Adam Smith.

Adam smith's 'stages in social development'.

There were four main stages in social development, Smith argued - hunting,
pasturage, agriculture and commerce, which generally followed one another in
that order. Each of these stages, as will be seen, is in effect defined in terms of
a "mode of subsistence". In the first stage, hunting, there is properly speaking
no government at all, because there is virtually no private property. In later
stages private property arises, and with it landlords, and government.

Prices and Value

The labour theory of value was not a new idea.

Hobbes (1650s), William Petty(1660-1670), and Locke (1690) inter alia, had all
made reference to it.
Book 1 ch Vi

He believes that “In that early and rude state of society which precedes both the
accumulation of stock and the appropriation of land, the proportion between the
quantities of labour necessary for acquiring different objects seems to be the
only circumstance which can afford any rule for exchanging the for one
another.” Book 1Chapter VI P 79

“The real price of every thing, what every thing really costs to the man who
wants to acquire it, is the toil and trouble of acquiring it. What every thing is
really worth to the man who has acquired it and who wants to dispose of it, or
exchange it for something else, is the toil and trouble which it can save to
himself, and which it can impose upon other people. What is bought with
money, or with goods, is purchased by labour, as much as what we acquire by
the toil of our own body.” Book 1 ch V p 49-50
“Labour, therefore, it appears evidently is the only universal, as well as the
only accurate measure of value, or the only standard by which we can
compare the values of different commodities at all times and at all places.”
Book 1 ch V

This would appear then to be a labour value based theory of value.

He also notes that other commodities such as gold and silver, vary in their value
over time Book 1 Ch Vp 53

Adam Smith 1
However, judging by the following he does not appear to believe that the labour
time used in producing a product determines its value in a simple way.

“But though labour be the real measure of the exchangeable value of all
commodities, it is not that by which their value is commonly estimated. It is
often difficult to ascertain the proportion between two different quantities of
labour. The time spent in two different sorts of work will not always alone
determine this proportion. The different degrees of hardship endured, and of
ingenuity exercised, must likewise be taken into account. There may be more
labour in an hour's hard work, than in two hours easy business; or in an hour's
application to a trade which it cost ten years labour to learn, than in a month's
industry, at an ordinary and obvious employment” Book 1 ch V, p 51

Thus the simple amount of labour used cannot fix the relative prices of goods,
but is adjusted by the “higgling and bargaining of the market”

Like many classical economists Smith sought to find some fixed measure of
value. However, he was aware that all commodities change in value, and thus
finding a fixed measuring rod to measure other values with is problematic.

“Gold and silver, however, like every other commodity, vary in their value”
Bok 1 Ch V p 53

However, he did recognise that equal quantities of labour are always likely to be
of equal value to the labourer ( under certain conditions). It is the value of
commodities that varies, not the labour. Chapter V P 54

He subsequently makes reference to a “corn model”. Here he argued that equal

quantities of labour can be better bought with equal quantities of corn, than with
other commodities such as gold and silver; although he does say “ more nearly
than equal quantities of almost any other commodity”, Chapter V , recognising
that even equal quantities of corn will show some variation in the amount of
labour it buys.

He argues that “Every other commodity, however, will, at any particular time,
purchase a greater or smaller quantity of labour, in proportion to the quantity of
subsistence which it can purchase at that time….” Book 1 Chapter V p 59

“The real price of every thing, what every thing really costs to the man who
wants to acquire it, is the toil and trouble of acquiring it. What every thing is
really worth to the man who has acquired it and who wants to dispose of it, or
exchange it for something else, is the toil and trouble which it can save to
himself, and which it can impose upon other people. What is bought with
money, or with goods, is purchased by labour, as much as what we acquire by
the toil of our own body.” Book 1 ch V p 49-50

Adam Smith 2
He maintains that every other commodity will purchase an amount of
subsistence of labour that will vary over time. What he describes as the
subsistence of the labourer, or the real price of labour is very different in
different circumstances. If a society is well off then the “subsistence of labour”
is likely to be higher than in one wish is not well off.

When considering, for example, rent as measured in a quantity of corn, it is

clear that it is subject solely to the variations in the quantity of labour which the
corn can purchase. Whereas a rent in any other commodity is subject, not only
to changes in the quantity of labour the corn can buy, but also to the variations
in the quantity of corn which can be bought by that commodity. ( for example,
how much corn can silver buy? - so there are two variations here)

Smith argues, Chapter V, that the real value of a corn rent varies little over long
periods but it varies much more from year to year. The average price of corn is
influenced by the value of silver, by the productivity of mines, or by the
quantity of labour which is required to produce the silver, and consequently of
the amount of corn which must be supplied to the labourers in order to mine the
silver and brig it to market. The value of the silver, he notes, is relatively
constant over a short period of time ( year to year), although its value might
vary greatly from century to century, but might be quite stable for an extended
period of time.

However, over time, from century to century, corn being a better measure than
silver, from year to year silver better than corn, as the silver price of labour is
relatively stable year to year.

He then concludes that labour is in fact the only universal measure of value, and
the only basis for comparing the value of commodities; as it is not possible to
estimate the real values of commodities over long periods of time ( centuries)
using silver, or short periods using corn, but it can be estimated with the
quantities of labour used top produce the commodity. Chapter V P 58-61

In what he calls an early and rude society if it takes twice as long to kill a
beaver than to kill a deer, one beaver should be worth two deer, however, he
then acknowledges that if one task is more demanding than another there should
be some allowance for this, as there should also be if more skill was involved in
one task, suggesting that this must have happened even in simple societies.
Chapter VI, P 79-80

“… labour requires an uncommon degree of dexterity and ingenuity, the esteem

which men have for such talents, will naturally give a value to their produce,
superior to what would be due to the time employed about it. Such talents can
seldom be acquired but in consequence of long application, and the superior
value of their produce may frequently be no more than a reasonable
Adam Smith 3
compensation for the time and labour which must be spent in acquiring them.
In the advanced state of society, allowances of this kind, for superior hardship
and superior skill, are commonly made in the wages of labour; and something
of the same kind must probably have taken place in its earliest and rudest
period.” Chapter VI, P 79-80

Adam Smith 4
SMITH, RICARDO AND THE LABOUR THEORY OF VALUE

Start with the simple technology of a nation producing only two goods.1
(Generalisations to n goods are easy). Assume that to get 280 units of output of
good 1, and 105 units of output of good 2, each year the following inputs of the
two goods themselves and labour are necessary.

Inputs
Good1 Good2 Labour
160 20 20 " 280
!! good 1output
40 55 80 " 105
!! good 2output

Using the symbols v and v to refer to the labour value of the two goods, that
1 2
is, the quantity of labour necessary to produce one unit of output of each good,
then v and v can be found by solving the following equations:
1 2

160v + 20v + 20 = 280v

1 2 1
40v + 55v + 80 = 105v
1 2 2

These solve for v = 1 ,v = 2 . ( or v1 = 1/v2).

1 2 2
That is, it takes half a labour year to produce good 1, and two labour years to
produce a unit of good 2.

1
Examples here supplied by A T Needham

Adam Smith 5
The exchange ratio

v
2 =4
v
1
simply says that in order to buy one unit of good two, one must pay 4 units of
good one. (Good two is four times as expensive as good one; requires four times
as much labour to produce it).

Natural Prices.

The natural price of a commodity is a price which is sufficient to pay the rent of
land, the wages of labour and the profits of stock employed in producing it and
bringing it to the market.

“There is in every society or neighbourhood an ordinary or average rate both of

wages and profit in every different employment of labour and stock. This rate is
naturally regulated, as I shall show hereafter, partly by the general
circumstances of the society, their riches or poverty, their advancing, stationary,
or declining condition; and partly by the particular nature of each employment.

“There is likewise in every society or neighbourhood an ordinary or average

rate of rent, which is regulated too, as I shall show hereafter, partly by the
general circumstances of the society or neighbourhood in which the land is
situated, and partly by the natural or improved fertility of the land.

“These ordinary or average rates may be called the natural rates of wages,
profit, and rent, at the time and place in which they commonly prevail.” Book
1Ch VII

The actual price at which any commodity is sold at is called the market price.
In the short run the natural and the market price may diverge due to market
conditions; however, in the long run, making certain assumptions, they should
converge. If they are different then this is a temporary observation, an accident.
If for example, rents were to rise above the natural rate, then more land would
be brought to market. Book 1 Chapter VII P 97. He describes the natural price
as the central price which all commodity prices were “gravitating”. Rents,
profits and wages are all supposed to behave in this way.

Adam Smith 6
Wages.

Wage differentials are thought to be due to:

agreeableness of the occupation,

costs of training, regularity of employment,

responsibility upon employees,

probability of employment.

There is scant detail on demand for labour here. Book 1 ch vi

Wealth is measured in terms of labour in places. The higher the real price of a
commodity in terms of labour the better off we are for having it. ( Back to LTV
again)

Initially, in a simple economy, labour could consume their whole wage.

However, a soon as land becomes private property and there is a landlord, that
landlord will now demand rents.

A labourer is unlikely to be able to sustain itself without income until the

harvest, and thus any income given to him by his employer is an advance to him
from the stock of his employer. This advancement needs to be returned with a
rate of profit, and this profit is a second deduction from the produce of the
labour ( the first being rent). This is akin to earlier physiocrat ideas of capital or
stock. As soon as land becomes private property, there will be a landlord who
will require a rent to be paid.

Labourers will obviously want higher wages, employers will obviously want
lower ones. Employers might band together to lower wages, the “natural price”
of labour being a subsistence wage. Clearly though it is likely to be easier for
employers to keep wages low, at a subsistence level, than for labour to raise the
wages. However, if there were shortages of labour then labour may be able to
bid up wages. Increases in demand might also bid up the natural wage, and
workmen have no need to attempt to bid up wages.

“….The scarcity of hands occasions a competition among masters, who bid

against one another, in order to get workmen, and thus voluntarily break

Adam Smith 7
through the natural combination of masters not to raise wages.” Book1 ch VII,
p117

A rate of profit will also be required from those who provide the capital.

“In this state of things, the whole produce of labour does not always belong to
the labourer. He must in most cases share it with the owner of the stock which
employs him. ….. an additional quantity, it is evident, must be due for the
profits of the stock which advanced the wages and furnished the materials of
that labour.” Chapter VI P83

Profit

Once stock has been acquired by people they will seek to use it for profitable
purposes, employing others to work for them. Those workmen will add value to
any inputs provided. This value can be seen as partly their wages, and partly
the profits of their employer, these profits being “upon the whole stock of
materials and wages which he advanced. He could have no interest to employ
them, unless he expected from the sale of their work something more than what
was sufficient to replace his stock to him; and he could have no interest to
employ a great stock rather than a small one, unless his profits were to bear
some proportion to the extent of his stock.” Chapter VI P 81

Smith points out that the profits of stock are not wages for the “labour of
inspection and direction”, and bear no relation to the difficulty faced by this
labour, or the skill of this labour of inspection and direction.

The profits are determined in part by the value of the stock employed. He gives
an example of two firms, both of which enjoy a rate of profit of 10%. Ch VI

One firm uses £700 of material, the other £7,000 Both firms use labour costing
£300 ( 20 staff each at £15 p.a.). In this case one firm will be using capital of
£1000, the other £7,300 one firm will expect profits of £100, the other profits
of £730

There profits are different, but with the same level of staff. Smith concludes
that “In the price of commodities, therefore, the profits of stock constitute a
component part altogether different from the wages of labour, and regulated by
quite different principles.” Ch VI P 81

He acknowledged that when merchants compete with each other in the same
line of business competition naturally tends to lower profits. Chapter IX.

It is also difficult to work out what the average rate of profit is in any particular
case.

Adam Smith 8
“It is not easy, it has already been observed, to ascertain what are the average
wages of labour even in a particular place, and at a particular time. We can,
even in this case, seldom determine more than what are the most usual wages.
But even this can seldom be done with regard to the profits of stock. Profits are
so very fluctuating, that the person who carries on a particular trade cannot
always tell you himself what is the average of his annual profit. It is affected,
not only by every variation of price in the commodities which he deals in, but
by the good or bad fortune both of his rivals and of his customers, and by a
thousand other accidents to which goods when carried by sea or by land, or
even when stored in a warehouse, are liable. It varies, therefore, not only from
year to year, but from day to day, and almost from hour to hour. To ascertain
what is the average profit of all the different trades carried on in a great
kingdom, must be much more difficult; and to judge of what it may have been
formerly, or in remote periods of time, with any degree of precision, must be
altogether impossible.” Book1 ch IX p 151

Rent.

Rent is likely to be set at the highest level which the tenant can pay given the
condition of the land. Book1 Chapter XI P 252

The landlord will leave him the minimum amount after rent to meet his labour
and other costs.

“The rent of land, therefore, considered as the price paid for the use of the land,
is naturally a monopoly price. It is not at all proportioned to what the landlord
may have laid out upon the improvement of the land, or to what he can afford to
take; but to what the farmer can afford to give.” Book 1Chapter XI P 254

If the ordinary price of a commodity is more than in required to replace stocks

and provide profits, the excess will be rent, if it is less then there will be no rent,
whether the price is higher or lower depends upon demand. Book 1 Chapter XI
P 254

As a given piece of land can produce more food than is needed to replace stock,
provide profits, and pay labour there is almost always a rent on land. Book
1Chapter XI P 257

“Rent, it is to be observed, therefore, enters into the composition of the price of

commodities in a different way from wages and profit. High or low wages and
profit, are the causes of high or low price; high or low rent is the effect of it. It
is because high or low wages and profit must be paid, in order to bring a
particular commodity to market, that its price is high or low. But it is because its

Adam Smith 9
price is high or low; a great deal more, or very little more, or no more, than
what is sufficient to pay those wages and profit, that it affords a high rent, or a
low rent, or no rent at all.” Book 1 Chapter XI p255

Prices.

“Labour measures the value, not only of that part of price which resolves itself
into labour, but of that which resolves itself into rent, and of that which resolves
itself into profit.” Chapter VI p 84

The components of the price were thought to be rents, wages and profits. He
argues that a fourth part, in the context of agriculture, replacing farm stocks,
compensating for wear and tear of equipment, is not needed, as each of these
items are themselves made up of the same components, rents, wages , profits.

In the context of farming Smith gives the example of a horse being used on a
farm. His price is made up of the rent of the land he was reared, the labour used
to rear him, and the profits of the farmer who reared him. The farmer would
have used both land and the wages of this labour on the horse. Chapter VI, p 84-
85

The price of any commodity must finally resolve itself into one or more of those
three parts…anything that remains after paying rent and labour must be profit,
with all incomes being derived from one of these, Chapter VI p 87-88

“But the whole price of any commodity must still finally resolve itself into
some one or other or all of those three parts; as whatever part of it remains after
paying the rent of the land, and the price of the whole labour employed in
raising, manufacturing, and bringing it to market, must necessarily be profit to
somebody.” Chapter VI P 87

Later Smith says, “It is because high or low wages and profit must be paid, in
order to bring a particular commodity to market, that its price is high or low.”
Chapter XI P 255

This is important – here Smith is saying prices are made up of Wages, Rents
and Profits.

Many are not uncritical of Smith’s explanation of prices. For example Blaug
(1985, p 42)

Adam Smith 10
“A cost-of-production theory of the value of a commodity is obviously empty
and meaningless if it does not include some explanation of how the prices of
productive services are determined. But Adam Smith had no consistent theory
of wages and rent and no theory of profit at all. To say that the normal price of
an article is the price that just covers money costs is to explain prices by prices.
In this sense, Adam Smith had no theory of value at all”

What is missing from Smith?

Production and prices? He simply fails to get to grips with the key issues of
what determines value. He attempts, in effect, to explain prices with prices.
Smith claims that there exists a ‘natural’ or average rate of all three incomes,
wages, profits and rents. Smith is therefore forced to give an explanation of
wages, profits and rents in order to explain the prices of commodities.

“These ordinary or average rates may be called the natural rates of wages, profit
and rent, at the time and place in which they commonly prevail.” Smith Chapter
VII P 92

“The natural price, therefore, is, as it were, the central price, to which the prices
of all commodities are continually gravitating.” Smith Chapter VII P97

Originality.

Much of his work is an eclectic collection of previous work – Physiocrats,

quesnay, some mercantilists – North, etc.

He may not be as analytical as we might like, much of the material is narrative

for example. However, “Smith is the first of the great eclectics who wove into
a harmonious whole the more important ideas of predecessors and
contemporaries alike…..”see Rima 1991 p 91

“So much was done [in the seventeenth and eighteenth centuries] that there
is scarcely any proposition of importance in the modern discussion of value
which was not either stated or suggested by the writers of this first period of
economic science, and which had not been discussed before Adam Smith
made political economy a world study.” H. Sewell. (1901)

Not everyone is impressed though, for example Douglas (1928) felt that his
contributions were not significant. P. Douglas (1928), p77. Cited in Rashid
(1989)

Viner agreed with Schumpter, that there is little rigour, or internal consistency.
Viner, (1928)

Adam Smith 11
However, Schumpter did praise the equilibrium model presented in chapter 7,
pointing out it points toward Say and to Walras., and that later developments
tend to be developments of it. (Schumpeter 1954, p.189), whilst Marshal felt
that: “there is scarcely any economic truth now known of which he did not get a
glimpse”, Marshall, A, (1907), p757.

A second approach including land, and thus rent.

Using the symbols v and v to refer to the labour value of the two goods, r as
1 2
the rate of profit, w as wages, R as rent.

Return to the original two-good technology, but now add land as a necessary
input.

Good 1 Good 2 land labour

16!!!20!!!4!!!20 ! 280 good 1

40!!!55!!!3!!!80 !105 good 2
Now define the following price and income system:

(160 p + 20 p )(1+ r) + 4R + 20w = 280 p

1 2 1
( 40 p + 55p )(1+ r) + 3R + 80w = 105p
1 2 2
Now do some simple national income accounting. Adding up the equations
gives:

Depreciation + profit + rent + wages = GNP

(200 p1 + 75p2 ) + (200 p1 + 75p2 )r + 7R + 100w = 280 p1 + 105p2

Alternatively, subtracting depreciation from both sides, gives:

Profit + Rent + Wages = NNP

(200 p1 + 75p2 )r + 7R + 100w = 80 p1 + 30 p2

Whilst obviously ‘correct’, does this help in understanding Smith?

Return to the price system

Adam Smith 12
 (160 p + 20 p )(1+ r) + 4R + 20w = 280 p
1 2 1
( 40 p + 55p )(1+ r) + 3R + 80w = 105p
1 2 2

We are interested in the ‘solutions’ to this set of equations. Take an obvious

one. If r = 0, R = 0, w = 1 , this set of equations simply reverts to the Labour
Theory of Value equations we had earlier

160v + 20v + 20 = 280v

1 2 1
40v + 55v + 80 = 105v
1 2 2

with p = v , p = v . As per earlier.

1 1 2 2
Labour values are simply the prices one gets when profits and rents are zero and
workers receive as wages the year of labour they have worked (w = 1). If wages
1
are measured in units of good 2, then w = 1 becomes w = .
v2

Now consider other solutions. Solve the first equation above for P1. Then
substitute it into the second to solve for w. The result is a single equation in the
three income variables. In this case, it is:

(13!8r)[5(2!5r)! R]
w=
20(13!15r)
It is obvious that this is a three-dimensional surface, and students are advised to
draw it carefully. To assist here, the following two diagrams reduce it to two
dimensions, the first with R=0, and the second with r = 0 . In both cases, it is
clear that when both R=0 and r = 0 , the maximum wage rate is the reciprocal of
the Classical Labour Value for the numeraire good, w = 1 = 1 = 0.5
v2 2

Adam Smith 13
 T h e W a g e /P ro fit lin e

0 .5

0 .4

0 .3
Thw wage rate, w

0 .2

0 .1

0 .0
0 0 .0 8 0 .1 6 0 .2 4 0 .3 2 0 .4

-0 .1

Th e ra te o f p ro fit, r

T h e W a g e /R e n t L in e

0 .5 0

0 .4 5

0 .4 0

0 .3 5
The Wage Rate, w

0 .3 0
0 .2 5

0 .2 0

0 .1 5

0 .1 0

0 .0 5

0 .0 0
0 1 2 3 4 5 6 7 8 9 10

R e n t p e r U n it o f L a n d , R

Using all this, try to make sense of Smith’s concepts, “the natural rates of
wages, profit, and rent”, and his idea that “the natural price” of a commodity is
the sum of these.

Adam Smith 14