting the death rate, for example war or famine), or preventative (affecting the birth rate, for example moral restraint). Since moral restraint involves abstention from marriage and regular sex until means become available to support a family, Malthus was against welfare payments to the poor since these would only encourage an increased birth rate and, ultimately, more misery for the poor.

In an Enquiry into the Nature and Progress of Rent 1815, Malthus links population theory and differential rent theories. As diminishing returns apply, investment in new agricultural output yields progressively lower amounts of food, thus differential rents become more marked. (We should note that diminishing returns have since been shown not to apply to agriculture as yields have increased substantially, while contraception has limited the birth rate.)

In Principles of Political Economy 1820, Malthus attacked Ricardo's theory of capital accumulation by proposing a theory of gluts. Ricardo and Smith believed in Say's Law, arguing that demand and supply are matched at the macro level, thus capital cannot accumulate above the requirement for it. Capital accumulation is therefore beneficial since it increases both supply and demand. Ricardo distinguished productive and unproductive consumption. Capital is that which is consumed to create net new production. Productive consumption thus involves consumption of capital. Unproductive consumption is that which does not yield net new production. Ricardo says that there cannot be a glut of capital because where it begins to exceed demand, the return on capital drops and the motive for further accumulation evaporates. Thus spending increases (i.e. unproductive consumption) and the natural balance between accumulation and spending returns.

Malthus on the other hand said that such equilibrium may not occur and over-production may continue. He defined effective demand as that amount of demand that fully absorbs production at an exchange value that covers labour, rent and profit components. Now, since the capitalists pay labourers less wages than the exchange value produced by labourers, the latter cannot afford to buy the goods they produce. In other words effective demand is insufficient to absorb production. Here Malthus introduces unproductive consumers as the solution since it is these individuals that allow effective demand to remain sufficient to absorb production. (Alternatively capitalists could consume one another's produce, but Malthus viewed this as against the miserly nature of capitalists.) For this reason, increased capital accumulation reduced spending (especially among the unproductive consumers), thus reducing effective demand and destroying the incentive for production. The idea was that although capital accumulation was necessary to create wealth, it could occur too rapidly and thus be counter-productive. Hence, for Malthus, the economic system may not be self-stabilising. This distinctly anti-classical idea anticipated the Keynesian concept of a shortfall in aggregate demand.