Adam Smith's Theory

7/29/2019 Adam Smith's Theory

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Assessment of Adam Smiths

Theory of Economic

DevelopmentDevelopment Economics Group Assignment 2

XLRI School of Business and Human Resources, Jamshedpur

Submitted By: Group 1, Section B

S M Asim Jamil H12104

Shubham Kochar H12111

Sneha Agrawal H12113

TCA Lakshminarasimhan H12119


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Table of ContentsIntroduction .................................................................................................................................................. 2

Natural Law ............................................................................................................................................... 3

Division of Labour and the Growth of the Labour Force .......................................................................... 3

Capital Accruement and Its Impact on Growth ........................................................................................ 4

Agents and Processes of Growth .............................................................................................................. 5

Critical Assessment of Adam Smiths Theory................................................................................................ 6

Merits ............................................................................................................................................................ 6

Process of Economic Growth .................................................................................................................... 6

Free market and foreign trade .................................................................................................................. 7

Highlighted the importance of Division of Labor ...................................................................................... 7

Process of Balanced Growth ..................................................................................................................... 7

Merchant Capital vs. Industrial Capital ..................................................................................................... 8Pillars of growth ........................................................................................................................................ 8

Weaknesses .................................................................................................................................................. 8

Natural Law & Invisible Hand .................................................................................................................... 8

Division of Labor ....................................................................................................................................... 8

Stationary State......................................................................................................................................... 9

Accumulation of Capital ............................................................................................................................ 9

One Sided Saving Bias ............................................................................................................................... 9

Pattern of Growth ..................................................................................................................................... 9

Real World Examples .............................................................................................................................. 10

1. Under-Developed Economies ......................................................................................................... 10

2. Great Depression in USA ................................................................................................................. 10

3. Subprime Mortgage Crisis ............................................................................................................... 11

4. Greek Debt Crisis ............................................................................................................................. 12

5. Chinas Growth in the 18th Century ............................................................................................... 12

6. Stimulus Packages by Government ................................................................................................. 12

Comparison of theories of Adam Smith, John Maynard Keynes and Milton Friedman ............................. 12

John Maynard Keynes ............................................................................................................................. 12

Milton Friedman ..................................................................................................................................... 13

Comparing the views of the three economists ....................................................................................... 14

References: ................................................................................................................................................. 15


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Introduction

The Wealth of Nations was published on the 9th

of March 1776at a time when manufacturing

was a dominant force of economy (more dominant than it is currently) and nascent capitalism

was defending against a siege by the waning powers of the feudal institutions. Adam Smiths

work, thus, cannot be viewed without understanding the background of the time in which the

book was written. Smith put his weight behind the rising class of manufacturers and farmers

rather than barons and earls to propose a theory of Free Trade that was to be accepted by those

whose side he had taken.

The Wealth of Nations was to provide a body of knowledge in which a country could equip itself

to procure the requirements of commerce in general and capitalist industry in particular. The

Doctrine of Free Trade implied liberalism and freedom from Government interference and thus

was quite a polarizing ideology in its time. But at its core, it is a philosophy that is driven by the

implicit assumption that human action has a rational purpose and that there are no irrational

traders, investors or buyers in the world.

Adam Smith waxes poetic, then, about the true objective of a countrys government:-

The great object of the political economy of every country is to increase the

riches and the powers of that country Political economy considered as a

branch of science of a statesman or legislators, proposes two distinct objects:

first to provide plentiful revenue or subsistence for the people, or more

properly to enable them to provide such a revenue or subsistence themselves;

and secondly, to supply the state or commonwealth with a revenue sufficient

for public services. It proposes to enrich both the people and the sovereign.

With this background, the theory of growth proposed by Smith in The Wealth of Nations can be

examined. While modern economists treat it as a study of allocation of scarce resources with

alternative uses, Smith himself was concerned with finding ways to increase these scarce

resources. These were the three factors of production that he identified: Land, Labour and

Capital.


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His production function was merely

( )

Where represents Capital, represents the Labour and represents Land.

In his treatise he does not imagine the Production Function to have a diminishing marginal

productivity, but it is subject to increasing returns to scale. This implies that in his view the size

of markets will increase leading to both internal economies of scale as well as external

economies of scale and thus reducing the cost of production.

Natural Law

In Economic affairs, Adam Smith believed in the doctrine of Natural Law. He believed that

every person in the world was a rational human being capable of making rational decisions that

only served to increase the personal wealth. Thus everyone in the world was driven by an

invisible hand that guided them towards making rational, selfish decisions. One of his best

known quotes about the theory is:-

It is not to the benevolence of the baker but to his self-interest that we owe

our bread

Thus, markets were guided by individuals who are all self-serving, and thus a laissez-faire policywas advocated by him in all matters concerning the markets.

Division of Labour and the Growth of the Labour Force

The division of labour is an important benchmark to measure how capitalist societies have risen

with specific tasks or roles assigned to skilled or unskilled workers thereby leading to an

inherent instability in the wage-equality but also according to Smith, leading to a qualitative

increase in productivity. This will be preluded by an improvement in production technology as

well as increased division of labour.

However, Smith states that the division of labour did not only depend on improvements to

technology but also on the size of the market to a very large extent. The market size itself

depends heavily on the availability of capital as well as trade restrictions on domestic and


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international trade. Capital accumulation is thus a precursor and a necessary condition to the

division of labour.

In addition, Smith correlates the growth of labour force entirely on the population growth with a

condition that the rate of population growth depends wholly on the money available for

sustenance. Simplifying thus, the wage rate in the market for labour is a determinant of

population growth. In his opinion the Iron Law of Wages is consistent with a constant

population, and positive deviations from this rate results in an increase in population, while a

negative deviation results in a declining population.

Consequently, a rising economy would see a rising population, while a stagnant economy is

characterized by a stagnant population and a depressed economy will observe a fall in the rate of

growth. Thus high wages would be a characteristic of rising populations, low wages with falling

populations and the iron wages on a population that has achieved steady state.

Capital Accruement and Its Impact on Growth

Growth is a functional outcome of investment according to Smith, and thus fixed financial

investment leads to stagnancy in the countrys growth. Thus, Smith conjectured that any sort of

increase in the financial stock of the economy will spur the growth of that economy because

increasing investment is a precursor to division of labour, which in itself is a symptom of growth.

Investments were equivalent to the savings in an economy as Smith assumed that there would be

no leakage between savings and investments even though the human vehicles of these two

activities are completely different in most cases. Both investment and savings are driven by

private profit and savings are directly proportional to the income higher the wages, higher the

savings and consequently higher the investments. Thus it is a congenial cycle (as opposed to

vicious ones) where higher growth leads to higher wages which leads to higher savings which

leads to higher growth.

However, there is a caveat when it concerns the profits of industries. Profit rates do not grow

with the economy; instead they show a tendency to plateau off as the economy grows. This is

because of perfect competition between industries as well as higher wages as the supply of

labour far exceeds the demand because of strong growth. The higher wages push down the


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profits of each industry. Additionally, investment will only work if there is an opportunity in the

current economyentrepreneurs would not be able to make products out of thin air, or for non-

existent buyers. For this reason, Smith postulated that for every additional unit of capital

employed, the return on capital as a whole decreases.

The rate of interest is negatively correlated with the capital accruement in that if the rate of

interest falls, the supply of capital increases. Capital accumulation would only cease when there

is no profit to be made from the investment the falling rate of capital exactly matches the

increasing rate of interest of capital. Beyond this entrepreneurs and investors will lose interest in

the investment.

Agents and Processes of Growth

Smith believed that the industrialists, farmers and traders were the agents of growth. A perfectly

competitive market with free trade leads to market expansion that consequently propels growth.

The farmer produces crops which leads to the development of commerce to sell these crops,

which leads to better technology and newer forms of derivative products that drives the

industrialist. Thus the complex interrelation between these three types of people leads to market

growth.

Smith firmly believed that the process of growth was like a tree slow, continuous, steady and

branching out. This decidedly deciduous doctrine is affected by external events but, like a tree, it

slowly overcomes them and internalizes them. Each situation is a product of the previous ones

and thus the entire process is a cumulative one. Progress in agriculture, manufacturing and trade

leads to capital accumulation, technical mastery which leads to division of labour that leads to

better wages which leads to an expansion in population which leads to more demand for

products. The scarcity of natural resources, much like the scarcity of nutrients in soil, is what

stops this unending growth.


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Critical Assessment of Adam Smiths Theory

Merits

Process of Economic Growth

Smiths theory is capable of explaining the economic growth of the developed economies. Also,

it also suggests the factors and policies that can affect the growth both positively and negatively.

Economists can take cue from his theory and frame.

Adam Smiths theory was based primarily on the behaviors of the prospering Eu ropean economy

of the 18th

century and was able to explain the same. Even to this date, his theory is capable of

explaining the economies displaying similar behaviors.

As per Smith, as far as a developing economy is concerned, there is a rise in both income level

and capital stock. In addition to this, the rate at which accumulation of capital takes place also

shows tendency to increase. As such, in successive periods, increase in the capital stock is seen

as the investment keeps on increasing. Adam Smiths theory clearly explains the process of

economic growth which is cumulative as explained below:

Investment

Capital

Technology

MarketExpansion

Divison ofLabor

Rise inProfits/Inc

ome

Virtuous

Circle


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Free market and foreign trade

Adam Smiths theory put forward the concept of invisible hand. Invisible hand meant market

dynamics determined by demand and supply and not controlled by the Government. Basically, it

meant opening up of economy in favor of a free market where movement of goods and services

could take place without any intervention. As world is moving becoming globalized, the

advantages of free market economy and free trade are being felt. Organizations are not only able

to derive advantage out of the cheap resources in different parts of the world but also sell their

goods throughout the globe and reap more benefits out of their businesses. No country is

capable of producing everything by itself and hence foreign trade becomes essential. As a matter

of fact, the prosperity of the free market economies is very well explained by Adam Smiths

theory.

Highlighted the importance of Division of Labor

Theory related to division of labor suggested that division of labor allowed labors to become

dexterous and industries could reap benefits out of it. The concept was employed widely across

industries right since then. The theory led to many changes in the way the industries operated

and led to many new solutions. It led to the introduction of assembly lines at a later point of time

and it led to economies of scale. Owing to the relation that the theory established with

technology and expanding markets, innovation of technology was justified and this led to

newer and more efficient technologies, in todays context, automation can be thought of as an

outcome of division of labor. Division of labor directly relates to higher productivity and more

profitable businesses. The theory also explained how the widening of markets impacted division

of labor and overall productivity.

Process of Balanced Growth

Smiths theory helped derived the theory of Absolute Advantage. Absolute advantage is the

capability of an individual or an organization or a nation to produce more of goods/services

using the same amount of resources. Adam Smith explained the concept using the only input as

labor and based it on labor productivities. This explains to an extent the differences in terms of

produce in between countries and highlights the importance of division of labor and superior

technology.


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Merchant Capital vs. Industrial Capital

Adam Smith was the first economist to distinguish between profits generating from merchant

capital and industrial capital. Merchant capital is a result of exchange and industrial capital out of

the production process. Adam Smith postulated that profits arising out of Industrial capitalism

help the economy grow faster than that in the case of merchant capitalism. It was seen that 18 th

century onwards, there was a shift from merchant capital to industrial capital.

Pillars of growth

Adam Smith explained how the farmers, producers and businessman were the pillars of growth

and also highlighted their interrelatedness. The theory in a way sets the guidelines for effective

growth and explains how capital accumulation takes place leading to economic development.

Weaknesses

Natural Law & Invisible Hand

The theory of Adam Smith suggests that market takes care of itself and there is an invisible hand

that takes care of maximizing the aggregate health. He was of the view that it is the self-interest

of the person that will force him to maximize his wealth and the invisible hand will in turn

maximize the aggregate wealth. However, invisible hand happens only in case of a Perfect

Competition. Pursuit of self-interest itself will kill perfect competition and lead to a situation

where monopoly or monopolistic competition will exist. Laissez faire today is not a realisticconcept in many economies.

Hence the assumption of a perfect competitive market by Adam Smith is not realistic.

Division of Labor

Adam Smith has assumed that there are just two classes of society, capitalists or landlords and

laborers. He has stated the theory based on the socio-economic classes of Great Britain and

Europe where there was no concept of middle class. However, there are many economies where

the middle class plays a crucial role in the economic development.

The role played by the middle class is not given attention by Adam Smith.


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Stationary State

Adam Smith has postulated that the economy comes to a stationary state. He has said that as a

result of progress in manufacturing, agriculture, commerce etc. capital accumulation occurs

which in turn leads to technical progress and expansion of markets and the cycle repeats to a

stationary state. However this process is not endless. The scarcity of natural resources will put an

end to the growth which was not taken into account by Adam Smith.

Accumulation of Capital

Adam Smith has postulated that investment is vital to growth which is inevitably true, but the

assumption that Savings is equal to Investment is not really true. Adam Smith assumed that

savings automatically convert themselves into accumulation of capital or investment. However

due to a variety of reasons that is not the case:

a. Investment Opportunities: Even though people save, there are many who do not knowwhere to invest

b. Capital Markets are not very maturec. Lack of Entrepreneurs in the economyd. Infrastructure Bottleneck: Issues in the backward linkage (input from suppliers)e. Policy Bottleneck: Issues in forward linkage (Distribution Channel)

Hence the assumption that savings automatically gets converted to investment is not true.

One Sided Saving Bias

According to Adam Smith, only capitalists, landlords and money lenders save. He has not

considered the savings of the income receivers who are a major source of savings in an advanced

society.

Pattern of Growth

Adam Smith has assumed that the growth of economy is stable, uniform like a tree. However he

has not taken into consideration the institutional, political and natural factors that will affect the

growth of the economy. The scarcity of the resources will definitely make the process of growth

unstable.


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Real World Examples

1. Under-Developed Economies

Adam Smiths theory does not explain the economic growth of underdeveloped (and developing

economies). There are many behind reasons behind it. In developing economies capacity to buy

is the capacity to produce. The propensity to consume is very high and there are many political,

social and institutional assumptions made by Adam Smith which are not valid. The concept of

Natural Law and Laissez Faire does not exist in under developed economies as Perfect

Competition is a myth when it comes to developing and underdeveloped nation. Under

developed economies face the issue of having a small market which leads to low productivity,

leading to low level of income, leading further low savings and low investment which in turn

leads to a small market. Hence, a vicious circle is created and it is very difficult for an under-

developed economy to come out of the market. The middle class is an important class when it

comes to explaining developing economies which are clearly ignored by Adam Smith.

2. Great Depression in USA

Adam Smiths Theory also failed to explain the infamous Great Depression in USA during the

1930s. Adam Smith had advocated that the economy should be left on its own and it would take

Small Size ofmarket

LowProductivity

Low level ofIncome

Less Savings

LessInvestment

Vicious

Circle


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care of itself, but the Invisible Hand did not help the case in the great depression. It was

unreliable and uncertain. There was a time when it looked like it is impossible to come out of

Great Depression. Adam Smiths theory was heavily criticized and this led to the born of Keynes

theory which advocated that it is the Government Intervention that will help the economy come

out of the slumber. He advocated that capitalism is not going to help the economy prosper and it

is socialism that will direct the economy to its most productive uses. Adam Smiths t heory is

relevant only to a purely laissez-faire economy but not to a post-war mixed capitalist economy. It

was the absence of 'regulation' and state intervention, and a belief in 'laissez-faire' that led to

these crises.

3. Subprime Mortgage Crisis

The subprime mortgage crisis again explains how Adam Smiths invisible hand concept is a

failure in todays economy. The crisis happened in USA as there were regulations to control the

situation and USA came out of the crisis as Government intervened and gave bail out packages

to the doomed banks. This also explains the situation of India which did not fall prey to the

subprime mortgage crisis because there were effective Government regulations which handled

the situation.


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4. Greek Debt Crisis

The Greek Debt crisis is another example where lack of proper regulations led to the situation of

economy failure. It was later seen that IMF and EU later came to bail out Greek from the

situation of crisis. It was believed to have been caused due to combination of structural weakness

of the Greek economy and inefficient tax and banking system of the European Monetary Union.

Government intervention in terms of austerity measures was required to restore the fiscal balance

and bring the situation under control.

5. Chinas Growth in the 18th Century

Adam Smiths theory also fails to explain the growth of China in the 18th

century. It was drafted

when Europe was at the prime stage of growth and suits the European style of growth. However

it fails to explain the growth of China which was quite different from the European style of

growth.

6. Stimulus Packages by Government

Today, most of the economies in the world are mixed economies where Government plays a

crucial role in economic growth. This can be clearly seen by the examples of US, where

President Obama has come up with stimulus packages that will create jobs for the society. The

MNREGA Scheme by the government of India can also be seen compared to a stimulus package

where government itself is creating jobs and helping the economic growth.

Comparison of theories of Adam Smith, John Maynard Keynes and Milton

Friedman

Since we have already discussed the Smiths theory in detail, we will now first discuss the

economic theories professed by Keynes and Friedman and will then draw a comparison of the

view point of the three theorists.

John Maynard Keynes

Keynes was a British economist whose economic concepts and ideas have radically affected the

theory and practice of modern macroeconomics. His theory seemed to offer a new explanation of

the great depression and the prolonged unemployment that plagued it. It was because of these

explanations and the timing of the theory that it was widely accepted and as a result he became

the most influential economist of the twentieth century.


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In the 1930s, Keynes led a revolution in economic thinking, overturning the ideas of classical

economics that was professed by Adam Smith. Classical economics was of the view that free

markets would automatically provide full employment, in the short and medium term. Keynes

theory was based on exactly the opposite phenomena and argued that aggregate demand was the

causal factor for economic activity, and that inadequacy in aggregate demand may result in

prolonged periods of high unemployment. According to Keynes, state intervention was necessary

to boost the aggregate demand in times of economic recession and depression. However, he also

believed that the bulk of decision making would remain in the hands of the decentralized market

rather than with the government.

Milton Friedman

Milton Friedman was an American economist who is best known for opposing the Keynesian

economics which was highly regarded in 1950s and 1960s. He strongly believed in free market

capitalism and strongly opposed the views of Keynesian economists. He was of the view that

governments should minimize their involvement in the economy by reducing taxes and ceasing

inflationary policies.

Table-1 shows a glimpse of major views held by the three economists being compared and their

quotes which reflect their ideas.

Economist Core Prescription Illustrative QuotationAdam Smith

(1723-90) Rely on the markets invisible handto allocate resources to the areaswhere they will secure the highestreturn

It is not from the benevolence of the

butcher, or the baker, that we expect our

dinner, but from their regard to their owninterest. (1776, p.22)

John Maynard

Keynes

(1883-1946)When demand is deficient, counter

unemployment by boosting publicspending

"If the Treasury were to fill old bottles with

banknotes, bury them at suitable depths indisused coalmines which are then filled up

to the surface with town rubbish, and

leave it to private enterprises on well-triedprinciples of laissez faire to dig the notesup again there need be no more

unemployment (1936, p.379)Milton Friedman

(1912-2006) To bring inflation under control,restrict growth in the money supply Inflation is always and everywhere amonetary phenomenon (1970, p.6)Table-1
http://en.wikipedia.org/wiki/Keynesian_revolutionhttp://en.wikipedia.org/wiki/Keynesian_revolution


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Comparing the views of the three economists

Major points of difference between the three economists are summed up in the following table:

Parameter Adam Smith Maynard Keynes Milton Friedman

Stance on Govt.

regulation

Should not be anygovernment

intervention in the

market

Govt. regulation is

necessary in times ofeconomic crises

Should not be any

government interventionin the market

No intervention by

government isrequired

Private economy on itsown might well be

subject to unbearable

instability-Macroeconomic

management was

necessary

Private economy on itsown might well be

subject to unbearable

instability-Macroeconomic

management was

necessary

What determines

the level ofoutput and

employment

Level of

employment

depended on theamount of capital

stock and in the way

its employed

Interaction of aggregate

demand and aggregate

supply

Depended on money

supply; increases in

money supply growth inshort run would cause

employment and output

to increase

Coming to a conclusion on which is the best economic theory is difficult because each of the

theory has its pros and cons, it is widely recognized that Milton Friedman had won the debate

and his theory is widely regarded as the most suitable macroeconomic theory.


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References

Braman, C. (1996). The Theories of John Maynard Keynes. Retrieved from chuckbraman:

http://www.chuckbraman.com/Writing/WritingFilesPhilosophy/keynes.htm

Scarlett. (n.d.). adam smith contributions to economics. Retrieved from economictheories:

http://www.economictheories.org/2008/06/adam-smith-contributions-to-economics.html

Stanislaw, D. A. (1998). Keynesian Economic Theory. In D. A. Stanislaw, The Commanding Heights.

tc.pbs. (n.d.). Keynesian Economic Theory. Retrieved from tc.pbs: http://www-

tc.pbs.org/wgbh/commandingheights/shared/pdf/ess_keynesiantheory.pdf

wikipedia. (n.d.).Absolute advantage. Retrieved from wikipedia:

http://en.wikipedia.org/wiki/Absolute_advantage

wikipedia. (n.d.). Classical theory of growth and stagnation. Retrieved from wikipedia:

http://en.wikipedia.org/wiki/Classical_theory_of_growth_and_stagnation

wikipedia. (n.d.).John_Maynard_Keynes. Retrieved from wikipedia:

http://en.wikipedia.org/wiki/John_Maynard_Keynes

wikipedia. (n.d.). Keynesian_economics. Retrieved from wikipedia:

http://en.wikipedia.org/wiki/Keynesian_economics

wikipedia. (n.d.). Milton friedman. Retrieved from wikipedia:

http://en.wikipedia.org/wiki/Milton_friedman

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