Adam Smith Reading Summary PDF

Adam Smith Studied at University of Glasgow & Oxford (did not like that) and later became professor at the University of Glasgow (field of logic first – then moral philosophy) 1st book: The Theory of Moral Sentiments discusses man’s moral attitudes [man as a moral and altruistic being] – said to co...

Adam Smith Studied at University of Glasgow & Oxford (did not like that) and later became professor at the University of Glasgow (field of logic first – then moral philosophy) 1st book: The Theory of Moral Sentiments discusses man’s moral attitudes [man as a moral and altruistic being] – said to contradict with his later book The Wealth of Nations [emphasizes self-interest as driving force behind human action] Explanation for the contradiction: in the 17 years between the books Smith changed his opinion – rather unbelievable o Possible to believe both that a human is moral and self-interested o Smith was unaware of these contradictions 1764 he resigned from his professorship & became private tutor for young Duke of Buccleuch during his journey through France Academic downgrade, but profitable (increase in wage & great pension) Enabled him to meet great personalities like philosopher Voltaire, Quesnay with his physiocrats including Turgot Had more time for his writing – especially The Wealth of the Nations (published 1776) o Book was a huge success from the beginning 1778: appointed to 1 of 5 customs inspectors in Scotland (moved to Edinburgh) Wealth of Nations Many passages can be described as abstract theory – not mathematics or diagrams, but carefully formulated logical chains of reasoning in literary form & contains detailed descriptions of social and economic institutions of Scotland Based on his own experience and readings (covers a huge range) – not a textbook in the modern sense (there was no market for these at the time) Against mercantilist view and in favour of free trade – necessary to explore the functioning of markets Divided into 5 books: 1. Microeconomics (todays notion) or price theory division of labour in a market economy formation of prices under competition and monopoly determination of factor prices distribution of income 2. capital accumulation and financial system 3. historical development of agriculture in Europe since the time of the Roman Empire 4. international trade essence of his criticism of mercantilism 5. public sector in the economy taxes and public expenditure theoretical and historical perspective Adam Smith’s Price Theory Age of classical economists: price theory = “theory of value” Studied determinants of prices/values of different goods and services Smith introduced distinction between value in use and value in exchange o Water is more useful, diamonds more expensive o Exchange value (low) of water does not reflect its value in use (high) o Decided to only focus on value in exchange Weakness of this classical theory of value: failure to construct a satisfactory theory of demand and to clarify the role of demand in the information of prices Labour theory of value: relative prices of commodities are determined by the relative amounts of labour needed to produce them (including different skills and time) For modern economists: special as there is no reference to demand conditions Fully consistent with modern insights Modern: price formation under perfect competition where supply and demand meet o Foreign to Smith, but can be related to his theory o Supply curve (unit costs of production) is horizontal o Price determined by costs of production o Demand determines volume of output Example with deer and beaver o Deer takes 1 hour to hunt, beaver 2 hours o Different skills needed o Important as whole produce of labour accrues to hunters o In a society: work of labourers organized by people who accumulated capital, provide hunters with tools and prepay their wages = wage fund Wage fund is an important part of concept of capital used by Smith o = contribution to production process o Employer must earn a profit to pay the wages (earned from value of production) o Value of produce distributed among 3 components of cost ▪ Labour ▪ Capital ▪ Land o Extents theory of price formation to more general cost-of-production theory Natural Price: Determined by wages, profit and rent which tend toward their normal levels Smith uses normal level of cost as causal explanation of price Did not have a general equilibrium perspective on price determination o Would make no sense that product prices are determined by these factors o Product and factor prices would be mutually dependent on each other 1st chapter: Analysis of division of labour in society with example of a pin factory (“complicated and difficult process with about 18 separate operations with each worker specializing in one of them” Unit cost of production not only determined by technological relationship o Depends on organization of labour (depends on technological possibilities) o Depends on size of market o = depend on factors on the demand side of the market Another connection between demand and prices: distinction between market price and natural price Natural: o corresponds to the normal level of wage, profits and rent Market: o prevails in market at a given moment o determined by relationship between quantity actually brought to the market and demand of those who are willing to pay the normal price = effectual demand o quantity brought to market > effectual demand 🡪 higher price o quantity supplies < effectual demand 🡪 lower price below natural price but natural price - central level to which will gravitate o fluctuations demand on production ▪ greater in markets for agricultural commodities than for manufactured goods ▪ due to greater variations in output & thereby supply of goods on market are larger in agriculture which is subject to condition changes due to weather o market price cannot stay long below the natural price ▪ would mean that wages, profits and rents would fall below their natural levels ▪ would lead to withdrawals from the market 🡪 outputs fall & prices increase to natural level o market price can be above natural prices for longer periods ▪ due to monopoly granted by government ▪ or happy solid and situation The Returns to the Factors of Production Natural or long-run prices of commodities are those that correspond to the natural or long-run level of the prices or returns to the three factors of production (labour, capital, land) What are the long-run determinants of the prices of the factors of production? As society moves away from being primitive 🡪 workers are employed and receive wages o Wages are agreed upon in a working contract o Employer and employee have conflicting interests – but employer has a stronger position because ▪ There are fewer employers than employees 🡪 easier for them to agree upon lowering wages ▪ However, wage must be high enough for worker to survive (even a good bit higher since working class has to survive) i.e. giving birth to 4 children as only 2/4 become adult o In countries with high economic growth, some workers make much more than they need ▪ Wage fund – resources that employers command for the payment of wages – increase faster than the population o Smith points out that the treatment of labour and wages as homogenous is a simplification of reality ▪ Wages: reflect the particular circumstances pertaining to different professions Can be above or below average Reasons for wage inequality: ease or hardship of employment (most detested job: public executioner – highest wage), how difficult and expensive it is to acquire needed skills, some professions are honourable others in disgrace, probability of succeeding in the profession honor part of the wage, the amount of trust placed in the worker; in/constancy of employment ▪ “Theory of compensating wage differentials” Very influential= wages in different professions reflect noneconomic advantages and disadvantages  Rewards for use of capital are variable as well o But far less than in case of wages o Main cause: difference in risk o Reward must also be a compensation for the work the owner has with the management and organization of the business o These inequalities are based on assumption of free and unregulated market ▪ Not true – wages & profits are influenced by institutional and political circumstances, especially the “politics of Europe” ▪ Private restraints on competition, represented by ancient guilds, are supported by governments for some professions 🡪 limit access to these and push up wages Rent: enters into determination very different to wages and return on capital o High wages and profits = causes of high commodity prices o High rents = effects of high prices o Landowner is by nature a monopolist ▪ Renter must pay price owner demands ▪ ≈ between tenant’s income and normal cost in the form of wages and profit The Invisible Hand Most important contribution of the Wealth of Nations is idea of the invisible hand 🡪 “propaganda for market economy and against public regulation & intervention” Invisible hand is only mentioned once in the 900 pages: Best for the individual is best for the society – invisible hand ensures this system of free competition (but there are more possible interpretations!) Each individual necessarily works to make national income larger o Individual is not aware of this – it is neither his personal aim to do so nor is he aware of the connection o Consequences of his actions are good for society even if he only has his self-interest in mind o Rule of harmony between the interests of an individual and the society is not absolute – conflict sometimes Does not actually mention what the invisible hand is Used example: based on full passage from the Wealth of Nations: Natural preference of individuals or investors in favour of domestic over foreign investment Often left out in citations because o Believe that shorter version represents his main message better o They read it in light of modern view of the connection between competition and social efficiency o Some use it to present their own opinions, not Smith’s What was Smith’s view? (“by preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value”) Were these lines just included as a mistake or are they an essential part o Essential argument: context in which it occurs – not in chapter on general properties of free markets, but in one whose subject is import restrictions “Each individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command” – in what does his own advantage consist? o Man of business has less control over the use of his resources if he is not present where the production takes place – he will choose to invest close to home o Given the difference between the required rate of profit abroad and at home, capital will be invested in such a manner that its total rate of return will be as large as possible (provides Smith with justification that self-interest tends to maximize national income) Need to achieve a balance between domestic and foreign investment Composition of domestic investment: such that it yields the greatest possible return on the nation’s capital Invisible hand should be seen as a mechanism that helps to neutralize a weakness of a market – a case of market failure 🡪 in context of Wealth of Nations this interpretation is quite unreasonable The invisible hand and the market economy Concept of invisible hand supported multiple times in Wealth of Nations Not only for the common good, but also in many other cases Many lines fully in line with conventional interpretation: producers think primarily of their own interest and not the welfare of their costumers, but it is their self-interest that provides us with the goods and services that we demand Free or Perfect Competition Book does not include any discussion on alternative concepts of competition Modern economics relate his insight to modern theories of perfect competition His concept of competition called “the system of perfect liberty” Far more comprehensive than modern concept of perfect competition His competition implies the absence of monopoly which ensures that prices tend towards their natural levels o If price were above 🡪 firms’ entry 🡪 downward pressure on price Competition only when prices reached their natural level that producers will face prices that are beyond their control Free entry and exit Relationship to monopoly o Monopoly price is highest it can be o Natural price is lowest which can be taken There must be an assumption that comes close to profit maximization on part of producers, but Smith is not clear about that Intermediate forms of competition: Increased number of sellers 🡪 increased degree of competition Too many sellers 🡪 not possible to agree between themselves to restrict competition Monopoly can be due to o Government privileges o Natural cost advantages o Sellers’ realisation that by cooperation they may be able to increase prices System of free competition is therefore not self-regulating as sellers have incentive to collaborate to increase their market power Smith: extreme market liberalist Believed everything should be left to the free play of market forces View of him as naïve believer in social harmony is misleading “Conspiracy against the public”: o Danger that free competition is destroyed by market actors themselves o Demonstrates that the self-interests of economic agents induces them to prevent the invisible hand to work for the interests of society Weakness of the market in regard to public interest = failure to achieve efficient use of resources & to attain social justice The Public Interest In his book there are multiple references to the interest of society of public interest Does not mention what this interest is, but in his passage with invisible hand: individual works to increase annual revenue of society (can be seen as the public interest) Without making ethical judgements: maximize national income 🡪 maximize resources for consumption “Consumption is the sole end and purpose of all production” In consumers’ interests to make judgements about effects of indivisible hand Creates a problem of interpretation concerning the connection between the public interest and the size of national income – 2 possibilities o Public interest is served best by an economic system with the largest possible national income o “annual revenue of society” is more than just national income – but rather like “social welfare” ▪ as not all individuals have same interests – must weight all interests together ▪ no attempt in his book to do so Multiple indications on the relationship between the poor and the rich necessary when making a balanced perspective on his view on markets and competition example: discussion of the attitude of employers regarding the connection between wages, prices and competitiveness o merchants & manufacturers frequently complain about unfortunate effects of high wages in rising prices and diminishing the sale of their commodities abroad and at home o they say nothing about the effects of high profits o “They are silent with regard to the pernicious of their own gains. They complain only of those of other people” Another example: discussion of system of tolls that should be charged for different types of public transport o Is against common principle of charging according to the weight of the carriage o Wants that there are higher rates on luxury carriages and lower rates on carriages of necessities o In tone of the line: no doubt on the author’s sympathy and social concern Modern economic thinking: Strength of market mechanism: under suitable conditions it leads to an efficient use of society’s resources Can hardly be maintained that resulting distribution of resources and income ensures economic justice What is meant by the invisible hand? That the market leads to use of resources that will be to the advantage of the representative or average consumer He was also fully aware of the possible inequalities that come with it 🡪 might motivate public intervention in markets Competition was good fir economic efficiency, but a just distribution of resources could not be achieved by markets alone International Trade Smith’s arguments in favour of encouraging domestic production of strategic goods 🡪 far from being representative of his general views on foreign trade International trade is an important aspect of free markets This chapter of the book includes sharp criticism of mercantilism: Concept of measuring a society’s wealth on its stock of gold and silver o Based on a false analogy between the popular way to measure an individual’s wealth (which is based on a confusion of wealth and money) and the measurement of wealth of the nation as a whole o Alternative true view: wealth consists in the stock of real goods ▪ “It would be too ridiculous to go about seriously to prove, that wealth does not consist in money, or in gold and silver; but in what money purchases, and is valuable only for purchasing” o Foreign trade policy starting from aim to increase stocks of gold and silver is therefore likely to go against public interest  Mercantilist foreign trade policies: o Barriers to imports (especially from countries with a negative balance) ▪ Prevents entry of foreign goods 🡪 may lead to monopoly for domestic producers ▪ Advantage for domestic producers, but not country as a whole ▪ Consumers would buy less productive resources (cheaper) than under the “system of perfect liberty” o Encouragement of exports by either direct subsidies or by commercial treaties with foreign countries o In these ways the policies prevent the market system from functioning efficiently o Imposes costs on society that are of the same nature as those associated with monopoly and restraints competition in general The Market and the State Smith as a laissez-faire economist: adherent view that public sector should be as small as possible to ensure best allocation of resources State should be minimal or “night watchman” Huge criticism of Mercantilists’ view on central planning and market regulation 🡪 he emphasised positive aspects of the market economy (but compared to Mercantilists’ rather extreme views!) Smith was regarded as radical by historians because of this view – only in 19th century he acquired reputation as “the employers’ economist” However, there is hardly any evidence that he should have identified the public interest with that of employers and producers This view is rather based on superficial reading of his economics – line with the invisible hand Writers in 19th century claimed Smith to be a supporter of free market helloing to perpetuate a misleading image of Smith among later writers Role of public sector? – According to Smith: state has 3 functions 1. Duty to protect society against violence and invasion from other societies 2. To protect each single member of society against injustice and oppression from other members of it 3. “Duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain; because the profit could never repay the expense to any individual or small number of individuals, though it may frequently do much more than repay it to a great society” Foreshadows modern theory of public or collective goods Public good has the property that no one can be excluded form consuming it Profitability: impossible to collect payments for the benefits enjoyed by others 🡪 market will provide too little of public goods Responsibility of state to provide them on behalf of the “great society” Smith also highlights good aspects of the state in an market-dominated economy Economic Growth Main question: What determines a nation’s level of economic development? 🡪 Theory of economic growth Analysis of economic benefits of a system of free competition, free international trade and well-function public sector do not form part of the theory, but are a framework How does the economy grow towards a higher level of growth? Perspective of reform: by changing the economic system in the direction of more competitive markets, less restrictions on international trade, better institutions and more enlightening public policies, the government will release productive forces that carry society to a higher level of wealth and better standards of living. For a given availability of resources, there are limits to how far economic development can be carried – what are factors that increase the amount of productive resources Role of population o Population growth 🡪 more workers and larger markets o More workers lead to increase of productivity capacity o Growth of markets 🡪 more possibilities for division of labour Increase in capital stock by saving o Workers are more productive if they have more real capital to work with o Individual saving is motivated by desire to improve one’s future standard of living – they do so by investing in real capital for his own use or by lending others who will invest in real capital goods o Individual saving leads to an increase of capital in the economy 🡪 more division of labour 🡪 improved productivity and increasing prosperity Technological Progress and the Industrial Revolution Some people speculate to see Smith as a direct offspring of the industrial revolution as he lived during that time in the country where it started – difficult to support this with his writings Only reference to modern manufacturing and technology: example with pin factory: “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; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands” No references to use of steam power (was well under way in his time) Inventor of steam machine James Watt was person friend of Smith Chapter 4: The Classical School Thomas Robert Malthus and David Ricardo Started with Adam Smith Many writers took his work as point of departure Calles the classical school o Often referred to as English Classical School o Should be British as there were many Scottish as well In 1770s to 1870s o Also some economists outside Britain also technically belonging to classical school e.g. French Jean-Baptiste Say o Many others who had very different views in Germany and France especially Smith as first, John Stuart Mill as last o Death in 1873 as transition to new neoclassical school Keynes: all those who did not share his thought on causes of unemployment = classical economists o Became a standard in modern times What makes these people a “school”? Constituted a fairly large but heterogenous group of people (also jobwise) In their (often extensive) leisure time they thought about economic questions Few of them had any connection with academic life Their common meeting place in London or its vicinity: Political Economy Club o Founded in 1821 o One person talked on a topic of current theoretical or practical interest followed by a debate (sometimes they disagreed) They very consciously related their work to each other o Later members emphasized their dependence on their predecessors o Especially Mill School is a concept of later historians to bring structure into complex past Malthus and Ricardo o Most important economists of 19th century  o Shared many of Smith’s views concerning social benefits of a system of free markets and many other basic issues in economic theory & policy – but not all Thomas Malthus 1766 – 1834 Son of a lawyer Studied science and mathematics in Oxford while acquiring knowledge of literature and history Became fellow of Jesus in college and priest 🡪 good income and modest workload Became professor for history, politics. Commerce and finance – first professor of political economy in Britain Complains about teaching and administration taking up too much time & had problems meeting deadlines The Theory of Population Known for this theory of population growth first presented in his book An Essay on the Principle of Population (1798) Was an important source of inspiration for Charles Darwin’s theory of evolution Left many generations thinking about population problem and related issues (birth control, poverty, …) 6 editions during his lifetime Biggest revision o Second book: Second essay (also following were called so) o Increasing volume due to increasing factual evidence for the theory o Strengthened his empirical foundations through travels through Europe (including all Scandinavian countries) o Basic theory remained the same Full title: An essay on the principle of population as it affects the future improvement of society, with remarks on the speculations of Mr. Godwin, M. Condorcet, and other writers o Condorcet: development of mankind and utopian vision of the future o Godwin: same utopian tradition with future without war and crime and therefore no need for law enforcement and diseases, anguish, melancholy  and resentment would vanish – also, each person would strive to promote the common good He talked a lot about such visions with his dad o Dad was enthusiastic about optimistic future, but he himself was not o His book was to reject the reasoning of these visions Main idea: tension between growth of population and production of food would set limits to how far human progress could be carried First edition begins with 2 basic postulates about his concern with the foundations of human existence: “I think I may fairly make two postulata. First, that food is necessary to the existence of man. Secondly, that the passion between the sexes is necessary and will remain nearly in its present state.” 1. Food necessary for humans 2. Passion between sexes is necessary Godwin: sexual instinct would decrease with increasing wealth Malthus did not agree, but gave small concession with “nearly” Core of the book presented with: “Population, when unchecked, increases in a geometrical ratio. Subsistence increases only in an arithmetical ratio. A slight acquaintance with numbers will shew the immensity of the first power in comparison of the second.” A population without any constraints on availability of resources will have a tendency to grow as a geometric series of the form 1, 2, 4, 8, 16, … This is the justification for the 2nd postulate Theoretical foundation of the assumption comes from biology Empirical justification: development in the US where the population doubled every 25 years when there was an abundance of food o Smith had similar observation in American colonies which became the USA When production of food only grows as an arithmetic series in from of 1, 2, 3, 4, 5, … o Interpretation: the distance in time between each element of the series is the same as in the population series o If both tendencies could develop independently of each other 🡪 steady fall in amount of food production per capita o Justification here less evident than biological of population hypothesis 6 cannot be derived from empirical generalizations o His intention: to put a clear contrast to geometric progress of the population  Relative increase of food production < relative increase of population o Modern formulation: decreasing returns to scale in agriculture Supported by a passage in 2nd essay: “it must be evident to those who have the slightest acquaintance with agriculture subject that in proportion as cultivation extended, the additions that could yearly be made to the former average produce must be gradually and regularly diminishing” Historical evidence: o Arithmetic series represents an upper limit of food production in England in intervals of 25 years Some historians criticised him o For not finding a deeper theoretical justification o That it would have been better if he used a more general assumption of decreasing return in agriculture Core of his theory: tension between availability of food and size of population Natural growth of population must be lowered to that of growth of food supply There must be mechanisms that hold down the rate of population growth 🡪 these were positive and preventive checks which he divided into “misery and vice” o Misery: famine o Sin: birth control In long run: per capital food supply would be constant Mechanisms to ensure that: o Decreasing returns in agriculture (the arithmetic series) o Infinitely elastic supply of labour at the subsistence wage ▪ Subsistence wage = level of income that was just sufficient for the reproduction of the working class (Cantillon and Smith) ▪ He believed: if wage was above that level for too long, income was too high, and families would have too many children ▪ Too many kids 🡪 more workforce 🡪 increased supply of labour 🡪 downward pressure on wages (would move back towards subsistence level) Idea of first essay were modified: Definition of subsistence wage o Became rather social & psychological than purely physical o Higher wage would make people get used to higher standard of living There were other checks on population that misery and vice o Self-control (“moral restraint”) as cause of reduced population growth o Late marriages (confirmed by observations made in Norway) Generally: pessimistic view of future