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Assessment of Adam Smiths Theory of Economic Development

Development Economics Group Assignment 2

XLRI School of Business and Human Resources, Jamshedpur

Submitted By: Group 1, Section B S M Asim Jamil Shubham Kochar Sneha Agrawal TCA Lakshminarasimhan H12104 H12111 H12113 H12119

Table of Contents
Introduction .................................................................................................................................................. 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 ..................................................................................................... 8 Pillars 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 1776 at 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 ( ) the Labour and represents Land.

Where

represents

Capital,

represents

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 policy was 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 economy entrepreneurs would not be able to make products out of thin air, or for nonexistent 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

Rise in Profits/Inc ome Virtuous Circle

Capital

Divison of Labor

Technology

Market Expansion

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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 realistic concept 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 know where to invest b. Capital Markets are not very mature c. Lack of Entrepreneurs in the economy d. 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 underdeveloped 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.

Small Size of market

Less Investment

Low Productivity

Vicious Circle

Less Savings

Low level of Income

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
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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 Adam Smith (1723-90) Core Prescription Rely on the markets invisible hand to allocate resources to the areas where they will secure the highest return When demand is deficient, counter unemployment by boosting public spending Illustrative Quotation It is not from the benevolence of the butcher, or the baker, that we expect our dinner, but from their regard to their own interest. (1776, p.22) "f the Treasury were to fill old bottles with I banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprises on well-tried principles of laissez faire to dig the notes up again there need be no more unemployment (1936, p.379) Inflation is always and everywhere a monetary phenomenon (1970, p.6)

John Maynard Keynes (1883-1946)

Milton Friedman (1912-2006)

To bring inflation under control, restrict growth in the money supply


Table-1

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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 Should not be any government intervention in the market Stance on Govt. regulation No intervention by government is required Maynard Keynes Govt. regulation is necessary in times of economic crises Milton Friedman Should not be any government intervention in the market

Private economy on its own might well be subject to unbearable instabilityMacroeconomic management was necessary

Private economy on its own might well be subject to unbearable instabilityMacroeconomic management was necessary Depended on money supply; increases in money supply growth in short run would cause employment and output to increase

What determines the level of output and employment

Level of employment depended on the amount of capital stock and in the way its employed

Interaction of aggregate demand and aggregate supply

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://wwwtc.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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