Adam Smith Chapter 4 January 29-February 4, 2007

Adam Smith Scottish moral philosopher and political economist Professor of philosophy at University of Glasgow Inquiry into the Nature and Causes of the Wealth of Nations – 1776 Father of economics Influenced by David Hume

Framework of Analysis What are the questions that Adam Smith is asking? What is the nature of the “wealth of nations” – that is, how is economic welfare measured? What causes economic growth to take place?

Framework of Analysis What are Smith’s assumptions? Economic welfare is determined by goods and services, not by stocks of precious metals – more goods and services are better! Competitive markets exist and within these markets the factors of production move freely to advance their economic position People are rational and calculating and largely driven by economic self-interest Markets (natural) work better than any arrangement devised by human beings (government?) Resources will always be fully employed

Framework of Analysis What is the economic/political / cultural/social environment of Smith? Beginning of Industrial Revolution Mercantilism breaking down – American Revolution Reduced power of and respect for monarchs

Framework of Analysis What is the role of the market? The market is king A natural process at work (markets) in the economy can resolve conflicts more effectively than any arrangements devised by human beings "The propensity to truck, barter and exchange one thing for another is common to all men, and to be found in no other race of animals."

Framework of Analysis What is the role of the market? (cont’d) Profit maximization (self-interest) is goal of producers – this minimizes costs of production Consumers direct the economy through their purchases – they buy what they want (self-interest)

Framework of Analysis What is the role of the market? (cont’d) Markets based on individual self-interest leads to the best possible outcome for society Invisible Hand "Every individual necessarily labors to render the annual revenue of the society as great as he can. He generally indeed neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good."

Framework of Analysis What is the role of the market? (cont’d) Short run (market prices) v. long-run (natural) prices Normal profit v. Economic profit – economic profit due to market prices causes resources to move into an industry, resulting in a tendency toward natural prices and normal profit.

Framework of Analysis What is the role of the market? (cont’d) Division of Labor leads to higher productivity and more output “The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour.” Ten workers could produce 48,000 pins per day if each of eighteen specialized tasks was assigned to particular workers. Average productivity: 4,800 pins per worker per day. But absent the division of labor, a worker would be lucky to produce even one pin per day.

Framework of Analysis What is the role of the market? (cont’d) There are economies of scale – size of the market is important because it affects division of labor Capitalists and capital accumulation are necessary Capital also determines the productivity of labor

Framework of Analysis What is the role of the market? (cont’d) Markets are not perfect Monopolies can arise "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. It is impossible indeed to prevent such meetings by any law which either could be executed, or would be consistent with liberty and justice."

Framework of Analysis What is the role of the market? (cont’d) Markets are not perfect Division of labor can lead to worker alienation

Framework of Analysis What is the role of government? Government interference in markets is undesirable Keep in mind that Smith’s view of government was affected by conditions of his day –e.g., monarchies, favorites of the court, large armies, etc. Under mercantilism, Smith observed that merchants used government to enrich themselves

Framework of Analysis What is the role of government (cont’d) BUT There is some room for government activities Public education (positive externalities – public goods) National defense Roads Judicial system Protectionism – infant industry argument He also argued for some recreational opportunities (parks, for one) to prevent worker alienation

What is “the nature and causes of the wealth of nations?” Markets based on self interest Productivity of Labor - Division of Labor Capital accumulation Unequal distribution of income in favor of capitalists – only they save and invest Little to landlords – they spend on unproductive things