Adam Smith Contributions To Economics

Adam Smith's Contributions to Economics (1723-1790)

Adam Smith Blog, Adam Smith History and Summary

Before the industrial revolution, world market products were so wide-open for English manufacturing goods that English merchants no longer needed domestic market demand to sell their finished goods. Traditional markets all over the world were considered as non-capitalist markets, and most profit seeking English merchants strived to eliminate these non-capitalist markets' structures. Traditional markets in most countries could not compete with the English. The English had huge manufacturing advantages in comparison to non-capitalist countries, especially in the area of technological innovation. Most of England's superiorities were founded in textile and iron industries. This growing industrial prowess and capture of new markets quickly led to new sources of profits and increased potentials for capital accumulation. After the invention of steam engines, whole English lands were dedicated to the production of manufacturing products. Soon, factories were built closer to markets located in the cities rather than near rivers that were easily accessible to transportation or near mines for easy access to raw materials. Furthermore, upon discovering that specialization and division of labor stimulate productivity, . manufacturers increasingly encouraged mechanizations and assembly line production in their factories. As a result, manufacturing productivity also continued to increase.

Highly impressed with these developments during his day, especially with the effects on productivity by specialization and division of labor, Adam Smith based most of his theories of and thoughts of economics on his understandings of this beginning of industrial revolution in England. Adam Smith was a Scottish professor who, after spending a few years in France and interacting with both Quesnay and Turgot, published the renowned book An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Within these writings, Smith was the first to complete a relatively consistent and abstract model of the nature, structure, and workings of the capitalist system.

Adam Smith wrote during a time of industrial revolution, increasing economies of scale (especially with the textile industry), invention of the steam engine in 1769, massive city growth and urban concentration, and the establishment of "manufactories" or centers of production from which the capitalist owned everything including hired labor.

Smith was very impressed by the increases of productivity that could be gained from division of labor and was the first to formally distinguish between profits originating from merchant capital (in exchange) versus industrial capital (from production). During his time, new technologies were being applied to the manufacture of several industries including textiles, agriculture, transportation, and steel. Smith illustrated the advantages of specialization and division of labor by using a pin manufacturing example. For example, Smith observed that using the right tools, one person living in the 1770s could make 20 pins per day. However, if that particular pin making operation could be broken up into a number of individually small operations in which workers specialize (i.e. one to cut the wire, a second to straighten it, a third to put a point on it, a fourth to grind it, a fifth worker to put finishing touches on it, etc.), then ten people could significantly increase their output by making up to 48,000 pins per day. Even better yet, if a large specialized labor market was available, an entire factory could produce and sell millions of pins per day.

Contrary to popular understanding Adam Smith was not necessarily a champion of capitalism. In fact, he felt very bad for capitalism's adverse effects, especially the pervasive and systematic social and individual degradation that was occurring during his time. Interestingly, Smith also provided the ideological starting material for opposing views of both contemporary neoclassical (mainstream capitalism) and Marxian or socialist economic thought. Based, on this perspective, Smith has not only been considered by many of today's economic scholars as the father of modern capitalism but also of the father of radical economics - including socialism and communism.

Unlike the Physiocrats, yet in similarity to Marxists, Adam Smith saw capitalism as a system of class conflict and argued that surplus and profit came from the sphere of production - not from exchange. He laid the foundation for the assertion that value was determined based on labor time in the sphere of production and not on the utility realized in the process of exchange (even though he later rejected both value theories). As a result of his beliefs, Smith was considered a radical for his time (because of his opposition to both mercantilism and Physiocrats) and wanted to move forward with capitalism, and even reform it so that it would be more humane. Smith supported most of the tenets that would eventually become the mainstay of neoclassical or mainstream economics. As already mentioned, he was especially very impressed by the strengths of the market, and he discussed extensively the merits of foreign trade and the importance division of labor, specialization, and productivity.
Smith's general support and basic economic thought regarding open foreign trade laid the foundation for modern neoclassical trade theory. For Smith, balanced foreign trade was highly beneficial because it overcame the narrowness of the home market and thus provided a vent for surplus. He believed that a general policy of free trade was also good for long-run productive potentialities because exposure to an increased market size could lead to opportunities for more specialization and division of labor. Foreign trade was also good because it allowed a country to "increase their enjoyments" as more variety and choices of products would become available and at prices that were possibly lower than they were before. Quoting from the Wealth of Nations:

Between whatever places foreign trade is carried on, they all of them derive two distinct benefits from it. It carries out that surplus part of the produce of their land and labour for which there is no demand among them, and brings back in return for it something else for which there is a demand. It gives a value to their superfluities, by exchanging them for something else, which may satisfy a part of their wants, and increase their enjoyments. By means of it, the narrowness of the home market does not hinder the division of labour in any particular branch of art or manufacture from being carried to the highest perfection. By opening a more extensive market for whatever parts of the produce of their labour may exceed the home consumption, it encourages them to improve its productive powers, and to augment its annual produce to the utmost, and thereby to increase the real revenue and wealth of the society. These great and important services foreign trade is continually occupied in performing, to all the different countries between which it is carried on. They all derive great benefit from it... (Smith, p. 475) (bold added).

From his writings, Smith also recommended' that a country manufacture and trade products from which they have a natural or acquired absolute advantage. He further recognized the important "educative effect" that an open economy could realize due to "mutual communications of knowledge of all sorts of improvements."

From Wealth of Nations, we find that Smith developed a theory of history, a theory of sociology, and a theory of value and price. To him, history (including social institutions and class relations) (Meek, 1967) was determined by the way in which humans produced and distributed the material necessities of life.

Smith identified four stages of economic and social development that were applicable, at least until his time period: hunting, pasturage, agriculture, and commerce. In the hunting stage, there were no institutionalized privileges and power relations among the members of society, and a condition of "equality" in terms of social class and material wealth existed.
The next higher stage was called pasturage. Beginning with this stage, property relations began to arise within society. The accumulation of cattle was the basis for wealth. From this stage on, the protection of privilege and power also began to be institutionalized. Based on Smith's analysis, an institutionalized civil government was created primarily for this very purpose, to defend the property of the rich against the poor. Smith also held that the prevailing form of government in a society was largely determined by property relations.

The third stage of development was agriculture. As agriculture became the heart of economic activities, ownership of lands became the most significant representation of property relationship and different classes within society and also the best source of political and social power. From this development -that of land ownership that was specifically set aside for agriculture production, two main societal classes emerged: the rulers (landowners), and the ruled (the rest of the society).

The fourth stage of development, the commerce stage, was the inevitable result of the third stage. Because economic powers of landowners were limited, landowners were thereby forced to accept extension of freedoms to other producers within society. Smith claimed that the revivals of the European cities, which were highly dependent on foreign trade and had no economic relations to the medieval agricultural economy, led to the commercial stage of social development. Commercialism rapidly developed as money flowed into the cities from the agricultural sector from landlords who increasingly needed to purchase goods and services that were manufactured therein. Soon, producers within the cities became the main dynamic force for this revival of the cities. As greater freedom and security within the borders of the cities evolved, the desire to accumulate wealth and capital by urban producers was stimulated even further.

Interestingly, Smith mentioned that it was the growth of the cities that transformed rural agriculture to one of a capitalist-mass producing type agriculture operation. The commercial stage of capitalism created markets where landlords could sell their goods and in return could buy manufactured goods produced in cities. The desire for manufactured goods also had the effect to encourage the enclosure movement (as discussed in the first chapter) because inefficient medieval agricultural methods and unnecessary costs, such as payments to tenants and serfs, did not create enough agricultural products to purchase the desired manufactured 'goods. Therefore, selfish motives encouraged landlords to abolish serfdom and enjoy the new found freedoms and rewards associated with of capitalism type-wealth producing property ownership. In this manner, efficient and mass manufactured production in cities helped establish an improved economic base in rural areas. As rural areas adopted more capitalist and efficient methods in production, the expansion of the cities inevitably became just a matter of time.

Regarding the field of development economics, Smith was actually the first to believe that increased modernization or efficiency of commercially oriented agriculture would provide an economic base for expansion of cities and the continuous enlargement of profitable manufacturing. In fact, the entire capitalist society was created from the growth of mutually beneficial exchange between the capitalist-agricultural industry and commerce development. From this perspective, Smith can be looked upon not only as the father of modern international trade theory, as already mentioned, but also the father of modern development economics.

Smith's theory of sociology (Samuels, 1973) was based on recognition that differing conditions of property relations led to major class divisions in a capitalist society (since property ownership determined income, which in turn determined social class and status). With a capitalist system, a worker could be dominated by a capitalist from three sources: wealth, ability to manipulate and control public opinion, and from having the government on their side. The value added by workers to materials had two parts: wages and profits. Wages and profits were determined in the struggle between laborers and capitalists. Since capitalists had more power, they would typically acquire a larger share of the produced value or wealth.
Despite the. consequences of this eminent class struggle, Smith asserted that market forces do have a tendency to mitigate conflict by unknowingly and unintentionally guiding individual, selfish acts of exchange into social beneficence and harmony. From Wealth of Nations we find that Smith specifically felt that each individual or player in a competitive market was "led by an invisible hand to promote an end which was no part of his intention." Interestingly enough, even though Smith's ideas of this "invisible hand" concept are so widely renowned and highly regarded today, they are only discussed in seven pages out of his greater than 1000 page book. Adam Smith also recognized (or at least claimed) that progressive social evolution could take place only when the appropriate set of geographical, economic, and cultural circumstances was present.

In the study of economic thought, there has always been a dispute regarding the source of "value" particularly whether value is created, on the one hand, in the realm of exchange as determined by individual utility or satisfaction, or on the other hand, in the sphere of production based on labor time. Smiths' theory of value formed the first frameworks of this theory. His theory was based on recognition that the process of production can be reduced to a series of human exertions. In other words, that all items going into a commodity, including capital (raw materials and tools) are products of labor either directly, indirectly, or from past labor. This view suggests that the amounts of both direct labor (labor that uses the means of production) and indirect labor (labor embodied in the means of production) along with past labor embodied in raw material, tools, and equipment determines the exchange value of the commodity. Therefore, in order for a commodity to have value, it must be a product of human labor. Smith was the first economist to link profit to production and the first to establish a relationship between profit and labor embodied in a commodity.

Interestingly, because of an unsuccessful attempt to prove the veracity of the labor theory of value, Smith ended up rejecting both perspectives -the utility theory of value and the labor theory of value. On the one hand, he rejected the utility theory of value based on the so-called "water-diamond paradox." Because water has a high use or demand yet low price, and diamonds have fewer users or demand yet high prices or high exchange value, the exchange or utility theory doesn't quite hold up. There is a high demand and rate of usage, utility, or use-value for water. However, water is either exchanged at no cost, or it is at least sold for a very low price. Diamonds, in comparison to water, have acquired very high values in the realm of exchange, yet their usage or utility is low. Smith ends up rejecting the labor theory of value as well as the utility theory of value because prices could only be directly proportional to amounts of labor embodied in a commodity if, and only if, capital and labor ratios are equal in all industries. However, because they are not, value/prices and labor time do not equate.

Smith's price theory was called the "adding-up" theory since profit and rent were also included with wages (Dobb, 1973). The primary difference between this theory and labor theory of value was the inclusion of profit and rent. The adding-up price theory holds that prices were equal to wages plus rent plus profits which were also equal to costs of production. However, based on Smith's analysis, costs of production was equal to labor time only if capital-to-labor ratios were the same across industries.

Smith's "natural price," the price around which market prices fluctuated, was an equilibrium price determined or created by the costs of production yet realized in the market by forces of supply and demand. In his price theory, demand would allocate capital among the industries and determine supply, but the cost of production would determine the natural price. In other words, Smith's theory of price claims that although societal demand determined the quantity produced for any one commodity, the natural or equilibrium price for that commodity could only be determined by the costs associated with its production.

There was a major weakness with Smith's price theory -the circularity problem. The circularity problem arose because the three components of prices or cost of production, including wages, rent, and profit, are themselves prices, and you cannot explain prices with prices. This circularity could only be resolved if an invariant measuring rod for value could be found. If, for instance, corn or food were used as the measuring rod, as food prices increased, wages would also increase causing costs of production to increase. This would then lead to an increase in all prices which would then lead back again to food prices - circularity*. Labor could also not be used as an invariant measuring rod because wages vary, likewise, gold or silver could not be used because of a variance in precious metal production conditions.


Overall, Smith's principal concern was to ascertain what social and economic forces were most conducive to increasing human welfare. He said welfare depended on the annual "production of labor" and the "the number of those who are to consume it." In other words, greater supply should meet greater demand or vice versa.

Smith divided production into two basic sectors: agriculture and manufacturing. The factors of production included land, labor and capital (today's economics includes a fourth factor called "entrepreneurship"). The distribution of both actual ownership and the laws of property ownership created three main classes within the society, landlords, laborers, and capitalists. Each class received different forms of money returns: rent, wages, and profit.

The level of production in any society depended on the number of productive laborers and the level of their' productivity. Productivity depended on specialization or the division of labor. The extent of the division of labor, in turn, was determined by the extent and magnitude of a well-developed market and a commercial exchange economy where specialization could increasingly take hold. The most obvious division of labor was rural agriculture-urban manufacturing.

According to Smith's analysis, economic development was expected first in agriculture, then in manufacturing, and third in foreign trade. Again, a commercial society was both a requirement and necessity to develop urban-rural specialization. While diverting from Physiocratic ideology which held that agriculture was the center of all economic life and meaningful production, Smith praised manufacturing sector's ability to accumulate capital and profit. While agreeing with Physiocratic ideas, Smith argued that capital employed in agriculture was the most' productive capital. In other words, in the context of a so-called natural order of things, agriculture came first -as long as, of course, all markets were kept free. After the development of the agricultural sector in laissez-faire (i.e. a condition of perfect competitiveness) capitalism, capital would then flow into the manufacturing sector and enable it to develop as well.

Smith indicated that accumulation of capital was the main source of economic progress, and that profit was the main source of new capital. To him, there were two types of laborers: "productive laborers" and "unproductive laborers." Productive laborers contributed in such a manner to generate revenues sufficient enough to pay wages and also contributed to the process of accumulation. In contrast, unproductive laborers offered work efforts that did not result in accumulation of capital nor contribute to further economic progress. Hence, productive labor was the source of economic welfare because productive labor contributed to increased capital accumulation and labor productivity.

Although Smith contributed many founding principles for Marxism and socialist thought, he felt that capitalism would reach its greatest height when government would adopt a "laissez-faire" policy, or as Smith called it, "the obvious and simple system of natural liberty" (Smith, 1776, p. 651). Laissez-faire policy encourages free interplay of supply and demand to regulate economies and allows all economic behavior to be characterized by selfish and acquisitive motives. Interestingly, the assumption of a "selfish and acquisitive behavior" has since become one of the foundations for neoclassical economics.

In the end of his analysis, Smith concluded that it was best promote a laissez-faire policy for improving economic welfare because as productivity increased, made possible through expanding markets and resulting opportunities for specialization and division of labor, everyone would be better off. He was also led to this laissez-faire conclusion based on the assertion that economic progress came from the accumulation of capital and that a "natural" flow of capital could contribute to overall economic welfare. Furthermore, free, competitive markets and harmonizing forces of the "invisible hand" would help capital be directed or employed in a productive manner. From this perspective, Smith believed that government interventions, including unnecessary regulations, monopolies, subsidies, et cetera, would therefore tend to misdirect these capital flows and diminish economic welfare. Hence, the role of government, in his view, should be restricted to provide for national defense and security, the enforcement of contracts or administering justice, and to provide a certain amount of infrastructure and public works/services.