HISTORY OF ECONOMIC THOUGHT
LECTURE 2
Adam Smith
1. BACKGROUND
Adam Smith was born in 1723 in the town of Kirkcadly, Scotland. At 17 he went to Oxford on a scholarship
and in 1751, at the age of 28, was offered first the Chair of Logic and shortly thereafter given the Chair of
Moral Philosophy at the University of Glasgow.
By 1750, Scots were among the most literate citizens of Europe, with an estimated 75% level of literacy.
Glasgow at the time was considered the center of Scottish Enlightenment. The thinkers of the Scottish
Enlightenment believed in the fundamental importance of human reason, rejecting any authority that could
not be justified by reason. Guided by reason, humanity can improve society and nature. Adam Smith was the
product of this intellectual environment.
Smith’s fame preceded the publication of The Wealth of Nations in 1776. By that time Smith was considered
the leading English philosopher, based on the popularity, both in Britain and continental Europe, of his earlier
book, published in 1759, The Theory of Moral Sentiments.
In 1764 Smith left Scotland for France, accompanying a young duke as a paid tutor. While in France, where he
stayed for two years, he met some of France’s leading intellectuals, among them Voltaire and members of a
group of economic thinkers called Physiocrats. Upon his return to Kirkcadly in 1766, he began to work on
The Wealth of Nations, which culminated in its publication in 1776.
2. THE WEALTH OF NATIONS
2.1.
An Overview of Smith’s Vision
Smith’s vision set forth in The Wealth of Nations is basically a blueprint for a whole new mode of social
organization. The new mode is based on the laws of the market, where “the private interests and passions of
men” are led in the direction “which is most agreeable to the interest of the whole society.”
The main objective of the book was to expose the fallacies of the mercantilist view of economic policy, by
showing in great detail how the laws of the market, in both national and international trade arenas, lead to an
increase in the welfare of the whole society.
Smith showed how it is possible, and desirable, for an economic system to operate in an environment where
similarly motivated individuals pursue their self-interest, without any mandates from or controls by the
government. That system is the self-regulating markets.
What assures self-regulation of markets? The answer is competition.
Smith showed, in a market system regulated by competition,

How society can induce its producers to produce goods that consumers want.
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
How prices of these goods are kept from rising arbitrarily above what it costs to produce them. And,
if prices rise above cost, competition will inevitably bring them down to the “natural” level.

How income is similarly distributed among the different producing sectors of the economy.
This brings us to the detailed mechanism of self-regulating competitive markets.
2.2.
The Theory of Value
To Adam Smith and other classical economists who came after him, “price theory”, as is known in modern
economics, was known as the “theory of value”.
What determines the value of a good? To address this question, Smith first distinguished between the value in
use (use value) and the value in exchange (exchange value). This distinction is offered in the famous example
of the water-diamond paradox. Water is useful (our lives depend on it) but has little exchange value, while
diamond (a luxury) has a great exchange value, but little use value.
Smith and other classical economists considered the exchange value of goods like diamond or works of art as
irrelevant to the discussion since they were exceptions. Their concern was the price of typical or common
goods, such as food, clothing, and other goods produced for mass consumption.
What determines, then, the exchange value of a good? The answer is the effort expended to produce that
good. In its simplest form, the effort is expressed as hours of labor. Hence, for smith and other classical
economists the price theory was termed as the labor theory of value.
The labor theory of value does not exclude the role of other factors of production, namely, capital and land. In
a more generalized version of the theory of value, the prices of commodities (their relative values in
exchange) are determined by how much it costs to produce them.
Note that in the cost theory of value demand plays no role in determining relative prices. Demand determines
the quantity of goods produced, not their prices. In the modern (neoclassical) price theory, demand and cost
(supply) jointly determine both price and quantity of goods. The following diagrams show a simplified
expression of the difference between the neoclassical and classical price theories.
(A)
(B)
S
P₂
(C)
S
P₁
P₁
D₁
Q₁ Q₂
S₁
P₁
P₂
D₂
D₁
Q₁
Q₂
S₂
D₂
D₁
Q₁
Q₂
Panel (A) shows the neoclassical version, which uses the familiar downward sloping demand curve and the
upward sloping supply curve. In the short-run any increase (rightward shift) in the demand curve would lead
to an increase in both quantity and price of a good.
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Panels (B) and (C) show the classical version. Supply is shown as a horizontal line, which also represents the
price. The height of the price line is determined by the state of technology, or the organization of production.
Smith referred to the organization of production as the division of labor.
In (B), for a given state of technology, any increase in demand for the good in question leads to an increase in
quantity from Q₁ to Q₂. There is no impact on price. In panel (C) the supply/price line shifts downward
because of accumulation of capital and the resulting improvement in division of labor. The improved
organization of production has reduced the cost, lowering the price from P₁ to P₂ and increased quantity from
Q₁ to Q₂. Once again, the event that has cause the change in price is the change in cost of production.
Smith recognizes the fact that an increase in demand leads to an increase in price. But, this is a temporary
deviation from the natural price because competition among producers would cause the market price to fall
back to the natural level.
Competition is thus the regulator of price and quantity. Consider the markets for gloves and shoes. If people
want more gloves and fewer shoes than are currently produced, the competition among buyers would
increase the price of gloves above the natural level. Since fewer shoes are demanded, then price of shoes fall
below the natural level. Facing reduced profits, shoemakers would switch from shoes to gloves. As some of
the shoemakers leave the shoe industry for the glove market, the quantity of shoes decreases and price rises
to the natural level, while the quantity of gloves increases and price of gloves falls to its natural level.
To Smith the main barrier for prices to gravitate to the natural level is the monopoly granted to producers,
which was widely practiced under the mercantilist regime.
2.3. Wage Determination
In more advanced stages of capitalist economy, according to Smith, wages are, in part, determined by the
contracts between the employers and workers. In this contractual agreements employers have the upper
hand, forcing wages to the lowest possible level:

Due to the fact that there are fewer of them, it is easier for different employers to agree among
themselves to pay the lowest possible wage to much more numerous and unorganized workers.

In case of industrial strife, employers can hold off much longer. Because wages are at or near
subsistence level, workers are unable to resist the capitalists demand, for workers and their families
survival is at stake.
Smith and other classical economists believed that the natural wage rate tends toward the subsistence level.
The subsistence wage is the minimum payment that allows working class to survive and reproduce itself.
Since labor is considered a commodity, similar to other commodities exchanged in the market, the natural
price of labor is determined by how much it costs to produce (and reproduce) it. This is the subsistence
wage.
2.4. The “Invisible Hand”
Perhaps the most widely quoted passage from any book about economics is Smith’s reference to the
mechanism that guides individual self-interest in the direction of social harmony as the “invisible hand”.
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“Every individual necessarily labours to render the annual revenue of society as great as he
can. He generally, indeed, neither intends to promote the publick 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. 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.”
This passage is quoted in defense of free market ideology and deregulation. Compare this to the title of a
famous article Milton Friedman, the Noble Prize-winning economist, wrote for The New York Times Magazine
(September 13, 1970): The Social Responsibility of Business is to Increase its Profits.
They both appear to send the same message. But, while Friedman is known for his unabashed defense of
“free” market and deregulation, Smith is no apologist for unregulated free market capitalism. His intent was
to redirect economic thinking away from mercantilists, who also supported capitalists who happened to be
state backed monopolists, toward the activities of independent producers in a competitive environment.
Smith directed his polemic against the government which was dominated by mercantilists, the monopolists
who controlled foreign trade, and by indirect impact, the domestic economy.
The difference between Smith’s version of free market and the conservative notion of free market is that for
Smith free market is achieved through competition, and competition is specifically defined as the absence of
barriers to entry by new firms to an industry. This state of affairs is not automatically attained. The free
market system, in other words, is not a natural organism that is self-generating. It is a mechanism that needs
nurturing and defending in the face of threats. Threats that are not posed by the government, but by the very
agents of the free market—the producers themselves.
Smith’s support of the capitalist class was tempered by his suspicion of capitalists’ motives and his concern
for the needs of the working class. The very self-interest that directs activities of individuals through the
invisible had toward higher public welfare, can also lead to a “conspiracy against the public”.
“People of same trade seldom meet together, even for merriment and diversion, but the
conversation ends in a conspiracy against the publick, or in some contrivance to raise
prices.”
The objective is the prevention of monopoly or any form of restraint of trade. But the modern conservative
concept of free market shows little concern about monopolization, or diminished competition. To the freemarket conservatives the threat against free market does not come from within the market system, rather
from the direction of the government regulation. Thus, if a single firm or a handful of firms come to dominate
a given industry, this is a natural development, the fruits of entrepreneurial talents and efforts of those who
rise above the crowd. Government regulations designed to support and maintain the competitive
environment only result in the suppression of “freedom” and the entrepreneurial spirit. When these firms
form a class of their own, the aristocracy of the rich, and when the government is dominated by these centers
of economic power, it is of little concern to the free-market conservatives.
Smith was the product of the age of Enlightenment. The ideas of Enlightenment played a significant role in
the French Revolution. The social philosophers of this age opposed the government that represented the
interests of the aristocracy, which included the established Church. Smith’s views on free market and
competition must be considered within this context. He did not shun government policies, rather he
advocated enlightened public policies
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Also, unlike the modern conservatives, Smith was concerned about the plight of the poor and the working
class and their disadvantage in uniting to seek better treatment by capitalists.
“We rarely hear ... of the combinations of masters, though frequently of those of workmen. But
whoever imagines, upon this account, that masters rarely combine, is as ignorant of the world as of
the subject. Masters are always and everywhere in a sort of tacit, but constant and uniform
combination, not to raise the wages of labour above their actual rate.”
2.5. Economic Growth
Consumer Goods
In all introductory microeconomic textbooks the concept of production possibilities frontier is used to
explain economic growth. We can use the same framework to explain Smith’s views on economic growth.
PPF₂
PPF₁
Capital Stock
The diagram shows two PPF curves each showing various combination of capital stock and consumer
goods that can be produced given available economic resources (factors of production). A shift to the
right from PPF₁ to PPF₂ implies more economic resources are available due to growth, allowing for larger
combinations of capital and consumer goods. Any points inside any given PPF indicates the available
economic resources are not fully or efficiently employed.
With minor exceptions, neither classical, nor neoclassical economists considered any possibility of longterm unemployment. In an environment of competition, resources were considered fully and efficiently
employed. Therefore, the main “macro-economic” concern was the issue of economic growth. In other
words, the issue was not how to move from a point inside a given PPF onto the curve, but rather how to
make the PPF move further to right.
For Smith population growth was a significant factor in economic growth. The growth in population
allows for the expansion of markets and the resulting possibilities for the division of labor and
improved labor productivity.
Another aspect of Smith’s views on economic growth can be explained by the comparison of the two
points 𝐴 and 𝐵 on PPF₁ in the above diagram. Each point on the PPF represents a different combination
or bundle of capital and consumer goods. The closer we get to the capital stock axis more capital goods
are produced with the available resources only by giving up consumer goods.
For Smith, workers become more productive if they have more real capital to work with. Thus, in the
interest of economic growth, point 𝐵 on PPF₁ is preferred to 𝐴. But this can only occur by reduced
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consumption and more saving. Increased investment in real capital, or capital accumulation, is possible
only with more funds made available for that investment, and savings are the source of these funds.
Observations for myself:
The question of who does the saving for more capital accumulation is important. There is a dilemma. Part
of the savings come from the capitalists themselves who invest their savings in real capital rather than the
consumption of luxuries.
What about the savings forced upon the working class (the involuntary saving)? This is, I think, what
happened during the industrial revolution. In this discussion the issue of “wages fund” is very important.
Capitalists control the wages fund, and the fund is necessarily pushed down to the subsistence level. The
subsistence level itself is determined by the relative price of food.
If food prices were lowered, then the wages fund would shrink and correspondingly more funds would be
available for capital accumulation. This issue played a significant role in the repeal of the Corn Laws.
The other related issue is, if wages are pushed down to subsistence, then who would consume the increased
production of goods (textiles in Britain). The answer is “free trade”: opening up foreign markets for British
goods.
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