By the early 19th century the effects of the Industrial Revolution were spreading from Britain to Europe and across North America, transforming agricultural nations into industrial economies. The change had been rapid and dramatic, bringing about a fundamental shift in the structure of economies. The focus had shifted from the merchants who traded in goods to the producers, the owners of capital. As well as a new way of thinking about the economy, capitalism also brought with it new social and political issues.
Most noticeable of the social changes was the emergence of a new “ruling class” of industrialist producers, and a steady growth in the number of firms producing goods, many of which were offering shares of their business for sale in the stock markets. These provided the competitive market that was the focus of the “classical” view of economics, in which the operations of the market are central. However, as market economies developed and grew, new problems began to emerge. For example, as Adam Smith had warned in 1776, there was a danger that large producers would dominate the market and operate either as monopolies or as cartels, fixing prices at a high level and keeping production low. Although regulation could prevent such practices, in instances where only a few producers operated, they could easily develop strategies to distort the competitiveness of the market.
Smith had assumed that men behaved rationally in an economy, but this also came into question as investors rushed to buy shares in companies whose worth had been exaggerated. This caused bubbles, contradicting the idea of a stable economy based on reasoned behavior. Despite this, some economists, such as Léon Walras and Vilfredo Pareto, argued that the market economy would always tend toward equilibrium, which would in turn determine the levels of production and prices. Their contemporary Alfred Marshall explained supply and demand and how these and prices interact in a system of perfect competition.
The question of price was one that concerned many economists at the time because it affected both producers and consumers in the new capitalist society. Taking their lead from the moral philosophers of the previous generation, they began to see the value of goods in terms of their utility (the satisfaction they would give), rather than the labor that added value to raw materials. The idea of marginal utility—the gain brought about by the consumption of a particular product—was explained in mathematical terms by William Jevons.
The theory that the value of a product is determined by the labor involved in producing it still had some adherents, particularly as it concerned not the producers or consumers so much as the workforce producing the goods for capitalist employers. Looking at value in this light, Karl Marx argued that the inequalities of a market economy amounted to an exploitation of the working class by the owners of capital. In the Communist Manifesto and his analysis of capitalism Capital, Marx argued for a proletarian revolution to replace capitalism with what he saw as the next stage in economic development: a socialist state in which the means of production are owned by the workers, and an eventual abolition of private property.
Although Marx’s ideas were subsequently adopted in many parts of the world, market economies continued to operate elsewhere. Generally, economists continued to defend capitalism as the best means of ensuring prosperity—although tempered to some extent with measures to compensate for its injustices. Following a mathematical approach to economics that focused on supply and demand, and as a reaction against the ideas of socialism, an Austrian School of economic thought emerged, stressing the creative power of the capitalist system.
The free market economy was soon to receive some hard knocks after the Wall Street Crash of 1929. However, the theories of neoclassical economists, and the Austrian School in particular, later resurfaced as the model for economies in the Western world in the late 20th century and even came to replace most of the world’s communist planned economies.