Chapter 4: Adam Smith

Questions for Review, Discussion and

Research (pp. 105-06)1, 2, 4, 7, 9

Overview

The publication of the Wealth of Nations was a watershed in the development of Economic Thought

Beginning of the “Classical” era

Breadth of Smith

An academic in Edinburgh with a high degree of detachment and objectivity

Was a great synthesizer Great insight into

interdependent relationships emerging in the economy of 1770’s

Sought the same scientific rigor that Newton established in Physics

Just as Newton found order and harmony in the Physical world, political economy could discover the natural laws governing society

Sought to explain the nature and causes of economic growth processes and wealth of highly developed societies

Breadth of Smith Cont’d

Methodology combined deductive theory with historical description

Arguments were rarely just theoretical treatise

They were contextual and based on observations of historical situations and the institutions of his era.

Overhead pp. 80 Contextual economic policy

is another way of expressing the art of economics

Natural Order

Believed it was possible to discover the laws of market economy by means of rigorous analysis

Scientific investigation could reveal cause and effect relationships

Natural process at work on a market economy resolves conflicts more effectively than human arrangements.

Harmony and public benefits could proceed from conflict and self interest

Natural Order Cont’d

Short-run prices -> “market” prices

Long-run prices -> “natural” prices

Government interference is undesirable because it infringes on the natural rights and liberties of individuals

Roots of modern public-choice theory extend back to Smith’s perception of how business and special interest groups use the public sector to enrich themselves

Key Role of Investment

Investment in real capital assets is crucial to the process of economic development and growth

Capital accumulation is a prerequisite for

1. The division of labour2. Proportion of labour

force engaged in productive labour

3. The level and pace of economic development

4. Optimal allocation of capital assets by capitalists

Key Role of Investment Cont’d

It is beneficial to have an unequal distribution of income in favour of capitalists

Wealth is often used to describe national income and is dependent on

1. Productivity of labour specialization division of labour Overhead pp. 88

2. Distinction between productive and unproductive labour

Overhead pp. 90

International Trade

Embedded in the analysis are the dynamic effects over time of larger markets

Rigorous proof of benefits from trade requires evidence that more goods and services are produced after international exchanges occur

Confusion in Early Theory of Value Discussions

No clear definitions No distinction between

1. Determination of relative prices

2. Determination of general price level

3. Measures of social and individual well being or welfare

Smith uses two concepts that become commonplace in classical writings

Confusion in Early Theory of Value Discussions Cont’d

1. Value in Exchange The power of a product to

purchase other goods and services

An objective measure expressed in market prices

2. Value in Use Ambiguous concept that

has ethical connotations

Smith’s Confusion in Explaining Relative Prices

He presents three (3) separate theories in his analysis

1. Labour Cost Theory in a Primitive Economy Overhead pp. 96 Land and capital inputs are

either non-existent or free The price of a product is

determined byI) Labour HoursII) IngenuityIII) SkillIV) Hardship of tasks

Smith’s Confusion in Explaining Relative Prices Cont’d

2. Labour Command Theory3. Cost of Production Theory of

Relative Prices Includes the cost of all factor

inputs In a modern capitalist economy,

it would include

Labour – wagesCapital – “interest” or

normal profitLand – (economic) rentEntrepreneurs –

(economic) profit

Smith’s Theory of Income Distribution

1. Determination of wages Identifies many

influences I) Subsistence theory of

wages II) Productivity theory of

wages III) Bargaining theory of

wages IV) Wage fund theory of

wages

The latter was an important concept in classical writings

Recognized that the production process yielded outputs long after inputs are applied in agricultural sector

Smith’s Theory of Income Distribution Cont’d

Cumulative savings of capitalists in the form ofI) An inventory of consumption goods to sustain labour between the start of the production process and its completionII) An inventory of intermediate inputs and/or capital inputs

Best illustrated in “Corn’ Model where wheat is both a consumption and investment good

Smith’s Theory of Income Distribution Cont’d

2. Determination of (Normal) Profit

Payment to capitalists for performing the socially useful function of providing labour with

I) The necessities of life

II) Materials is used up in the production process

III) Real capital assets Smith predicted that the

rate of profit would fall over time

Welfare and the General Level of Prices

Read pp. 101-03 on your own

Summary

Smith had insight into the central ideas and forces that govern a market economy

Failure to distinguish between and create separate theories for:1. Relative prices2. General price level3. Measure changes in

wealth

Smith primarily interested in questions of economic policy affecting economic growth and development

Overhead pp. 104-05