Adam Smith

(1723-1790)

The father of Thomas Malthus David Ricardo

(Classical) (1766 – 1834) (1772 – 1823)

Economics

The Beginning of Modern Economics

John Stuart Mill (1806 – 1873)

Adam Smith (1723-1790)
Adam Smith (1723-1790)

1 Historical & Intellectual context

The grand vision: Broad understanding of the

2
interconnectedness of the economy

3 Smith’s analysis of markets and policy conclusions:

Influence on economic policies

4 The nature and causes of the wealth of nations

Historical context: Before Adam Smith: “Mercantile system” (Mercantilism)
- A system of political economy that sought to enrich the country by restraining imports
and encouraging exports
- Dominated Western European economic thought & policies from the 16th -18th centuries
- Principal benefit of foreign trade was the importation of gold and silver
- The goal of mercantilist policies was to achieve a “favorable” balance of trade [trade
surplus] and also to maintain domestic employment.
- Economic rationale:
1. The large and competitive nation-states: The consolidation of regional power centers
2. The establishment of colonies outside Europe
3. The growth of European commerce and industry, especially international trade
4. The increase in the use of metallic monetary systems, particularly gold and silver (not
barter transactions)
3. Smith’s analysis of markets and policy conclusion

Activities of the capitalists:

- The capitalist produces the commodities that people desire. Competition among capitalists will result in these
goods’ being produced at a cost of production that will return to the producer an amount just sufficient to pay the
opportunity costs of the various factors (If profits above a normal rate of return exist in any sector of the economy,
other firms will enter these industries and force down prices to a cost of production at which no excess profits exist)

- Capitalists will bid for the various factors of production, offering higher prices for the more productive factors
and thereby channeling labor and land into those areas of the economy in which their efficiency is greatest.

- Consumers direct the economy by their dollar votes in the market 🡪 changes in their desires are shown in rising
and falling prices🡪 rising and falling profits.
3. Smith’s analysis of markets and policy conclusion

The working of competitive markets:

- The mechanism whereby the price resulting from competition would equal the cost of
production in the long-run:

+ Competition between a large number of sellers (resources owners) who were

knowledgeable about profits, wages, and rents

+ Freedom of movement for resources among industry

🡪 the self-interest of resource owners would lead to long-run natural prices that would
equalize the rates of profits, wages, and rents among the various sectors of the economy.
“Every man, as long as he does not violate the laws of
justice, is left perfectly free to pursue his own interest
his own way, and to bring both his industry and
capital into competition with those of any other man,
or order of man”
3. Smith’s analysis of markets and policy conclusion

- Having established the superiority of competitive markets, Smith easily constructed his case
against monopoly.

“People from the same trade seldom meet together,…but the conversation ends in a
conspiracy against the public, or in some diversion to raise prices.” [monopoly]

- Smith’s argument against government intervention in the economy has political,

philosophical, and economic bases. He reviewed many of the mercantilist regulations of
domestic and foreign trade and showed that they resulted in an allocation of resources that
was less desirable than that produced by competitive market forces🡪 not a purely
theoretical argument; but from personal observation of how governments actually operate
3. Smith’s analysis of markets and policy conclusion

“Adam Smith’s flash of genius was his recognition that the prices that
emerged from voluntary transactions between buyers and sellers – for short,
in a free market – could coordinate the activity of millions of people, each
seeking his own interest, in such a way as to make everyone better off. It was a
startling idea then, and it remains one today, that economic order can emerge
as the unintended consequence of the actions of many people, each seeking
his own interest”

(Milton and Rose Friedman)

 3. Smith’s analysis of markets and policy conclusion

Policy conclusion: the government should follow a policy of laissez

faire
- This argument is based in part upon a theoretical model of how markets
produce certain results. But, significantly, it is contextual, based on Smith’s
observations of the existing historical and institutional circumstances.
- Smith advocated laissez faire (French: leave alone) not because he believed
markets to be perfect but because, in the context of history and the
institutional structure of his time, markets usually produced better results
than did government intervention.
 4. The nature and causes of the wealth of nations

Nature of the wealth of nations:

-For Smith, wealth was an annual flow of goods and services, not
an accumulated fund of precious metals
-The end purpose of economic activity is consumption:
consumption is “the sole end and purpose of all production”
-Fundamental role of exports is to pay for imports
-Labor is the source of the wealth of a nation
4. The nature and causes of the wealth of nations

Causes of the wealth of nations:

The wealth of nations depend upon:

(1) the productivity of labor

(2) the proportion of laborers who are usefully or

productively employed.
4. The nature and causes of the wealth of nations

- Productivity of labor: dependsupon the division

of labor 🡪Division of labor or specialization
increase the productivity of labor
In Smith’s example of straight pins factory, when the
process is divided into 18 distinct operations, output
per worker increases from 20 pins per day to 4800.
4. The nature and causes of the wealth of nations

- Social costs of specialization: workers are given

repetitious tasks that soon become monotonous. Human
beings become machines tied to a production process and
are dehumanized by the simple, repetitive, boring tasks
they perform.

- But Adam Smith believed human welfare would increase

4. The nature and causes of the wealth of nations

Specialization increases productivity of labor by

- Increasing the dexterity of individual workers (Trăm

hay không bằng tay quen)

- Saving time moving from one task to another

- Encouraging the invention of machines

4. The nature and causes of the wealth of nations

- The division of labor, in turn, depends upon the extent of

the market and the accumulation of capital.

+ The larger the market, the greater the volume that can be sold
and the greater the opportunity for division of labor

+ The division of labor is limited by the accumulation of capital

4. The nature and causes of the wealth of nations

- Distributing large incomes to the capitalists, who

save and invest, and low incomes to the landlords,
- Because economic growth is inhibited by government
spending for unproductive labor, it is better to have
less government and lower taxes on the capitalists
so that they may accumulate more capital.
 4. The nature and causes of the wealth of nations
Capital accumulation:

- Capital accumulation determines the division of labor and the proportion of the population
engaged in productive labor

- The present wealth of a nation depends upon capital accumulation and capital accumulation also
leads to economic development

- Individual self-interest coupled with the accumulation of capital leads to an optimum allocation
of capital among the various industries.

- It is the members of the rising industrial class, striving for profits, striving to accumulate capital
to increase their wealth through saving and investment, who are the benefactors of society 🡪 An
unequal distribution of income in favor of the capitalists is of tremendous social importance,
especially for growth
 Summary: Adam Smith vs Mercantilists

- Common assumptions:

(1) Believed that it is possible to discover the laws of the economy [scientific investigation]

(2) Assumed about human nature: rational, economic self-interest

- Different implication:

Mercantilism: Government intervention is a must to accumulate the wealth of nation

Adam Smith: Because competitive market exists, within these markets, factors of production
move freely believed, natural process can resolves conflicts better than any government
intervention
4. The nature and causes of the wealth of nations

- Productive and unproductive labor:

+ The activities of the capitalists, which resulted in an increased output of

real goods, were beneficial to economic growth, whereas the expenditures
of the landowners for servants and other intangible goods were wasteful

+ Capital is required to support the productive labor force 🡪 the greater the
capital accumulation, the larger the proportion of the total labor force
involved in productive labor.
 Modern ideas on “invisible hand”

- Self-interest may promote the public interest.

- Competitive markets allocate resources more efficiently than government
- Markets are self-equilibrating
- Capital accumulation, innovation, and specialization are the three most
important factzors in increasing the standard of living.
- As people specialize in products, they are made better off by trading
domestically or internationally.
- “Consumption is the sole end and the purpose of all production”: consumer
sovereignty
Adam Smith and roles of government

- Smith theory might lead to the doctrine of laissez-faire: against almost all
government intervention against the natural laws of markets (market
mechanism) 🡪 less mercantilist government that regulated price and quality,
controlled production, and supported monopoly 🡪 minimalist government
(popular anti-government interpretation, reflects the majority view of
conservative Chicago School)

- It does not logically imply that smith is against any government intervention
7
Question:

Your opinion on government intervention:

Should or shouldn’t the government intervene

in the market?
Adam Smith and role of government

Minimalist government

- National defense and military security: International trade is important, but national
defense is more important

- Making sure laws are properly enforced: “exact administration of justice” for all
citizens

- Providing public institutions and public works

- Establishing national currency

 Adam Smith and role of government

Positive role of government:

- Anti-monopoly laws to foster open competition and support the market mechanism.
- Provide for public education, especially for the youth of common people, and infrastructure.
- Smith’s dichotomous views on tariffs: when domestic taxation alone was insufficient to pay
for certain necessary functions of government, including national defense
- Government spending needs to be financed by revenues and taxes are a vital source.
- Government has a duty to protect the public from financial swindles and speculative
panics, e.g.+ to prevent a recurrence of credit busts, Smith advocated prevent­ing banks from
issuing notes to speculative lenders
 Conclusion
- Smith is a proponent of open and competitive markets where individuals pursue their
self-interest: The transition from regulation to natural liberty leads to larger market size,
more specialization, higher productivity, and an improved standard of living (wealth).
- Smith is anti-mercantilist government. He wants to remove price, quantity, and quality
controls over goods and services.
- Smith is in favor of minimalist government at a first glance.
- A more expansive reading reveals that Adam Smith argued for a positive role for
government that goes beyond minimalism. In modern jargon, Smith argued for
government intervention in the case of externalities.