EDITION
History of
Econoll1ic Thought
Harry Landreth
Centre College
David C. Colander
Middlebury College
Part One: Aristotle and St. Thomas Aquinas: The Bettmann Archive; William Petty and
Franlfois Quesnay: Historical Collections, Baker Library, Graduate School of Business
Administration, Harvard University
Part Two: Adam Smith, David Ricardo, and John Stuart Mill: Historical Collections,
Baker Library, Graduate School of Business Administration, Harvard University; Karl
Marx: Courtesy of German Information Center
Part Three: William Stanley Jevons: Stock Montage; Carl Menger and Alfred Marshall:
Historical Collections, Baker Library, Graduate School of Business Administration,
Harvard University; Leon Walras: Universite de Lausanne, Switzerland; Thorstein
Bunde Veblen: Brown Brothers; John R. Commons: State Historical Society of Wiscon
sin
Part Four: John Maynard Keynes: courtesy of Dr. Milo Keynes; Paul Samuelson: cour
tesy of Paul Samuelson; Milton Friedman: photograph by Bachrach; Kenneth Arrow:
Bettmann/CORBIS
Chapter 5: Excerpts from The General Theory ofEmployment, Interest, and Money by
John Keynes are reprinted by permission of Harcourt Brace Jovanovich, Inc., Cam
bridge University, and Macmillan.
Adam Smith
Adam Smith
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Chapter 4
r:
1Adam Smith, An Inquiry into the Nature and Causes ofthe Wealth of Nations, edited with
an introduction, notes, marginal summary, and enlarged index by Edwin Cannan, with an
introduction by Max Lerner (New York: ModemLibrary, 1937).
2Adam Smith, The Theory ofMoral Sentiments (New York: A. M. Kelley, 1966).
3Adam Smith, Lectures on Justice, Police, Revenue, and Arms, reported by a student in 1763,
edited with an introduction and notes by Edwin Cannan, Reprints of Economic Classics
(New York: A. M. Kelley, 1964).
Adam Smith
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,
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Chapter 4
view of Smith's theoretical strucrure and to examine the policy conclusions that
flow from a more detailed economic analysis. Smith's great strength as an
economist lay in his vision (1) of the interdependence of the segments of the
economy and (2) of the policies to be followed to promote the wealth of a nation.
He was not an economist in the narrow sense of the word, but rather a
philosopher who pointed the way toward economic development and affluence.
His impact on subsequent economic thinking with respect to policy has been
equaled by few:.
Adam Smith
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82
Chapter 4
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.4
The syllogism from which Smith drew his major policy conclusion is very
simple. Human beings are rational and calculating and driven by self-interest. If
left alone, each individual will follow his or her own self-interest, and in
promoting self-interest promote the interest of society. Government should not
interfere in this process and should therefore follow a policy of laissez faire.
Throughout his book Smith pointed out how private self-interest will lead to the
public good in a nonregulated market economy. The key to understanding how
some degree of harmony and good proceed from conflict and self-interest lies in
the activities of the capitalist. Smith showed that capitalists are driven not by
altruistic motives but by a desire to make profits-it is not as a result of the
benevolence of the baker that we get our bread. The capitalist views the market
in terms of final goods and, in order to increase revenues, produces the
commodities that people desire. Competition among capitalists will result in
these goods' being produced at a cost of production that will return to the
producer an amount just sufficient to pay the opportunity costs of the various
factors. If profits above a normal rate of return exist in any sector of the economy,
other firms will enter these industries and force down prices to a cost of
production at which no excess profits exist. Capitalists will bid for the various
factors of production, offering higher prices for the more productive factors and
thereby channeling labor and land into those areas of the economy in which their
efficiency is greatest. Consumers direct the economy by their dollar votes in the
market; changes in their desires are shown in rising and falling prices-and,
consequently, rising and falling profits. Smith concluded that it is wonderful how
the market, without planning or governmental direction, leads to the satisfaction
of consumer desires at the lowest possible social cost. In the terminology of
modern economics, he concluded that an optimum allocation of resources occurs
in competitive markets without government intervention.
Adam Smith
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<
,
:
84
Chapter 4
Adam Smith
8s
One aspect of Smith's view of the role of the capitalist and capital accumula
tion needs further elaboration. It is clear that the capitalist plays the key role in
the functioning of the economy. His pursuit of wealth and profits directs the
economy to an efficient allocation of resources and to economic growth. The
source of capital in a private property economy is savings by individuals. Smith
believed that labor could not accumulate capital because the level of wages
permitted only the satisfaction of immediate consumption desires. Members of
the landowning class, he observed, have incomes sufficient to accumulate capital,
but they spend them on unproductive labor to satisfy their immense desires for
high living. It is the members of the rising industrial class, striving for profits,
striving to accumulate capital to increase their wealth through saving and
investment, who are the benefactors of society, Smith concluded. An unequal
distribution of income in favor of the capitalists is therefore of tremendous social
importance. Without an unequal distribution of income, economic growth is not
possible, for the whole of the yearly output will be consumed.
5Ibid., pp. 328-329.
6Ibid., p. 421.
86
Chapter 4
Adam Smith
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88
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The division of labor, in turn, depends upon what Smith called the extent of
the market and the accumulation of capital. The larger the market, the greater
the volume that can be sold and the greater the opportunity for division of labor.
A limited market, on the other hand, permits only limited division of labor. The
division of labor is limited by the accumulation of capital because the production
process is time-consuming: there is a time lag berween the beginning of produc
tion and the final sale of the finished product.
In a simple economy in which each household produces all of its own
consumption needs and the division oflabor is slight, very little capital is required
to maintain (feed, clothe, house) the laborers during the production process. As
the division of labor is increased, laborers no longer produce goods for their own
consumption, and a stock of consumer goods must exist to maintain the laborers
during the time-consuming production process. This stock of goods comes from
saving and is, in this context, what Smith called capital. A major function of the
capitalist is to provide the means for bridging the gap berween the time when
production begins and the time when the final product is sold. Thus, the extent
to which production processes requiring division of labor may be used is limited
by the amount of capital accumulation available. Smith therefore concluded: "As
the accumulation of stock must, in the nature of things, be previous to the
division of labour, so labour can be more and more subdivided in proportion
only as stock is previously more and more accumulated."9
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Figure 4.1
Wealth of a-Nation
depends upon
Productivity of Labor
I
which depends upon
Division of Labor
I
which depends upon
Ratio of Productive
and
Unproductive Labor
I Capital Accumulation
II Capital Accumulation
Capital Accumulation
machines and instruments which facilitate and abridge labour; or of a more proper
division and distribution of employment. In either case an additional capital is
almost always required. 14
For Adam Smith there was no question that capital accumulation required an
institutional framework of free markets and private property. In a system of free
markets operating without government direction, a given level of investment
spending would be allocated so as to ensure the highest rates of economic growth.
In a system of private property, a funher requirement for high rates of capital
accumulation is an unequal distribution of income.
INTERNATIONAL TRADE
One of the major aims of Smith's Wealth ofNations was to demonstrate the falsity
of the rather extensive set of ideas now called mercantilism-about 25 percent
of his book is devoted to an examination of mercantilist doctrine and practice.
Some mercantilists argued that government regulation of foreign trade was
14Ibid., p. 326.
Adam Smith
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92
as consisting of the bullion the nation held, rather than correctly defining a
nation's wealth as a flow of goods. The proper governmental policy toward
international trade, Smith held, should be the same as that toward domestic
trade--one of letting voluntary exchanges take place in free-unregulated mar
kets. A policy of laissez faire, he believed, would lead to ever higher levels of
well-being in all countries.
Modern economics, in assessing the dominant ideas of this period, has
discovered another difference between, the classicals and the mercantilists that
significantly influenced their views concerning the relative imponance of free
markets versus government regulation. These differences, though never fully
aniculated in either Smithian or subsequent classical economics, are fundamental
to classical views on the consequences of economic activity and remain funda
mental even today. They have to do with the fact that if one holds that the total
Adam Smith
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VALUE THEORY
Certain questions regarding value, or price, that should be kept separate were
sometimes confused by early economists. (1) What determines the price of a
good? In the language of modern economics, 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; the
second, although it defies the usually simple micro-macro dichotomy, is generally
included under the broad umbrella of macroeconomics. Smith. did not provide
an unambiguous answer to any of these different questions. His treatment of
them is, in places, confusing in this regard because he intermingled his discussion
of what determines relative prices with his attempt to discover a measure of
changes in welfare over time.
It is not surprising that historians of economic ideas have argued over Smith's
true opinion. One group of writers holds that Smith had three theories of relative
prices (labor cost, labor command, and cost of production) and a theory
explaining the general level of prices. Another group maintains that he settled
on a cost of production theory of relative prices, a theory measuring changes in
welfare over time, and a theory of the general level of prices. The latter group
denies that Smith had a labor theory of relative prices. We believe that Smith
experimented with all these theories: a theory of relative prices consisting of