The Wealth of Nations: An Introduction to Adam Smith

The Only Resource You’ll Ever Need

As every individual, therefore, endeavours as much as he can both 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… 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… 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. — Adam Smith, The Wealth of Nations, Chapter II

The great Adam Smith, father of modern economics, Scottish moral philosopher and pioneer of political economy, is one of the key figures of the Scottish Enlightenment. The Wealth of Nations is considered the first modern work of economics.

Smith explained how rational self-interest and competition can lead to economic prosperity. His ideas were considered controversial at the time, but today Smith is still among the most influential thinkers of his field. It is said that UK Prime Minister Margaret Thatcher used to carry a copy of the book in her handbag.

This resource is written to give you a foundation of Adam Smith’s The Wealth of Nations. It is very comprehensive, but does not answer all questions.

Newton of Economics

The conventional wisdom dictated that wealth consisted in money, particularlly gold and silver. Adam Smith, however, recognized that wealth was the “annual produce of land and labor of the society,” which ran counter to the prevailing wisdom of the time. He recognized, too, that the free market was superior to one in which trade was protected. And he believed that government can actually make people worse off.

Specialization and Productivity

Division of labor and specialization is what makes the process of production more efficient. Not only for individuals, but also for countries. What explains the enormous rise?

1. Rapidity and increased productivity thereof. Skilled workers can do a task much faster if they only focus on one task.
2. Less time wasted moving from one task to another. There are fewer disruptions.
3. Tools and Machinery save time. Through inventions by the workers and improvements made possible by R&D.

“The greatest improvement in the productive power of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seems to have been the effects of the division of labour.” — Adam Smith, The Wealth of Nations, Book I, Chapter I, p. 13, par. 1.

The Pin Factory

Through collaboration of thousands of highly efficient specialists the foundation is laid for an advanced economic system, which as a result increases the wealth of a nation. Fortunately, this process decreases prizes of goods and makes them affordable even for poor people.

Mutual Exchange of Goods

Since people will not give us things, which we desire, for nothing in return, specialization arises out of the mutual desire to trade. Self-interest, therefore, does not equal greed or selfishness. All of a sudden it makes sense to build a surplus of a good that we do not personally require. Trade stems not out of benevolence but of benefit.

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. — Adam Smith, The Wealth of Nations, Book I, Chapter II, p. 26–7, par. 12.

At the same time the extent to which we can benefit depends on the scope of the market. Specializing our trade and producing a surplus benefits us only so long as we have a market we can trade in.

For example, a man in the city of London will have more opportunity than a man in the Highlands of Scotland, who will need to be more self-reliant and produce everything for himself.

Money and Value

As barter is infeasible we need to introduce a third means of exchange to facilitate trade and that is money.

Smith distinguishes between value in use and value in exchange. Water is value in use as it is extremely useful but has little exchange value. Diamonds are value in exchange as they are largely useless but have enormous exchange value.

Supply and Demand

In a hunting society there is only one means of production. There is no stock and land is free. In a society of land, labor and capital, there are 3 means of production. Where land is taken into private ownership, the landlord will demand rent. Similarly, the capitalist will ask for profits.

Supply and demand governs many things. Markets prices determine profits and market prices, in turn, are determined by supply and demand. When supply falls short of demand, prices go up. When supply exceeds demand, prices go down.

If a market is overstocked and prices are below the cost of production, supply will decrease. Slowly market prices will be bid up again, and vice versa. In rare cases the natural price and market price converge.

Wages

Wages depend on economic growth and they can only rise when the GNP rises. In Great Britain, wages were rising but prices fell due to increased specialization. Smith also argues that it is in the interest of the employer to increase the wages of their employees. They will work more diligently when they don’t worry about food.

Capital and Profits

Interest rates provide a rough measure of profitability. An increase in capital allows more business to take place and generally increases wages. But this also reduces profits. Increased competition between capital reduces rate of return and therefore reduces interest rate. The exception was America, where interest rates and wages were high.

Market Wage Rates

Some jobs are easier, cleaner or more respectable. (i.e. Weaver vs. tailor) Some jobs are more difficult to learn or take up a lot of time. (i.e. skilled labor vs unskilled labor)Some jobs are seasonal and therefore make more money during certain months of the year. Earnings are higher in professions that require trust (such as doctor, or lawyers). Earnings reflect the probability of success in any profession.

Wages and Politics

By restricting entry into certain professions, the government may limit supply, and therefore increase the wages of people in that profession. Smith argues that a competitive market in which the customer is sovereign is better than any official rule which often produces the opposite of its intention.

Self-Interest of the Different Agents

Workers, capitalists and landlords have different interests, but workers have little power to lobby for their interests. Laborers do best when society is booming. The interest of the capitalist are opposed as their profits are squeezed when business is booming. Instead what they want to do is expand the market and limit competition. Smith says that private benefit comes at the expense of the public when markets are distorted and monopolized.

The proposal of any new law or regulation of commerce which comes from this order, ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it” — Adam Smith, The Wealth of Nations, Book I, Chapter XI, Conclusion of the Chapter, p. 267, par. 10.

The Accumulation of Capital

There is a virtuous cycle. The growth of capital promotes specialization. This creates surpluses. And those surpluses can be reinvested into new equipment which makes even more specialization and growth possible

There is also a division of capital: fixed capital and capital that supplies immediate consumption. Again, money is not wealth. Money is a tool of exchange and has no intrinsic value.

Productive vs Unproductive Labor

Productive labor: a manufacturer, who adds value to an item, which can then be sold at a profit.

Unproductive labor (or rather pure consumption): a menial servant does not add value to anything. It is consumed immediately.

A man grows rich by employing a multitude of manufacturers: he grows poor by maintaining a multitude of menial servants. — Adam Smith, The Wealth of Nations, Book II, Chapter III, p. 330, par. 1.

Saving, not spending

Future income depends on the extent of our capital. The more services we consume, the less income and capital are left for the future. The only way to accumulate capital is by saving

If instead of saving, we consume,we eat into our own capital. The prevalent “mercantilist” view said that dis-saving does not matter if spending is done domestically. But Smith says that capital is being consumed anyway. Since future income depends on the accumulation of capital, it must be necessarily lower in the future.

Interest

When there is more capital available, borrowers can offer a lower rate of interest. The growth of capital and its lower cost will boost productive industry, which will result in more hiring and higher wages. Unfortunately profit rates will also decline. However, outlawing lending at interest or government efforts to peg the interest rate below the market rate distort the market.

The Four Uses of Capital

1. Some assets (i.e. fisheries) yield raw produce for immediate consumption or processing.
2. Some (i.e. machinery) are used to prepare raw materials for consumption.
3. Some (i.e. ships) are used to transport raw or manufactured products to market.
4. Some (i.e. retailing) to divide raw or manufactured goods into smaller amounts for consumers. For example, butchers.

The Progress of Economic Growth

The piorities in an agricultural economy are as follows: 1. Land 2. Manufacturers 3. Trade. The inhabitants of towns and country are mutually dependent. North America has grown because its capital has gone into agriculture while its trade has been financed by British merchants

The rise of towns: towns provide large markets for the country. Rich people buy and improve land. Commerce in the town promotes order and good government, which spreads to the country. Townspeople won independence in part to ally with the weak king against the rich landowning baron

In Europe, the fact that land is only sold at monopoly prices makes land use inefficient: cost-effective improvement of land takes the same close attention to detail and to profit as any other business. In North America, there is an open market for land and so more people come to the market making the land productive. Smith argues that slavery limits agricultural efficiency.

Economic Theory and Policy

The Mercantile system: Money = Wealth

Wealth consists in money, i.e. gold or silver. A rich person is someone, who has a lot of money. Under this view hoarding large quantities of gold would be good policy. Example: Spanish America’s quest for gold and silver

The ‘free trade’ system: Money ≠ Wealth

Most wealth is created and consumed domestically so outflows of gold can rarely ruin a country. Wealth does not only reside in money, and money is just a medium of exchange. Gold is durable and serves as a good holder of value, but it has no intrinsic value.

The “Invisible” Hand

The number of people who can be employed is directly proportional with the amount of capital that is available.

Businessmen have a much better idea on where to allocate capital than regulators. This is what Smith refers to as the “invisible hand.”

Trade Restrictions

In the mercantilist view, restricting trade gives domestic producers monopoly of the home market. Also if the domestic product is not cheaper than the foreign product, then regulation is pointless. However, if the foreign product is cheaper, then restricting trade is harmful.

By means of glasses, hotbeds, and hotwalls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expense for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland? — Adam Smith, The Wealth of Nations, Book IV, Chapter II, p. 458, par. 15.

Unjustified vs Justified Barriers

Unjustified barriers

Interest groups can pervert the trade policies of a great country. In any exchange there must not necessarily be a winner and loser. A nation is more likely to grow rich from trade if its neighbor are also rich, commercial, industrious nations.

Justified barriers

Imposing a tax on an imported article if the same article produced domestically is taxed for some reason. (i.e. the Navigation Acts). Retaliatory tariffs might work in some rare cases.

The Role of Government

The government needs to finance defense. Workers due to their specialization are not able to leave their work and fights instead. Also the government needs to protect private property.

The affluence of the rich excites the indignation of the poor, who are often both driven by want, and prompted by envy, to invade his possessions. It is only under the shelter of the civil magistrate that the owner of that valuable property, which is acquired by the labour of many years, or perhaps of many successive generations, can sleep a single night in security. — Adam Smith, The Wealth of Nations, Book V, Chapter I, Part II, p. 710, par. c2.

The government also needs to finance public works. Smith says that public works could never yield a profit in the private industry. (i.e. the education of the young)

But he made a qualification…

The greater part of such public works may easily be so managed, as to afford a particular revenue sufficient for defraying their own expense, without bringing any burden upon the general revenue of the society. — Adam Smith, The Wealth of Nations, Book V, Chapter I, Part III, Article I, p. 724, par. d2.

The Principle of Taxation

1. People ought to contribute in proportion to the income they derive.
2. They ought to be certain and not arbitrary.
3. They ought to be levied at a convenient time.
4. They should not cost more than necessary.

Smith also argued that profits are not a good object of taxation because peple need to be compensated for risk. If one raises taxes on things such as licenses to sell alcohol, the dealers will transfer the cost unto consumer.

The proprietor of stock is properly a citizen of the world, and is not necessarily attached to any particular country. He would be apt to abandon the country in which he was exposed to a vexatious inquisition, in order to be assessed to a burdensome tax, and would remove his stock to some other country where he could either carry on his business, or enjoy his fortune more at his ease. — Adam Smith The Wealth of Nations, Book V, Chapter II, Part II, Article II, p. 848–9. par. f8

Public Debt

When costs of running public services is achieved through running a deficit, capital is consumed. However, sometimes a deficit can be more effective than raising taxes, esp. when financing a war. Transfer of capital from those who “care” about the land and use it productively to creditors who have less interest in maintaining the land or stock of capital. There is no record that once public debt has been run up, that it has fairly been repaid.