The personal distribution of income depends on the prices and quantities of factors of production sold by individuals. Labor is the only factor of production owned by most households; so a household's income generally depends upon the wage rate and the number of hours worked. The amount of property income received by those households that do own property depends on the quantity of capital and land held by the household and the prices of these factors. Because wages, profits, and rents are prices in an economy, their relative values—along with the quantities of labor, capital, and land that individuals bring to the market—determine the distribution of income. Although distribution of income was not of prime concern to Smith, he did offer several different and sometimes contradictory theories of wages, profits, and rents. We shall confine ourselves to mentioning some aspects of his analysis that anticipate later writers and illustrate both his insights and his misunderstandings.
Adam Smith Wages, Adam Smith Minimum Wage
Smith offered a number of theories to explain wages. In Chapter 8, Book I, he suggested a subsistence theory of wages, a productivity theory, a bargaining theory, a residual claimant theory, and a wages fund theory. Apparently he was not disturbed by the contradictions among these positions, and in other parts of his book he explicitly rejected some of his own propositions. However, two aspects of his discussion of wages deserve further comment.
Smith pointed out that labor is at a disadvantage in the wage-bargaining process. Because there are fewer employers than employees, he said, employers can more easily join together to strengthen their position. Furthermore, the law permits these employer combinations but prohibits employees from forming unions. Parliament has many acts against raising wages, according to Smith, but none against lowering them. Finally, employers have ample resources that make it possible for them to live even if they employ no labor during a strike or lockout. On the other hand, "many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment."18 In these passages Smith weakened his case for the beneficent working of market forces and appears to have recognized that his assumption of perfectly competitive markets is subject to qualifications.
Wages Fund Doctrine
In his discussion of wages, Smith presented his version of the wages fund doctrine, which became an important tool of the classical economists. This doctrine supposes that there is a fixed fund of capital destined to pay wages. Because the production process is time-consuming, previously produced goods that laborers can use for food, clothing, housing, and other things between the start of the process and the final sale are required. This inventory of goods or capital is termed the wages fund, and its source is the saving, or failure to consume, of the capitalists. Given the size of the labor force and the wages fund, the wage rate is determined as wage rate = wages fund/labor force. Smith did not develop all the theoretical and policy implications of this doctrine. We will return in the next chapter to the implications of the wages fund doctrine and its importance in the classical system.
Adam Smith Profit
Surprisingly, Smith's discussion of the nature and source of profits is extremely brief. In general, the classical economists made no serious attempts to explain the nature and source of profits until the 1820s, when they responded to socialist criticism of profit. Smith apparently accepted without question the legitimacy of profits as a payment to the capitalist for performing a socially useful function, namely, to provide labor with the necessities of life and with materials and machinery with which to work during the time-consuming production process. According to Smith, labor permits this deduction of profits from its output because it has no materials to work with and no independent means of support. Here, then, profit is composed of two parts: a pure interest return and a return for risk.
Smith's brief and inadequate treatment of profits opened the door to the exploitation theory of profit advanced by Marx:
The produce of labour constitutes the natural recompence or wages of labour.
In that original state of things, which precedes both the appropriation of land and the accumulation of stock, the whole produce of labour belongs to the labourer. He has neither landlord nor master to share with him."
Thus, in Smith's primitive economy the laborer received the whole of the product, but in his own time labor had to share the product with the capitalist and the landlord. Smith never explained why profits and rents are deducted from the output of labor, and he thereby exposed his system to attack by any reader who is critical of a private property, capitalist economy. Readers who, like Smith, believe in the basic harmony of the system would probably not even notice this omission.
Adam Smith Rent
Smith suggested at least four theories of rent, all of which contradict one another. The origins of rent are variously held to be (1) demands by the landlord, (2) monopoly, (3) differential advantages, and (4) the bounty of nature. Early in Wealth of Nations, rent is regarded as price-determining,20 whereas later Smith anticipated Ricardo and regarded rent as price-determined.Smith was usually very critical of landlords who "love to reap where they never sowed." He sensed the basic conflict between the interests of the landlords and those of the capitalists, which Ricardo expounded in full. This is another example of Smith's realization that the basic harmony in the economy is subject to some areas of discord.
The Rate of Profit over Time
Smith believed that the economic growth of a nation depended on the accumulation of capital. Although he paid little attention to the nature and source of profits, he was extremely interested in changes in the rate of profit over time. He predicted that the rate of profit would fall over time for three reasons:
(1) Competition in the labor market. The accumulation of capital will result in competition among capitalists in the labor market, with the result that wages will rise. Smith concluded that the increased wages would bring about a fall in profits.
(2) Competition in the commodity market. Smith reasoned that as output increased, so would competition among producers, with the consequences that commodity prices would fall and profits decline. This implies the possibility of overproduction for the entire economy, which conflicts with Smith's position that overproduction cannot occur. (3) Competition in the investment market. Smith apparently believed that there were a limited number of investment opportunities and that increased capital accumulation would therefore lead to falling profits. When he examined what historical information was available on the secular trend of interest rates, the data supported his theoretical conclusions. He did note that some of the colonies (e.g., those in North America) were characterized by both high wages and high profits.