Scoutish Journal of Poltical Economy, Vol. 39, No. 1, February 1992 1992 Scottish Eeonomic Society ADAM SMITH ON THE FALLING RATE OF PROFIT: A REAPPRAISAL FRANCISCO VERDERA™ New School for Social Research, New York; and Instituto de Estudios Peruanos, Lima, Peru INTRODUCTION One of the neglected aspects in the studies of Adam Smith's Wealth of Nations is his thesis of the tendency for the rate of profit to fall. A significant number of interpreters have accepted Ricardo’s critique concerning this.' Marx also accepted the authority of Ricardo’s interpretation. Marx writes: A. Smith explained the fall of the rate of profit, as capital grows, by the competition among capitals. To which ricardo replied that competition can indeed reduce profits in the various branches of business to an average level, can equalize the rate, but cannot depress this average rate itself.? This paper has one central purpose: to question Ricardo’s interpretation of the causes for this tendency in Smith’s thought. We will try to show in Smith’s own words that the tendency for the rate of profit to fall does not result from competition, but from an increase in the stock (or capital) in all the society. L will present the argument in three stages in the next three sections. Section 11 contains observations on Ricardo. Section III presents a re-reading of Smith's Book 1, The Wealth of Nations (hereafter refered as WN), where he establishes that both the level and the variations of the natural rate of profit are not determined by competition. Section IV deals with Smith’s rationale of how the accumulation of capital leads to a decline in the rate of profit by increasing the productivity of labour. The final section contains the conclusions. "1 am indebted to Professor Robert Heilbroner for comments and stimulus and also to Martin Kolhi, Alex Polo and Eduardo Vioiti. 1 also want to thank an anonymous referee for several suggestions. ' See Dobb (1975, p. 326 and p. 331); Hollander (1973, p. 179); Tucker (1960, p. 60); Bowley (1975, p. 366). The latter has been one of the sources of reflexion about this topic; Bowley intends ‘to show how the role of capital came to dominate (The Wealth of Nations) as the major influence on growth’ (p. 361). See also Marx (1967, p. 213). It is striking that Marx does not pay attention to Smith’s writings on this issue. * Marx (1973, p. 751). Date of receipt of final manuscript: 15th April 1991 100ADAM SMITH ON FALLING PROFIT RATE 101 I OBSERVATIONS ON RICARDO Ricardo dedicates Chapter XXI of his Principles to the effects of accumulation on profits, His first observation about Smith on this topic states: Adam Smith, however, uniformly ascribes the fall of profits to accumulation of capital, and to the competition which will result from 3 (should say the fall of the rate of profit, FV.; italics added). The second observation is to be found in one of the most frequently cited references to Smith, which Ricardo uses to sustain his interpretation as to Smith's explanation for the falling rate of profit: The increase of stock, which raises wages, tends to lower profit. When the stocks of many rich merchants are turned into the same trade, their mutual competition naturally tends to lower its profit; and when there is a like increase of stock in all the different trades carried on in the same society, the same competition must produce the same effect in them all (WN, p. 87). Note that Ricardo says the intensification of competition will result from the accumulation of capital. He fails to recognize that there are two steps in the explanation, and that the increase of competition is a consequence of the increase of stock. In his interpretation of Smith's quotation, Ricardo says that the increase in wages due fo an increase of stocks can only be a temporary rise, which would come from a temporary increase in the demand for labour.* \n consequence, the fall of profits should also be a temporary one. Thus we find that Ricardo makes an inversion of Smith's position. According to Ricardo, Smith says that competition would be the reason for a permanent decrease in the rate of profit. This Ricardo rejects as wrong. But Ricardo does not realize that Smith is arguing that these variations come from an increase of stock. We have only to note the previous paragraph of the citation, where Smith says: The rise and fall in the profits of stock depend upon the same causes with the rise and fall in the wages of labour, the increasing or declining state of the wealth of the society; but those causes affect the one and the other very differently (WN, p. 87, italics added), Thus there exists one kind of variation—a permanent one—depending on the state of the wealth of the society (or the amount of stock accumulated); and another kind—temporary—coming from competition among individual capitalists, or ‘when the stocks of many rich merchants are turned into the same trade Ricardo links the increase of stock, when permanent, only to an increase of * Ricardo, Principles (1951, p. 289). * Ibid. Ibid.102 FRANCISCO VERDERA. wages, and uses the latter as the reason for the fall of the rate of profit. Central to Ricardo’s thought is the terrain of distribution between wages and profits. Thus, when the increase of the demand of labour is permanent, wages rise: «++ in consequence of the rise of necessaries, and so little consequently remains for the profits of stock, ... ° Smith relates profits to accumulation, while wages are determined by some level of subsistence for the workers.” He distinguishes between an increase of wages above this level when there is competition among masters, and an increase of demand for workers resulting from an increase in the stock of a country.® Ricardo thus shifts the centre of the discussion from the relation between capital and profits to the relationship between wages and profits; ie., from accumulation to distribution. Ricardo opens another debate concerning the cause of the falling rate of profit in Chapter XXI. The new focus consists in his defence of Say’s Law against his particular interpretation of Smith. Ricardo thought that Smith was concerned with the problem of ‘realization’, and opened the so-called ‘lack of opportunities’ argument (or the insufficiency of demand) for the new stock accumulated.” Ricardo says: M. Say has, however, most satisfactory shewn, that there is no amount of capital which may not be employed in a country, because demand is only limited by production ... .«. Adam Smith, however, speaks of the carrying trade as one, not of choice, but of necessity; as if the capital engaged in it would be inert if not so employed, as if the capital in the home trade could overflow, if not confined to a limited amount. '° Smith presents, as a possible outcome of the fall in the rate of profit, the export of capital. He holds that to obtain higher rates of profit, capital has to be exported to poor countries: As capitals increase in any country, the profits which can be made by employing them necessarily diminish. It becomes gradually more and more * Ibid.. p. 290. 7 Smith says: *,.. even in the lowest species of common labour (workers must) be able to earn something more than what is precisely necessary for their own maintenance;” and also, on p. 69: ‘There are certain circumstances, however, which sometimes give the labourers an advantage, and enable them to raise their wages considerably above shis rate; evidently the lowest which is consistent with common “humanity”’ (WN, p. 68, italics added). * “The demand for those who live by wages, it is evident, can not increase but in proportion to the increase of the funds which are destined for the payment of wages. These funds are -« the revenue .., and,... the stock... ()...therefore, (this demand) necessarily increases with the increase of the revenue and stock of every country, and cannot possibly increase without it. The increase of revenue and stock is the increase of national wealth’ (WN, p. 69). A direct statement against Ricardo is the following: The wages of labour do not sink with the profits of stock. The demand for labour increases with the increase of stock whatever be its profits;* (WN, p. 93), On the ‘lack of opportunities’ argument see Bowley (1975, p. 375), Hollander (1973, p. 183), Tucker (1960, p. 92). " Ricardo (1951, pp. 290-291).ADAM SMITH ON FALLING PROFIT RATE 103 difficult to find within the country a profitable method of employing any new capital ... [or] ... When [it]is increased to such a degree, that it cannot be all employed in supplying the consumption, and supporting the productive labor of that particular country, the surplus part of it naturally disgorges itself into the carrying trade, ... (WN, pp. 336 and 354),"" This is also seen by Ricardo as an attack on Say’s Law. Ricardo could not accept the existence of an ‘excess of stock’. Instead of relating this phenomenon to a low rate of profit, he links it to an insufficiency of demand, independent of the rate of profit. He concludes: there is no limit to demand—no limit to the employment of capital while it yields any projit, and that however abundant capital may become, there is no other adequate reason for a fall of profit but a rise of wages, ... (italics added). Ricardo thinks that Smith conceived a realization problem, whereas, in fact, Smith is simply elaborating a consistent point of view about the accumulation of capital—namely, its effect on the rate of profit and, in consequence, the necessity of capital export. i SMITH ON THE RATE OF PROFIT Having considered two aspects of Ricardo’s interpretation—competition and ‘lack of opportunities’—we can deal directly with Smith. As Meek notes, Smith was the first economist who appreciated the significance of the general rate of profit.'? He also made the distinction between the general (or ordinary, natural, average) rate of profit for the whole of society (or country), the different proportions among individual rates of profit and, finally, the market rate of profit. To clarify our argument, it is necessary to understand these basic concepts of Smith and their relation to each other. ‘The first concept—the general rate—is the only one regulated by the mass of profits and the amount of stock of all the society. The two others are regulated by competition among industries or individual capitalists. Obviously, when the accumulation of stock proceeds, competition will be intensified. This will become evident through variations between the relative rates of profits, and/or variations in the market rates of profit around the ‘natural’ level. Smith's definition of the general rate of profit is that a portion of the value "In a country which had acquired its full complement of riches, where in every particular branch of business there was the greatest quantity of stock that could be employed in it, as the ordinary rate of cleat profit would be very small, so the usual market rate of interest which could be afforded out of it ..." (WN, p. 96). " Ricardo (1951, p. 296). " Meek (1967, p. 18).104 FRANCISCO VERDERA created, the profits, were to bear some proportion to the whole stock of materials and wages the capitalists have advanced. “* The general rate of profit is given for an individual capitalist. If the capitalist’s stock increases, its mass of profits will also increase. This natural rate of profit is one of the components of the natural price and varies according to the degree of wealth of a society: The natural price itself varies with the natural rate of each its component parts, of wages, profit, and rent; and in every society this rate varies according to their circumstances, according to their riches or poverty, their advancing, stationary, or declining condition (WN, p. 62).'* Smith establishes the difference between those circumstances that affect the general rate of profit and those that affect the proportion among the rates of profit in all the different employments of stock. He posits that the latter seems to be little affected by the state of the society: «+. @ certain proportion seems commonly to take place between... [] ... the pecuniary profits in all the different employments of stock. This proportion,...,depends partly upon the nature of the different employments, and partly upon the different laws and policy of the society in which they are carried on, But though in many respects dependent upon the laws and policy, this proportion seems to be little affected by the riches or poverty of that society; by its advancing, stationary, or declining condition; but to remain the same or very nearly the same in all those different states (WN, p. 63, italics added). Smith repeats the same argument in Chapter X. He states that ‘revolutions in the public welfare’ affect the general rate but the proportions among them remain the same. The proportion depends upon the nature of the different employments and the different laws and policy of the society: The proportion between the different rates both of wages and profit in the different employments of labour and stock, seems not to be much affected, as has already been observed, by the riches or poverty, the advancing, stationary, or declining state of the society. Such revolutions in the public welfare, though they affect the general rates both of wages and profit, must in the end affect them equally in all different employments. The proportion between them, therefore, must remain the same, and cannot well be altered, at least for any considerable time, by any such revolutions (WN, p. 143, italics added), Finally, he presents the market rate of profit, the one affected by competition among individual capitalists of the same trade. This process of competition will ‘| WN, p. 48: also p. SS on the notion of average rate. 'S On this Smith says: ‘... 1 shall endeavour to show what are the circumstances which naturally determine the rate of profit, and in what manner too those circumstances are affected by the like variations in the state of the society’ (WN, p. 63).ADAM SMITH ON FALLING PROFIT RATE 105 make the market rate gravitate around the natural rate but will not affect the latter: Whatever part of [the natural price] was paid below the natural rate, the persons whose interest it affected would immediately feel the loss, and would immediately withdraw either so much ... stock, from being employed about it, that the quantity brought to market would soon be no more than sufficient to supply the effectual demand. Its market price, therefore, would soon rise to the natural price (WN, p. 62). IV CAPITAL, PROFIT AND THE PRODUCTIVITY OF LABOUR The conclusion of Book I is that the natural rate of profit is neither determined nor affected by competition, but by the accumulation of stock and the mass of profits. In Book II, Smith reinforces three points: (i) the intensification of competition is a consequence of the increase in the stock of capital, and this increase is the unique cause for the falling rate of profit; (ii) there are two units of analysis: one is ‘the whole capital of the country’ and the other ‘the different capitals of which [it] was composed’; (iii) there are two different types of variations of wages and the rate of profit. One is permanent, as a result of the increase of capital; the other, temporary, coming from competition among the owners of capital. The former affects the natural rate of profit, the latter, the market rate. Smith writes: As capitals increase in any country, the profits which can be made by employing them necessarily diminish. It becomes gradually more and more difficult to find within the country a profitable method of employing any new capital. There arises in consequence a competition between different capitals, the owner of one endeavouring to get possession of that employment which is occupied by another. But upon most occasions he can hope to justle that other out of this employment, by no other means but by dealing upon more reasonable terms...()... competition [between the owners of capitals] raises the wages of labour, and sinks the profits of stock. But when the profits which can be made by the use of a capital are in this manner diminished, ... (WN, p. 336, italics added), and also, The whole capital of the country being augmented, the competition between the different capitals of which it was composed, would naturally be augmented along with it. The owners of those particular capitals would be obliged to content themselves with @ smaller proportion of the produce of that labour which their respective capitals employed (WN, p. 338-339, italics added),106 FRANCISCO VERDERA I want to stress two additional considerations from these quotations. Once the capital of the country has augmented, and the profits of stock have diminished, the capitalists have to accept a smaller proportion of the produce of that labour, which their respective capitals employed. This means that a reduced general rate of profit is applied to their capitals. The motive for the intensification of competition (or capital export) comes up when it is difficult to find a ‘profitable method of employing any new capital’ (quoted above). This occurs only after the general rate of profit has decreased. A second step in re-constructing Smith’s argument concerns the increase of the stock (or accumulation) leading to the fall of the rate of profit. For this Purpose we have to perceive the connection between capital, the stock over which the profit has to be related, and labour, the source of that profit. At the end of Book I, he makes a concise statement: It is the stock that is employed for the sake of profit, which puts into motion the greater part of the useful labour of every society ...() ... But the rate of profit does not, like rent and wages, rise with the prosperity, and fall with the declension, of the society. On the contrary, it is naturally low in rich, and high in poor countries, ... (WN, pp. 249-250, italics added). Here Adam Smith clearly relates the stock employed and the volume of useful labour put into motion. We must ask what is the mechanism beneath this relationship that produces the fall in the rate of profit? The answer is the productive powers of labour. When stock increases its most important use, in order to increase the productivity of labour, is the creation of fixed capital, At the beginning of Book II Smith defines this term as: .+- all useful machines and instruments of trade which facilitate and abridge labour ... (WN, p. 265). '® We find in Book I an enhancement of this definition: s++y the increase of stock, tends to increase its productive powers, and to make a smaller quantity of labour produce a greater quantity of work (WN, p. 86).'7 It remains only to make the connection between an increase of stock and the '® Meek (1967, p. 26) writes: ‘The typical master manufacturer of the ‘Wealth of Nations’ is one who has invested a fairly large proportion of his capital in machines and the ‘instruments of his trade’ ... (WN, p. 270). It is this investment in fixed capital which constitutes, as it were, the undertaker's stake in the manufacture, and broadly speaking it is this investment in fixed capital which marks him off as a manufacturer rather than as a merchant’. There is a reference on this topic in Bowley (1975, p. 368). "’ Bowley (1975, p. 368), refers to the same notion: ‘Here then is an unambiguous recognition of the existence of a positive marginal product of capital, but it is stated in terms of increases in the productivity of labour’, and ‘.,, Smith says that the purpose of fixed capital is to increase the productive powers of labour, that is to enable the same number of labourers to produce more [WN IL.ii.7]. It follows that capital is not only an essential means of allocating and advancing subsistence and materials to labour, but that capital is also regarded by Adam Smith as productive in a direct manner’. This is, of course, a very particular interpretation.ADAM SMITH ON FALLING PROFIT RATE 107 increase of the productive powers of labour through fixed capital: The intention of the fixed capital is to increase the productive powers of labour, or to enable the same number of labourers to perform a much greater quantity of work (WN, p. 271). One needs to underline the relation between this process and the generation of new value, or profits, by demonstrating that it is possible to derive the fall in the rate of profit from the increase in fixed capital in Smith’s terms. The increased use of fixed capital has two effects for Smith: (1) it raises the productivity of labour; (2) it raises its own maintenance (depreciation) and the cost of circulating capital (mainly inputs). Capital costs thus become a larger proportion of the total value produced. Using less ‘living labour’, in Marx’s vocabulary, the amount of profits over the total capital, both per unit or on masse decreases. In Smith's words: No fixed capital can yield any revenue but by means of a circulating capital. The most useful machines and instruments of trade will produce nothing without the circulating capital which affords the materials they are employed upon, and the maintenance of the workmen who employ them (WN, p. 267). The foundation for this interpretation arises from Book II, Chapter Ill, ‘Of the accumulation of capital, or of productive and unproductive labour’. Here Smith presents a fully articulated argument in favour of the falling rate of profit as a result of the increase of the stock of capital. He reiterates what is the source of profits: Thus the labour of a manufacturer adds, generally, to the value of the materials which he works upon, that of his own maintenance, and of his master’s profit (WN, p. 314). Next, he develops a new point: the importance of the portion of the total product utilized in the replacement of the total capital used: Of the produce of great manufactory,... one part [of the whole annual produce}, and that always the largest, replaces the capital of the undertaker of the work; the other pays his profit, ... (WN, p. 316; italics added). The proportion between the part of the annual produce which is destined for replacing capital and that which is destined for constituting a revenue is crucial in determining the proportion between productive and unproductive labour. In our argumentation the former proportion is a key element in determining the rate of profit: This proportion is very different in rich from what it is in poor countries. Thus, at present, in the opulent countries of Europe, a very large, frequently the largest portion of the produce of the land, is destined for replacing the capital of the rich and independent farmer; the other for paying his profits, and the rent of the landlord. But anciently,..., very108 FRANCISCO VERDERA small portion of the produce was sufficient to replace the capital employed in cultivation (WN, p. 317). ‘Smith posits that in the advanced countries the portion of the product used for replacing capital is increasing. This means that as accumulation proceeds, the portion destined to replace both fixed and circulating capital becomes a greater part of the total product. This is precisely what Smith means in the next citation, the decisive argument for this paper. I establishes that the profits become a smaller share of the produce of manufactures: That part of the annual produce, ..., which, ... is destined for replacing a capital, is not only much greater in rich than in poor countries, but bears @ much greater proportion to that which is immediately destined for constituting a revenue either as rent or as profit (WN, pp. 318—319).'® Thus the capital/output or capital/profit relation increases, or the rate of profit falls. Smith completes this construction with a theory of growth. He postulates how the new value increases as a consequence of either the increase of capital or the growth of labour productivity. As a result of the increase of fixed capital and the consequent rise in labour productivity, the amount of both fixed and circulating capital will increase with respect to the output. This factor makes the rate of profit decline: The annual produce of the land and labour of any nation can be increased in its value by no other means, but by increasing either the number of its productive labourers, or the productive powers of those labourers who had before been employed. The number of its productive labourers, ..., can never be much increased, but in consequence of an increase of capital, ... The productive powers of the same number of labourers cannot be increased, but in consequence either of some addition and improvement to those machines and instruments which facilitate and abridge labour; or of a more proper division and distribution of employment. In either case an additional capital is almost always required. It is by means of an additional capital only, that the undertaker of any work can either provide his workmen with better machinery ... When we compare, therefore, the state of a nation at two different periods, and find, that the annual produce of its land and labour is evidently greater at the latter than at the former, ..., we may be assured that its capital must have increased during the interval between those two periods, ... (WN, p. 326). Increase in ‘its value’ is understood as new value or as a mass of profits (plus rent). There are two modes to augment it: increasing the number of labourers '* Close to this point, Bowley (1975, p. 368), says: ‘In Book I1, Smith sets out in some detail the reasons why the proportion of stock devoted to different purposes, ic., provisions, machinery, materials and tools and wages, will change. Provisions, he points out, will become @ smaller proportion as each labourer is supported by more capital invested in materials, ‘machinery and tools.” This is closer to Marx's concept of ‘technical composition of capital’ than to Smith.ADAM SMITH ON FALLING PROFIT RATE 109 andjor increasing their productive powers. The second mode is achieved through an increase of productivity of labour coming from an additional capital (or ‘a better machinery’). It has to be taken into account that improvements in productivity of labour can also arise from the division of labour and/or intensifying labour. These two Processes are pointed out as counterforces to the tendency of the rate of profit to fall.'* Moreover, the working of these counterforces indicates that the tendency for the rate of profit to decline is not an inevitable path for an economy. We can combine Smith’s conception of growth through the rise in productivity of labour with the argument that the part destined for replacing capital ‘bears a much greater proportion’ to that destined as profit. Smith's argument that accumulation is the cause for the decline in the rate of profit then anticipates Marx’s later detailed explanation of this tendency. v ‘CONCLUSIONS Our reappraisal of Smith’s explanation of the falling rate of profit can now be recapitulated: (i) Ricardo initiated a misunderstanding of Smith’s argument concerning the falling rate of profit—a misunderstanding that has been followed by most of Smith’s interpreters, Ricardo attributes to Smith the idea that ‘competition’ and the ‘lack of opportunities’ are the reasons why the rate of profit fall. This is because Ricardo did not pay sufficient attention to the fact that for Smith competition only makes the market rate of profit ‘gravitate’ around the natural rate, He also failed to understand that accumulation and not ‘realization’ was Smith's major concern. (ii) Searching for the nexus between the accumulation of capital and the rate of profit in Book II of the Wealth, we can derive an alternative explanation for the decline in the rate of profit. Smith defines fixed capital as a major component of capital. Any increase in the productive powers of labourers comes from an increase in this fixed capital. This leads to an increase in the proportion of the product destined to replace the total capital used in its production. This is equivalent to a decrease in the ratio between the mass of profits and the capital. As capital accumulates, the rate of profit falls. REFERENCES Bowtey, M, (1975), Some aspects of the treatment of capital in ‘The Wealth of Nations’. In Skinner, A. S. and Wilson, T. (eds.), Essays on Adam Smith. Oxford: Claredon Press, pp. 361-376. '” On these arguments see Reid (1989, p. 181) and Marx (1967, pp. 232-233).110 FRANCISCO VERDERA Dose, M. (1975). Ricardo and Adam Smith. In Skinner, A. S. and Wilson, T. (eds.). Op. cit.; pp. 324-335. HOoLLanpeR, S. (1973). The Economics of Adam Smith. Toronto: U. of Toronto Press. Marx, K. (1967). Capital. Volume 11. New York: International Publishers. Marx, K. (1973). Grundrisse. New York: Vintage. Meex, R. (1967). Adam Smith and the classical theory of profit. In Economics and Ideology and Other Essays. London: Chapman and Hall, pp. 18-33 REID, G. (1989). Classical Economic Growth: An Analysis in the Tradition of Adam Smith. Oxford: Basil Blackwell. Ricarpo, D. (1951). On the Principles of Political Economy and Taxation, Srafta, P. (ed.), Cambridge U. Press. Swit, A. (1937). The Wealth of Nations. Cannan, E. (ed.), New York: The Modern Library, Tucker, G. L. S. (1960). Progress and Profits in British Economic Thought 1650-1850. London: Cambridge U. Press.Copyright of Scottish Journal of Political Economy is the property of Blackwell Publishing Limited and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use.