Belief: Free markets will achieve an efficient allocation of resources as a result of the price mechanism and invisible hand.
Policy recommendation: The government should take a laissez-faire approach and let the market work by itself … unless they have to correct market failures.
The Classical school is the first school of economic thought and derived from the works of Adam Smith in the 18th Century, Robert Malthus and David Ricardo.
Basically, Classical economics posits that markets distribute resources efficiently if they are left to operate on their own. A market economy will allocate resources efficiently because the price mechanism acts as an ‘invisible hand’ that helps markets to automatically self-adjust following any period of disequilibrium. For instance, if there is an increase in demand for housing then the housing market falls into disequilibrium, prices and profits are higher, and this attracts new firms to produce housing, increasing supply. Across all markets, any changes in supply will be matched by demand, and vice versa, so the economy will always return to full employment equilibrium.
Smith contends that competition and free trade are essential factors in maximising the welfare of society. Assuming agents are self-interested and aim to maximise their own benefits when engaging in trade, if all agents are allowed to trade as they wish, then all trades must be mutually beneficial. In a free market, firms make profits by producing goods which consumers demand, and consumers spend their income on goods which they want to buy; if all agents behave in this manner then societies’ welfare is maximised.
Classical economists conclude that the government must adopt a laissez-faire approach and only intervene in the economy to enforce the legal system to protect free markets and competition. For instance, the government must protect property rights and ensure that harmful monopoles do not dominate markets and distort the price mechanism.
One of the most important theories in Classical economics is Ricardo’s comparative advantage. This theory asserts that world output will be maximised if all counties specialise in producing the goods in which they have a comparative advantage, and then trade these goods with one another.
The Classical school remained the dominant school of economic thought until the 1870s, when the Neoclassical school arose.