Evolution of Economic Thought

Adam Smith

Question:  Why did Adam Smith win the title of "Father of Economics" -- or why was An Inquiry Into the Nature and Causes of the Wealth of Nations considered the first systematic look at economics when it certainly was not?  Why did the knowledge of Cantillon and Turgot, most especially, drop out? 

Most certainly had this not happened, modern day economics might be very different today.

Here are some theories but only theories:

In the French tradition (which includes Cantillon and Turgot) - J.B. Say – never referred to Turgot.   Why didn’t he talk about the French tradition?  He knew them – he carried on the laissez faire tradiation through the French Revolution and after.  He disagreed with Smith on many issues.  Especially the value theory.  Yet he is put into the Classical school tradition today.  Had Say talked more about Turgot, perhaps the paradigm developed there would not have disappeared -- only to be rediscovered in the late 1800s and again in the 20th century.

Two possible explanations (Rothbard):

As we discussed before - Turgot was associated with the Physiocrats -- although he really very much differed from them with respect to ideas.  He was linked to them politically.

1.        The Physiocrats were eventually discredited in France.

a.    Therefore, Turgot was discredited.  The strategy of the Physiocrats: wanted to convert the King to their ideas.  If they did that, he would institute them.  But, their ideas said that the King follows the laws of nature (or should).  So there’s no role for the king – this wasn’t popular.  And they were essentially linked up with absolute monarchy although they wanted the king to be less powerful.  So after the French revolution they were discredited.  This discredited Turgot as well.

2.       The primacy of agriculture idea also discredited.  This also discredited Turgot.

So we had a paradigm lost – and what was left was a century with the British.

The really strange, yet interesting thing about Smith as well - is that his lectures (unpublished at the time) were very different than what he put in An Inquiry into the Nature and Causes of the Wealth of Nations.  For example, he had a utility theory of value in his lectures (and to some degree solved the diamond/water paradox).  This was all left out of the book.  He also left out Hume's specie flow -- even though they were good friends.  There were other things as well. 

Were there political pressures?  Was the labor theory of value more politically appealing?  Hard to tell?  More on this later.

Adam Smith (1723-1790)

Introduction:

Few writers, with the exception of Marx, are as well-known as Adam Smith (in economics and social philosophy anyway).

Human nature, history, social psychology, morality are all subjects he touched – and are the foundations of his writings on political economy.

Smith as Modern-Day Conservative

    Although Smith is usually associated with liberalism (as with the French liberals we have discussed -- and will discuss more of them) - he really might called a modern-day conservative.  Why?

Order in Society:  Adam Smith, like many of his contemporaries, believed firmly in the need for a well-defined social hierarchy.

From The Theory of Moral Sentiments p. 226 - “The peace and order of society is of more importance than even the relief of the miserable.”

Education was a means of achieving a better-functioning society that embodied very ancient values, not a means for tearing down the existing order to build a new one.

Adam Smith’s Life (briefly)

Born in 1723 in Kurkaldy, Scotland.  His father died before his birth.  His mother was the daughter of a substantial landowner.   At age 14, Smith entered the University of Glasgow where he studied under Francis Hutcheson.  Three years later he went to Balliol College, Oxford.   Smith was nearly expelled when a copy of David Hume’s “heretical” Treatise of Human Nature was discovered in his room.   He was largely self-taught.   He was eventually offered a chair at Glasgow University (in logic).  A year later went to a professorship of moral philosophy.

The Theory of Moral Sentiments was published in 1759.

The book was a great success.

Charles Townsend (statesmen) hired Smith to tutor his stepson… the Duke of Buccleuch.

In 1763 Smith set off for France….where he started to write a book “to while away the time.”

This would eventually be An Inquiry Into The Nature and Causes of the Wealth of Nations….finally published in 1776.

He died in 1790, at the age of 67.

Little is really known of Smith’s private life.  He never married and was very devoted to his mother – whom he lived with until her death in 1784; thereafter with his cousin.

The Theory of Moral Sentiments

Was revised through six editions – 1759, last published in 1790.  But few read this book as compared with An Inquiry Into the Nature and Causes of the Wealth of Nations.

1)     The central theme was an explanation of the manner in which we form moral judgments.

2)     Connected with this central problem is a discussion of the Invisible Hand, the name Smith gives to the covert intervention of the Deity into the affairs of humankind.

3)     The third theme is the issue of social stability and dependable hierarchy.

The Passions - The Invisible Hand - Moral Order and Economic Order

Smith said we are born with certain "passions"  - which are God given - and thereby, through these passions, both a moral order and an economic order (of prosperity) will naturally come about.

Man is by nature incapable of foreseeing the consequences of his actions beyond a very narrow range.  How then does he know what to do?

The Passions: The question is answered through the idea that God gave to humankind a surer guide than reason – the call of the passions.

Thus the Invisible Hand refers to the means by which God has assured that humankind will achieve his purpose despite its lack of reasoning powers.

The means are a number of powerful instincts and promptings that God instilled within us, which we obey because we have to, quite unconscious of their long-term social purpose.

In this way, “without intending it; without knowing it” the pursuit of our immediate desires brings us to follow courses of action that would otherwise require a God-like intelligence to pursue.

Two main passions:  Self-Interest and Sympathy

Sympathy will lead to a moral order.

Self-interest will lead to an economic order (of prosperity).

So:   the two orders come about for two different reasons.

Don’t confuse virtue and wealth:

Passions to seek wealth.  Although “wealth and greatness are mere trinkets of frivolous utility” according to Smith… “it is well that nature imposes upon us in this manner” Why?  Because of our vulnerability to wanting wealth, our superhuman efforts are aroused…

We “cultivate the ground, …invent and improve all the sciences and arts…., turn the rude forests into agreeable and fertile plains.”

In this way the actions undertaken solely for private gain are turned into the social act of creating wealth that will benefit all.

“[the rich] are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without knowing it, without intending it, advance the interest of the society, and afford means to the manipulation of the species.”

Hence we get an economic order.  Much more on this later.

Moral Order

The Sympathy Principle

How can human beings, who are self-interested by nature, suspend selfish considerations to form disinterested, “moral” judgments?  That is, moral judgments that are based on what is right and wrong in some objective sense -- not what is right or wrong for "me" in terms of benefits and costs.

In the first chapter Smith writes:

“How selfish so ever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it.”

This is the basic principle upon which Smith builds his theory of morality…sympathy (or sometimes called empathy).

“When we see a stroke aimed, and just ready to fall upon the leg or arm of another person, we naturally shrink and draw back our own leg or our own arm; and when it does fall, we feel it in some measure, and are hurt by it as well as the sufferer.”

"By the imagination we place ourselves in his situation, we conceive ourselves enduring all the same torments, we enter as it were into his body, and become in some measure the same person with him, and thence form some idea of his sensations, and even feel something which, though weaker in degree, is not altogether unlike them."

Sympathy is one of the “original passions. Our sympathy depends on our ability to approve of another’s behavior because it is appropriate to the situation.  Until we understand the context of another’s behavior, we cannot know whether our own emotional response will be one of positive sympathy a negative revulsion, of approval or disgust.

Our sympathy depends upon our understanding of someone’s situation.

We put ourselves in the position of a spectator –

Thus the extension of the sympathy principle leads to an explanation of moral sentiments. 

In a society of perfect liberty, we are no longer constrained by traditional moral codes any more than by an ordained social position.  We are free to “realize” ourselves according to our capacities and ambitions.

But the inescapable bond of sympathy will force upon us a socially approved mode of behavior.  It will stabilize our social conduct, and it will normalize our standards.

We move from the level of merely wishing to be praised to that of being worthy of praise – even though the actual spectator of our actions may condemn them because he does not know the full reasons for our behavior –

This is because gradually these norms become idealized modes – the modes that an impartial spectator would like.

Virtue – Smith’s word for the embodiment of morality.

Morality is not given to us, but made by ourselves.

So to sum:

Sympathy (Empathy)

↓

Imagination (Spectator)

↓

Reason (from experience - but limited)

↓

Reflection

↓

Virtue (worthy of praise)

↓

Moral Order (Social Norms - "Idealized Modes of Behavior")

DO ICE SEVEN

Adam Smith's Economics

The Influence of the French and Physiocrats (rule of nature)

In his travels as tutor Smith met men such as Votaire and Benjamin Franklin…and Francois Quesnay.

Although Smith accepted the Physiocrats ideas of private property and private gain, he did not accept their ideas on productive and sterile sectors.

Nor did Hume, who asked a friend to “thunder them, and crush them, and pound them, and reduce them to dust and ashes”  The Letters of David Hume, p. 19

But Smith said that Physiocracy is “with all its imperfections,” perhaps, “the nearest approximation to the truth that has yet been published upon the subject of political economy.”  And he added it is “a system, which never has done, and probably never will do any harm in any part of the world.”  An Inquiry Into the Nature and Causes of the Wealth of Nations

An Inquiry into the Nature and Causes of the Wealth of Nations

Four Parts:  This book grew out of a series of lectures on public policy which were divided into four parts: 

justice, police, revenue, and arms.

It was not meant as a textbook on economics.

He tried to understand questions such as:

·         Why are some nations richer than others?

·         What determines prices?

·         What determines wages, profits and rent?

·         What is the nature of money?

·         How can you compare standards of living across time and space?

And policy questions such as:

·         Should there be tariffs, export subsidies, etc.?  His analysis was not up to modern academic standards, since Ricardo (or maybe James Mill?) had not yet written about the theory of comparative advantage, but was well ahead of modern newspaper discussions of such issues.

·         Should schooling be public or private?

·         How should universities be organized? Compulsory attendance? Faculty run?

·         How should taxes be collected?

Enormous range of questions.

An Inquiry Into the Nature and Causes of The Wealth of Nations was comprehensive (to a point), a theory of an economy (although in my opinion did not match Cantillon or even Turgot in terms of understanding the whole picture). 

It:

a) Shows connections and relationships among variables.

b) Didn’t focus on a single element.

c) Is a model of workings of an economy that shows how a system can continually generate accumulation

    of wealth.

Free trade was key to Smith (at least that seems clear to most who read him) - we will see why.

Smith's Human Nature Axiom

Lets first start with his assumptions regarding “Human nature” (which are key to his system)

a) Humans are interested in those things that are nearest to us in time and space.

b) Humans want to better their condition - they are by nature self interested.

 “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”

c) Sympathy holds self interested behavior in check, if not jurisprudence (law).

Smith discusses both Microeconomics and Macroeconomics, but he was more of a macro economist – he missed some of the elements of micro that, for example, Cantillon was so good at understanding.

Free markets were advocated to allow the operation of "natural forces."

 Economic Growth and the Division and Specialization of Labor

National wealth is the “exchangeable value of the annual produce of land and labor of a country”  (so therefore, wealth to Smith consisted of real goods and services that people valued in their daily lives)

The division of labor starts the process of economic growth and capital accumulation keeps it going.

“The differences between the most dissimilar characters, between a philosopher and a common street porter, for example, seems to arise not so much from nature, as from habit, custom, and education.”

a) Three benefits of division of labor

(1)

(2)

(3)

 “Men are much more likely to discover easier and readier methods of attaining any object, when the whole attention of their minds is directed towards that single object, than when it is dissipated among a great variety of things.”

“…it is naturally to be expected….soon find out easier and readier methods of performing their own particular work….”

http://www.marketplace.org/topics/life/how-build-sandwich-ground

The Division of Labor is Limited by The Extent of the Market (and capital accumulation)

Division of labor is dependent (and limited) on the “extent of the market” and capital accumulation. The division of labor determines the productivity of labor.

Later on in the the book, Smith does discuss some sociological conclusions of the division of labor (see the paragraph I handed out) - that people become "stupid" from doing the same thing over and over, etc. 

He seems to be setting up a social hierarchy.  He was most certainly into "social order" above all else.  And the idea that some people should have "control" over others -- and that education was the key to dealing with those in society that needed dealt with.

Economic growth and productivity were also dependent on the proportion of productive to unproductive labor. Productive labor is that labor that produces tangible goods that have value in exchange.

Unproductive labor is not useless, it just doesn’t produce tangible goods to be exchanged.

Division of Labor Leads to Interdependence  

Once we divide and specialize we are dependent upon others for things we don't produce.  But this is not a problem to Smith as long as we have ...

Free Trade. 

So free trade was necessary for increases in productivity and economic growth because it allowed for division and specialization of labor.

Policies That Hinder Free Trade

Special privileges (such as an import tariff placed on a good also sold within the country) will benefit some but will not give the country a "general benefit."

Why?

"The general industry of the society never can exceed what the capital of the society can employ."    So no regulation can increase employment beyond what the capital can employ.  

But it can divert capital and labor into directions that otherwise they would not have gone.  This "artificial" direction of resources is not necessarily better.  Because:

People acting in their own self interest will:

try to find out the best employment for themselves -- the employment that is "most advantageous to society."

They will:

1) employ their capital as near as home as possible - so domestic industry will be supported "naturally."  See the reading -- he goes on to explain why people want to stay domestic.  Does this argument hold true today?  What do you think?

2) "every individual who employs his capital in the support of domestic industry, necessarily endeavours so to direct that industry that its produce may be of the greatest possible value."  Again, people will direct resources to where they are valued.  An "artificial" direction will not necessarily do that.

    This is the instinct of self interest -- given to mankind by God, thereby the "invisible hand" of God (the instinct) directs resources to the right place (highest value for society). 

DO ICE EIGHT

Smith on “Value”

He distinguished between:

a)    Value in use.

b)    Value in exchange, Smith focuses on value in exchange.

Exchange value vs. use value:  in the center of one of the fundamental problems Smith wanted to solve is the definition of the concept of exchange value – since Smith considered the “intrinsic” or “natural” value of goods basic to the conditions under which the exchange of the goods takes place.

Hence, he undertook to determine the “real” measure of this value.

He eliminated the monetary unit.

The Paradox of Value: He also rejected any reference to the utility of the goods, since he associated the concept of utility (like the Scholastics) with the classes of goods – thus he was faced with the “paradox of value.”

He illustrated this with the water/diamond paradox:

Smith did realize that scarcity relationships were involved in the problem – and he argued that the whole quantity of a cheap commodity brought to the market is commonly not only greater but of greater value than the whole quantity of an expensive one.

    So he was getting to the answer - but he was still confusing TOTAL value with MARGINAL value.

The Labor Theory of Value:  “The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labour which it enables him to purchase or command.  Labour, therefore, is the real measure of the exchangeable value of all commodities.”

He regarded labor as a more stable standard of measuring values than any of the monetary metals or grains.

He argued that “equal quantities of labor at all times and places may be said to be of equal value to the laborer.”

“Labour, therefore, appears evidently, is the only universal, as well as the only accurate measure of value, or the only standard by which we can compare the values of different commodities at all times and at all places.” Etc.

Smith's Definition:

Hence he defined the “real measure” of the value of a commodity as the quantity of labor which the buyer of the commodity would be required to spend if he had to produce the goods received in exchange.

It appears really that he is saying that one person, when deciding to buy something, thinks in terms of how much labor that thing will cost them.  So this is the "standard of value" that an individual uses when buying or exchanging.  Interpreted this way - it is not an "objective" value but can be different from person to person.  But how does this then translate into a market price?

Famous deer/beaver example in your reading:

But notice too that he says, "In that early and rude society" . . .  .  This indicates that he understands that land and capital add to productivity.  But labor still seemed to be the most stable standard of value.

“Labor measures the value not only of that part of the price which resolves itself into labor, but of that which resolves itself into rent and of that which resolves itself into profit.”

So he has a kind of Labor Theory of Value turned into a Cost of Production Theory

Thus rents and profits were included in the value which a good could “command."

Deb's Interpretation:

So it appears that:  Price = labor value + rent (land value) + profit (capital value)

However -- this is from the consumer's point of view.  What would someone have to give up in terms of labor, rent and profit to make this good themselves -- this is the value they would put on the good -- and therefore, this is where the price comes from.

Bob is looking to buy Betty's output.  Betty priced her good at $20 (this includes Betty's labor value, rent and profit).  But Bob decides to buy this only if he thinks the value of the good is greater than the value of his labor (and land and capital) he would have to expend to make it himself.  And the price, therefore, will equal Bob's value of these three things.

This is basically Smith's "labor theory of value."

Smith was somewhat ambivalent in these discussions of value – and he conceded that, when used to measure exchange values, labor was really an “abstract notion” which, though it can be made sufficiently intelligible, is not altogether so “natural and obvious.”

Smith on Prices

Smith has 4 “prices”-

(1) “real” price is the real value of a good determined by the “toil and trouble of acquiring it.” It “consists of the necessaries and conveniences of life which are given for it.”  This what we just discussed.

In rudimentary or primitive society this is =  labor,

in other societies (less primitive) = includes land value and capital value as well.

(2) “nominal” price is of different values depending on the value of gold and silver. It is the price in quantity of money.

(3) “market” price is the “actual price at which any commodity is commonly sold....It may either be above, or below, or exactly the same with its natural price.”

(4) “natural” price is “When the price of any commodity is neither more nor less than what is sufficient to pay the rent of land, the wages of the labour, and the profits of the stock employed in raising preparing, and bringing to market, according to their natural rates, the commodity is then sold for what may be called its natural price.”

So this is from the producer's point of view -- what are the producer's cost in terms of labor, rent and capital?  The natural price will include these.

In today’s mainstream economics this is interpreted as the “natural rate of return” or zero economic profit (long run equilibrium) --

GRAPH (not from Smith – modern interpretation):

So prices will adjust to the cost of production (remember, today's theory includes the opportunity cost of the producer).

Richard Cantillon’s observation that in advanced societies the market prices tended to adjust themselves to the costs of production provided Smith with a starting point for the theorem that under the rule of free competition market prices oscillated around the “natural” prices – the prices determined by long run production costs.

Therefore – effective demand for, and supply of, goods was equalized by the mechanism of the market.

This is also true for factor (input) markets as well:

Without clearly defining the rule of free competition, Smith also attributed to the operation of that rule the function of allocating the productive factors among the industries in such a way that the “whole advantages and disadvantages” as well as the earnings would be leveled off… tend toward “equality.”

But since he centered his attention on increases in wealth, conceived of as an ever-expanding process, he did not pay much attention to the problems connected with the allocation of resources, nor did he provide a clear picture of the functioning of the economic machinery. He was a "macro" economist -- and seemed to miss some of the "micro" underpinnings.

Smith on Money

Money is regarded primarily as a medium of exchange. It is the “wheel of circulation”  but is not real wealth to society.

Similar to Hume.

Smith on the Role of Government

(1)  provide for national defense,

(2)  provide for domestic justice (defend property rights, for example), and

(3)  those things that are not “in the interest for any individual to provide.” [public works, roads bridges, schools,...]

(4)  but he also seemed to have a role of government in maintaining a social order -- certainly for education, for example, and beyond that...

What about taxes?

 “..subjects of every state ought to contribute towards the support of government, as nearly as possible, in proportion to their respective abilities: that is, in

proportion to the revenue which they respectively" enjoy under the protection of the state.

        1. Taxes should be levied “fairly” (hard to determine exactly what he means by fair except for the quotation above).  So that sounds like a progressive income tax system.

        Today economists talk about two principles of taxation that might apply here,

        the ability-to-pay principle (people with higher incomes/wealth should pay more) and

         the benefits received principle (people who receive more services from the government should pay more). These are two different views of what is “fair.”

        Which do you think Smith meant by the quotation above?

        2. Taxes should be neutral in their effects on economic activity, i.e., they should be “neutral,” or “efficient,” and not distort people’s economic decisions and behavior. 

So it appears that Smith did not want to use taxes for any other reason than to raise revenue for the government.  He was not a big fan of using them for “social engineering” – which we see a lot of today.

What would be an example of a neutral tax?

A poll tax, or head tax, which taxes each person exactly the same as every other person, such as a tax which required every American to pay $1,000 in tax, regardless of income, spending, etc. The idea typically is that this tax would not distort economic behavior (well, not much) since the only ways to avoid the tax would be to leave the country or die.  So maybe there is no such thing as a "neutral" tax!!

        3. Taxpayers should be certain as to their liability. Uncertain taxes mean uncertain costs and hence uncertain profits for business firms.

        Unpredictable tax systems prevent businesses from starting and jobs from being created, and slow down economic growth. (Is Smith rolling over in his grave today)?

        4. Administrative costs should be reasonable. This applies not only to the costs incurred by the government for tax collection, but also for the cost of compliance faced by taxpayers.

        5. Revenues should be adequate to finance the desired level of expenditures. I.e., government should balance its budget.

        Yes, this was a problem even in Adam Smith’s day. Then, as now, government goods that are not paid for when they are received seem to be free. But, as we know, they are not free, as they always impose an opportunity cost.  Although Smith did not use that term of course. 

        Politicians consistently run budget deficits in the USA (and elsewhere) because voters want plenty of government goods and services, and low taxes, at the same time. It is human nature to want something for nothing, but that tendency causes trouble only when an economy tries to make that a basis for government spending and tax policy.

        Smith seemed to understand this.

Smith’s Big Vision 

 Natural instincts, invisible hand, economic growth, self interest benefiting society as a whole – if the right rules were in place.  What rules?

Generally speaking:  Property rights and free trade.

Nature (God) has provided us with the tools (the “instincts” we are born with) to have both a moral order and an economic order.  Through education and experience, we will obtain both of these and will live moral, good, productive, wealthy lives.

DO ICE NINE