112 D. P. O’BRIEN
CHAPTER EIGHT
Classical Economics
Denis P. O’Brien
8.1 INTRODUCTION
Classical economics ruled economic thought for about 100 years. It focused on
macroeconomic issues and economic growth. Because the growth was taking
place in an open economy, with a currency that (except during 1797–1819) was
convertible into gold, the classical writers were necessarily concerned with the
balance of payments, the money supply, and the price level. Monetary theory
occupied a central place, and their achievements in this area were substantial and
– with their trade theory – are still with us today. Those ideas developed amid an
international economy free from major wars. However, the French wars of 1793–
1815 had a powerful influence on classical economics, leading to major problems
with public finance, and to a significant national debt. Because convertibility of
the note issue into gold was suspended, it was necessary to develop a theory of
the operation of an inconvertible paper currency.
8.2 FOUNDATIONS
The intellectual basis for virtually all classical economics is found in Adam Smith’s
Wealth of Nations of 1776 (O’Brien, 1975). Earlier work, including that by Smith
himself (his Theory of Moral Sentiments, 1759, and Lectures, 1763) and of David Hume
(1711–76) can be seen in the context of the research program that Smith established.
Apart from Adam Smith (1723–90), the most famous and influential figure was
David Ricardo (1772–1823). There are several views of Ricardo. Schumpeter (1954)
regarded Ricardo’s work as essentially a detour. The Sraffians regard it as the
start of the only valid tradition in economics, running from Ricardo to Marx and
thence to Sraffa. Alfred Marshall and Samuel Hollander (1979) have interpreted
Ricardo as a neoclassical economist.
Ricardo excelled in model building, but his restrictive type of model grafted
uneasily on to the main part of classical economics, and the work of later writers
CLASSICAL ECONOMICS 113

productive of social benefit reflects that of Mandeville. Smith avoids mentioning
Mandeville and Sir William Petty (1623–87), who undoubtedly influenced Smith’s
views on public finance, if only on the treatment of equality in taxation.
The wide-ranging basic concepts of the Wealth of Nations set the agenda for the
whole classical era. The individual pursues self-interest that, constrained by a
framework of law, religion, and custom, and an inherent moral sense (sympathy),
brings about a coincidence of private and public satisfaction. Competition in
response to price signals allocates resources as capital pursues profit opportunities,
and the search for greater output from the resources commanded by capital leads
to specialization and division of labor, the mainspring of technical progress.
Freedom of trade stimulates technical progress and widens the market, allowing
disposal of the increased output – division of labor depends on the extent of the
market.
Ricardo, reading Smith with the mind of a model builder (Ricardo, 1815, 1817–
21), was to have a huge, if ultimately transient, influence on the way in which
that agenda was developed. For Ricardo was concerned with two immediate
114 D. P. O’BRIEN
practical problems, inflation and agricultural protection; and he found that the
material in the Wealth of Nations failed to provide clear-cut answers.
In the Bullion Controversy, the price level in relation to the balance of pay-
ments was critical. Smith had argued that a rise in wages would ultimately raise
the price level. But Ricardo concluded that, in an open economy on the gold
standard, the price level could not rise permanently; after an initial increase,
a balance-of-payments deficit would ensue, gold would flow out, the money sup-
ply would be reduced, and prices would return to the initial level. This insight,
it has been plausibly argued (Hollander, 1979; cf., Peach, 1988), led Ricardo to
argue that profits would be compressed by a rise in wages.
Applying the argument to agricultural protection, one could predict dire
consequences for growth. Protection increased agricultural costs as inferior land
was brought into use to feed a growing population; this meant a rising price of

not by actual shortage, but by anticipation of it. J. S. Mill allowed Malthus an
honored place in his Principles (1848) while denying that Malthus had attached
any importance to his arithmetical and geometric ratios, restating the tautological
CLASSICAL ECONOMICS 115
“tendency” as an economic law that could be modified only by the spread of
methods of family limitation.
To understand how all these threads fit together, it is best to look at the classical
treatment of particular aspects of economic analysis.
8.3 VALUE AND DISTRIBUTION
8.3.1 Value
Smith designed his value theory to produce a theory of relative price, on the
basis of adding up the per-unit costs of the labor, capital, and land inputs into
production, the valuation of the inputs being determined separately. He explained
the value of commodities in long-run equilibrium, in terms of wages, profit, and
rent. Market price fluctuated around long-run equilibrium price, with departures
from long-run equilibrium eliminated by the mobility of capital in response to
profit opportunities or losses.
Ricardo attempted to replace Smith’s adding-up approach with a labor theory
of value, creating problems for his contemporaries and successors. Even if capital
amortization were treated as payments to stored-up labor, relative values could
change without any change in labor input, if the capital–labor ratios were not
uniform across all commodities. This would happen when wages rose and profits
fell. Ricardo claimed that this would only produce variations of 6 or 7 percent in
value. But the problems were tied up with the basic Ricardian model: for money
wages were supposed to rise with the growth of population and the rising cost of
obtaining food, thus altering values. Ricardo further posited an average capital–
labor ratio, and the existence of a commodity produced under such conditions –
the “Invariable Measure.” He then decided that gold would fit that specification,
and treated agriculture as operating with the same capital–labor ratio. Thus a
rise in wages would not, of its own, alter the money price of corn. If the money

cost of production. Things could only differ in relative value if they required
more labor, or labor paid at higher wages, differed with respect to the capital–
labor ratio, or were the products of industries that required a higher rate of
profit. Ricardo’s influence is apparent both in the “getting rid of rent” and the
recognition that varying capital–labor ratios would produce changes in relative
values if average wages rose and profits fell: but his contributions only modified
a basically Smithian cost of production approach.
The French tradition of J B. Say had a wholly different approach, one consist-
ent with the post-1870 approach to value theory: of the interaction of subjective
valuation (underlying demand) and limitations in supply. Say argued that both
goods and productive services derived their value from the utility of the final
product. Price was determined by the intersection of a negatively sloped demand
curve (described verbally) and a rising supply schedule.
Say (1817) explained the declining demand schedule in terms of income dis-
tribution, not utility. Two later writers developed the argument further. Nassau
Senior explained the idea of diminishing marginal utility, although he did not
relate it to a demand curve (Senior, 1836), while the Irish economist Mountifort
Longfield put forward a strikingly modern subjective value theory (Longfield,
1834). Value depends upon demand and supply: cost of production limits supply,
and demand depends upon diminishing marginal utility. Marginal utility varies
between units of a commodity and between persons. Rather than relying upon
income distribution to derive a negatively sloped demand schedule, Longfield
derived it explicitly from diminishing marginal utility. Longfield was followed by
others in this tradition (Black, 1945).
8.3.2 Distribution
To avoid explaining prices by prices, the cost-of-production theorists had to
provide a theory of the valuation of factor services.
WAGES
The main development followed two lines. One involved the concept of subsistence
wages. Commentators disagree about the extent to which the subsistence was

at the margin could be identified with the marginal product of capital; Mill
independently advanced the same argument.
The level of profit was thus dependent on both the demand for investment
(in relation to the available supply of investment funds) and the demand for
consumption goods (which influenced the productivity of that investment), as
the classicists from Smith onward recognized. Ricardo argued differently, that
the rate of profit for the economy as a whole was determined by the marginal
rate of profit in the agricultural sector. This was consistent with showing how
diminishing returns in agriculture would bring the economy to a stationary state.
His contemporaries felt that increasing manufacturing productivity would offset
diminishing returns in agriculture. Ricardo’s view was arrived at by dividing the
whole economy into one giant farm and a series of manufacturing tributaries.
Then the profit-raising effect of innovation in any tributary would be swamped
by both capital inflow and the effect of rising wages (due to agricultural dimin-
ishing returns), both of which raised costs and lowered the relative value of
(capital-intensive) manufactures.
118 D. P. O’BRIEN
RENT
The Ricardian theory of rent as intramarginal surplus was due at least equally to
Sir Edward West, Malthus, and Torrens; all four men published in 1815.
Given the classical treatment of rent, wages, and profits, the treatment of rel-
ative shares was easily discernable. Wages would eventually reach subsistence
(although perhaps not physical subsistence); but wage-earners would enjoy spells
during which wages were greater than subsistence as capital accumulation ran
ahead of population increase. Profits would fall to a minimum, as a result of both
capital accumulation in relation to investment opportunities (Smith, Malthus,
and J. S. Mill) and diminishing returns in agriculture (Ricardo). Rent would rise
both as a share of national income and in absolute amount.
8.4 MONEY
8.4.1 Background

the short run, arise from other causes (Thornton, 1939 [1802]), such as harvest
failure or financial panic. Severe damage to the economy could be caused by
contracting the note issue in response to transient causes of pressure.
Nevertheless, both groups agreed that in the long run the Bank must restrict its
note issue sufficiently to permit a return to convertibility of its notes into gold.
The Anti-Bullionists, by contrast, argued that the Bank’s note issue was simply
responding to “the needs of trade” as indicated by the “real bills” presented to it
for discount. The “real bills” were bills of exchange resulting from real transac-
tions in goods and services.
Their position was not sustainable. First, many of the notes issued had nothing
whatever to do with “real” transactions, but were ultimately a consequence
of the Bank’s position both as the government’s bank and as lender of last resort
to the financial sector, a position recognized since statements of it by Francis
Baring (1797) and Thornton. Secondly, as Thornton pointed out, even had the
Bank confined itself to “real bills,” the transactions to which they related had to
take place at some absolute price level – and in the Bullionist analysis the price
level depended on the money supply. Thirdly, Anti-Bullionists argued that the
Bank could not over-issue its notes because it charged interest (discount) when
issuing notes, so no one would demand notes for which they had no need. But,
as Thornton indicated, there was an indefinitely large demand for loans and
discounts if the rate that the Bank charged was less than the marginal rate of
profit.
Ultimately the Bullionist case triumphed. Convertiblity was progressively
restored from 1819. However, the 1820s and 1830s witnessed a series of financial
crises and brought convertibility into question, as the Bank of England became
hard pressed for gold. The debate on the terms on which the Bank’s charter
would be renewed in 1844 formed the basis of the next controversy.
8.4.3 The Currency and Banking Debate
Issues from the Bullion Controversy reappeared in the Currency and Banking
Debate. The Currency school, positing an endogenous cycle of real income

in Revolutionary France had demonstrated the danger of hyperinflation.
Aggregate demand was not ignored by the classical writers. Say’s Law
provided an explanation of the underlying circularity of the economic system.
But the classical writers, especially J. S. Mill in his Unsettled Questions (1844), re-
cognized that outside a barter system there could be excess demand for money,
and that market clearing in a monetary, as distinct from a hypothetical barter,
economy was an equilibrium proposition. Monetary changes were not neutral –
if the classical economists had believed they were, the Bullion and Currency and
Banking Controversies would have been pointless.
8.5 TRADE
8.5.1 Smith and the gains from trade
Perhaps the most prominent feature of classical economics is the central import-
ance attached to trade, and the corollary that trade should be free of restrictions.
The intellectual underpinnings of this position are complex.
Adam Smith set the tone by offering a critique of existing restrictionist trade
policy, sustained and defended as it was by interest groups. The basic grounds
for Smith’s position, however, involved a blurring of the distinction between
home and foreign trade. Specialization and division of labor increased output per
head, but were limited by the extent of the market. Freedom of trade increased
the extent of that market, allowing greater division of labor. International trade,
like interregional trade, was thus based upon the source of supply being the
producer with absolute advantage. An international outlet for the increased
output was offered by trade – this was later called the Vent-for-Surplus doctrine
– in exchange for goods (and raw materials) produced more efficiently abroad.
But for sources of supply to be absolutely the most efficient, it was necessary for
CLASSICAL ECONOMICS 121
factors to migrate to where they could work most efficiently, which labor could
not. J. S. Mill explained that for trade to be based upon absolute advantage, labor
would have to migrate in search of its highest productivity, as its output would
have to be sold in the same market wherever it worked, but the return to capital

and somewhat undermined the Smithian case for free trade. Torrens showed that
unilateral free trade would lead to a balance-of-payments deficit, which would
cause an outflow of metal, reducing the money supply, lowering the price level,
and turning the terms of trade against the free-trade country (O’Brien, 1977).
Moreover, the fall in the price level would increase the weight of fixed charges,
such as taxes, and produce economic depression. Conversely, a country would
benefit from protection.
122 D. P. O’BRIEN
Torrens’s work was comprehensively criticized. Senior (1843) argued that a
country imposing protectionist duties would lose the advantage of specialization;
the reduction in output per head could lead to a balance-of-payments deficit
with third countries, to offset the gain of metal from the country whose pro-
ducts were now dutied. George Warde Norman (1860) showed that the effects
assumed by Torrens would be much reduced if the assumption of constant
outlay (a reciprocal demand curve of unit elasticity) were abandoned, and
argued that Torrens’s case led to retaliation on the part of a country faced with
new import duties on its exports, with the prospect of a tariff war, the original
terms of trade restored, but international trade at much reduced levels – a
welfare loss for all participants.
8.6 ECONOMIC GROWTH
8.6.1 Adam Smith
The Wealth of Nations established that economics is about economic growth. Smith
pays attention to both the required institutional framework and the mechanics
that operate within that framework. The framework included well-defined and
secure property rights, diffusion of agricultural property through control over
the concentration of inheritance, and the provision of an infrastructure. (Here
government had a key role to play.) Within this framework, individuals pursued
their self-interest, as limited by law, religion, and custom (Robbins, 1952), allocat-
ing capital to where the return was greatest. Capital employed labor, and the
output per head from a given population determined national income. The deter-

with the exception of Ricardo, who focused instead on the mechanics of his
model, in which economic growth came to an early halt because of agricultural
protection. The rest manifest a continuation of Smith’s research program, though
now bearing Ricardian marks.
Malthus also stressed security of property, capital accumulation, natural
resources, and trade; and, given the technical explosion of the Industrial Revolu-
tion, he added invention. His treatment of population went beyond Smith. The
most novel element in his approach (also stressed by Lauderdale) was the need
to ensure sufficient aggregate demand, an important element of which was the
existence of what Smith had classified as unproductive labor.
McCulloch added religious tolerance, an expanded role for government, and a
banking system. He stressed the importance of invention, and introduced the
concept of human capital (which assisted invention), and thus emphasized the
importance of education. Like some other writers (notably Say), he rejected Smith’s
distinction between productive and unproductive labor – his grounds being that
the desire for the products of unproductive labor could stimulate activity.
J. S. Mill’s treatment of economic growth, like that of Ricardo, stressed the
inevitability of diminishing returns in agriculture, despite asserting that technical
progress held them in abeyance for the 20 years before the appearance of his
Principles. The stationary state might not be as miserable as Ricardo had envisaged
– family limitation would ensure that wages were not unduly depressed, and
legacy duties could redistribute wealth. Despite Ricardian elements, the majority
of Mill’s treatment could be described as Smith brought up to the 1840s. Mill
borrowed material relating to technology, scale, organization, and joint stock
companies from Babbage (1832). From John Rae (1796–1872) he borrowed mater-
ial on invention and a remarkable treatment of capital (Rae, 1834), to produce a
theory of investment that involved the interaction of time-preference and the
marginal productivity of investment.
Ricardo, drawing on John Barton (1789–1852), had advanced, in the third edition
(1821) of his Principles, a numerical example in which the introduction of machinery

and that they stimulated effort and ingenuity. He also believed that indirect
taxes, which discouraged consumption, could stimulate saving.
The main exception to the general approval of such taxes was Ricardo, who
believed that a tax on wages (which in his model would be passed on and paid
out of profit, a conclusion telescoping the long run and short run), together with
a tax on rent, and one on interest on government securities, was the ideal tax
system. J. S. Mill favored only a limited use of direct taxes on houses, land, and
increments of rental value.
The classical economists approached the analysis of taxation in two different
ways. The first was taxation of factor rewards – wages, profits, and rent. The
second was particular modes of taxation, such as the income tax. While the
majority covered taxation in both ways, the more empirically orientated eco-
nomists, especially McCulloch (1845–63), paid particular attention to forms of
revenue raising.
8.7.1 Functional rewards
Smith and Ricardo believed that a tax on wages would be passed on, because in
the long run wages could not be pressed below subsistence. Hume, and later,
McCulloch, disagreed. With the exception of Ricardo, there was general opposi-
tion to such taxes. Nor was there any enthusiasm for taxing profits. To Smith,
CLASSICAL ECONOMICS 125
profits were undiscoverable and contained a necessary reward to risk-bearing
that was part of the supply price of capital to different occupations. Taxes on
profits might also affect resource allocation; Ricardo argued that a tax on profits
in particular trades would alter relative prices through capital mobility, reducing
the supply of commodities that generated taxed profits to the point at which
price had risen far enough to restore profit to the same level as in other
employments of capital. Both McCulloch and J. S. Mill were critical of this
conclusion, noting barriers to capital mobility and the possibility that technical
progress might offset the tax. It was generally accepted that a tax on agricultural
profits not offset by technical progress would increase rent by raising marginal

covered. Thus from Smith onward, a legitimate role for the state was recognized.
126 D. P. O’BRIEN
Bentham and J. S. Mill distinguished between what the state should do and what
it should leave alone, the contents of each list depending upon the stage of eco-
nomic and political development.
Classical economists did not assume an omniscient, benevolent, state; govern-
ment intervention had to be justified. Moreover, there was the ever-present
danger of abuse of public authority for rent-seeking – the mercantilism that
Smith had attacked so vigorously.
Smith stressed the role of the state in the provision of defense, justice, a legal
system, infrastructure, and coinage, and even advocated the regulation of
inheritance and of leases. He defended shipping restrictions (the Navigation
Laws), and legal limitations on the rate of interest. Here, he was not followed
by later classical writers. His advocacy of public health regulation and banking
regulation was supported, and a number of writers went further – McCulloch
advocating employer accident liability and laws to prevent the overloading of
ships. Even the regulation of public utility charges was approved by McCulloch
and J. S. Mill. In part, they were simply following the trend of public opinion,
but they were not hampered by any laissez-faire dogmatism: they examined the
economic implications of possible legislative remedies to amend and regulate
a functioning price system. Socialism held no attraction for them, although
J. S. Mill flirted with cooperation. Centralized and totalitarian socialism was
completely foreign to their outlook.
8.8.1 Factories
The classical economists were reluctant to endorse intervention in industrial
organization. Although they supported the regulation of child labor, they were
ambiguous about regulation of women’s work, and opposed the limitation of
factory hours – Torrens and Senior opposed the Ten Hour Bill on grounds that
the resultant increase in costs would reduce exports, causing a balance-of-
payments deficit, an outflow of metal, a fall in the price level, and a reduction

access to education. Education also enabled people to understand the need for
security of property, thus favoring economic growth.
8.9 CONCLUSION
Classical economics covered virtually all areas of concern to later economists, laying
the foundations for the development of economics since. Some parts of it – essen-
tially the microeconomics – were submerged in the course of that development;
but the work on trade, growth, and money has proved to be extremely durable.
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