Smith and the Onset of Modern Economics

Smith is where the classical school begins. This page follows the Week 5 lecture slides in order: the 18th-century setting, the tenets of classical political economy, Smith’s life and books, the invisible hand, the division of labor, competition and prices, value theory, growth and institutions, and Smith’s legacy.

1. The Setting: Two Revolutions Behind Classical Economics

Last week covered early modern economic thought: mercantilism, physiocracy, and the early forerunners of the classical school. Smith gets a separate class because he founded the classical school and is often called the founder of modern economics: he gave the first formal and comprehensive analysis of political economy.

Two 18th-century revolutions prepared the ground.

The scientific revolution

• Isaac Newton (1642-1727) and the law of gravitation.
• Reliance on experimental evidence.
• Popularization of the existing idea that the universe is governed by natural laws.
• This promoted a static view of the universe: space, time and matter are independent of each other.

The classicists took the next step: if nature is governed by natural laws, so are society and the economy. That is where the classical search for universal, immutable economic laws comes from.

The industrial revolution

• In 1776 it was just beginning; it intensified at the time of the later classicists.
• England had gained world supremacy in trade and manufacturing.
• Privileges, tariffs and government subsidies were already being removed.
• The labor force was becoming free, mobile, low-paid and hardworking.
• Enclosure movements spread private property on land and capital-intensive, larger-scale agriculture.

The result: productivity of labor and land rose; peasants turned into wage laborers; privileged organizations were removed; population grew, through a higher birth rate and a lower death rate.

2. Classical Political Economy: Tenets and Legacy

The main tenets

• Economic liberalism: personal liberty, private property, individual initiative, private enterprise.
• Minimal government intervention: “the best government governs the least”.
• Self-interested economic behavior: everyone wants first to satisfy their own wants.
• Harmony of interests: the pursuit of individual interests also serves the interests of society.
• Importance of all economic resources and activities: land, labor, capital and entrepreneurship; agriculture, commerce, production and international exchange.
• Economic laws: explicit laws that are universal and immutable.

Beneficiaries and validity

The classical writers claimed their ideas would serve all of society, because they promoted capital accumulation and economic growth. Businesspeople were given a respectable position: seeking profit was good, and merchants and industrialists were serving society. Not everyone shared equally from industrialization, though: wage earners worked under harsh conditions, and the lecture also asks about long-term effects on the environment.

Classical economics justified the decline of mercantilism. Growing competition plus corrupt and wasteful governments made less government intervention look sensible.

Lasting contributions

• So far it was the best analysis of the economic world, and some of its laws are still accepted.
• Over time, laissez-faire declined, because it was not sufficient to deal with crises, monopolies, externalities and the provision of public goods.
• The prediction that rental income would rise and profits would fall as the economy advanced was proven wrong.
• The classical school laid the foundation of the neoclassical school, which formed mainstream economics up until now.

How Smith’s view of wealth compares with the schools before him:

3. Adam Smith: Life, Influences and The Theory of Moral Sentiments

Life

Adam Smith was born in Kirkcaldy, Scotland, and went to Glasgow College at 14. He studied moral and political sciences and languages at Oxford. He moved back to his hometown first and then to Edinburgh, where he gave lectures on rhetoric and literature.

In 1751 he was elected professor of logic at Glasgow College, where he later held the chair of moral philosophy for 20 years. In 1759 he published The Theory of Moral Sentiments, after which his lectures focused on jurisprudence and political economy. He served as a private tutor in France, where he became friends with Quesnay and Turgot. In 1776 came The Wealth of Nations, after which he lived for two years in London. He returned to Edinburgh, where he spent the rest of his life (he died in 1790).

Influences

• The influence of the Enlightenment.
• The physiocrats: not a perfect system, Smith felt, but still the nearest approximation.
• His instructor Francis Hutcheson.
• His friend David Hume.
• The forerunners of the classical school (last week).

The Theory of Moral Sentiments (1759)

The topic: the moral forces that limit selfishness and bind people together in a workable society. The first chapter argues that sympathy overcomes selfishness.

Smith divides the passions:

• Social passions: generosity, humanity, kindness, compassion, friendship, esteem.
• Unsocial passions: hatred and resentment.

People feel for the social passions more, and thus sympathy overcomes selfishness. People also identify with our joy more than with our sorrow, and we tend to show our riches and hide our poverty.

People can exist only within society, where they have mutual injuries and need each other’s help. When this help is offered out of love, society becomes happy. Without love and affection, society can still exist, but less happily. Society cannot exist without justice, so justice is required.

How is selfishness controlled? Our morality determines rules of conduct that restrain our selfishness. These rules are the commands and laws of God. If we violate them, we are punished by shame and self-condemnation; if we obey them, we are rewarded with contentment and self-satisfaction.

The Wealth of Nations is a 900-page book that gave Smith his fame as an economist. On wealth, the views of the schools differed: mercantilists looked at national wealth; physiocracy looked at agriculture; Smith’s analysis was much more complex.

4. The Invisible Hand

Where the problem came from: Hobbes and Locke

The origin of the problem is Thomas Hobbes and his social contract theory in Leviathan. Individuals are selfish, which leads to chaos and anarchy; states are then established to ensure that social interests are protected.

John Locke offered a moderate version. He rejects Hobbes’s idea that “man is wolf to man” (homo homini lupus) and stresses the capacity of consent and dialogue among rational individuals. But in this line of thought, the idea that a social order can be established is missing.

Mandeville, and Smith’s first answer: sympathy

Mandeville (The Fable of the Bees; the slide dates it 1704, the book appeared in 1714 after a 1705 poem) claimed that self-interest, laziness and hedonism are the basic motives that create a rich society. Smith did not hold this view, but he reconciled individual interests with virtuous behavior.

His first attempt was the concept of sympathy: the human capacity to put oneself in the shoes of others. Human beings have similar properties, which make them understand each other, and this understanding enables a social order that protects individual rights and freedom.

The invisible hand in the Wealth of Nations

In the Wealth of Nations, the mechanism is different: self-interested behavior (not sympathy) leads to social order. The difference between the two books was called “Das Adam Smith problem” by German writers.

The lecture’s resolution: when Smith talked about sympathy, he referred to a rational process of reflection and the human capacity of understanding, rather than to emotions.

From the economic point of view, the invisible hand describes how the market system works. The market system prevents the depletion of resources by regulating supply and demand, and no government intervention is needed. The market system provides both an efficient allocation of resources and the protection of individual rights and freedoms.

5. Division of Labor and Capital Accumulation

The Wealth of Nations opens with this statement:

The greatest improvement in the productive powers of labor, and the greater part of the skill, dexterity and judgment with which it is anywhere directed or applied, seem to have been the effects of the division of labor.

The lecture’s example: a pin manufacturer makes one pin a day by completing every stage himself. When production is divided into specific stages and each stage is carried out by a single worker, average productivity increases greatly. (In the book’s famous version of the pin factory, about ten workers performing roughly eighteen distinct operations made tens of thousands of pins a day, far more per worker than one pin a day. That detail is textbook context for the book example, not the lecture’s numbers.)

Why does the division of labor emerge? From the propensity in human nature to truck, barter and exchange one thing for another. Animals do not do that: dogs do not exchange bones.

The productivity gain results from three circumstances:

1. Increase of dexterity (skills) in every particular workman.
2. Saving of the time commonly lost in passing from one work to another.
3. Invention of many machines that facilitate and abridge labor.

The result is a circle: higher productivity leads to new goods and markets, and to a deepening of existing markets (via innovation), which leads to even more exchange, and thus to even more productivity. In short: labor productivity leads to greater wealth or total output, which leads to capital accumulation.

6. Competition, Equilibrium and Disequilibrium

Competition fulfills two functions at once:

1. It brings about equilibrium.
2. It is the major driving force behind the division of labor and capital accumulation.

In this second role, competition reflects the dynamic aspect of capitalism. In its equilibrating role, Smith shows how prices and the long-run equilibrium are determined.

Market prices fluctuate around the natural prices depending on changes in the effectual demand (demand backed by the ability and willingness to pay). Demand plays no role in the determination of natural prices, because only production costs are included in the natural price. In the long run, market prices converge to the natural prices. Natural prices act as the “centers of gravity” - remember Newton.

The lecture’s example: when there is a public mourning, the demand for black clothes increases temporarily and the market price rises. In the long run, the effect of demand disappears and prices return to their normal or natural levels. What does this is the free competition process: the process in which capital seeks higher profits by moving across the sectors.

In short: competition tends to create a long-run equilibrium characterized by natural prices.

Technology and innovation create new possibilities for profit and growth by increasing productivity. At the same time, they destroy the old ways of carrying out production. This is what gives capitalism its dynamic character - similar to Schumpeter’s famous idea of “creative destruction.”

7. Prices and Values

Capital, profit and wages

In the classical school, capital does not refer to “produced production goods” in physical terms, but to a sum of money out of which both labor and capital equipment are paid. A capitalist has capital in the beginning, pays the costs of labor, land and machines as advances, and the difference at the end between the total revenue and these costs constitutes the capitalist’s profit. Profit is therefore a surplus, and a necessary element for capital accumulation.

Capital has two components:

• Fixed capital: the portion of capital spent on capital goods.
• Circulating capital: the payments for raw materials, energy and labor costs.

The demand for labor and capital goods depends on the amount of the capital fund that the capitalists have at the beginning. Labor supply is determined by the growth of population. Smith was not as pessimistic as Malthus: population growth is good for the division of labor, growth and consumption, and wages depend on capital accumulation, which raises the demand for labor.

Why this is not a rigorous theory of prices

The natural price is the long-run equilibrium value of wages and rents, but these are themselves natural prices of labor and land. So a natural price is explained with other natural prices. Such a formulation can only yield general prices, not relative prices. A change in one of the prices in the system will change all other prices as well: a wage change, for example, will bring about higher increases in the prices of agricultural goods, which are more labor intensive, than in the prices of industrial goods.

Use value and exchange value

Smith distinguishes use value from exchange value. Exchange value is not important for the determination of use value. His famous example:

Nothing is more useful than water, but it will purchase scarcely anything; scarcely anything can be owned in exchange for it. A diamond, on the contrary, has scarcely any value in use; but a very great quantity of other goods may frequently be obtained in exchange for it.

So use value is not a good measure of value.

The labor theory of value and its limits

Most goods produced are products of labor, so the amount of labor is the source and measure of value. This is valid only in the early and rude state of society, which precedes both the accumulation of stock and the appropriation of land. So:

• In a primitive economy: labor is the only determinant of production costs, and thus of price.
• In an advanced economy with capital accumulation: both labor and land determine price.

The labor theory of value is not valid in advanced economies. The lecture’s example: suppose two commodities whose production takes two hours each. Commodity A, potatoes, is grown where land is fertile and requires no capital to produce. Commodity B, cotton yarn, requires expensive machinery in the production process. They are produced using the same amount of labor; if one kilo of cotton yarn and ten kilos of potatoes could be exchanged for each other in the market, which one would people choose to produce? Potatoes, of course, because they could avoid investing large amounts of capital if they are convinced that they would get the same return.

So in an advanced economy, where capital investments and land resources are important, goods will normally be exchanged for other goods, for money and for labor, and real value can no longer be measured by labor alone.

Demand is not a factor of price. In the long run, the determinants of price are only the costs of production: wages, rent and profits. This is valid only in the case of constant costs per unit of output. If unit costs are changing with production levels, demand, supply and economies of scale are also important.

8. Growth and Institutions

What drives economic growth in Smith’s system? First and foremost: the division of labor. Then:

• Technological inventions.
• Gains in the quality of the workforce (human capital).
• Savings on time.

All of these increase productivity. In the lecture’s words: so Smithian growth is all about productivity.

Economic development also depends on institutions:

• Private ownership of property.
• A ban on monopolistic practices (like government monopolies).
• Rules:
  • Moral rules: self-interested behavior could serve the interests of the community, but it should be supported by some moral and institutional restraints. Only under moral sentiments is it possible for the pursuit of self-interest to produce positive results.
  • Legal rules: these also guarantee the orderly functioning of the market.

The institutional component in Smith’s works has been largely neglected.

9. Smith’s Place: Conclusion and What Comes Next

• Adam Smith was revolutionary for his detailed theorization of economic principles.
• Many of his ideas inspired later scholars, including those who criticized him.
• Despite the widely accepted view, Smith did not promote selfishness.
• Smith promoted liberalism in both the political and the economic sense of the word.
• Was he the founding father of modern economics? Perhaps so: even Marx was influenced by him. Marx’s real ideological enemy was rather David Ricardo, not so much Smith.
• One of the scholars influenced by Smith was Jeremy Bentham, a founder of utilitarian thought, which laid the foundation for the marginalist revolution and neoclassical economics (next week).

Exam practice

Summary and review

• Two 18th-century revolutions framed classical economics: the scientific revolution (Newton, natural laws, experimental evidence) and the industrial revolution (English supremacy in trade, removed privileges, free and mobile labor, enclosures, population growth).
• Classical tenets: economic liberalism, minimal government, self-interest, harmony of interests, importance of all resources and activities, universal and immutable economic laws.
• Classical economics justified the decline of mercantilism; laissez-faire later declined (crises, monopolies, externalities, public goods); the prediction of rising rents and falling profits was proven wrong; the school laid the foundation of neoclassical economics.
• Smith’s life: Kirkcaldy, Glasgow College at 14, Oxford, professor of logic at Glasgow in 1751, chair of moral philosophy, The Theory of Moral Sentiments (1759), tutor in France (friends with Quesnay and Turgot), The Wealth of Nations (1776), last years in Edinburgh.
• Influences: the Enlightenment, the physiocrats, Francis Hutcheson, David Hume, and the classical forerunners.
• The Theory of Moral Sentiments: sympathy overcomes selfishness; social versus unsocial passions; society needs justice; morality and God’s laws restrain selfishness through shame and self-approval.
• The invisible hand: unintended consequences of intentional action; self-interest produces social benefit; Hobbes and Locke framed the problem; Mandeville is contrasted with Smith; “Das Adam Smith problem” is resolved by reading sympathy as rational reflection.
• Smith was a liberal but not an absolutist: three functions of the state, plus two tolerated protectionist tariffs.
• Division of labor follows from the propensity to truck, barter and exchange; three productivity circumstances (dexterity, saved time, machines); productivity leads to wealth (national output) and capital accumulation.
• Competition does two jobs: it equilibrates (natural prices as centers of gravity, market prices fluctuating with effectual demand) and it drives division of labor and accumulation; technology gives capitalism its dynamic, “creative destruction” character.
• Capital is a money fund advanced by capitalists; fixed versus circulating capital; profit is a surplus; wages depend on capital accumulation; Smith was more optimistic than Malthus about population.
• Value: use value versus exchange value (water and diamond); the labor theory of value holds only in the early and rude state; in advanced economies labor and land determine price, and demand matters only when unit costs change.
• Growth: division of labor first, then technology, human capital and time savings. Institutions: private property, ban on monopolies, moral and legal rules - an aspect later readers largely neglected.
• Legacy: Smith did not promote selfishness; he promoted liberalism in both senses; Marx was influenced by him (real enemy: Ricardo); Bentham’s utilitarianism led to the marginalist revolution and neoclassical economics.

Flashcards

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