Adam Smith contribution to Economics theories and Developments

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Introduction

The classical economist economics or “economics theories” proposition is largely rooted on the work of Adam Smith who is regarded today as the father of economics. Adam Smith contained all his ideas in his “Wealth of Nations”. The most important aspect of this book was a Theory of Economic Development. Adam Smith’s ‘Wealth of Nations’ was scientific not because it contained the absolute truth but because it came as a turning point, the beginning of all that came after, as it was the end of all that came before.

Adam Smith established five fundamental, interrelated, propositions which may be taken to characterise his ‘classical’ theory of economic growth. These are:

  • Natural law of nature supersede government laws and he advocated the philosophy of free and independent action of the individuals.
  • The most fundamental force of productivity growth is increasing division of labour.
  • Increasing division of labour requires increasing scale of production and an increasing scale of market.
  • Increasing division of labour and scale of production leads historically to an increasing percentage of investment in the economy.
  • Technological progress is a product of this increasing division of labour – i.e. it is endogenously and not exogenously determined.

The specificity of this classical theory becomes clearer if contrasted to the alternative views to which it is counter posed.

  • In the classical theory, economic growth is driven by division of labour, not by ‘entrepreneurship’, as in Schumpeter’s growth theory for example.
  • Smith’s view that the percentage of the economy devoted to investment rises historically was followed by others, including Keynes, but such a conclusion was challenged by Friedman and still does not play a central role in many growth theories.
  • In Smith’s analysis technological progress is driven by the consequences of division of labour, rather than technology being an external driving force of productivity – as for example in the analysis of views typically deriving from Solow

The main features Smith theory are discussed under the following headings:

Natural Law and Laissez Faire:

Adam Smith believes that the natural law is more potent in regulating the economy than government law. He believed in the existence of laissez faire economy, an economy which freedom of action brings out the best of an individual which increases society wealth and progress.  To him if every individual member of society is left to peruse his economic activity, he will maximize the output to the best of his ability. He was a staunch free trader and advocated the policy of Laissez-Faire in economic affairs. He opines that statutory law or manmade law can never be perfect and beneficial for the society, that is why Smith respects nature’s law because nature is just and moral. Nature teaches man the lesson of morality and honesty.

He believed that “there is a set of rules or rights of justice and perhaps even of morality in general which are, or may be known by all men by hello either or reason or of a moral sense, and which possesses an authority superior to that of such commands of human sovereigns and such customary legal and moral regulations as may contravene them”. The policy of laissez-faire allows the producers to produce as much they like, earn as much income as they can and save as much they like. Adam Smith believed that it is safe to leave the economy to be propelled, regulated and controlled by invisible hand i.e. the forces of competition motivated by self interest be allowed to play their part in minimizing the volume of savings for development.

Division of labour

Adam Smith unequivocally establishes division of labour as the fundamental lynch pin of productivity growth by stating it as the first sentence of the first chapter of The Wealth of Nations. This asserts simply:

‘The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgement with which it is directed, or applied, seem to have been the effect of the division of labour.’ (Smith, 1776, p. 13)

The whole first three chapters of the Wealth of Nations are devoted to the division of labour. Later, reprising his views after elaboration of further developments, Smith choses to remind his readers ‘perfection of manufacturing industry, it must be remembered, depends altogether upon the division of labour.’ (Smith, 1776, p. 680)

Indeed, Smith formulated his view of division of labour as the driving force of productivity development and economic growth well before writing The Wealth of Nations. In his Lectures on Jurisprudence of the 1760s he noted, in a comparison incorporated wholesale into his magnum opus:

‘In yesterday’s lecture I endeavoured to explain the causes which prompt man to industry and are peculiar to him of all the animals… These wants a solitary savage can supply in some manner, but not in that which is reckoned absolutely necessary in every country where government has been some time established…

‘The unassisted industry of a savage cannot any way procure him those things which are now become necessary to the meanest artist. We may see this… in comparing the way of life of an ordinary day-labourer in England or Holland to that of a savage prince, who has the lives and liberties of a thousand or 10,000 naked savages at his disposal. It appears evident that this man, whom we falsely account to live in a simple and plain manner, is far better supplied than the monarch himself. Every part of his clothing, utensils, and food has been produced by the joint labour of an infinite number of hands, and these again required a vast number to provide them in tools for their respective employments. So that this labourer could not be provided in this simple manner (as we call it) without the concurrence of some 1,000 hands.

‘His life indeed is simple when compared to the luxury and profusion of an European grandee. But perhaps the affluence and luxury of the richest does not so far exceed the plenty and abundance of an industrious farmer as this latter does the unprovided… manner of life of the most respected savage…. In what manner then shall we account for the great share he and the lowest of the people have of the conveniences of life. The division of labour amongst different hands can alone account for this.’ (Smith, Lectures on Jurisprudence, p. 341 – English spelling modernised)

Smith was naturally not the first economist to note division of labour. Aristotle has discussed division of labour before Smith.  However, he was the first to unequivocally identify it as the most fundamental force of economic development and draw out the conclusions which followed from this. Smith therefore noted as a necessary consequence that the more developed, i.e. the more productive, an economy was the more developed division of labour would have to be:

‘The division of labour, however, so far as it can be introduced occasions, in every art, a proportionable increase of the productive powers of labour. The separation of different trades and employments from one another seems to take place in consequence of this advantage. This separation, too, is generally carried furthest in those countries which enjoy the highest degree of industry and improvement.’ (Smith, 1776, p. 15)

Smith drew the consequent conclusion that economic areas, whether sectors or countries, where division of labour could not be or was not pursued would be less productive. Schumpeter as “nobody, either before or after Adam Smith ever thought of putting such a burden upon division of labour. With Adam Smith it is practically the only factor in economic progress”.

Division of labour increases the productivity of labour through specialization of tasks. When a work is sub-divided into various parts and the worker is asked to perform small parts of whole job, his efficiency increases as now he can focus his attention more carefully. Thus, the concept of division of labour means the transference of a complex production process into number of simpler process in order to facilitate the introduction of various methods of production.

Scale of production and market

Given that division of labour is the most fundamental and underlying driving force raising productivity, Smith drew the immediate conclusion that the possibilities of division of labour depend on the scale of the market and scale of production. Chapter 3 of The Wealth of Nations is straightforwardly titled ‘That the division of labour is limited by the extent of the market’. In its first paragraph Smith notes:

‘the extent of this division must always be limited by… the extent of the market. When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour.’ (Smith, 1776, p. 31)

Scale of market is linked to scale of production at numerous levels:

‘There are some sorts of industry, even of the lowest kind, which can be carried on nowhere but in a great town. A porter, for example, can find employment and subsistence in no other place… It is impossible that there should be such a trade as even that of a nailer in the remote and inland parts of the Highlands of Scotland. Such a workman at the rate of a thousand nails a day, and three hundred working days in the year, will make three hundred thousand nails in the year. But in such a situation it would be impossible to dispose of one thousand, that is, of one day’s work in the year. (Smith, 1776, p. 31)

It may be noted from this that Smith has a much wider concept of the advantages of large scale production than the more limited sense in which most frequently the term ‘economies of scale’ is used. The concept ‘economy of scale’ is typically used as relating to a single productive unit, and the cost reductions that may be achieved by large as opposed to small scale production in it. Smith utilises a much wider sense that a large market, and therefore large scale production, makes possible division of labour – which is itself the most powerful force for raising productivity. Therefore, scale of market raises productivity in the entire economy, and not only in a single productive unit.

It may immediately be seen from this that the advantages of foreign trade flow from increased possibility of the division of labour, and not some specific virtue of crossing international borders. While The Wealth of Nations is most famous for its advocacy of free trade between countries, this is a by-product of the fact that the fundamental driving force of economic and productivity growth is division of labour – the significance of international trade is that it makes possible a larger development of the market, not that it crosses national boundaries.

Smith also saw the consequences of what, in modern terminology, would be termed effective demand on productivity as operating through increasing the scale of the market and thereby division of labour:

‘The increase of demand, besides, though in the beginning it may sometimes raise the price of goods, never fails to lower it in the long-run. It encourages production, and thereby increases the competition of the producers, who, in order to undersell one another, have recourse to new divisions of labour and new improvements of art which might never otherwise have been thought of.’ (Smith, 1776, p. 748)

Capital Accumulation:

Smith noted that a country economic growth is functionally related to rate of investment. According to Smith, “any increase in capital stock in a country generally leads to more than proportionate increase in output on account of continually growing division of labour”.

Capital stock consists of:

(а) Goods for the maintenance of productive workers.

(b) Goods for helping the workers in their productive activities.

Adam Smith distinguished between non capital, circulating capital and fixed capital goods. Non capital goods refer to those which are useful directly and immediately to their owner. Fixed capital refers to those goods which are directly used in production processes, without changing hands. Fixed capital consists of all the means of production.

Capital is increased by parsimony and diminished by prodigality and misconduct. The rate of investment was determined by the rate of saving and savings were invested in full. The classical economists also believed in the existence of wage fund. The idea is that wages tend to equal to the amount necessary for the subsistence of labourers.

If the total wages at any time become higher than subsistence level, the labour force will increase, competition for employment will become keener and the wages come down to the subsistence level. Thus, Smith believed that, “under stationary conditions, wage rate falls to the subsistence level, whereas in periods of rapid capital accumulation, they rise above this level. The extent to which they rise depends upon the rate of population growth”. Thus, it can be concluded that wage fund could be raised by increasing the rate of net investment. According to Smith, “investments are made because the capitalist want to earn profits on them. When a country develops and its capital stock expands, the rate of profit declines. The increasing competition among capitalists raises wages and tends to lower profits”. So it is a great difficulty of finding new profitable investment outlets that leads to falling profits.

Regarding the role of interest, Smith postulated a negatively sloped supply curve of capital implying that supply of capital increased in response to decline in interest rate. Smith wrote that with the increase in prosperity, progress and population, the rate of interest falls and as a result, capital is augmented. With the fall in interest rate, the money lenders will lend more to earn more interest for the purpose of maintaining their standard of living at the previous level.

Thus, the quantity of capital for lending will increase with the fall in rate of interest. But when the rate of interest falls considerably, the money lenders are unable to lend more in order to earn more to maintain their standard of living. Under these circumstances, they will themselves start investing and become entrepreneurs. Smith believed that economic progress- involves rise in money as well as real rentals, and a rise in rental share of national income. This is because the interest of land owners is closely related to general interest of the society.

Endogenous theory of innovation

Finally, Smith held that it was division of labour that determined technological development – not that technology was an independent factor, or that division of labour was a result of technology . Thus, in modern terminology, Smith had an endogenous, not an exogenous, theory of technological development. His conclusion on this was emphatic, and covered both proximate and ultimate causes of technological progress. Smith noted:

‘The owner of the stock which employs a great number of labourers, necessarily endeavours, for his own advantage, to make such a proper division and distribution of employment, that they may be enabled to produce the greatest quantity of work possible. For the same reason, he endeavours to supply them with the best machinery which either he or they can think of. What takes place among the labourers in a particular workhouse, takes place, for the same reason, among those of a great society. The greater their number, the more they naturally divide themselves into different classes and subdivisions of employment. More heads are occupied in inventing the most proper machinery for executing the work of each, and it is, therefore, more likely to be invented.’ (Smith, 1776, p. 104)

Smith made explicit that this analysis of the development of technology as being a result of the division of labour applied both to direct invention by users of technology and to more specialised scientific research. Smith related this principle to the training of labour that is the improvement of human capital, as well as technology:

‘The difference of natural talents in different men is, in reality, much less than we are aware of; and the very different genius which appears to distinguish men of different professions, when grown up to maturity, is not upon many occasions so much the cause, as the effect of the division of labour. The difference between the most dissimilar characters, between a philosopher and a common street porter, for example, seems to arise not so much from nature, as from habit, custom, and education…

‘By nature a philosopher is not in genius and disposition half so different from a street porter, as a mastiff is from a greyhound, or a greyhound from a spaniel, or this last from a shepherd’s dog.’ (Smith, 1776, pp. 28-30)

Smith has observed that farmers, producers and businessmen are the important agents of economic growth. It was the free trade, enterprise and competition that led farmers, producers and businessmen to expand the market and which, in turn, made the economic development inter-related. The development of agriculture leads to increase in construction works and commerce. When agricultural surplus arises as a result of economic development, the demand for commercial services and manufactured articles arises. This leads to commercial progress and establishment of manufacturing industries. On the other hand, their development leads to increase in agricultural production when farmers use advanced techniques. Thus, capital accumulation and economic development take place due to the emergence of the farmer, the producer and the businessmen.

 

The competition for employment reduces wages to subsistence level and competition among the businessmen brings profits as low as possible. Once profit falls, it continues to fall. Investment also starts declining and in this way, the end results of capitalist is stationary state.

Level of investment and division of labour

While Smith analysed that the contribution of fixed investment to growth increased with time, it is important to note that he analysed that this was a product of division of labour – i.e. division of labour was the most fundamental and determining element, not rising investment. Modern econometrics, also finds that the growth of intermediate products is greater than that of capital accumulation during economic growth – capital accumulation is the second most rapidly growing element in economic growth, but one remaining behind growth of intermediate products/division of labour. This is in line with Smith’s analysis.

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This order of determination has clear implications against strategies which see increase in the percentage of the economy devoted to investment on the national terrain, without opening of the economy, as the decisive way to achieve growth. This was the strategy pursued, for example, in Stalin’s USSR and in China prior to the 1978 economic reform. It was also attempted in a less extreme form, and using regulated market as opposed to planned economic methods, in a number of developing countries.

It follows from Smith’s analysis of division of labour (economics theories) as the most fundamental force raising productivity that such a strategy of ‘closed economy plus high fixed investment level’ will not succeed – division of labour, including international division of labour, is more fundamental than increasing the level of fixed investment in an economy cut off from large scale, and therefore necessarily international, division of labour.

Conclusion:

It can be concluded that Adam Smith did not propound any specific growth theory. His views relating to economic development are part of general economic principle propounded by him. R. Lekachaman says, “A good deal of Smith’s analysis reads as though written with todays developing countries in mind”. In a very important aspect then this book (Wealth of Nations) was the theory of economic development. Every other theory of growth especially the endogenous growth theories can be related with smith postulation on economic development and growth.

References

Adam S. (1776). An inquiry into the nature and causes of wealth of Nation.

Barro, R. J., & Sala-i-Martin, X. (2004). Economic Growth. Cambridge, Massachusetts, US: MIT Press.

Erumban, A. A., Gouma, R., Los, B., Stehrer, R., Temurshoev, U., Timmer, M., et al. (2010). World Input-Output Database (WIOD): Construction, Challenges and Applications. Paper prepared for Thirty-first General IARIW Conference Sankt Gallen, 2010.

Friedman, M. (1957). A Theory of the Consumption Function. Princeton: Princeton University Press.

Jorgenson, D. W. (2009). ‘Introduction’. In D. W. Jorgenson (Ed.), The Economics of Productivity (pp. ix-xxviii). Cheltenham, UK: Edward Elgar.

 

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