ADAM SMITH

SOME READINGS

• 1. “Adam’s Fallacy”: Duncan Foley. Extremely critical of Smith, but very

good outline of his thought.
• 2. Articles by Amartya Sen (uploaded on UMS). Do not focus on Smith’s
theory of justice (which Sen talks about), but read Sen’s outlining of
Smith’s political and moral philosophical ideas.
• 3. “How Adam Smith can change your life”. Russ Roberts. Very
interesting, accessible take on Smith’s moral and ethical ideas.
THE WORLD BEFORE SMITH

• The Enlightenment: Describes the changes happening in

philosophy and theory during the 17th and 18th century.
• Reflected the belief that human reason and rational thought
can combat superstition, tyranny etc, can make a better
world. Beginning of idea of “rational” self-interest.
• The slow beginning of industrialisation. The spread of
industrial production, and the rise to importance of the
producer, not the merchant or the farmer, as important,
especially in England.
BIOGRAPHICAL DETAILS
He was born in 1723, in Kircaldy in Scotland.
Was sent at age 13 to Glasgow College, then
attended Balliol College at Oxford.
His landmark book The Wealth of Nations was
published in 1776, the year America got
independence.
• His father was a customs collector; a local official who was, ironically,
part of the protectionist mercantilist policy that Smith criticized.
• (Even more ironically, after publication of Wealth of Nations, he was
made collector of customs in Edinburgh, a position he held until his
death).
• After school, went to University of Glasgow and then Oxford. Criticised
professors there for not being interested in teaching, thought that
professors should be paid according to how many students were
interested in their class (something no academic would agree with
today!)
• After Oxford, returned to Glasgow, where he taught moral philosophy. In
1759, he published Theory of Moral Sentiments, basically a work of
philosophy, about human motivations and behaviour, about questions of
justice and individual action (read Sen for a better appreciation of
Smith’s theories of justice).
• In 1763, resigned to become tutor of young Duke of Buccleuch,
accompanied him on travels to Europe. In Switzerland, Smith visited
Voltaire, In France, met Quesnay and Turgot. Returned to England in
1766, began work on his most famous book, The Wealth of Nations.
Published in 1776.
• Died in 1790.
CONTRIBUTIONS OF SMITH

• Opposed mercantilism, earliest writers who spoke about self-interest,

the power of the market mechanism, competition. Central to many
modern economic ideas.
• Milton Friedman: “.. “[t]he market, with each individual going his own
way, with no central authority setting social priorities, avoiding
duplication, and coordinating activities, looks like chaos to untutored
eyes.” Yet, “through Smith’s eyes we see that it is a finely ordered and
effectively tuned system, one which arises out of men’s individually
motivated actions, yet is not deliberately created by men”
• Yet was he so single-minded in his defence of self-interest? Much more
than just a cheerleader of capitalism; a nuanced, important (though
flawed) and highly original thinker.
WHAT WE SHALL STUDY OF SMITH

• 1. Self-interest in Smith, and his moral and philosophical view

of human nature.
• 2. Prices, Wages and Profits: early classical theories of Value
and Distribution in a market economy.
• 3. The factors governing the “Wealth of Nations”. What brings
about growth and the healthy functioning of markets?
• 4. The role of the State in the growing market economy.
• (Important, Smith doesn’t use the word “capitalist” in his
early writings.)
PART 1: SELF-INTEREST AND THE “INVISIBLE
HAND”
• “Natural law” relies on what is natural, as opposed to something
that is constructed, imposed on nature or human society. Believes in
an independent existing order which is superior to any that is
artificially constructed.
• Successful social organisation is that which acts in harmony with
this natural order, as close as possible to it. According to Smith, God
created natural laws. Human thought and society should strive to
understand these laws.
• Smith: “The happiness of mankind, as well as all other rational
creatures, seems to have been the original purpose intended by the
Author of nature, when he brought them into existence.” (Theory of
 THE IMPORTANCE
OF SELF-INTEREST
A very important idea for its time: that
self-interest can motivate and ensure
economic activity.

We do not need a strong kingdom, or a

central planning mechanism, or notions
of charity, to ensure output and sales in
a market economy. Individual self-
interest is a powerful enough driver of
activity.
 THE INVISIBLE HAND
Self-interest of individuals is enough for
societal welfare. Self-interested individuals
do not care for welfare of others, but still
can promote overall welfare in a market
economy.

Much of modern microeconomic thought

dedicated to understanding the invisible
hand metaphor. Is it price mechanism?
Profit motive?
 LEGACY OF THE
INVISIBLE HAND
Self-interest is i) A good description of
individuals’ motives. ii) A good driver of
economic activity iii) A good instrument to
bring about social welfare.

Idea that has pervaded mainstream

discourse: individuals acting out of self-
interest will always bring better outcomes
than Government or the State.
• The idea of “rational” individuals is a part and parcel of
modern economics, where individual agents are modelled
as being driven purely by self-interest, and “rationality”
simply means intelligently and consistently pursuing one’s
self-interest.
• This has now been used in other social sciences, in law, in
international relations (are countries “rational” agents?).
• No doubt, received significant backlash, especially given
repeated crises of capitalism faced in the last couple of
years.
 DUNCAN FOLEY’S
CRITICISMS OF
SMITH’S IDEAS OF
SELF-INTEREST
This is what critics of capitalism would
say.

Foley’s essential criticism. Does not

deny that individuals are self-interested
(can debate whether this is a good
characterization of individual
behaviour), but that if you assume self-
interest drives social welfare, then you
excuse a lot of evils and ills that
capitalism can bring about.
DOES SMITH FOCUS ONLY ON SELF-INTEREST?

• In Theory of Moral Sentiments:

• “However selfish 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 they derive nothing from
it except the pleasure of seeing it.”
• Sympathy, generosity, public spirit also drives individuals’ actions.
Reasoning can prevent us from being uncaring. “Established rules of
behaviour” and social conventions also influence actions, not just self-
interest. (read Sen, 2010 and 2011).
• Smith DID NOT reduce individuals to self-interest. His theory of justice
depends on role of “impartial spectator”, i.e stepping outside one’s own
self-interest to view and judge other situations.
SELF-INTEREST AND THE MARKET ECONOMY

• Sen: Smith spoke about self-interest only in context of market activities

and trade. If one were to talk about trade, using self-interest to describe
and analyse trade is sufficient. Does not mean it necessarily implies
that self-interest is all that is required for welfare.
• Trust is important as well:
• In 1600s and 170ss, economies rocked by massive financial crises
(South Sea Crises, Dutch Tulip Mania). Smith criticized “prodigals and
projectors”, i.e. financial speculators and investors who follow financial
crazes. Believed there needed to be financial regulation on such agents.
• Criticised by Bentham, who believed speculators brought about
“innovation”.
• Smith was also aware of class conflict between workers and capital
owners, with power dynamics favouring business owners.
• “The law…authorises or at least does not prohibit (business owners’)
combinations, while it prohibits those of the workmen”. (Wealth of
Nations).
• Nuanced view of Smith: individuals are not wholly or completely self-
interested.
• Self-interest is important, and powerful (maybe even natural).
Revolutionary idea considering importance of kings and monarchies, that
individuals can organize their own affairs themselves.
• If institutions strong, if unfair acts curtailed, if speculation and certain
activities regulated, social welfare improved by markets made up of
individuals actions and agents.
• Marx: Self-interest not natural, it is idea that best benefits capitalists. Can
never have social welfare because inherent logic of capital will ensure
beneficial institutions – such as regulation, prevention of monopolies –
never emerge.
VALUE, WAGES AND
PROFITS IN ADAM
SMITH
WHAT IS VALUE?

• Classical economists wanted to understand what gives a commodity

value, and what determines the proportions in which commodities
exchange, i.e. relative values.
• Physiocrats believed only agriculture produced a surplus, and generated
value over and above costs. But what determines inherent value of a
commodity?
• Study of distribution is important to see how value of a commodity is
divided into payments to factors of production, wages (payment to
labour), profits (payment to capital) and rent (payment to landowners).
• Importance of wages and labour seen as factory system emerged. What
factors determined wages? Needed to know this if capitalism were to
thrive.
THE LABOUR THEORY OF VALUE

• Nominal price: Amount of money for which a commodity is exchanged.

• Real price: What determines how valuable it is, relative to other goods?
How much of resources used in its production?
• John Locke (1632-1704): One of the earliest to write about how the act
of physical labour can create some economic value, and how individuals
can have right to property if they labour to create it. Land alone does
not generate value, only when some labour done on it.
• Economists needed theory of how relative values generated, to know
proportions in which commodities exchange with ach other.
• Smith: labour is the only real resource used. Expansion of labour provides
value to commodities. Commodities exchanged in ratio of amount of
labour used in them.
• Real source of wealth of nations is human labour, or labour productivity.
Not agriculture (Physiocrats), or accumulation of gold (mercantilists).
• Assume society made up only of deer hunters and beaver hunters. If it
takes one day’s labour to hunt deer and two days’ labour to hunt a
beaver, equilibrium exchange ratio of deer for beaver will be 2:1.
• Competition establishes this ratio. If beaver hunters want 3 deer, for 1
beaver, deer hunters will simply go hunt beaver (assuming costless shifts
between sectors). Instead of hunting 2 deer in two days and buying
beaver, will hunt 1 beaver over two days.
SMITH AND “VALUE-ADDED” ACCOUNTING

• Imagine a firm purchases raw material (cotton), makes it into shirts. Value-
added is price of shirt minus price of cotton.
• Total price of shirt = Wages + Rent + Profits + cost of raw cotton.
• Price of raw cotton = Wages of cotton farmer + rent of landlord + profits +
Input prices.
• Price of any input can be resolved into wages + rent + profits. Thus, the
value of any commodity is given by:
• Value = Wages + Profits + Rent.
• (GDP is essentially a measure of value produced in an economy).
• Smith: Natural price therefore can be determined by:
• Natural price = (Labour requirement*Natural Wage) + (Capital
requirement*Natural profit rate) + (Land
requirement*Natural Rent).
• Smith then goes into theory of profit, wage and rent. But two major
problems.
• 1. Assumes a certain harmony of interests between labour, capital and
land. Increase in wage or rent doesn’t necessarily reduce profit. (Ricardo
and Marx tackle this).
• 2. If labour produces value, where does profit arise from? Is profit a
deduction from value created by labour, or a genuine addition to value?
(Ideas taken up by Marx).
WAGES, PROFITS AND ACCUMULATION

• What determines wages and profits?

• WAGES: The level of wages determined by what it costs for workers to
“reproduce” themselves. What is the cost of goods required for the
worker to keep them healthy enough to come to work the next day?
• Can be thought of as cost of basic basket of “subsistence”. If wages fall
below this level, workers will leave city and go back to rural areas.
• This subsistence is not determined by physical subsistence alone. Can
have social aspects. For eg, in North India, wage goods will include
wheat, in South India, rice. Wine in France, Beer in England.
PROFITS, ACCUMULATION AND COMPETITION

• If labour produces value, from where does profit arise? Is profit a

genuine addition of value – in which case labour alone does not produce
value – or is it a residual after wages paid out? Smith unclear on this.
• He does outline theory of changes in the profit rate. If no restrictions to
movement of capital across sectors, profit rates will equalize, and there
will emerge an average rate of profit across all sectors. (What
determines this? Unclear.)
• As capital stock increases, rate of profit will fall, because increased
competition leads to lower profits. Also rising wages, rents may reduce
profits. Important question tackled by many later economists, that of
falling rate of profit.
• But important idea: capital accumulation lowers profits, raises wages.
IMPORTANCE OF COMPETITION

• Natural price = Value = Wages + Profits + Rent. Demand-supply

mismatch can lead to Price>Value.
• Important: Demand-supply determines market prices, while equilibrium
prices determined by value (i.e labour).
• If price>value, one or more components – wages or rent or profits –
above its natural value. If wages high, inflow of labour will lower wages.
If profits high, inflow of capital will lower it.
• Competition important for equilibrium prices=value, for natural law to
establish itself. Monopoly and restrictions, in hindering free movement,
can lead to deviations of price from value, and hence restricting natural
equilibrium.
DIVISION OF LABOUR

• True source of wealth of nations is the division of labour:

breaking down of individual tasks into series of separate
task, each to be produced by separate labourer.
• This increases labour productivity, or output per worker, for
individual firm, and for economy as a whole.
• Division can be at level of single factory, or global
marketplace.
• Labour productivity increases through:
• 1. Increase in ability of workers
• 2. Reduction in time lost in passing from one work to the
next
• 3. Invention of machinery specialised for certain tasks.
• Technological change mostly associated with aspect 3.
• Division of labour depends on size of market. No point in
setting up huge factory, huge capital investment to reduce
per unit labour costs if no one will buy goods.
• Depends on, therefore: Size of population, income, demand,
distribution of income, changing patterns of demand,
number of firms etc.
• Economic development, therefore, depends on positive
feedbacks between division of labour and size of market.
• Division of labour lowers costs, raises wages and incomes,
extends markets, and leads to more division of labour.
• For development, must make use of this positive process,
policy must be geared towards this.
• Problems of division of labour:
• 1. Fatigue
• 2. Boredom
• 3. Alienation