Adam Smith - Part Two

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

Smith is typically known as being part of what is now known as the Classical School of Economics:  1776-1870s.  (Smith,Ricardo, Mill and Say)

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.

Not meant as a textbook on economics:

Tried to understand questions such as:

·         Why are some nations richer than others.

·         What determines prices

·         What determines wages, profits and rent

·         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 had not yet invented 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 knowledge.

Many of us us have a prejudice towards our own superiority over people of the past. I know of no evidence of improvement in intelligence over the long term.

The Wealth of Nations was comprehensive (to a point), systematic 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.

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

a) Much of Smith’s work is permeated by a sociological approach

b) Humans are interested in those things that are nearest to us in time

and space

c) 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.”

d) 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, that Cantillon was so good at understanding.

Free markets were advocated to allow the operation of ‘natural forces’

 ECONOMIC GROWTH:

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 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.”

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

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….”

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

Later on in the W of N Smith does discuss some sociological conclusions of the division of labor - that people become "stupid" from doing the same thing over and over, etc.  But he seems to be setting up a social hierarchy more than anything else.  He was most certainly into "social order" above all else.  And the idea that some people should control others -- and that education was the key to dealing with those in society that needed dealt with.

Economic growth is 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.

 Interdependent:   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.

 Special privileges will benefit some but will not give the country a "general benefit."

"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 Section IV.2.6 in the reading -- he goes on to explain why people want to stay domestic.  Not sure this argument holds up 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).

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.

    Getting to the answer - but 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 paces.” Etc.

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?

Thus the “real” or “natural” value of a good could be measured with the greatest accuracy by the amount of labor expended in its production.

Famous deer/beaver example

But also:

“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” and the labor cost theory was transformed into a cost of production theory.

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.”

In rudimentary or primitive society this is =  labor,

in other societies (less primitive) = a cost of production. Real prices always the “same.”

(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.”

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):

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 measured in forms of command labor.

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

Note:  back to ‘natural” rate of U.

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 Wages:

Smith really had several theories regarding wages.  They are

(1)  based on bargaining and contract [issue of combinations of masters and workmen].  So this is the supply and demand of labor model:

GRAPH (not from Smith – modern interpretation):

(2)  wages fund argument

and (3) the amount necessary to bring up a family and more workers (kind of a residual theory).

Smith on Profits/Rent:

 Profits are subject to variations.

Wages and profits are inversely related:

Profits equalize across industries (probably got this from Cantillon (: )

Rent is a residual (what is left over)

Wages and profits are causes of price: rent is an effect.

Price = f (wages and profit)  but

Rent = f (agricultural prices)

Here we see the beginnings of a differential theory of rent based on yield and location

Profits:  He covered a variety of incomes accruing to the employer from different sources:

-          the yield of the capital invested in the enterprise

-          the payment for entrepreneurial, managerial, and possibly technical services

-          reward for risk

-          additional earnings resulting from the introduction of technological improvements and other cost-saving devices and from favorable market conditions, monopoly situations, and the like.

The conception of profits as a surplus was alluded to in the distinction which Smith drew between “clear profits” and receipt of interest on capital invested by the employers.

He regarded interest as a payment for the use of borrowed money capital and derived it from the profits which could be earned by rising that capital for productive purposes.

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.

 Paper money saves resources of extracting gold and silver

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...

Smith on 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 $1000 in tax, regardless of income, spending, etc. 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.

        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 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?

Property rights, 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, we will obtain both of these and will live good, productive, wealthy lives.