HISTORY OF
ECONOMIC IDEAS
LECTURE 2
Questions/Indications Raised
by Physiocrats
• Surplus
• Prices---Natural Prices, Value
• Distribution
• Labour creates wealth / Labour Theory of
Value/Division of Labour
• Laissez-Faire economy means naturally the economy
settles down to natural prices
• Emergence of Capitalism—Requirement to explain
the working of the capitalist system
Adam Smith
• The theory of Moral Sentiments ---Morality, Justice,
Law > Value and Distribution >Subjective Theory of
Value –indicated by Physiocrats
• Wealth of Nations –Birth of Political Economy ---
• Microeconomics, Macroeconomics, Distribution
Theory, Institutional Economics
Adam Smith
• Theory of Invisible Hand
• Influenced by Laissez-Faire
• Influenced by Newtonian “Natural Order”: Question
of Rationality .
• Conviction: Human relationships were regulated by
objective mechanical laws
• Theoretical need arose within the social and political
thought
• Accounting for Social Life without metaphysical
justification
Adam Smith
• Social classes emerged in capitalist development
• Absolutist state was questioned
• Money was power
• There was need for a political economic philosophy
by which civil society could justify itself independent
of the state
• Theory of Moral Sentiments: man experiences
towards the fellows
• How can individual serve collective interest?
Adam Smith
• Smith thought /proposed economic laws which are for the society.
• Society is capitalist society.
• Smith was responding in the background of emerging capitalist
economy.
• Smith was explaining capitalism
• Morality, Justice , Law effective in a capitalist society were discussed
in Theory of Moral Sentiments
• These are necessary for the working of capitalism
• Smithian interest was to explain capitalism in a deterministic, rational
way
Adam Smith
• Invisible Hand: Individuals serve the collective
interest precisely because they are guided by
self-interest
• Individuals can serve collective interest by
operating through selfish motives, but collective
interest is restored through invisible hand
• Similar attempt was made by Quesnay: natural
tendency of social agents to produce order
• What was invisible hand?
Adam Smith
• Self-guided exchange and exchange restores
equilibrium/balance
• Market system acted as a guiding principle
• Society of greedy and self-seeking people constrained
by criminal law and the law of property and contract
should be capable of an orderly and coherent
disposition of economic resources
Theory of Invisible Hand
• Private property and contracts are supported by law
• Economic environments are fully specified and prices
are given
• Individual knows everything that he needs to know
• Idea of Complete Market was there
• When market power is present vision of Smith’s
Invisible Hand is lost
• There will be no surplus anywhere
Theory of Invisible Hand
• The concept—properly understood—is central to Smith’s insights, although he
uses the phrase only once in The Theory of Moral Sentiments and once in An
Inquiry into the Nature and Causes of the Wealth of Nations. In Moral
Sentiments, he suggests that “The rich … are led by an Invisible Hand to make
nearly the same distribution of the necessaries of life, which would have been
made, had the earth been divided into equal portions among all its inhabitants.” In
other words, they “share the wealth” despite themselves.
• In Wealth of Nations, Smith uses the term to refer to a merchant naturally
preferring and supporting his domestic economy. “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,
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.”
• This could be taken to suggest that Smith was promoting local investment over the
foreign variety. In fact, he was referring to people’s natural—and wise—tendency
to stick to markets that they know. The context of this passage was Smith’s
opposition to the artificial promotion of the export trade, but he is also clearly
pointing to the more extensive benefits of self-interested commercial behaviour.
Theory of Invisible Hand
• Smith’s most important indirect reference lies in his example of how the market
provides for even the most humble labourer. To accommodate the labourer’s
simple needs, Smith observed, required an amount of cooperation that “exceeds
all computation.” Smith took as his prime example the labourer’s plain woollen
coat, which, “as coarse and rough as it may appear, is the produce of the joint
labour of a great multitude of workmen.” Smith enumerated all the parts of the
wool industry, all the merchants and carriers, all the elaborate machinery—from
ships and mills to looms and furnaces—that would have been involved.
Producing the rest of the workman’s attire, and his tools, home, furniture and
utensils, similarly required vast interconnected industries. “Without the
assistance and co-operation of many thousands,” wrote Smith, “the very
meanest person in a civilized country could not be provided, even according to
what we very falsely imagine, the easy and simple manner in which he is
commonly accommodated.”
Theory of Invisible Hand
• Theory of Justice and Law: Agents are not having market
power
• Equilibrium is coherent state
• Prices are acting as signals
• Property rights are there to protect the situation
• Fred Hirsch: Social Limits of Growth
• Invisible hand cannot provide what people desire: Greed
and the desire for self advancement must give way to the
gentler social virtues of affection and cooperation
Invisible Hand
• John Stuart Mill also expanded the theory
• They were aware of limitations of the market
• Is this the rise of General Equilibrium Theory?
• GET underestimated the limits of the market?
• Law of supply and demand OR Theory of value,
distribution and prices?
• Smith went for Theory of Value, Distribution and
Prices
Accumulation and
Distribution
• Smith was concerned with economic growth and
economic surplus as Smith was concerned with
development of capitalism
• Accumulation as an economic process of capitalist
transformation
• Productive power of labour is to increase for
accumulation
• Social classes play a significant role in Smith’s theory
of growth
Accumulation and
Distribution
• Social Classes: distinguished by productive
resources which they held-land, labour and
capital
• Determined by the way they spend profits,
wages and rents
• Theory of Income Distribution coming up
with the theory of accumulation
Accumulation and
Distribution
• Additive theory of distribution-prices
equal the adding up of wages, profit and
rent
• Theory of Surplus or Accumulation was
discussed simultaneously with
Distribution
Crucial Questions
• Influenced by Aristotle
• Three basic questions:
• Value, Prices and Money
• Theory of Invisible Hand required a theory of prices,
theory of divergence between value and prices, theory of
convergence of value into prices
• What is natural in natural order?
• This also requires a theory of accumulation, growth and
distribution
Adam Smith
• Rothschild(1994): According to Smith invisible hand
leads to a perfection and grand system. Arrow and
Hahn- invisible hand is poetic.
• Perkskey (1989): Retrospectives: similarity of
invisible hand with market system. Say and Ricardo’s
principles, states and markets
Theory of Value
• Smith had a microeconomic theory: Theory of Invisible Hand
• Productive System will produce the goods that consumer
demands
• Chosen productive methods were efficient and they did not
waste resources
• Goods are sold at lowest price possible , which is the
production cost inclusive of normal profit.
• This was natural order and not proved.
• Existence, Uniqueness, and Stability of Equilibrium ----this was
taken over by General Equilibrium Theory and Competitive
Equilibrium.
• Market is its own guardian.
•
Theory of Value
• Smith was an institutionalist
• Theory of Moral Sentiments
• Market is a set of institutions –private ownership, property rights, ban
on monopolistic practices
• Justice and Law
• Institutions and State
• Smith had a theory of growth
• Explain capitalist development
• Smith had a theory of accumulation of capital
• Smith had a theory of distribution
• Additive Theory
• But all these theories were supported by the theory of value and prices
Value
• What is the structure of productive process?
• How are prices determined?
• Smith knew that the idea of natural value cannot be a
metaphysical statement
• Natural price is the sum of natural rates of wages, profit
and rent
• Natural rates are the ordinary or average rates prevailing in
the general circumstances of the society or determined by
the general conditions of supply and demand for labour,
stock of capital and land.
Value
• What precedes productive activity?
• Accumulation of stock of capital and appropriation of land
• Why exchange takes place?
• The proportion between the quantities of labour necessary for
acquiring different objects is the only reason for explaining a rule
of exchange
• Smith distinguished between productive labour and unproductive
labour
• Value which worker adds to the material resolves into two parts:
wages and profits
• Prices of commodities are determined by different principles
Value
• There actually exists a series of quantities of labour employed to
produce a good
• Labour is the real measure of exchangeable value of the
commodities/goods
• Value of a commodity/good is determined by the ability of the
commodity/good to exchange
• Hence value of a commodity is determined by the quantity of labour it is
able to “command”
• X exchanged for Y > Producer of X gains Command over Necessary
Labour in Y
• Value of a commodity is equal to the quantity of labour which it can
enable them to produce or command
Value
• Measure of value of a commodity in labour commanded does
not coincide with the amount of labour the commodity
embodies
• Labour commanded means exchange and labour embodied
means production
• Labour commanded is a relative price, it is the value of one
good expressed in terms of value of the other; the labour that
can be bought with it
• Labour commanded is greater than labour embodied as there is
profit
• Theory of profit is based on profit as a residue
•
Value
Labour theory of natural value
• Necessary prerequisite to have value is that it is a product of
human labour.
• This is a deduction theory of profit
• Profit and rent are deductions from what is naturally a product of
labour
• Incipient theory of exploitation later taken up by Marx
• Theory of price is “Adding Up Theory” or Simple Cost of
Production theory
• Adding cum supply and demand theory are adequate explanation
of value
Value
• Exchange value or relative value was linked to labour
• Standard of measurement in terms of which the values
of commodities and changes in them are to be
properly estimated
• This was taken up later by Ricardo in his thoughts
• Smith pointed out that money is itself a variable
depending on the labour to mine precious metals
Value
• Distinction between Use Value and Exchange Value :
Some have Value in Use (later developed by
Utilitarians) , other goods have Value in exchange
• Water-Diamond Paradox: Water posseses High Use
Value but Low Exchange Value, opposite to
Diamonds which have Low Use Value and High
Exchange Value
• Exchange Value and Use Value are different , (this
was dissolved to utility determined market price in
Utilitarianism)
Value
• Beaver-deer model of exchange:
• In early stage before accumulation of stock and
appropriation of land, the proportion between the
quantities of labour necessary for acquiring different
objects was the only circumstance which determine
the rule of exchange. For the hunter it usually costs
twice the labour to kill a beaver which is required to
kill a deer. One beaver would be naturally exchanged
for two deer.
Value
• Productive Process ---Labour in use and labour is the
cause of Value
• Value in Exchange is measured by Labour
• Value of a good is determined by Labour Commanded
meaning the labour the good is able to command.
• Labour Commanded is not the same as Labour Embodied
• Embodied Labour enables the good to command labour
which is Relative Price
