Adam Smith - History of Economic Thought - Lecture Slides, Slides of Economics

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Adam Smith (1723–1790)

Chief contributions

• Built a coherent and logical theory of how the

economy works

• The elements of Smith's theory were mostly already

available in the writings of earlier writers.

• However, in those earlier writings, good ideas

coexisted alongside numerous other bad ideas

• Somebody had to figure out which theories were

useful and which were useless and combine the useful

theories into a consistent and persuasive overall theory

that could be used reliably to think about society.

• This is what Smith did. For this he is called the father of

economics.

Theory of Moral Sentiments

• This book was an argument against the views of writers such as Hobbes and Rousseau who argued that the pursuit of self-interest, an important human instinct, inevitably leads to a cruel and nightmarish society.
• Smith argued that we are able to imagine what others are going through; we are able to empathize with the sufferings of others.
• We feel pain when we see the pain of others.
• We can act to relieve the pain of others in order to reduce our own discomfort, if nothing else.
• So, it is perfectly consistent to believe that human beings pursue self-interest and are generous towards others.

Passions, bias, moral rules

• Sometimes our passions cause us to do bad things.
• We have an instinctive tendency to defend ourselves

even when we know that we did something bad.

• This leads to a bias that prevents us from seeing that

we did something bad.

• This problem is partially corrected by the wide

acceptance of moral rules in a society.

• When the moral rules are clear cut, a misdeed may so

clearly violate a moral rule that it might be impossible

even for the perpetrator to deny the misdeed, bias

notwithstanding.

Peace = Prosperity

• Moreover, apart from the human ability to

empathize with the sorrows of others, the

sheer practicality of peace—the fact that we

realize that peace is necessary for

prosperity—may be enough to encourage

good behavior.

Wealth of Nations

• The causes of economic progress and the

creation of wealth was Adam Smith’s main topic

of interest

• David Ricardo, by contrast, focused on how wealth is

shared among different groups in society

• According to Smith, the wealth of a nation

derives from the level of the technology in use.

• The level of technology and its rate of

improvement depend on the division of labor.

Division of labor, extent of the market,

economic progress

• The division of labor is determined by the extent of the market.
• This creates the possibility of an ever-expanding economy.
  • For example, if the extent of the market increases—perhaps because of an expansion of trade within the country or with another country—there will be greater division of labor, which will lead to improvements in the level of technology, which will lead to greater national income, which will lead to another increase in the extent of the market, which will lead to another increase in the division of labor, which will lead to another increase in the level of technology, and so on and on.
• However, Adam Smith felt that a scenario in which this growth gradually peters out (with each round of increases being smaller than those of the preceding round) was more likely.

Division of labor and capital

• Division of labor is enabled by capital

• In a backward, agricultural economy, people

produce, on a regular basis, the simple things

they need

• When workers specialize in the production of

more complex goods, production may take time

• The worker can be sustained during the lengthy

production period only when capitalists can make

loans

• In this way, the accumulation of additional capital

enables additional division of labor

Capitalists hold the key

• Given the importance of division of labor and the workers’ need for loans when division of labor necessarily lengthens the production process, capital accumulation is crucial to economic progress
• But which class of people can be relied upon to save and accumulate capital?
• Not the workers; they barely earn enough to pay for necessities
• Not the landlords; they are dissolute and prone to ostentation
• Only the capitalist strivers who earn profits would save and accumulate capital
• The state could raise the rate of growth by redistributing income from landlords to capitalists

Free Trade

• Smith was in favor of free trade.
• He derived his support for free trade among nations by basing it on the obvious desirability of trade among individuals : - "It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy".
• According to Smith, free trade expands the extent of the market and, thereby, allows greater division of labor
• Free trade also increases productivity by allowing countries to specialize in what they do well.
• This is the Law of Absolute Advantage.
  • David Ricardo refined this idea into the Law of Comparative Advantage

Theory of value: labor

• For primitive economies sustained by hunting and

fishing, Smith adopted the Labor Theory of Value

• This was adopted by Classical economists such as

Smith, Malthus and Ricardo.

• “If among a nation of hunters, for example, it usually

costs twice the labor to kill a beaver which it does to

kill a deer, one beaver should naturally exchange for

or be worth two deer.”

• This theory was meant to apply to economies that did

not use capital goods and all land used in production

was free

• But even in such a case, there is no standard unit of

labor. The hardship and ingenuity involved can vary

from task to task

Theory of value: unit cost

• When analyzing the industrialized economy of the Great Britain of his time, Smith thought of the ‘natural price’ (or, long run price) of a product as the cost of all resources used in production
• Cost includes wages (payment for labor), rent (for land), and profit (for the capital of the entrepreneur).
• Note: price = unit cost does not mean profits = zero; it only means supernormal profits = zero.
• Profit is what the entrepreneur gets for risk-taking
• As workers need to be paid even if the output is not ready for sale, the entrepreneur is essentially a money lender to the workers. Therefore, profit also includes what we call interest today
• From today's point of view the classical theory of value, which denies the influence of demand and identifies production cost as the only influence on prices, has some validity in the long run but is not useful for short run analysis.

Wages: Iron Law of Wages

• Smith used different theories of the wage rate at different times
• One was a form of the Iron Law of Wages
  • This theory held that wages are by and large equal to the subsistence level of wages.
  • If wages exceed the level that is just enough to keep the worker and his dependents alive, there will be an increase in population that will drive wages down to the subsistence level.
  • If wages fall below what the workers need to stay alive, population will fall and wages will rise to the subsistence level.
• This meant that any increase in total output went not to the workers but to capitalists who would save and invest in machinery that would make possible further division of labor and technological progress.

Wages: bargaining

• The wage rate depends on the bargaining power of

workers and businesses

• Employers can collude with greater ease because

employees are numerous

• In Great Britain at Smith’s time, employers’ collusion

was allowed but unions were not. There were laws

against raising wages, but none against lowering them

• Employers have more wealth to survive a strike;

workers have few savings to tide them over

• It is clear that Smith had a very complex view of the

nature of a market economy