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CHAPTER 7 THE CLASSICAL MODEL THE KEYNESIAN REJOINDER There are several alternative theories or models available to explain the way macro-economies function with different implications for government economic policy. There is far more disagreement in this area of macroeconomics than we ever saw in microeconomics – this is why different analysts in government and the media say completely contradictory things about what the government should do even if they agree about the current state of the economy. We will examine each of the major economic theories that has influenced economic thought and/or government policy in the US over the course of the last 100 years. In the late 1800s and early 1900s American economic theory in both microeconomics and macroeconomics was dominated by Classical theory. Classical economic theory largely came from the study of individual market behavior in microeconomics and its macroeconomic theory was based on the contention that market based economies are just an amalgamation of individual markets and, therefore, the same behavioral patterns prevail. Classical economics viewed markets as incredibly powerful and efficient mechanisms that could not be improved upon by any intervention; as a consequence, they strongly urged laissez-faire policy by the government – that the government should leave the economy alone and let it work properly. The Assumptions of the Classical Model An economic model is based on certain conditions or assumptions; it is important to examine these to understand why the theory makes the conclusions that it does. The assumptions of a model function as its foundation and flaws in the foundation undermine the structural integrity of the building. Flaws in a model’s assumptions undermine the accuracy of the model itself. The main assumptions of the Classical model are as follows. Markets are highly competitive: If markets are highly competitive, than no one can hold a market off its full employment equilibrium. Firms competing with each other will have to make the best product they can for the lowest acceptable price – any firm trying to take advantage of consumers by selling an inferior product for an inflated price will just lose its customers to other firms. Price will, therefore, always reflect the minimum efficient cost of making the good. As long as consumer benefit is high enough to justify paying for the good, they will keep buying it and we will keep making it. Consequently, if individual markets do this, all the markets together will - we will make the socially optimal level of production, i.e. full employment. Wages and prices are completely flexible: Wages and prices will rapidly adjust to reflect supply and demand in the labor and goods markets. If producers are making more output than consumers want, price will simply fall until the quantity demanded and quantity supplied for goods are equal. If workers are unable to find enough jobs, wages will simply fall until the quantity demanded and quantity supplied for labor are equal.
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