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Development Theories by Adam Smith, Ricardo, Marx

Adam Smith’s Development Theory- An Enquiry into the Nature and
Causes of the Wealth of Nations 1776

• Natural law: He regarded every person as the best judge of his self-interest
who should be left to judge and pursue his own advantage.

• Everything will be guided by the invisible hands of markets

• He mentioned that if we set all people free then all will be set free and in this
pursuit, they all will raise the economic welfare of the society.

• He mentioned that the bread that we get is basically, because the baker wants
to bake bread, which is his self interest.

• Laissez-faire economy

• The “invisible hand” the automatic equilibrating mechanism of the perfectly

competitive market tended to maximise national wealth.

• Division of Labour (DoL): He mentioned that is the DoL that results in the
greatest improvement in the productive powers of labour.

• This increase in productivity is mainly because of a) raising skills of labour,

b) saving time to produce goods c) invention of labour-saving machines.

• It is the improved technology that leads to DoL and market expansion.

• He mentioned that as population rises, transport facilities will also rises and
there will greater division of labour and increase in capital

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• Capital Accumulation Process: He mentioned that capital accumulation

should precede the introduction of DoL.

• He regarded the Cap. Accumulation is a necessary condition for economic dev,

which is largely dependent upon the ability of people to save more and invest
more.

• The rate of investment was determined by the rate of saving and savings are to
be invested in full.

• But as all savings are from capital or renting out land, so savings are done by
the capitalists. Labour can’t save- IRON LAW OF WAGES.

• This is because total wages fund = subsistence amount of labour. If TWF >
SAL, then Labour rises, competition rises and wages falls.

• Agents of Growth: He stated that farmers, producers, and businessmen are the
agents of growth. Their functions are interrelated. He mentioned that
agricultural surpluses arises due to economic development. He also focused
upon the interlinkages between agriculture and industry and tertiary sectors.

• Growth Process: Due to savings, nation experience a certain rate of economic

growth. Gradually, this leads to widening of markets which leads to division of
labour and productivity increases. He stated growth as cumulative. When
agriculture, manufacturing and industries and commerce expans, capital
accumulation and technical progress, market expansion, DoL, profits and
finally population rises. –this happens in PROGRESSIVE STATE.

• But this progressive state will end, which leads to stationary state, as scarcity
of natural resources will stop the growth process. Competition among labour
increases, employment falls, wages falls, competition among businessmen
rises, price fall, profits falls, investment fall- END OF CAPITALISM

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• Capital accumulation stops, population becomes stationary, profits are

minimum, wages are at its subsistence level and there is no change in per
capita income and production→ STATIONARY STATE reaches
STAGNATION

• The economy grows from K to S during the time path T. After T, the economy
reaches the stationary state linked to S where further growth does not take
place because wages rise so high that profits become zero and capital
accumulation stops.

Ricardian Theory- The Principles of Political Economy and Taxation, 1817

• He never propounded any theory of development, he simply discussed theory of

distribution.

• His theory is based upon marginal and surplus principles.

• Marginal principle explains the share of rent in the national output

• Surplus principle explains the division of remaining share between wages and
profits.

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Assumptions
(i) All land is used for the production of corn and the working forces in agriculture
help in determining distribution in industry.
(ii) The law of diminishing returns operates on land.
(iii) The supply of land is fixed, but differs in quality- heterogeneous land
(iv) The demand for corn is perfectly inelastic.
(v) Labour and capital are variable inputs.
(vi) Capital consists of circulating capital.
(vii) There is capital homogeneity.
(viii) The state of technical knowledge is given.
(ix) All workers are paid a subsistence wage.
(x) The supply price of labour is given and constant.
(xi) Demand for labour depends upon accumulation of capital & both demand &
supply price of labour are independent of marginal productivity of labour.
(xii) There is perfect competition.
(xiii) Capital accumulation results from profits
(xiv) Labour and capital are used in fixed co-efficients.
Ricardian Theory
• He modified Smith’s theory to include diminishing returns of land.
• Like Smith, Ricardian theory consists of landlords, capitalists and
labourers.
• Capital Accumulation is the outcome of profit because profits leads to
saving of wealth which is used for capital formations. The rate of profit =
ratio of profit to capital employed.
• Wages rises when prices of goods rises.
• It is the capitalists who initiate the process of economic development in the
society by reinvesting profits and, thus, increasing capital formation.

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The Ricardian model is based on the interrelation of three groups in the economy-
landlords, capitalists and labourers among whom the entire produce of land is
distributed.

Rent, Profit and Wages

(a) rent is that portion of the produce which is paid to the landlord for the use of original
and indestructible powers of the soil. Rent is the difference between average and
marginal product. Since land is heterogeneous by assumption, so there exists a
difference in rent arising from different land pieces. If it would have been that all land
pieces have the same property, then rent would have not occurred.

(b) The wage rate is determined by wage fund divided by number of workers employed
at the subsistence level.

Wage fund
= Subsistence level of wage
No. of Labourers

Out of the total corn produced, first rent is paid and the residual produce is distributed
between labour and capitalists as wage and profits and interests, respectively.

Capital Accumulation – According to Ricardo capital accumulation is the outcome

of profit because profit leads to saving of wealth which is used for capital formations.
Thus, the larger the surplus i.e. profit, the larger will be capacity to save.

i) The Profit Rate - The rate of profit is equal to the ratio of profit to capital employed.
But since capital consists of only working capital, it is equal to the wage bill. So
long as the rate of profit is positive, capital accumulation will take place.

Surplus Surplus
Rate of Profit = =  Wages = Circulating Capital
Capital Wages

There is an inverse relationship between w and r; as w increases, r decreases

In reality, profits depend upon wages, wages on price of corn and the price of corn
depends upon the fertility of the marginal land. So there is an inverse relation

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between wages and profits. When due to improvement in agriculture, production

increases, the price of corn falls and subsistence wages also fall and profits will
increase leading to capital accumulation. This will raise demand for labourers
raising wage rate and reducing profits.

ii) Increase in Wages – The wage rate increases when the prices of commodities
forming the subsistence of the workers increase. As the demand for food increases,
less fertile land is brought under control and more labourers are needed raising wage
rate. Thus wages would rise with the increase in the price of corn. In a situation rent
also increases, with the decline of capitalists’ profit capital accumulation also
declines.

iii) Declining profits in other industries – The profits of the farmer regulate the
profits of all other trades. Therefore the money rate of profit earned on capital must
be equal both in agriculture and industry. If profit rate declines in the agricultural
sector it will also decline is the manufacturing industry.

Other Sources of Capital Accumulation: According to Ricardo economic

development depends upon difference between production and consumption. Capital
may be increased by increased production or by a diminished unproductive
consumption. However, the productivity of labour may be increased through
technological changes and better organisation. It is in this way that capital
accumulation can be increased. But the use of more machines employs less workers
leading to unemployment. So Ricardo regards technological conditions as given and
constant.

a) Taxes:- Taxes are a source of capital accumulation in the hands of government.

According to Ricardo, taxes are to be levied to reduce conspicuous consumption.
Otherwise the imposition of taxes on capitalists land lords and labourers will
transfer resources from these groups to the government, adversely effecting
investment. So he does not favour the imposition of taxes.

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b) Free Trade:- Ricardo is in favour of free trade. The profit rate can be saved from
declining by importing corn. The capital accumulation therefore continues to be high.

Total National Income = Rent + Profits + Wages

• Rent is determined as Rent = (Average Rent – Marginal Product) x QL or
QK
• Wage rate is determined as Wage Fund  Number of workers employed at
subsistence wage.
• Out of the total income, rent will be paid first and the residual is
distributed among wages and profits (profits including interest).
• Y = F (K ,N,L), where, K = Capital | N = Labour| L = Land

Refer to the live session for the derivation portion

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Ricardian Stationary State Smithian Stationary State

• As economic development proceeds with real wage • Growth Process: Due to savings, nation
rate remaining at the subsistence level and profit experience a certain rate of economic growth.
tends to rise → Capital accumulation rises→ Total Gradually, this leads to widening of markets
output rises→ Wage fund rises→ Population rises which leads to division of labour and
→ Demand for Corn & Price rises → Inferior lands productivity increases. He stated growth as
are cultivated to meet increasing demand of corn. cumulative. When agriculture, manufacturing
(labour and landlord consume everything and no and industries and commerce expans, capital
saving) accumulation and technical progress, market
• The saving is done by the capitalist for profit expansion, DoL, profits and finally population
earners. But ae society progresses, the share of rises. –this happens in PROGRESSIVE
profit begins to decline. Fall in the rate of profit STATE.
slackens the process of capital accumulation and • But this progressive state will end, which leads
the development receives a set back and at this to stationary state, as scarcity of natural
stage, there is no further increase in capital and the resources will stop the growth process.
economy enters in a stationary state. Competition among labour increases,
• Capital accumulation stops, population does not employment falls, wages falls, competition
grow, the wage rate is at subsistence level and among businessmen rises, price fall, profits
technological progress ceases. “The basic casual falls, investment fall- END OF CAPITALISM
force in this scheme is the fact of diminishing • Capital accumulation stops, population
returns in agriculture, & the onset of stationary becomes stationary, profits are minimum,
state. wages are at its subsistence level and there is no
change in per capita income and production→
STATIONARY STATE reaches
STAGNATION

• With the increase in capital accumulation, profits and wages tend to increase and the
rise in wages bring about a decline in profits. The decline in profits will continue till
a stage comes when the net product curve intersects the wage line OW at P. At this
point, wages are equal to net product and the profit is nil. Any disturbance to the right

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of point P, will make the net product less than wage level which is impossible. So P
is the point at which economy is in a stationary state.

As Smithian economy grows at an accelerated rate, Ricardian economy develops at a

progressively slower pace.

Marxian Theory of Economic Development- 1867

• He expected capitalistic change to break down because of sociological reasons

and not due to economic stagnation and only after a very high degree of
development is attained. His famous book ‘Das Kapital’ is known as the Bible
of socialism (1867). He presented the process of growth and collapse of the
capital economy.
• Marx's theory differed from classical economists in the following ways:
▪ Unlike Smith or Ricardo, Marx assumed that labour supply as exogenous
to the wage. This implies that in Marxian theory, wages are determined
not by necessity or by natural factors but indeed by bargaining process
between capitalists and workers. The bargaining process is influenced by

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the number of unemployed labourers or the reserve army of labour. He

argued profits as the determinants of savings and capital accumulation.
Assumptions

1. There are two principal classes in society. (a) Bourgeoisie (capitalist class, the
‘haves’ or the oppressors) and (b) Proletariat (labour group, the have-nots, or
the oppressed).

2. Labour theory of value holds good. Thus labour is the main source of value
generation.

3. Factors of production are owned by the capitalists.

4. Capital is of two types: constant capital and variable capital.

5. Capitalists exploit the workers.

6. Labour is homogenous and perfectly mobile.

7. Perfect competition in the economy.

8. National income is distributed in terms of wages and profits.

Marx gave an economic interpretation of history which can be summarized in two

propositions.
i. The basic factor in the historical evolution of society is the mode of production. It
is the mode of production that explains the whole superstructure of ideas and
institutions.
ii. Society develops in accordance with the dialectical principle inherent in its
structure. Marx maintained that, historically, social change takes place in a regular
pattern.

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The sequence of the Marxian stages of social evolution is:

Primitive communism → Slavery → Feudalism → Capitalism → Socialism.
Marx attempted to explain how contradictions in the capitalist system will lead to the
downfall of this system which will be replaced by socialism.
The two important constituents of Marxian philosophy are
i) Dialectical Materialism and ii) Historical Materialism.
Dialectical Materialism
Marx’s theory of history is called Dialectical Materialism.
• Dialectical implies that history follows a pattern of progress through
(ideological) conflict—“thesis, antithesis, synthesis”
• Materialism means all things, including mental states and consciousness, are
results of material interactions.

Historical Materialism

It is the study of society and the laws of its development. The subject matter of historical

materialism includes the study of:

a) the mode of production

b) the dialectics of the mode of production
c) the historical evolution of society.

a) The modes of production: As per Marx, the production of material wealth is the
basis of human existence, and the mode of production of wealth is the determining
factor of social development. Society is inseparable from the rest of nature, and
constantly interacts with it. People cannot exist without food, clothing, shelter, and
other necessities of life. Nature, however, does not provide things readymade. Thus,
people must work to produce these things. Labour, or productive activity, is,

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therefore, the basis of social life. The mode of production, which determines the
economic structure of society, has two aspects:

(i) the forces of production: This refers to the organization, skill and status of labour
the techniques and traditions of production the geographical conditions and degree
of knowledge to utilize materials and resources. The forces of production determine
the relationship between man and nature. Regardless of the form of society, the
interaction between man and nature consists of the unity of three elements

▪ labour: It is productive human activity which transforms natural objects to

satisfy human wants.
▪ the objects of labour: These are the things to which labour is applied, like
raw materials.
▪ the means of labour: Things used by man to act upon objects of labour, such
as machines, tools, buildings, transports, etc.

The objects of labour and means of labour together are termed as Means of Production.

(ii) the relations of production: This refers to a particular relation which determines
the nature of society's class structure. The relations of production determine the
relation between man and machine. According to Marx, production relations are
based on the form of ownership of the means of production. The form of ownership
depends on

a) the position (dominating, or subordinate) of various social groups in production

b) their relations (exploitative, or cooperative) in the production process

c) the distribution of wealth

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b) Dialectics of the Mode of Production Society develops in accordance with the

dialectical principle inherent in its structure. This means that the mode of production
changes because of inherent necessity, and is not due to any external force. The
mode of production is governed by three laws:

i) The Law of Unity: It states that the productive forces and the production
relations, taken together, determine the mode of production of material wealth.

ii) The Law of Correspondence: It states that production relations tend to

correspond to productive forces. The changes in the productive forces induce
adjustment in the production relations. The correspondence of production relations
to productive forces operates only as an economic tendency. It imposes no rigid
dependence of the former on the latter.

iii) The Law of Conflict: It states that conflict emerges from the intrinsic nature of
the two sides of the mode of production, i.e., the forces of production, and the
relations of production. This conflict is not accidental. It is inherent in the mode of
production. It brings development in the mode of production.

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c) Historical Evolution of Society: The relations of production form the economic

basis of the society, while political and legal views, and ideology and institutions form
its superstructure.

Productive forces + Economic basis + Superstructure = Socioeconomic System.

Sum of production relations (i.e. Includes political, legal, philosophical,

property + peoples' relations + moral, religious, artistic, and their
and distribution of wealth) corresponding relations, institutions
and organizations

The economic basis is that aspect of the mode of production which directly shapes the
society, its ideas, and institutions. The superstructure plays a very significant role in
social development. According to Marx, the history of society consists of the history
of the sequence of socioeconomic formations, or the replacement of one mode of
production by another.

Marx stated five different stages of social evolution

i) primitive communism
ii) slavery
iii) feudalism
iv) capitalism
v) socialism.
Class relations do change with the change in the socioeconomic structure of each stage.

The Marxian Economic System

It is composed of four components

a) The capitalist economic system c) The theory of surplus value

b) The labour theory of value d) The theory of capital accumulation.

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a) The Capitalist Economic System: According to Marx, capitalism is consists of

following elements:

i. Divided into two classes: the capitalists, and the workers. The capitalists own
the means of production, while the workers do not. The workers sell their
services, i.e., labour power, to the capitalists for wages.
ii. A commodity forms the unit of production in a capitalistic society. A commodity
is defined as the carrier of use-value (utility) and exchange-value (with other
commodities).
iii. The growth of capitalism is based on the exploitation of labour. Labour produces
surplus value which is appropriated by the capitalist.
iv. All commodities are produced with a profit motive and the exchange equation
is M-C-M’ (such that M < M’). The capitalist purchases commodity, C, (labour-
power) with money, M, with an intention to sell it (after production) for profit,
M’.
v. The motive force behind capitalism is profit. The capitalist always reinvests the
profit in his business to upgrade technology.
vi. Capitalists adopt labour saving machinery which creates a 'reserve army of the
unemployed'. It results in growing the misery of the working class.

b) The Labour Theory of Value: According to Marx, the value of a commodity is

determined by the quantity of labour required to produce it. One commodity has both
use-value and exchange-value. When commodities represent use-values, they are
qualitatively different due to the different forms of useful labour used in them. Marx
was an advocate of the labour theory of value and believed that all production belongs
to labour, because workers produce all value within society. Marx predicted that
capitalism would produce growing misery for workers as competition for profit leads
capitalists to adopt labour-saving machinery. The Marxian 'industrial reserve army'
concept is another way of looking at 'technological unemployment'. For Marx, a

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surplus population was largely the consequence of capitalistic tendencies of capital

accumulation, labour displacing technological change, and the concentration of capital.
The following points explain how the capitalistic process of production leads to the
creation of an ever increasing population.

i. Economic development under capitalism depends upon the accumulation of

capital, which in turn, depends upon surplus value (or, profits). As long as
there is profit, there will be continuous re-investment in the production
process.
ii. In static conditions, capitalists accumulate capital and reinvest it to expand
production, and to reap further profits. Since all round expansion in
production results in an increase in demand for labour (i.e., higher wages),
the surplus value has a tendency to fall. It provides additional reason to
accumulate more capital.
iii. Under dynamic conditions, the greater amount of surplus-value goes to those
producers who are capable of producing advanced technology in production.
Technological progress, according to Marx, means adoption of capital
intensive and labour-replacing technology. Hence, the race for capital
accumulation among the capitalists raises the capital output ratio, which,
reduces profits. Ultimately, the capitalist suffers.

c) The Theory of Surplus Value: Labour power has the unique characteristic of being
capable of producing more than its own value when it is put to productive use. The
excess of value produced by labour power over its own value is called surplus value.
The aim of the capitalist is to, always, increase this surplus value. Surplus value refers
to the extra labour of the worker, for which he receives nothing fiom the producer or
employer. It is appropriated by the capitalist. This implies exploitation of labour. It is
the only cause of class conflict, or class struggle.

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i) Y = C + V + S Y= total income,
S
ii ) s = C= constant capital,
V
C
iii ) k = V= variable capital,
C +V
S S = surplus value,
iv)  =
C +V
Proof of (iv) s = rate of surplus value,
S k = organic composition of capital
=
C +V (capital intensity)
Multiplying & Dividing by V
S (V + C ) − SC
n = rate of profit
SV SV + SC − SC
=  
V (C + V ) V (C + V ) V (C + V )
S (V + C ) SC S SC
 −  −
V (C + V ) V (C + V ) V V (C + V )
S C 
 1 − 
V  C +V 
 = s (1 − k )

This equation shows that  is directly related to s, and inversely related to k.

It means that the profitability of the producer depends, directly, on his capacity to
exploit labour, and, indirectly, on the organic composition of capital. Due to severe
competition, the capitalist tries to raise productivity. Therefore, the degree of
automation rises, and, in turn, the organic composition of capital grows. It means that
the rate of profit increases with the rise in exploitation of labour, and falls with the rise
in constant capital. Therefore, the capitalist suffers from continual reduction of his
profit and profitability. It will meet its natural death, eventually, in the long run.

d) The Theory of Capital Accumulation: Marx argued that under static conditions
capitalists are compelled to accumulate due to: The emergence of surplus value in
capitalist production induces the capitalist to accumulate, and to re-invest→ increased
expansion of production → increase in the demand for labour → rise in wage rates,
and reduction in surplus value → Thus, capitalist invest in labour-saving or capital

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intensive production technology to earn more profits. Surplus value can be increased
in three ways:

i. by reducing the wage rates (temporary effect)

ii. by extending the working hours (temporary effect)

iii. by increasing the productivity of labour.

Marx, emphasized on the third method, which involves technological improvements,

which raises the volume of output produced, hence, the surplus value. The capital
accumulation or technological improvements lead to growing misery of the working
class.

1. Capital Accumulation 2. More Production 3. Wages squeezed

6. Gluts in markets 5. Supply is more 4. Demand is less

7. Small Capitalists shut down 8. Purchased by biggies 9. More Concentration

• In Marxian theory, production means the generation of value. Thus economic

development is the process of more value generating, labour generates value. But high
level of production is possible through more and more capital accumulation and
technological improvement.

• At the start, growth under capitalism, generation of value and accumulation of capital
underwent at a high rate. After reaching its peak, there is a concentration of capital
associated with falling rate of profit. In turn, it reduces the rate of investment and as
such rate of economic growth. Unemployment increases. Class conflicts increase.
Labour conflicts start and there is class revolts. Ultimately, there is a downfall of
capitalism and rise of socialism.

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Systems of Simultaneous Equations [Just Identified]

1) Total output (Q) depends on the size of labour force (L), amount of land (R), stock
of capital (K), and technological progress (T).
Q =f (L, K, R, T),
2) Technological progress (T) depends on investment (I).
T = T (I)
3) Investment (I) depends on the rate of profit ().
I=I()
4) The rate of profit (IT) is the ratio of surplus value and capital
S
=
(C + V )
5) Wages (W) depend on the level of investment and employment.
W = W (I, L)
6) Labour employment depends on the level of investment.
L = L (I)
7) Consumption Expenditure (E) depends on wage bill (W).
E = E (W)
8) Profits are determined by the level of technology and consumption.
 =  (T, E)
9) Total output (Q) is equal to profits (n) plus wages (W).
Q =  +w
10) The economy has two sectors: consumer goods and producer goods sectors. So,
the total output is the sum of consumer goods and producer goods
Q = Dg+Kg = E+I
The Marxian theory has been covered in two sessions. Nevertheless, the content has been provided in this
PDF for maintaining the continuity and smooth learning experience of the learners.

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