Adam Smith - History of Economic Thought - Lecture Slides, Slides of Economics

Download Adam Smith - History of Economic Thought - Lecture Slides and more Slides Economics in PDF only on Docsity! Adam Smith (1723–1790) docsity.com Chief contributions • Built a coherent and logical theory of how the economy works • The elements of Smith's theory were mostly already available in the writings of earlier writers. • However, in those earlier writings, good ideas coexisted alongside numerous other bad ideas • Somebody had to figure out which theories were useful and which were useless and combine the useful theories into a consistent and persuasive overall theory that could be used reliably to think about society. • This is what Smith did. For this he is called the father of economics. docsity.com Passions, bias, moral rules • Sometimes our passions cause us to do bad things. • We have an instinctive tendency to defend ourselves even when we know that we did something bad. • This leads to a bias that prevents us from seeing that we did something bad. • This problem is partially corrected by the wide acceptance of moral rules in a society. • When the moral rules are clear cut, a misdeed may so clearly violate a moral rule that it might be impossible even for the perpetrator to deny the misdeed, bias notwithstanding. docsity.com Laws • At times, even moral rules may not be enough to keep society together • In that case, laws and the enforcement of those laws would be necessary to keep society together. • However, unlike Hobbes and Rousseau, Smith did not believe that, in the absence of a structure of laws, society would inevitably descend to chaos. docsity.com Peace = Prosperity • Moreover, apart from the human ability to empathize with the sorrows of others, the sheer practicality of peace—the fact that we realize that peace is necessary for prosperity—may be enough to encourage good behavior. docsity.com Division of labor, extent of the market, economic progress • The division of labor is determined by the extent of the market. • This creates the possibility of an ever-expanding economy. – For example, if the extent of the market increases—perhaps because of an expansion of trade within the country or with another country—there will be greater division of labor, which will lead to improvements in the level of technology, which will lead to greater national income, which will lead to another increase in the extent of the market, which will lead to another increase in the division of labor, which will lead to another increase in the level of technology, and so on and on. • However, Adam Smith felt that a scenario in which this growth gradually peters out (with each round of increases being smaller than those of the preceding round) was more likely. docsity.com Division of labor and capital • Division of labor is enabled by capital • In a backward, agricultural economy, people produce, on a regular basis, the simple things they need • When workers specialize in the production of more complex goods, production may take time • The worker can be sustained during the lengthy production period only when capitalists can make loans • In this way, the accumulation of additional capital enables additional division of labor docsity.com Luxury spending not crucial • Earlier writers had argued that the growth of an economy depended heavily on the luxury spending by the rich; the poor consumed just the bare necessities and, therefore, more would not be produced unless the rich would buy the extra output. • Smith argued that this idea was false. – If the rich saved any money they would lend it to businessmen (to earn interest). – The businessmen would borrow the money and spend it on capital equipment. – Therefore, all income would be spent and all production would be purchased. – There was no need to encourage luxury spending. – In fact, the more the rich saved the greater would be the level of investment by businesses and the faster would be the rate of growth. docsity.com Theory of value • Smith used different theories of value at different points in the Wealth of Nations • His discussion is at times contradictory docsity.com Theory of value: labor • For primitive economies sustained by hunting and fishing, Smith adopted the Labor Theory of Value – This was adopted by Classical economists such as Smith, Malthus and Ricardo. – “If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.” – This theory was meant to apply to economies that did not use capital goods and all land used in production was free – But even in such a case, there is no standard unit of labor. The hardship and ingenuity involved can vary from task to task docsity.com Theory of value: unit cost • When analyzing the industrialized economy of the Great Britain of his time, Smith thought of the ‘natural price’ (or, long run price) of a product as the cost of all resources used in production • Cost includes wages (payment for labor), rent (for land), and profit (for the capital of the entrepreneur). • Note: price = unit cost does not mean profits = zero; it only means supernormal profits = zero. • Profit is what the entrepreneur gets for risk-taking • As workers need to be paid even if the output is not ready for sale, the entrepreneur is essentially a money lender to the workers. Therefore, profit also includes what we call interest today • From today's point of view the classical theory of value, which denies the influence of demand and identifies production cost as the only influence on prices, has some validity in the long run but is not useful for short run analysis. docsity.com Wages: bargaining • The wage rate depends on the bargaining power of workers and businesses • Employers can collude with greater ease because employees are numerous • In Great Britain at Smith’s time, employers’ collusion was allowed but unions were not. There were laws against raising wages, but none against lowering them • Employers have more wealth to survive a strike; workers have few savings to tide them over • It is clear that Smith had a very complex view of the nature of a market economy docsity.com Profits • “In that original state of things, which precedes both the appropriation of land and the accumulation of stock [i.e., capital], the whole produce of labour belongs to the labourer. He has neither landlord nor master to share with him.” • But in an industrial society, the worker needs equipment (which he can’t afford to buy) and he needs wages to survive during the possibly lengthy production period • The capitalist provides these out of his own savings and extracts payment for these services • This is Smith’s explanation for the emergence of profits docsity.com Rent • Smith had multiple theories of rent, some of them contradictory • Smith thought of rent as a residual that is leftover after wages and profits had been paid out of total output. • Wages would be reduced to the subsistence level, as we saw before. • Competition would gradually reduce the rate of profit to a low level that would also be uniform across all industries. • Therefore, only those who earn rent income would benefit from progress. docsity.com The Invisible Hand • “*E+very individual … generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. … 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. …” docsity.com The Invisible Hand • “…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 the 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 …” docsity.com The Invisible Hand • Consumer sovereignty and business competition are the key components of Smith’s argument that the pursuit of individual self interest leads to an excellent social outcome • Consumer sovereignty ensures that consumer needs determine what gets produced • Business competition ensures that prices are driven down to unit cost • Thus, without any government control, the most beneficial goods get produced, and at the lowest possible price docsity.com Role of government • As one might expect from Smith’s conviction that markets were extremely efficient, he was in favor of a government that did not hamper the working of the market. • However, Smith emphasized the fact that the government should – maintain law and order, – ensure the defense of the nation from foreign enemies, – erect and maintain public works that private citizens would not build, – Subsidize education for those who could not afford it, and – Regulate international trade when free trade endangers ‘infant industries’ or compromises national security docsity.com E 9 ° > = Q 6 ° Ss