Adam Smith, 1723 – 1790 • Glasgow University

– Student of Francis HutchesonGreatest happiness of greatest number

• Friendship with David Hume– Chair of Logic (1751),Moral Philosophy (1752)

• Theory of Moral Sentiments, 1759

• Lectures on Jurisprudence, early 1760s

• Tutor of Townshend’s stepson Continental travel, 1764 – 1766 Acquaintance with French Physiocrats Generous pension

• Kirkcaldy, 1766 – 1776 – The Wealth of Nations, 1776

• Scotland Commissioner of Customs Scottish Enlightenment

Smith’ s Contacts• Hutcheson/Hume• Quesnay/Physiocrats• Burke/Johnson/Reynolds/

Gibbon/Franklin

The Visions of Adam Smith• Self – regulating system of markets• Virtuous circles … Progress

• Rule of Law/Property Rights Productivity Rule of LawInclusive Political Institutions Inclusive Economic Institutions

• Division of Labor Extent of Market Division of Labor• Division of Labor Invention Division of Labor• Accumulation Demand for Labor Wage Up

Extent of Market Division of Labor Productivity Profit Accumulation

Social interdependence[Social science]—Invisible handEconomy Solar System Social Physics

Self –regulating system of marketsNewtonian influence

The Visions of Adam Smith• Progress!• Material progress:

Hunters Shepherds Farmers Merchants• Progress in governance:

Increased liberty/security of propertyFeedback to material sphere

The Wisdom of Adam Smith

From The Theory of Moral Sentiments, 1759• How selfish soever 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.• Anticipates General Utility Functions:

Include others’ incomes as well as ownLets translate the rest

• It hurts to be the object of hatred and indignation; and there is satisfaction in being beloved [and respected]. This is more important to happiness than all the [material] advantage a person expects to get from it.

Theory of Moral Sentiments• Because others sympathize more with our joy than with our

sorrow, we show off our riches and conceal our poverty … it is from this regard to the sentiments of mankind that we pursue riches and avoid poverty.

• We want to be respectable and respected… To deserve, get and enjoy the respect and admiration of others are the great objects of ambition.

• There are two different ways to achieve this: » one, by the study of wisdom and the practice of

virtue;» the other, by the acquisition of wealth and

greatness.• Smith’s martial spirit

Saving hundreds of millions in China at the cost of our little finger:… what is it which prompts the generous upon all occasions and the mean upon many to sacrifice their own interests to the greater interests of others, …counteracting the strongest impulses of self-love?. . . It is a stronger love, a more powerful affection, the love of what is honorable and noble …

An affection more powerful than self – love! Selfish behavior subject to norms

Wealth of Nations: Contents• Book I Of the causes of improvement in the productive powers

of labor, and of the order to which its produce is naturally distributed among the different ranks– Technology and Costs: Value and Distribution Foundation of Theory

• Book II Of the nature, accumulation and employment of stock– Money & Capital Facilitates division of labor

• Book III Of the different progress of opulence in different nations– History of development– “Government policies distort the natural progress of opulence”

• Book IV Of Systems of political economy– Mercantile system {bad}/Agricultural system of Physiocrats {unrealistic}

Free enterprise capitalism {How it might work}• Book V Of the revenue of the Sovereign or Commonwealth

Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776

Division of laborSelf Interest and Cooperation in Markets

Role of governmentForeign trade

Labor/Cost-of-production theories of valueTheory of distribution

Accumulation and progress

Adam Smith Problems?• Inconsistency between Moral Sentiments and Wealth

of Nations?• Skepticism of tradesmen ... and others

– Workers: alienated and ignorant because of specialization– Landlords: “reap where they do not sow”– Employers: tacit conspiracy against workers– Merchants: complain only about gains of others– Manufacturers: strive for monopoly against public interest– Lawyers: multiply words beyond all necessity– MPs: support vested monopoly interest– Civil government: secures property of the rich against poor

• Important roles of government• Defense/Justice/Public Goods…Education

• Plagiarism

Adam Smith Problems?• Inconsistency between Moral Sentiments and Wealth

of Nations?Theory of Moral Sentiments as foundation of Wealth of Nations

• Freedom within self-imposed ethical constraints• Moral Sentiments explains how self-interested “economic

man” erects barriers against his own passion generally accepted rules of behavior

• Man is formed for society with an original desire to please– Desire for praise…and for praiseworthiness in own mind

• Rules of Justice/System of Law: preconditions for social order

Smith: Stages of History/DevelopmentInteractions between rule of law and economic progress

Rude StateHunter/Gatherer

(American Indians)

Personal Liberty+

Lack of institutions to secure private

property

Small Communities

Few Disputes

PastureShepherd

(Arabs, Tartars)

Private Property in Cattle

Civil Government(Defend rich against poor)

Nomadic

AgricultureFarmer

(Feudal Europe)

Property inLand

FeudalAuthority

(Landlord Rules)

Conquest

CommerceMerchants(City-States)

City ascounterwtto landed

aristocracy

Trade & Mfrs

“Good Gov’t”

GROWTH

King

Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776

Division of labor

Increasing Returns to Scale

From An Inquiry Into the Nature and Causes of the Wealth of Nations…the division of labor is limited by the extent of the market• To take an example, the trade of the pin-maker; a workman not

educated to this business could scarce, perhaps, with his utmost industry, make one pin in a day… But [pin making] is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head…Making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands… I have seen a small manufactory … but indifferently accommodated with the necessary machinery [where ten men could] make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size… Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day…

Smith on Division of Labor• All men are create equal…the Enlightenment principle

Technology differentiated employmentsTechnological advanceincreased division of labor

Specialization increased dexteritySpecialization eliminate set-up time

Specialization INVENTION

• With division of labor comes interdependence – exchange – Man needs “the help of his brethren, and it is vain to expect it from their

benevolence. He will be more likely to prevail if he can interest their self-love in his favor.”

Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776

Self Interest, Competition and Cooperation in Markets

The invisible hand

• Law of Markets (Say’s Law)– Quesnay’s Tableau Economique:

fragility, like human body (biological analogy)– Smith: flexible wages and profits

full employment equilibrium (physical analogy)

Economic Man: Self – interest, competition and exchange• This division of labor…is not originally the effect of any human

wisdom, which foresees and intends the general opulence to which it gives occasion. It is the necessary … consequence of a propensity in human nature … to truck, barter, and exchange one thing for another.

• In civilized society [man] stands at all times in need of cooperation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons.... [M]an has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only.

• 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. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages...

• [Value] is adjusted... by the higgling and bargaining of the market, according to that sort of rough equality which, though not exact, is sufficient for carrying on the business of common life.

• …the rivalship of competitors, who are all endeavoring to jostle one another out of employment, obliges every man to execute his work with a certain degree of exactness.

Evils of monopoly • Monopoly...is a great enemy to good management. • People of the same trade seldom meet together, even for

merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

• As soon as the land of any country has all become private property the landlords, like other men, love to reap where they never sowed and demand a rent even for its natural produce.

• The monopolists, by keeping the market constantly under-stocked…sell their commodities much above their natural price and raise their emoluments, whether they consist of wages or profits, greatly above their natural rate…

Virtues of competition• [W]here competition is free, the rivalry of competitors, who are all trying to

jostle one another out of employment, obliges each to work with a certain degree of exactness...

• The natural price, or the price of free competition ... is the lowest which can be taken, not on every occasion, but for any considerable time ...[It] is the lowest price which sellers can commonly afford to take and stay in business.

Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776

Limited role of government»Protect society from invasion»Administer of justice»Public works and public institutions

» Public roads and bridges» Private toll canals

» Need incentive to dredge canals

The Role of Government and Laissez – Faire• Every individual... neither intends to

promote the public interest nor knows how much he is promoting it...[B]y directing [his] industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this … led by an invisible hand to promote an end which was no part of his intention.

Social Physics: Newton in the Economic Universe• In context, Smith applied the invisible hand phrase to

businessman’s choice of domestic over foreign investment.

• He may have meant to be ironic…but never mind

Smith: Need for Public Education• In the progress of the division of labor [the worker] comes to be

confined to a few very simple operations…[He] has no occasion to exert his understanding…and generally becomes stupid and ignorant…The torpor of his mind renders him incapable…of conceiving any generous, noble, or tender sentiment.

• And so, in order to avoid these deplorable results, … the most essential parts of education – to read, write, and account – can be acquired at an early period of life.

• For a very small expense the public can facilitate, can encourage, and can even impose…the necessity of acquiring those most essential parts of education…

Smith on University Education• …In other universities the teacher is prohibited from receiving any fee

from his pupils and his salary is the whole of what he gets. His interest is set as directly in opposition to his duty as is possible …[I]f his emoluments are to be precisely the same if he does or does not perform some very laborious duty, it is certainly in his interest as is vulgarly understood, either to neglect it or, if he is subject to some authority…, to perform it as carelessly as slovenly a manner as that authority will permit.

• If the authority to which he is subject resides in the body corporate of which he is a member and in which the other members are or ought to be teachers, they are likely to make a common cause…In the university of Oxford, the greater part of the public professors have, for these many years, given up altogether even the pretense of teaching.

• The discipline of colleges…is in general contrived, not for the benefit of the students, but for…the ease of the masters… No discipline is ever requisite to force attendance upon lectures which are really worth attending.

Smith’s Principles of Taxation

• “Equality” of burden– At times proportional, at times progressive

• Certainty– Transparency of direct & indirect taxes…know

what you’re paying• Convenience

– Avoid complexities• Economy

– Efficient collection

Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776

Foreign trade(Absolute Advantage)

Free trade

Extended market

Increased division of labor

Free trade• … never make at home what it costs more to make than to buy... If a

foreign country can supply a commodity cheaper than we can make it, buy from them with goods where we have an advantage.

– By means of glasses, hotbeds, and hotwalls, very good grapes can be

raised in Scotland, and very good wine can be made of them at about thirty times the expense for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland?

– A great empire [America] has been established for the sole purpose of raising up a nation of customers who are obliged to buy from our shops and producers all the goods we can supply. For the sake of that little enhancement of price which this monopoly might afford our producers, the home-consumers have been burdened with the whole expense of maintaining and defending that empire…The interest on the debt incurred is not only greater than the whole extraordinary profit made by the monopoly of the colony trade, but greater than the whole value of that trade...

Smith: Thoughts on American colonies

Cost – benefit analysis: value of taxes vs. cost of defeating and policing the colonies

• If retain colonies, should give them (and Ireland) representation in Parliament

• Because of America’s growth potential, she would become the “seat of the empire” in line with her contribution to defense via taxes

• Worst case scenario for Smith:– Lose the United Colonies– Retain Canada, which is expensive to defend

Cost – Benefit of United Colonies

• If any of the provinces of the British empire cannot be made to contribute towards the support of the whole empire, it is surely time that Great Britain free herself from the expense of defending those provinces.

Prescient Smith• Smith (1776): …every member of the [East India

Company] wishes to get out of the country as soon as he can, and once he has left and carried his whole fortune with him, is perfectly indifferent though the whole country was swallowed up by an earthquake

• Acemoglu, Johnson, Robinson (2001): Settler mortality Extractive Institutions Stifled Growth

Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776

Theories of value

Labor theory of value(rude state)

Place of profit

Smith’s Theory of Value“Every man lives by exchanging becomes by some measure a merchant”Value in use—Value in exchange—Market price…not the same• Natural price: the central price, the price to which all prices are

continually gravitating…this center of repose…neither more nor less than what is sufficient to pay the rent of land, the wages of labor, and the profits of stock employed in raising, preparing and bringing it to market cost-of-productionS—D interactions: market price reverts to natural price

• {Labor} Theory of ValueLabor cost theory / Labor command theory

• The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it … What is bought with money or with goods is purchased by labor

the labor commanded by the product from the buyer• Labor was the first price, the original purchase-money that was paid for all

things … and its value to those … who want to exchange it for some new productions is precisely equal to the quantity of labor which it can enable them to purchase or command

the labor commanded by the product from the buyer

Smith’s Labor Theory of Value• At all times and places that is dear which it is difficult to come at, or which it

costs much labor to acquire; and that cheap which is to be had easily, or with very little labor. Labor alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared.

the labor commanded by the product from the buyer• Smith’s theory of money: just a convenience

» Gold and silver’s values depend on the toil and trouble (labor) of mining them.

Deer and beavers: 2 Deer = 1 Beaver• In that early and rude state of society which precedes both the accumulation

of stock and the appropriation of land, the proportion between the quantities of labor necessary for acquiring different objects seems to be the only circumstance which can afford any rule for exchanging them for one another. If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.

» No return to capital?» Later, once land is appropriated, what about rent?

Smith’s Theory of Distribution• … the three great social classes Alternative theory of value

– Labor wage– Capital profit Cost-of-production theory of value– Landlord rent

But if all value comes from labor, where do profit & rent come from?… Rent makes the first deduction from the produce of labor employed upon the land … and the produce of almost all other labor is liable to the like deduction of profit.

» Exploitation? … Smith doesn’t go there

Profit rate: a multiple of the interest rate on money… wherever a great deal can be made by the use of money, a great deal

will be given for the use of it … The progress of interest therefore may lead us to form some notion of the progress of profit.

Net Profit = Gross Profit – Interest{Both interest and profit fluctuate with investment opportunities}

• Rent: … High and low wages and profits are causes of high or low prices; high or low rent is the effect of it (high or low prices) Rent not a costProgress Increased Demand Higher Prices Higher Rent

Accumulation, Wages, and Profits(Accumulation: Saving and Investment by Capitalists)

Accumulation

Wage fund

Wage(Iron Law of Wages)

Population Productivity

Profit

Smith’s Theory of ProgressThe division of labor is limited by the extent of the market• What extends the market and increases division of labor?

Spatial factors:• Urbanization agglomeration economies• Location on seashores and rivers• Improvements in transportation

Colonial settlement … imperialismForeign tradeFree competitionIncreased domestic income

• Higher wage• Increased populationExtent of the market Division of Labor Productivity Output

IncomePrice

Smith’s Spiral of Growth

National Wealth I

Opportunity for division of labor

Profit Expectations

Demand for Investment

Increased interest rate

Increased Saving

Accumulation

Increased Demand for Labor

Higher Wage

Increased Labor Supply(Reduced Mortality)

Employment with increasedDivision of Labor

National Wealth II

More Adam Smith Problems• Division of labor Alienation

… The man whose whole life is spent in performing a few simple operations … has no occasion to exert his understanding or to exercise his invention … [He] becomes as stupid and ignorant as it is possible for a human creature to become. His dexterity at his own trade [is] acquired at the expense of his intellectual, social, and martial virtues.

… It is otherwise in the barbarous societies … every man is a warrior.

Economic progress Moral decay & economic stagnation• Division of labor = Increasing Returns Monopoly

Industrial Age concentration

Globalization and information age Agglomerationand networking, not concentration

• Spiraling progress … or stationary state?It is in the progressive state, while society is advancing toward further acquisition, rather than when it has acquired its full complement of riches, that the condition of the great body of people seems to be happiest and most comfortable. It is hard in the stationary state and miserable in the declining state.…that full complement of riches which the nature of its soil and climate and its situation with respect to other countries allows it to acquire.In a country fully peopled in proportion to what either its territory could maintain or its stock employ … In a country fully stocked in proportion to all the business it had to transact … the competition would be great and the ordinary profit as low as possible.

An extinguished Sun … in the very long-runBut until then, Smith prophesies progress for the commercial age (he does not see beyond that age).

So…Don’t worry! Be happy!Also, Natural price of labor = “necessaries and conveniences”– “Convenience” component of subsistence can rise with attainment

Heimann on Natural Order• Enlightened, rational man working within laws of

nature can achieve a harmonious state without the dictate of an overbearing authority– scientific understanding – and an inner impulse to contribute to universal harmony

• he intends only his own gain, and he is in this … led by an invisible hand to promote an end which was no part of his intention

• Intervention by an authority is disruptive of natural harmony.– Liberal democracy and laissez-faire economy Freedom– Natural harmony is an ideal that is approached– Natural harmony is self-perpetuating

• Don’t mess with enterprise economy

Adam Smith: A Summation• Moral sentiments a first principle.• Market coordination of self – interested individuals

“Economic man” led by an “invisible hand”Competition Efficiency and Equity

» Guard against monopoly• Laissez – faire!

Restricted government trumps government restrictions• Labor theory of value … and beyond• Progress through specialization and exchange

The division of labor is limited by the extent of the market.Spiraling progressRule of LawSpiraling Progress

Stagnation and decline in the distant future

Smith on University Education• …In other universities the teacher is prohibited from receiving any fee

from his pupils and his salary is the whole of what he gets. His interest is set as directly in opposition to his duty as is possible …[I]f his emoluments are to be precisely the same if he does or does not perform some very laborious duty, it is certainly in his interest as is vulgarly understood, either to neglect it or, if he is subject to some authority…, to perform it as carelessly as slovenly a manner as that authority will permit.

• If the authority to which he is subject resides in the body corporate of which he is a member and in which the other members are or ought to be teachers, they are likely to make a common cause…In the university of Oxford, the greater part of the public professors have, for these many years, given up altogether even the pretense of teaching.

• The discipline of colleges…is in general contrived, not for the benefit of the students, but for…the ease of the masters… No discipline is ever requisite to force attendance upon lectures which are really worth attending.