Introduction to Adam Smith's Economic Thoughts.

 

Essense of Adam Smith...

Smith is frequently referred to as the father of economics. His famous book "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776) is the most important work of him. His earlier book, "The Theory of Moral Sentiments" (1759), and the lectures he delivered at the University of Glasgow are two more significant sources of his theories. In his book “Wealth of Nations” he emphasized how the free market provides incentives for individuals to act in their own self-interest while producing what is necessary for society. According to Adam Smith market needs to function freely without the intervention of the government, hence buyers, sellers, and society will have mutual benefits. Moreover, he stated that competition and self-interest act as an “invisible hand” in the free market scenario. 

Further, Adam Smith commented on “Free International Trade”. He suggested the idea of “Absolute Advantage”, which holds that a nation should focus on manufacturing things in which it has a clear competitive edge in terms of production. In other words, a nation should concentrate on manufacturing the things it can do so most effectively, and then trade those items for those produced by other nations more effectively. According to his book, the division of labour was a vital component of productivity and economic success. Smith believed that overall efficiency and output could be significantly boosted by segmenting the manufacturing process into specialized activities and directing workers' attention to certain production elements. 

Adam Smith's value theory is a significant component of his economic philosophy. Smith was an advocate of the labour theory of value. This idea holds that the amount of labour necessary to produce an item or service determines its worth. In other words, a product's worth is inversely correlated with the labour required to produce it. Further, under his “Distribution Theory” he examined the distribution of the total national income among several production inputs, including land, labour, and capital, and he elaborated his theory by considering wage, rent, interest, and capital.

Throughout this blog we expect to share more on the economic thoughts of the father of economics; “Adam Smith”. Let’s go in the footsteps of Smith and explore more knowledge on economics.  

Written by G.A.S. Navodya

References: 

Berry, C. J. (2018). ADAM SMITH A Very Short Introduction. Madison Avenue, New York: Oxford University Press.

Roncaglia, A. (2017). A Brief History of Economic. New York: Cambridge University Press. doi:10.1017/9781316798416

Skinner), A. S. (1990). The Wealth of Nations Book I - III. . London: Penguin Group.

Skousen, M. (2007). The big three in economics: Adam Smith, Karl Marx, and John Maynard Keyne. New York: M.E. Sharpe. Inc.

Infographic created by: G.A. Shehani Navodya (using Canva)

Image credit: Link to access the image

SMITH’S ANALYSIS OF THE MARKETS.

 The founder of modern economics, Adam Smith, suggested a contextual approach to economic policy in his ground-breaking book, "The Wealth of Nations." In his view, people acting in their own best interests would result in overall prosperity, he stressed the significance of letting market forces function with the least possible government interference. Smith's theories helped establish free-market capitalism by supporting measures that promote competition, private property rights, and minimal government intervention. His concepts, which are still applicable in the given environment, continue to guide the development of frameworks for economic policy that are tailored to the unique requirements and conditions of every civilization.

Natural Order, Harmony, and Laissez Faire

Adam Smith stressed the idea that economies can run effectively when people pursue their own interests in his theories of natural order, harmony, and laissez-faire. He thought that when people are allowed to pursue their own economic interests without undue interference from the government, the competition and cooperation that results can result in an overall harmonious and balanced economic system. This way of thinking, sometimes known as laissez-faire capitalism, supports limited government intervention and the notion that the market's "invisible hand" can direct resources to their most advantageous uses. This strategy promotes the natural order in which supply and demand decide on pricing, the distribution of resources, and economic expansion.

Smith's support for laissez-faire must be modified, though, because he listed multiple instances where, in the context of the institutional, political, and historical structure of his period, he thought action from the government was required, safeguarded emerging industries, trade control was also important when the possible weakening of national defense, the government was tasked with maintaining the nation's infrastructure, building, and maintaining roads and schools, executing justice, and maintaining critical documents and promoting the government's provision of items with significant social benefits but which are not available on the private market.

The Working of Competitive Market.

Smith's examination of how competitive markets operate represents his most important contribution to economic theory. 

Short-run prices are referred to as "market prices" in his analysis of price formation and resource allocation, whereas long-run prices are referred to as "natural prices." His primary concern was the development of long-term natural prices.

He saw competition as fundamentally requiring a large number of sellers, a group of resource owners who were knowledgeable about profits, wages, and rents in the economy, and the freedom of movement for resources among industries.

Given these circumstances, resource owners' self-interest would result in long-term natural prices that would balance the rates of profits, wages, and rents among the various economic sectors.

Natural pricing, which comes from competitive markets and a lack of government intervention, ensures that customers get the products they desire at the highest growth rates while also ensuring that resources are allocated as efficiently as possible.

📹 Following is a video created by our team to explain Adam Smith's analysis of the market. The video will show the situation in a hypothetical country where, first they adopted a planned economy, and then adopted the 'Free Market Mechanism' by following Adam Smith's theory.

Written by : M.Dinushi Madushika & R.M.Chathurika Samanmali

Video Credit: Krishantha Kumara

References:

Skinner, A. S. (1990). The Wealth of Nations Book I - III. . London: Penguin Group

SMITHS THOUGHTS ON CAPITAL AND POLICY CONCLUSIONS

 

Regarding the function of capital in the process of generating wealth and in economic development, Smith made several significant contributions. First, he made the argument that a country's current wealth is dependent on capital accumulation because this defines the distribution of labor and the percentage of the population engaged in productive work. Second, Smith concluded that economic growth is also a result of capital accumulation. Third, the optimal distribution of capital throughout the various industries is the result of individual self-interest combined with the accumulation of capital.

The function of the capitalist system is crucial to the health of the economy. His pursuit of material gain and financial gain lead the economy toward resource efficiency and economic expansion. Individual savings are the main source of capital in a private property economy. Smith thought that because of the number of wages, which only allowed for the fulfillment of urgent consumer needs, labor could not accumulate capital. He noted that while members of the landowning elite had salaries sufficient to develop capital, they instead used them to support their enormous demand for a high standard of living by engaging in useless labor. The beneficiaries of society, according to Smith, are the members of the emerging industrial class who are working hard for profits and accumulating capital to grow their wealth by saving and investing. Therefore, an unequal income distribution that benefits capitalists is extremely important to society. Economic growth is impossible without an unequal distribution of income since entire years’ worth of output will be consumed.

The Impact of Smith on Policy

The ways in which economies and societies operate have been significantly impacted by Adam Smith's policies. His theories, which are frequently referred to as the "Principles of Capitalism," placed a strong emphasis on the role that individual liberty, rivalry, and self-interest play in promoting economic progress and success.

Businesses were encouraged to function freely under Smith's "Laissez-Faire" doctrine, which refers to letting things happen without a lot of government intervention. Due to the competition among businesses to offer consumers better goods and services, this stimulated innovation and output.

His "Invisible Hand" theory postulated that people unwittingly advance the interests of society while they pursue their personal goals. According to this theory, markets could self-regulate, which would lead to effective resource allocation and economic expansion.

Overall, Adam Smith's economic theories helped to establish modern economics and significantly influenced the way other nations approach their respective economic systems. They still have an impact on debates concerning the advantages of free market competition and the function of government in the economy.

🎯 Following is an animated video that summarizes the theory of Invisible Hand...

Written by : M.Dinushi Madushika & R.M.Chathurika Samanmali

Video Credit: G.A. Shehani Navodya

References:

Skinner, A. S. (1990). The Wealth of Nations Book I - III. . London: Penguin Group.

MAJASKI, C. (2023, March 21). What Is the Invisible Hand in Economics? Retrieved from Investopedia: https://www.investopedia.com/terms/i/invisiblehand.asp#:~:text=The%20invisible%20hand%20is%20a%20metaphor%20for%20how%2C%20in%20a,about%20their%20own%20well%2Dbeing.

THE NATURE AND CAUSES OF THE WEALTH OF NATIONS

 

📌Adam Smith separated his viewpoint from that of the Mercantilists and Physiocrats in the first sentence of "The Wealth of Nations”. Smith Criticized the Merchants, in Wealth of Nations, for their concern with the identification of gold with the wealth of a nation and the accumulation of gold. According to Adam Smith, wealth was an annual flow of goods and services, not an accumulated fund of precious metals.

 

📌Adam Smith provided insight into the relationship between exports and imports, understanding that the primary role of exports is to pay for imports and he also, implied that consumption is the purpose of economic activity. Smith emphasized labor as the source of a nation's wealth, and he differed from the physiocrats who emphasized land.

 

📌Adam Smith further proposed that the wealth of nations should be measured per capita.  For example, it is understood that England is wealthier than China today, based on the per capita income of the population of both countries. Not on total output or income.

“Wealth of Nations” book is concerned with the causes of the wealth of nations.

Causes of the Wealth of Nations

Smith said that the wealth of a nation depends on;

1. The productivity of labor and
2. The proportion of workers usefully or productively employed.

He assumed that the economy would automatically achieve full employment of its resources.

Productivity of labor:

Smith said productivity of labor is increased by specialization and division of labor. Smith illustrated the advantages economic benefits and social costs of division of labor. Division of labor reduced humans to machines bound to a production process, Smith believed that a balanced division of labor increased human welfare. Division of labor depends on the e extent of the market and the accum

Productive and unproductive labor

Accumulation of capital also determines the ratio between the number of productive laborers and unproductive laborers. According to Smith, for the economy as a whole, as the labor force involved in the production of real goods increases, so does the capital required to support the productive labor force. Therefore, the greater the accumulation of capital, the greater the total labor force involved in the production process. Furthermore, Smith said, it is better to have less government intervention, which lowers taxes on capitalists and allows them to accumulate more capital. Furthermore, a framework of free markets and private property was required for capital accumulation, and Adam Smith had no question about this.

Written by: Niluka Damayanthi Manike

Reference:

Harry Landreth, D. C. (2002). History of Economic Thought (4th ed.). Boston, Toronto: Houghton Mifflin Company.

Picture Credits: Link to access the photo

Infographic Design by: G.A. Shehani Navodya (using Canva)

INTERNATIONAL TRADE

 

Written by: Niluka Damayanthi Manike.

Reference:

Skinner, A. S. (1990). The Wealth of Nations Book I - III. . London: Penguin Group.

Adam Smith's Value Theory

 Value Theory

Economists of the past had different questions about values. There are,

 (1) What determines the price of a good? (What determines relative prices?)

 (2) What determines the general level of prices?

 (3) What is the best measure of welfare?

The first and third questions are part of modern microeconomics, and the second, although it defies the usually simple micro-macro dichotomy. Adam Smith has not been able to give a definite answer to these questions.

Relative Prices

Adam Smith explained that relative price is determined by supply or cost of production. In here he did not ignore the role of demand. He mentioned that both supply and demand are considered in determining the short-term price. Long-run or natural prices generally depend on the cost of production. But in some places, he said, demand and supply influence long-term price determination. These inconsistencies provide an opportunity for historians of economic theory to debate Smith's real meaning.

	Short run (market price)	Long run (Natural price)
Agriculture	Downward-sloping demand curve Upward-sloping supply curve
Manufacturing	Downward-sloping demand curve   Upward-sloping supply curve	When the supply curve is perfectly elastic, the price depends entirely on the cost of production; When it is downward-sloping, natural price depends upon both demand and supply

 Meaning of Value

Smith believed that the word value has two different meanings.

1. Utility of some particular object referred to as value in use
2. The power of purchasing other goods which the possession of the object conveys referred to as value in exchange   

 

Adam Smith used examples to present the meaning of value. In his works, Smith asked why diamonds are more valuable than water if water is essential to life but diamonds are not.  He saw a clear disparity in value: people valued diamonds more than water, even though one could not live without water and diamonds were essentially rocks. Smith suggested that this disparity in value arose because diamonds were rarer than water and harder to obtain and sell.  This determination has been defined as the diamond-water paradox. Value in use is the utility derived from keeping or consuming a good.  There are several types of utility when a good is consumed:

• Total Utility
• Average Utility
• Marginal Utility. 

Smith's focus was on total utility. Pointing out the high utility value of water relative to the utility value of diamonds, Smith noted that since the marginal utility of a commodity often decreases as it is consumed, another unit of water may provide a lower marginal utility than another unit of diamonds.  But the price we are willing to pay for a good depends not on its total utility but on its marginal utility. Because Smith did not recognize this, he was unable to find a definitive solution to the diamond-water paradox.

So, let's summarize the value theory with a song...

Written by : P.K. Wasana Sathsarani

Lyrics by : Dinushi Madushika & Chathurika Samanmali

References: Harry Landreth, D. C. (2002). History of Economic Thought (4th ed.). Boston, Toronto: Houghton Mifflin Company.

SMITH ON RELATIVE PRICES

 

Because Smith was somewhat confused about the factors determining relative prices, he developed three separate theories relating to them.

• The early and rude state

• Primitive society

 (1) Labor cost theory of value

 (2) Labor command theory of value

 (3) Cost of production theory of value.

Written by : P.K.Wasana Sathsarani

References: Harry Landreth, D. C. (2002). History of Economic Thought (4th ed.). Boston, Toronto: Houghton Mifflin Company.

Infographic design by: G.A. Shehani Navodya

II

DISTRIBUTION THEORY

Adam Smith was not of prime concern about the distribution of income but he presented several different and sometimes contradictory theories of wages, profits, and rents. The distribution of income depends on the price and quantity of factors of production sold by individuals. Labor is the only factor of production owned by most households; Therefore, the income of a household usually depends on the wage rate and the number of working hours.

Determine the distribution of income,

Wages    >  Quantities of labor

Profits    >  Capital    

Rents     >  Land that individuals bring to the market

 

Written by: Tharushi Kanishka Herath 

References: 

Harry Landreth, D. C. (2002). History of Economic Thought (4th ed.). Boston, Toronto: Houghton Mifflin Company.

WELFARE AND THE GENERAL LEVEL OF PRICES

 

Adam Smith tried to find,

1.     The factors that determine the general price level

2.     The best measure of changes in welfare over time

The second question is more difficult. How do we define welfare in an unambiguous way so that differences in welfare can be measured?

Welfare for the economy can be defined and measured in terms of quantity consumed. Can differences in welfare be defined and measured for an economy of two or more products? Smith tried to answer this question.

If welfare is defined as the total consumption or output of society, then the basic problem to be solved for a multi-product economy is to find a way to aggregate the production or consumption of products. A solution to this problem is to convert all goods into one common step. However, if the relative prices of goods and commodities change as their outputs change, the problem of measuring welfare becomes more complex. In a multi-product economy, the relative prices of goods are usually expressed in a common measure, which is the government's currency. In theory and occasionally in practice, this common measure could be any commodity in the economy.

—for example, cattle, corn, or gold.

In our economy, we measure output by adding the monetary value of each good and to get the GDP. If GDP increases from one year to the next, can we conclude that welfare has increased?

Measuring changes in output in a multi-product economy with this method creates difficulties because the unit of measurement, the benchmark currency, is itself variable. The average price level varies; Therefore, the monetary value of the output may not accurately reflect the actual output. Smith considered the possibility of using gold or silver as a common measure or number, but since the prices of these commodities varied,

They are not satisfied with this work. He then turned to labor but found that the price of labor also changed over time. Ultimately, the only invariant measure he could find to assess differences in welfare was that "equal quantities of labor may be said to be of equal value to the worker at all times and places".

Given Smith's conclusion that labor disorders can be used in calculating a welfare index, the problem of measuring differences in welfare is easily solved. We first measure changes in total output by currency; We then adjust for changes in average price levels based on changes in the price of gold, silver, or corn. By this process, we have converted money income and nominal price into real income and real price.

For example, if the monetary value of output increases by 10 percent and the average price level, as measured by the price of gold, also increases by 10 percent, the real value of output remains the same. If the inactivity of producing this output decreases, welfare increases. If we can produce, and translate into everyday language, the same amount of output with less labor, we will be more rested and better off.

However, measuring changes in welfare is much more complex than Smith thought, and our discussion cannot touch on all the issues involved. Smith did not discuss how to define the inefficiency of labor. One of his assumptions, which was not questioned by orthodox economists until the twentieth century, was that more goods are better than less, or that an increase in production without an increase in labor unrest must always lead to an increase in welfare. An increase in output is an improvement in welfare, even if the increased production includes goods of doubtful benefit to society. Furthermore, Smith and the orthodox economists who followed did not consider the "quality of life" produced by this increased output. Little or no attention was paid to the form of corruption or other harmful external costs that society might pay for large outputs. 

Written by: Tharushi Kanishka Herath

References: Harry Landreth, D. C. (2002). History of Economic Thought (4th ed.). Boston, Toronto: Houghton Mifflin Company.

CRITICISMS OF ADAM SMITH’S THEORY, AND THE CONCLUSION.

 

Criticisms of Adam Smith’s Theory

Summary and Conclusion 

Scottish economist and philosopher Adam Smith made a major impact on economic theory, most notably with his ground-breaking book "The Wealth of Nations." Smith's theories covered a wide range of topics in economics, including market analysis, international trade, value theory, income distribution, welfare, and the general level of prices. His ideas are fundamental to modern economics.

Smith's examination of markets highlighted the contribution that competition and self-interest make to economic growth. He was a supporter of limited government involvement and the idea of the "invisible hand," which holds that each person's seeking their own interests advances society as a whole. He also talked about the value of free trade internationally, the advantages of specialisation, and the division of labour.

Smith's theories have been widely accepted and have made a substantial contribution to our understanding of economics, but they are not without drawbacks and restrictions. These criticisms cover a wide range of topics, including inequality, environmental sustainability, the disregard of ethical and social considerations, and the oversimplification of human behaviour and the assumption of perfect competition.

In conclusion, many of Adam Smith's theories are still applicable in modern economics, and his theories have been instrumental in shaping economic thought. But in economic analysis, they ought to be regarded as a beginning point as opposed to a conclusion. A more sophisticated understanding of human behaviour, the function of government, and the significance of addressing social and environmental issues are frequently incorporated into modern economic thought. While Adam Smith's work is still regarded as a classic in economics, more recent theories that take into account the complexities of the real world have both challenged and enhanced it.

Written by G.A. Shehani Navodya

Reference:

Harry Landreth, D. C. (2002). History of Economic Thought (4th ed.). Boston, Toronto: Houghton Mifflin Company.