Theory of Growth

Adam Smith

• 16 June 1723

• Born in Scotland

• Was Scottish moral philosopher

• Considered to be Father of Economics

• Smith began delivering public lectures in 1748

in University of Edinburgh

• In 1762, the University of Glasgow conferred

on Smith the title of Doctor of Laws (L.L.D).).

• His Book: An Inquiry into Nature and Causes

of the Wealth of Nations (1776)

• He wanted to examine :

– Why some countries are richer and some poorer ?

– What are the basic economic factors that can

increase the wealth of an economy ?

Wealth of a country is not gold as assumed by

Mercantilists or agriculture as assumed by

Physiocrats.

• According to Adam Smith :

– Wealth of an economy is the value of its Total Output

– includes industrial and agricultural output.

– Growth increases wealth by increasing total output,

income and wealth and standard of living.

• How can growth increase ?

If inputs increase, output will also increase.

Three factors (inputs) – land, labour and capital – owned

by landlords, workers and capitalists.

Assumptions:

• Supply of land cannot increase – it is finite

• Labour is available in infinite quantity, so wage rate is at subsistence

• Labour productivity increases through

1. Division of labour 2. Increase in K/L

• Investment is endogenous – determined by savings

• Market economy with Prefect Competition

• Diminishing Returns

• Laissez faire, invisible hand allocates resources

Specialization of Labour

• Labour specialization increases output, by

increasing productivity of labour

• This leads to increasing returns to scale. So

growth is self-reinforcing

• He gives the example of a pin factory:

– If each worker produces entire pin, O/L is low, one

worker produces only 20 pins a day

– But if there is specialization, with 18 sub processes,

output per man increases to 4800 pins a day .

• Labour specialization increases output because :

– Skill increases with repetition

– Time is saved

– The worker can innovate and improve his

performance

• But increase in Labour specialization depends on

demand (Market) for the product. So Adam

Smith states :

“ Division of labour must always be limited by

the extent of the market”

Capital Accumulation

• It is crucial for economic growth

• As capital increases, capital per man (K/L) also

increases, leading to increase in labour

productivity and growth

• Investment → Capital formation

• Only Capitalist class invests

– Workers receive subsistence wages, cannot save

– Landlords only consume, not save

The Virtuous Cycle

• Capital Accumulation increases K/L

• Higher productivity of labour with higher K/L

• Higher productivity leads to higher incomes

• Higher income leads to increased demand and bigger markets

• Leads to specialization of labour with more division of labour

• But more division of labour leads on to higher productivity

• This is Smith’s Virtuous Circle

Smith’s Virtuous Cycle of Growth

Increase in K/L

Division of Labour

Increase in Output, income

Market Increases

Increase in Investment

Stationary Stage

• Although there are increasing returns to labour specialization, growth cannot go on forever. This is because:

1. Competition for labour increases, as K accumulation increases

2. Employment increases and total wage payment increases

3. Profits decrease, investment falls and growth levels fall

4. Ultimately, rate of growth becomes Zero

5. This is the Stationary State.

• Features:

–No increase in

investment

–No increase in

output – Zero

growth

–No increase in

wage rate

–No increase in

standard of living

Criticism

• Adam Smith was a pioneer in Economics

• Crude theory of growth, profits and investment

• Neglects the growth of agriculture

• Based on “Iron Law” of wages

• Stationary state – ignores the role of technical

progress

Any

Confusion ???