Foundational Economic Theories and Systems Defined

Major Economic Schools of Thought

Classical Economics

The core belief is that government should not be involved in economics, emphasizing economic freedom and the principle of Laissez Faire, Laissez Passer.

Key tenets:

• People are motivated by rational self-interest.
• The Invisible Hand is a natural force that maintains harmony between individual, selfish decisions and leads to overall prosperity.

This theory was famously explained in The Wealth of Nations by Adam Smith.

Marxian Economics

Based on the work of Karl Marx, this school focuses heavily on the role of labor.

Marx argued that the specialization of labor combined with population growth leads to a decrease in wages. Profit obtained by the owner includes surplus value (labor not paid to the worker).

Keynesian Economics

Developed by John Maynard Keynes, this theory posits that total spending (aggregate demand) in the economy affects output and inflation.

Keynesian policy promotes:

• Increased government spending in public works.
• Adjusting taxes to stimulate demand.

Keynesianism strongly promotes a mixed economy.

Chicago School of Economics

Advocates for free markets to allocate resources with minimal government intervention. A central tenet (Monetarism) stresses that the money supply should be kept in equilibrium with the demand for money.

Milton Friedman was a key figure, known for his strong belief in free-market capitalism and his strong opposition to Keynesian economists.

Four Fundamental Economic Systems

1. Traditional Economic System

This system is shaped entirely by tradition. The work people do, the goods and services they provide, and how they use and exchange resources all tend to follow long-established patterns.

Characteristics:

• Not very dynamic; things do not change much.
• Standards of living are static; individuals lack financial or occupational mobility.
• Economic behaviors and relationships are highly predictable. You know what you are supposed to do, who you trade with, and what to expect from others.

2. Command Economic System

In this system, the government controls the economy. The state decides how to use and distribute resources. The government regulates prices and wages, and may even determine the sorts of work individuals do.

Socialism is a type of command economic system.

3. Market Economy

Economic decisions are made by individuals. The unfettered interaction of individuals and companies in the marketplace determines how resources are allocated and goods are distributed.

Individuals choose:

• How to invest personal resources (jobs to take, goods/services to produce).
• What to consume.

Within a pure market economy, the government is entirely absent from economic affairs.

4. Mixed Economic System

This system combines elements of the market and command economies. While many economic decisions are made in the market by individuals, the government also plays a significant role in the allocation and distribution of resources.