Major Schools of Economic Thought

Why This Matters

Understanding the major schools of economic thought isn't just intellectual history—it's the foundation for analyzing every policy debate, market phenomenon, and economic crisis you'll encounter on the exam. Each school emerged as a response to real-world problems and the perceived failures of previous frameworks, so you're really learning a conversation that spans three centuries. The exam will test whether you can connect specific thinkers to their core ideas, explain why schools diverged on questions like government intervention, market efficiency, and human rationality, and trace how later schools built upon or rejected earlier foundations.

Don't just memorize names and dates. Know what problem each school was trying to solve, what assumptions it challenged, and where it sits in the broader debate between market self-regulation and active intervention. When you see an FRQ about inflation, unemployment, or market failure, you need to immediately recognize which schools offer competing explanations—and why their answers differ.

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The Foundations: Classical and Marxian Critiques

These schools established the original terms of debate: how does capitalism work, and does it serve everyone? Classical economics celebrated market mechanisms; Marxian economics dissected their contradictions.

Classical Economics

• Adam Smith's "invisible hand"—the idea that self-interested individuals unintentionally promote social good through market exchange, foundational to all pro-market arguments
• Comparative advantage (Ricardo) explains why nations benefit from trade even when one country produces everything more efficiently—a concept still central to trade policy debates
• Labor theory of value held that a good's worth derives from the labor required to produce it—later adopted and transformed by Marx, rejected by neoclassicals

Marxian Economics

• Class struggle between bourgeoisie (capital owners) and proletariat (workers) drives historical change—economics as inherently political, not neutral science
• Surplus value concept argues capitalists extract profit by paying workers less than the value their labor creates—a direct critique of classical assumptions about fair exchange
• Tendency of the rate of profit to fall predicts capitalism's internal contradictions will lead to crisis—connecting economic analysis to revolutionary politics

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The Marginalist Revolution: Neoclassical and Austrian Approaches

In the 1870s, economists shifted focus from labor and production to individual choice and subjective value. This "marginalist revolution" gave economics its modern mathematical toolkit—though the Austrian school resisted formalization.

Neoclassical Economics

• Marginal utility replaced the labor theory of value—prices reflect the additional satisfaction from consuming one more unit, not labor input
• Equilibrium analysis models markets as tending toward balance where supply equals demand—the foundation of standard microeconomics textbooks
• Rational utility maximization assumes individuals make optimal choices given constraints—a powerful simplification that later schools would challenge

Austrian School

• Subjective value theory (Menger) emphasizes that value exists only in individual minds, not objectively in goods—rejecting both classical and Marxian value theories
• Entrepreneurship and uncertainty (Mises, Hayek) highlight that real markets involve discovery and error, not just equilibrium—critique of socialist central planning follows from this
• Spontaneous order concept argues complex social institutions emerge without design—Hayek's "knowledge problem" shows why planners can't replicate market coordination

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The Keynesian Revolution and Its Rivals

The Great Depression shattered confidence in self-correcting markets. Keynes argued that economies could get stuck in prolonged slumps without government action—sparking decades of debate with monetarists and eventually producing a synthesis.

Keynesian Economics

• Aggregate demand drives output and employment in the short run—if people and businesses stop spending, the economy contracts regardless of supply conditions
• Multiplier effect shows how initial spending ripples through the economy—$\Delta Y = k \times \Delta G$, where $k$ is the multiplier and $G$ is government spending
• Liquidity preference explains why people hold cash rather than bonds, connecting interest rates to money demand—challenges classical assumption that savings automatically become investment

Monetarism

• Money supply is the primary determinant of nominal GDP and inflation—Milton Friedman's counter to Keynesian fiscal policy emphasis
• Natural rate of unemployment exists regardless of policy; attempts to push below it cause accelerating inflation—undermines Keynesian confidence in demand management
• Rules over discretion argues central banks should follow predictable money growth targets rather than activist fine-tuning—distrust of government competence

New Keynesian Economics

• Price stickiness provides microeconomic foundations for Keynesian conclusions—wages and prices don't adjust instantly due to contracts, menu costs, and coordination failures
• Rational expectations incorporated from critics—people anticipate policy effects, but market imperfections still justify intervention
• Monetary policy emphasis shifted from fiscal stimulus to interest rate management by central banks—the framework behind modern Fed policy

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Institutions, Incentives, and Behavior

These schools share skepticism toward abstract models divorced from real-world complexity. They ask: what do actual institutions, political incentives, and psychological limitations mean for economic outcomes?

Institutional Economics

• Institutions—formal laws, informal norms, and organizational structures—shape economic behavior more than abstract market forces alone
• Thorstein Veblen critiqued neoclassical rationality, introducing concepts like conspicuous consumption to explain status-driven spending
• Path dependence emphasizes that history matters—today's institutions reflect past choices, not just current efficiency

Chicago School

• Market efficiency doctrine argues prices incorporate all available information—justifies skepticism toward regulation that assumes government knows better
• Public choice theory (Stigler, Buchanan) applies economic logic to politics—regulators may serve special interests rather than public good, explaining regulatory capture
• Incentive analysis of policy asks who benefits and who bears costs—connects to monetarism but extends to law, crime, and family behavior

Behavioral Economics

• Bounded rationality (Herbert Simon) acknowledges humans use shortcuts and make systematic errors—not irrational, but not optimizing machines either
• Prospect theory (Kahneman, Tversky) shows people weigh losses more heavily than equivalent gains and evaluate outcomes relative to reference points
• Nudges apply behavioral insights to policy design—changing default options or framing can improve decisions without restricting choice

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Quick Reference Table

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Self-Check Questions

1. Both Classical and Marxian economics use the labor theory of value—how do their conclusions about capitalism differ, and why?

2. What methodological disagreement separates Austrian economists from Neoclassicals, despite their shared support for free markets?

3. If an FRQ asks you to explain competing responses to a recession, which three schools would offer the most distinct policy prescriptions, and what would each recommend?

4. Compare Monetarism and Keynesian economics: what do they agree on about the Great Depression's cause, and where do they diverge on solutions?

5. How does Behavioral economics challenge the assumptions underlying both Neoclassical and Chicago School analysis—and what policy implications follow from this challenge?