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History of Economic Thought 3

History of Economic Thought
Lecture III France
• Francois Quesnay (1694–1774) and his followers are
jointly referred to as the Physiocrats.
• They were heavily influenced by Cantillon.
• They further developed two of Cantillon’s ideas:
• land as the source of wealth and
• the circular flow of income.
Quesnay: circular flow
• Quesnay analyzed the circular flow of income using numerical
examples that showed
• how one sector’s spending became another sector’s income and
• the idea that the output of one sector may be another sector’s raw material.
• These numerical examples anticipated the development of input-output analysis in the
1930s by Wassily Leontief.
• The physiocrats wrote spiritedly in favor of
• reduced government intervention in the economy and
• free trade.
Turgot (1727 – 81)
• Turgot opposed government intervention by
France’s mercantilist government
• “in general, every man knows his own interest better
than another to whom it is of no concern”
• The main thread is that the government should not meddle
• This idea emerged as a reaction against the excesses of Colbert-style
• The ideas of the Physiocrats and others strongly influenced English
classical writers, notably Adam Smith
Two main works of Adam Smith
The Theory of Moral Sentiments (1759)
An Inquiry Into the Nature and Causes of the Wealth of Nations
(1776) He was interested in explaining the nature and causes of the
wealth of nations
Adam Smith’s life (1723-1790)
Adam Smith was typically an early writer. Smith was born
in Scotland. He received his MS from the University of
Glasgow at age 17 where he came under the influence of
moral philosopher Francis Hutcheson and David Hume.
He lived most of his life with his mother until she reached
the age of 90.
Chief contributions
Built a coherent and logical theory of how the economy works
The elements of Smith's theory were mostly already available in the
writings of earlier writers.
However, in those earlier writings, good ideas existed alongside with
other bad ideas
Smith and Laissez faire
Smith advocated laissez faire not because he believed markets to be
perfect but because history and the institutional structure of the
England of his time, showed that market usually produced better
results than did government intervention.
Theory of Moral Sentiments
This book was an argument against the views of writers such as Hobbes and
Rousseau who argued that the pursuit of self-interest, an important human
instinct, inevitably leads to a cruel and nightmarish society.
Impartial spectator
How do we decide what is right and wrong? How do we solve moral
dilemmas? We turn to ourselves and start conversations with
ourselves. And this conversations are with a fictitious person. He
calls it an “impartial spectator”.
The Wealth of Nations
Before the Wealth of Nations
In 1763, he resigned his professorship to become a tutor to
the Duke of Buccleuch and spent nearly three years
accompanying the young Duke on a tour of Europe.
An Inquiry into the Nature and Causes of the
Wealth of Nations
Book I: Value theory, division of labor, distribution of
Book II: Capital as a cause of wealth of nation
Book III: Economic history of several nations used as
Book IV: History of economic thought & practice
including mercantilism & Physiocracy
Book V: Public Finance
Capital and Capitalists
The present wealth of nation depends upon capital accumulation
(determines labor) and capital accumulation leads to economic
Exchange is important for Adam Smith. This organization is
unconstrained and not planned, it is driven by self-interest: «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 (p.83-84).
Theory of Value
What determines the price of a good? What determines the
general level of prices?
b) Nominal and Real Prices
Smith dedicated ch.5 to differentiating between real and
nominal prices. Nominal price is merely the price of a good in
terms of money (e.g a meter of cloth sells for $10), while real
price is the price of goods in terms of other goods.
C- Market and Natural Prices
In chapter 7, Smith differentiates between natural price and market
price. Basically natural price is the long run price, whereas the
market price is what we see on the market at any moment.
(d) Labour Theory of Value
But what determines the natural price? And here he outlines his
labour theory of value. The labour theory of value asserts that the
natural value of a commodity reflects the labour that went into its
production. Smith’s own example is with hunter. It takes two hours
to hunt a beaver and one hour to hunt a deer, so natural price of one
beaver is two deer. Why?
(e) Adding-Up Theory of Value
Here he calculates the cost of production. Basically, he proposes
that wages, rents and profits determine price. Price are determined
by its cost of production.
Of the wages of labor (Iron law of wages)
Smith used different theories of the wage rate at different times
One was a form of the Iron Law of Wages
The theory that wages tend towards a level sufficient only to
maintain a subsistence standard of living.
If wages fall below what workers need to survive, the population will
decline and wages rise to the subsistence level.
Smith accepted the legitimacy of profits as a payment to the
capitalist for performing a socially useful function, to provide
materials and machinery for production. He admits a share of
laborers output goes to employers but without capitalist they would
have no materials to work.
The Invisible Hand
“[E]very individual … 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. …”
The Invisible Hand
“…Nor is it always the worse for the society that it was no part of it.
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. It is an affectation, indeed, not very common
among merchants, and very few words need be employed in
dissuading them from it …”
Book V
The most important duty of the sovereign is to protect society from
violence and invasion from other societies, and this can only be done
by means of military force.
The second duty of the sovereign is to protect each member of society
from injustice or oppression enacted by other members.
Better education, Smith argues, is finally a social good.
Summary of the causes of the wealth of
Accumulation of capital is the bottom line
Requirements for highest rate of growth:
Free markets (no government intervention)
Private Property
Unequal distribution of income to allow accumulation of capital
The Real Adam Smith: Morality and Markets youtube