ADAM SMITH (1723-1790)

 The founder of the

Classical School.
 A Scottish economist who
is known as the “father of
modern economics”.
 He believed that the state
should not interfere in
economic matters.
 He developed “laissez-
faire” economic theory.

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 ADAM SMITH (1723-1790)

Discussion will focus on his:

 Biographical Details
 Important Influences

 Important Books
 The Theory of Moral
Sentiments (1759)
 An Inquiry into the Nature
and Causes of the Wealth of
Nation (1776)

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 ADAM SMITH
(Biographical Details)
 Born in Kirkcaldy Scotland
 Raise by his mother Margaret
Douglas Smith (his father died
before he was born)
 Attended Glasgow College at
14 years of age.
 Studied moral & political
science and language at Balliol
College Oxford.
 Elected professor of logic at
Glasgow College (1751).
 In 1752, he was given the chair
of moral philosophy, which he
held for nearly 12 years.

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 ADAM SMITH
(Biographical Details)
 Published “The Theory of Moral
Sentiments (1759).
 Published “An Inquiry into the
Nature and Causes of the Wealth of
Nation (1776).
 Established close personal friendship
with Quesnay & Turgot in France.
 Among the honors bestowed on
Smith was his election as lord rector
of Glasgow College.
 Shortly before he died in 1790 most
of his unpublished manuscripts were
destroyed according to his wish &
without explanation.

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 IMPORTANT INFLUENCES

• Scientific Revolution.
• Industrial Revolution.
• Physiocrats (Quesnay &
Turgot)
• Francis Hutcheson
• David Hume

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THE THEORY OF MORAL SENTIMENTS

 Published in 1759, 17 years before

“Wealth of Nations (WON)”.
 It went through 6 editions during
Smith’s lifetime.
 It cannot be said that TOMS
represented Smith earlier ideas &
WON his later ideas.
 The books stand side by side,
presenting different but
complementary facets of his
thinking.

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THE THEORY OF MORAL SENTIMENTS
 TOMS discussed the moral
forces that restrain selfishness
and bind people together in a
workable society.
 TOMS open with a chapter titled
“Of Sympathy”.
 According to Adam Smith
sympathy & benevolence
(desire to do good to others)
restrain selfishness.
 The social passions (generosity,
humanity, kindness,
compassion) > unsocial passion
(hatred, resentment)
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THE THEORY OF MORAL SENTIMENTS
 Both TOMS & WON reconcile
the individual with the social
interest through the principle of
the invisible hand, or natural
harmony & the principle of
natural liberty of the individual, or
the right to justice.
 In TOMS, sympathy and
benevolence restrain selfishness
 In WON, competition channels
economic self-interest toward the
social good.

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 WEALTH OF NATIONS
 Published in 1776
 “An Inquiry into the Nature and
Causes of the Wealth of Nations
(WON)”.
 900 pages
 Establish Smith as one of the
premier economic thinkers in the
history of economic thought.

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 WEALTH OF NATIONS
 Discussion in this book can be
divided into several topics:
 Division of labour
 Self interest behavior, competition,
harmony of interests & limited
government
 Value theory
 Market price
 Wages
 Profit
 Rent
 Role of money & debt
 Economic development

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 Division of Labour
 DOL increases the quantity of
output for 3 reasons:
i. Each worker develops increase
dexterity in performing one
single task repeatedly.
ii. Time is saved if the worker
need not go from one kind of
works to another.
iii. Machinery can be invented to
increase productivity once tasks
have been simplified & made
routine through DOL.

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 Self interest behaviour, competition,
harmony of interests & limited government
 All participants in the economy tend
to pursues their own personal
interests:
• Consumer looks to find the
lowest price for a good, given its
quality
• Workers tries to find the highest
pay, given the non wage aspect of
the job.
• Employers tries to find the best
worker
 However, there is an invisible hand
(natural order) that channels self-
interested behavior in such a way that
the social good emerges.
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 Self interest behaviour, competition,
harmony of interests & limited government
 The key to understanding Smith’s invisible
hand is the concept of “competition”.
 Consumers compete with one another
for the right to consume products
 Employers compete with one another
for the best workers
 Workers compete with each other for
the best jobs.
 The pursuit of self-interest, restrained by
competition, thus tends to produce Smith’s
social good – maximum output & economic
growth.
 Resources get allocated to their highest
valued uses (economic efficiency).

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 Self interest behaviour, competition,
harmony of interests & limited government
 This harmony of interests
implies that intrusion by
government into the economy
is unneeded & undesirable.
 3 limited government functions
i. To protect society from foreign
attack.
ii. To establish the administration
of justice.
iii. To erect & maintain the public
works & institutions that
private entrepreneurs cannot
undertake profitability.

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 Relationship between “self interest behaviour”,
“competition”, “harmony of interest” & “limited
government intervention in economy”

Competition
(invisible hand)

Self-interest harmony of interest

behaviour
 Consumers (cheaper product)
 Producer (higher profit)
 Workers (higher wage)
 Employers (best worker) limited government
intervention in economy
Theory of Value
 Water-diamond paradox: Water is cheap & diamonds are expensive!
 Things that have the greatest value in use (water) have little value
in exchange (diamonds)
 How can this be explained ? (total utility vs marginal utility)
 Adam Smith did not solve the paradox of value.
 Smith directed his attention towards exchange value
 labour cost vs labour command
 Labour theory of value (primitive society vs advanced
economy)

CH 21 • 120
 Wages
 Smith addressed 3 facets of wages: the
aggregate level of wages, the growth of wages
over time & the wage structure.
 With respect to the first two, he employed the
wage fund theory.
 Wage fund
 a stock of circulating capital out of which present
wages are paid.
 Consists of the savings of the capitalists & is
dependent on the revenue from the previous
production & sales.
 This fund is fix in the short run but it can be increased
from one year to the next.

Average annual wage = wage fund

number of labourers

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 Wages
 Minimum wage rate = wage rate which will
enable a worker with a family to survive &
perpetuate the labour supply.
 If capital accumulation ↑ wage fund ↑ labour
DD ↑
 If labour DD > labour SS, wages will ↑ above
the minimum wage.
 Wages ↑ health & strength of workers ↑
productivity ↑ national output ↑ wealth of
nation ↑.
 However, if the wealth of a country were great
but stationary, population & thus labour SS
would eventually multiply > labour DD &
wages would ↓ back to the minimum level (low
wage doctrine of Mercantilism)
 This explain why Smith’s emphasis on capital
accumulation & economic growth.
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 Wages
 Wage rates for different jobs
(wage structure) would be vary
according to 5 factors:
 Agreeableness of the occupation
 Cost of acquiring the necessary
skills & knowledge
 Regularity of employment
 Level of trust & responsibility
 Probability or improbability of
success

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 Profit
 Because every investment is exposed to the risk
of loss, the lowest rate of profit must be high
enough to compensate for such losses & still
leave a surplus for the entrepreneur.
 Gross profit = compensation for any loss &
the surplus
 Net profit = surplus alone (net revenue of
the business)

 Competition among businesses will ↓ the rate of

profit
 Profit ↓ WF ↓ (assumption: fix number of
labourers)

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 Economic Development
 Smith viewed the economy as a whole & emphasized growth
& economic development. (Figure 5-1).
 DOL spurs capital accumulation (arrow a)
 However, Adam Smith fail to recognize that new technology often
creates new tools & equipment that themselves cause the DOL (arrow a
point only in one direction).
 DOL & capital accumulation then work together to ↑ labour
productivity (arrow b & c)
 The rise in labour productivity ↑ national output (arrow d) & ↑
wealth of nation (arrow e).
 The rise in national output also widens or extends the market
& justifies further DOL & capital accumulation (arrow f)
 The cycle of events promoting economic growth then repeat
itself.
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 Economic Development
Question: How does the common person fare in this process?

 According to Smith, capital accumulation will ↑ wage fund

(arrow g)
 If the ↑ in wage fund > ↑ in the number of labourers, average
wage ↑ (arrow h).
 Furthermore, higher wages may enhance the health & vitality
of workers, further ↑ their productivity (arrow i) and the cycle
continue.

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