Adam Smith Market Theory
There are two possible approaches to the writings of Adam Smith. One is to examine the overall theoretical structure and the policy implications that are either inherent in the theoretical system or stated explicitly by Smith. Another is to examine the theoretical structure in detail to evaluate its internal consistency or lack thereof. We will use the first approach because Smith's importance in the history of economic thought is a result of (1) his broad understanding of the interconnectedness of the economy and (2) his influence on economic policy. Smith is still read today for these insights, not for his contributions to the technical part of economic theory. Our task, therefore, will be to take a broad view of Smith's theoretical structure 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.
Contextual Economic Policy
Adam Smith's methodological approach shaped both his analysis of the economy and his determinations concerning government policy. More abstract metho-dologists base their arguments on reasonably tight theoretical structures. An abstract theorist might conclude, for example, that markets without government intervention result in an optimum allocation of resources because, in the long run under competitive markets, firms produce at the lowest possible average cost. Another abstract theorist might argue against markets and for government intervention, using theoretical constructs such as those dealing with externalities or third-party effects. In short, the more theoretical economists judge whether markets work or fail on the basis of abstract arguments separated from historical or institutional context. Adam Smith's argument for laissez faire is, of course, based in part upon a theoretical model of how markets produce certain results. But, significantly, his arguments are more than just theoretical; they are contextual—that is, they are based on his observations of the existing historical and institutional circumstances. Smith's advocacy of laissez faire is rooted in a methodological approach that asks this question: Does experience show that government intervention will produce better results than will the unimpeded workings of markets? Smith conceded that markets often fail to produce ideal social results, but current reality convinced him that the results of government intervention were less acceptable than those flowing from free markets. Hence Smith advocated laissez faire not because he believed markets to be perfect but because, in the context of history and the institutional structure of the England of his time, markets usually produced better results than did government intervention.
The science of economics deals with positive, matter-of-fact relationships between economic variables— often expressed as "what is." Normative economics involves questions of what should be—often expressed as "what ought to be." The art of economics is policy-oriented. It takes our knowledge of how things are (the science of economics) and our goals (normative economics), and it makes recommendations on the best ways to achieve our goals given our understanding of the science of economics and our comprehension of how policies are put into operation through government actions.
Adam Smith's particular proclivities were not those of an abstract theorist. Instead, he was a policy formulator par excellence. His broad knowledge of history and of how people behave in practice, if not in theory, made him a master of the art of economics. Contextual economic policy, then, is just another way of expressing the idea of the art of economics.
Later economic thinkers varied in their approach. Ricardo's advocacy of laissez faire was noncontextual, in accordance with his abstract, ahistorical methodology. J. S. Mill and Alfred Marshall returned to the Smithian tradition of judiciously trying to blend theory, history, and contemporary institutions in their analyses and policy conclusions.
Modern economics is moving away from abstract theorizing, and a number of modern economists and political scientists are examining how governments and governmental policies actually work. One unintended result of the work of these modern public-choice theorists may be a renewed interest in contextual economic policy—the art of economics.
Natural Order, Harmony, and Laissez Faire
The economics of Adam Smith and the mercantilists share certain basic elements. Influenced by developments in the physical sciences, the mercantilists and Smith believed that it was possible to discover the laws of the economy by means of hard analysis. Matter-of-fact, cause-and-effect relationships, they believed, could be revealed through scientific investigation. Smith also assumed the same things about human nature as the mercantilists: human beings are rational and calculating and largely driven by economic self-interest.
One difference between Smith's system and that of most mercantilists was his assumption that, for the most part, competitive markets exist, and that within these markets the factors of production move freely to advance their economic advantage. A second difference was the assumption that a natural process at work in the economy can resolve conflicts more effectively than any arrangements devised by human beings. Smith expressed this beneficent working of market forces in the following passage:
As every individual, therefore, endeavours as much as he can to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it. I have never known much good done 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.
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.
The Working of Competitive Markets, Adam Smith Competition
Smith's most significant contribution to economic theory was his analysis of the workings of competitive markets. He was able to specify with greater accuracy than previous writers the mechanism whereby the price resulting from competition would, in the long run, equal the cost of production. In his analysis of price formation and resource allocation, he called short-run prices "market prices" and long-run prices "natural prices." His primary concern was with the formation of long-run natural prices. He saw competition as fundamentally requiring a large number of sellers; a group of resource owners who were knowledgeable about profits, wages, and rents in the economy; and freedom of movement for resources among industries. Given these conditions, the self-interest of resource owners would lead to long-run natural prices that would equalize the rates of profits, wages, and rents among the various sectors of the economy. If, for example, the price of a final good is higher than its long-run natural price, then either profits, wages, or rent in this sector of the economy must be higher than its natural level, and adjustments will take place via the movement of resources until the natural price prevails. With competitive markets and an absence of government regulation, the resulting natural prices bring about an optimum allocation of resources in that consumers receive the goods they want at the lowest possible cost and maximum rates of growth are ensured.
Having established the superiority of competitive markets, Smith easily constructed his case against monopoly and government intervention. He recognized the desire of businessmen to monopolize trade by joining forces, and although he was not able to specify what the monopoly price would be, he recognized that monopolists would extract a higher price by restricting output. Note that Smith's advocacy of laissez faire assumes the existence of competitive markets. Various groups in the economy have parroted Smith's denunciation of government intervention while ignoring his precept that a laissez-faire policy presupposes the existence of competitive markets.
Smith's argument against government intervention in the economy has political, philosophical, and economic bases. He argued that in general any government interference is undesirable, because it infringes'upon the natural rights and liberties of individuals. However, he examined the economic arguments against government intervention much more extensively. He reviewed many of the mercantilist regulations of domestic and foreign trade and showed that they resulted in an allocation of resources that was less desirable than that produced by competitive market forces. Smith believed that many of the mercantilist arguments for government intervention, although purporting to promote the social good, were in fact self-serving. The regulation of domestic and foreign commerce benefited not the nation but the merchant. This was not a purely theoretical argument; it came from Smith's personal observation of how governments actually operate. It was Smith practicing the art of economics, looking at the policy of regulation in the context of the institutions of his time. If governments were different, they could promote the social good; but given the way they are, they inevitably do more harm than good. In this sense, the roots of modern public-choice theory extend back to Adam Smith's perception of how merchants use government to enrich themselves.
Smith's great achievement was his brilliant overview of the workings of markets. Though he did not himself fashion his analytical tools, and despite the difficulties and inaccuracies in his analysis of the formation of relative prices, his accomplishment was immense. He supplemented his broad overview of market processes with descriptive and historical material and produced a work that could be read and understood by the educated people of his time. In this manner he was able to exert an influence on economic policy and lend support to the increasingly favored view that the wealth of England would best be promoted by a government policy of laissez faire.
Smith's advocacy of laissez faire must be qualified, however, for he cited several areas in which he believed government intervention, in the context of the historical, political, and institutional structure of his time, was necessary. For example, although he was generally against the regulation of international trade, he made exceptions for tariffs that protected infant industries. Trade regulation was also necessary when national defense might be weakened by a policy of perfectly free international trade. The government was to provide for the national defense, build and maintain roads and schools, administer justice, and keep vital records. It is most significant that Smith qualified his argument for laissez faire by advocating government provision of goods that have great social benefits but that are not supplied by the private market because supplying them would not be sufficiently profitable. For example, the social benefits of education are very great, but the profits to be realized from the private provision of education are so small that, if the market is left alone, less education will be supplied than is socially desirable. (Much of modern welfare economics deals with externalities, third-party or spillover effects, and how these must be considered if maximum social welfare is to be achieved.) The qualifications of the laissez-faire maxim are an index of Smith's scholarship and intellectual honesty. They did little, however, to diminish the vigor of his laissez-faire creed.
Adam Smith and Capitalism, Capital and the Capitalists
Smith contributed several important concepts concerning the role of capital in the process of producing wealth and in economic development. He pointed out, first, that the present wealth of a nation depends upon capital accumulation, because this is what determines the division of labor and the proportion of the population engaged in productive labor. Second, Smith concluded that capital accumulation also leads to economic development.
In the midst of all the exactions of government, this capital has been silently and gradually accumulated by private frugality and good conduct of individuals, by their universal, continual, and uninterrupted effort to better their own condition. It is this effort, protected by law and allowed by liberty to exert itself in the manner that is most advantageous, which has maintained the progress of England towards opulence and improvement in almost all former times, and which, it is to be hoped, will do so in all future times.
Third, individual self-interest coupled with the accumulation of capital leads to an optimum allocation of capital among the various industries.
Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society, which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society.
One aspect of Smith's view of the role of the capitalist and capital accumulation 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
The Impact of Smith on Policy
Adam Smith's fundamental contribution to economic theory was not a detailed theoretical analysis but a broad overview of the way in which a market economy allocates scarce resources among alternative uses. His major policy conclusion was that the government should follow a policy of laissez faire. The impact of this conclusion on economic policy in the industrialized world, especially in the United States, has been immense. It has become the economic ideology of our society, and we attempt to promote this view in the underdeveloped areas of the world. It is possible that no idea and no single writer have had more influence on the development of our economy and society.