Chapter 3€¢ Smith was concerned with the wealth of ALL citizens, ... produce and consume goods...

Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Chapter 3 Adam Smith, Classical Liberalism, and the Division of Labor

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-2

Adam Smith wrote from a holistic perspective

•  Emphasized evolution of the economy, –  Unlike static models which assume that the economy is fixed

in nature •  Smith did see certain aspects of the market system as

fixed –  In a chaotic “market” society, –  Smith saw order, design and purpose –  A competitive market system should always provide the best

possible goods at the lowest possible prices


Karl Polanyi in The Great Transformation

•  Rise of the markets market the subordination of social considerations to the laws of the market – For the first time in human history, peoples’ lives

were governed by their successes (or failures) in markets

– Rather than by social relations


•  Smith is often viewed as a pro-business, pro-capitalist economist. This is a bit of an oversimplification.

•  What is Smith’s actual attitude towards businessmen?

Smith on businessmen


Smith, the Populist

•  Smith was concerned with the wealth of ALL citizens, especially the poor

•  He distrusted merchants and capitalists who asked for special favors –  An efficient system must prevent individual capitalists or

groups of capitalists from dominating the economy –  Greatest evils in the economies of Smith’s era:

•  Monopoly & Government intervention on behalf of monopolists (Mercantilism)


Smith on Economic Policy & Mercantilism

•  Smith believed mercantilist policies interfered with innovation and growth – Especially problematic was the idea that wealth

came from gold •  Which led to a policy to restrain imports with tariffs •  And promote exports with rebates on imported inputs,

subsidies, colonization


Smith on Economic Policy

•  Mercantilists allowed and encouraged monopolies (1 seller) and monopsonies (1 buyer) – Which kept prices high and wages low – Mercantilism was the use of the state on behalf of

powerful business interests


Smith on Economic Policy

•  Smith: LAISSEZ-FAIRE IS PREFERABLE TO A GOVERNMENT RUN ON BEHALF OF BIG BUSINESS – The invisible hand is a better regulator of the

economy than this type of government •  How do you think Smith would feel about our

current government?


Wealth comes from productivity, not money

•  Spain’s mercantilist system generated much gold during the 16th & 17th centuries – But eventually Spain didn't produce much, simply

imported goods from abroad – When the gold ran out, they had little domestic

industry •  Smith: True wealth comes from the ability to

produce and consume goods and services – Gold cannot always buy what you want – Smith: Laissez-faire capitalism generates the greatest

growth in productivity & wealth


How to eliminate poverty

•  Smith’s major goal was to figure out how to eliminate working class poverty – His goal was to create a society that is so

productive that there is enough for the •  “slothful and oppressive profusion of the great, and at

the same time abundantly to supply the wants of the artisan, the laborer, and the peasant.”

– Here, Smith is quite critical of the upper classes


How to eliminate poverty

•  To achieve prosperity for all, a country must have economic growth – Which capitalism does generate – But also must have less inequality, and an increase

in the quality of life for the poor. – Smith believed that competition within capitalism

would limit the incomes of the rich •  And increase the wellbeing of the poor


•  What key factors and institutions did Smith think would keep an unregulated, capitalist economy working efficiently and growing? – I.e., What institutions and conditions are

required to make the invisible hand work?

Institutions necessary for competitive capitalism


Laws of the market

•  Self-interest ends up benefiting society: •  Firms are self-interested and they want to

make money by producing goods – To do this they have to please consumers

•  Insures that society will get what it wants/needs and that it will grow


Why did Smith put significant emphasis on the specialization of labor?


Economic growth is product of increase in productivity of labor

•  Labor productivity comes chiefly from the division of labor –  Division of labor into separate jobs results in

specialization –  As the market expanded, firms got bigger and

bigger and invested more and more, •  As the scale of operations increased, jobs became much

more specialized


Economic growth is product of increase in productivity of labor

•  Specialization increases productivity because 1. Workman get better at their job by specializing 2. Less time is spent moving from one job to another 3. Specialization leads to the invention of machines

that facilitate & replace labor •  Inventions, improvements in technology are crucial to

growth and development


The Assembly Line

•  Assembly line is incredibly productive –  First car was built by 2 people, who built all

different parts –  Workers were not very good at any one job

•  Now there is a different plant for engines, for the frame, for tires, etc. –  Resulting in major productivity improvements


Downside of the specialization of labor

•  Very boring work, leading to alienation •  Splits society into two classes: capitalist and

worker –  Independent artisans are replaced by larger firms


Benefits of Trade

•  Greater surplus produced because of higher productivity led to more trade (exchange)

–  More surplus to trade –  Workers must now make purchases in order to

survive since they don’t produce food


With the Expansion of Markets

•  Production could occur on an even larger scale

–  Allowing even more specialization

•  Extent of the market thus contributes to the process of specialization & invention


The Role of Competition in Smith

•  COMPETITION insures that firms will produce high quality goods at the lowest possible price, – Firms strive to supplant each other by slashing

prices, improving quality •  Suppliers do not passively adjust to changes in price, as

implied by the supply and demand model

– Consumers benefit from self-interest and competition because prices are kept low and quality high


The Role of Competition in Smith

•  Entrepreneurs engage in risky innovations – New machines, greater division of labor

•  Which lowers costs and increases output •  Thereby generating economic growth

•  Strive to innovate to get ahead of competition – But to innovate, must have funds to invest � must

accumulate capital – Must take profits out of the produce of labor to

accumulate capital


Innovation is a 4 step process

1. Capital accumulation, 2. Expenditure of capital on inventions, 3. Installation of inventions, 4. Start-up of inventions. •  Greater innovation � greater scale, greater

productivity (and lower costs), and greater profits.


Regulation of Incomes

•  New entrepreneurs will IMITATE the technologies, –  Enter the market to take advantage of above-normal profits

•  (Smith assumed markets would be easy to enter) –  This increases market supply, decreases market price,

eliminates excess profits •  (Profits fall back to a normal, sustainable level)

–  Growth increases the demand for labor so laborers benefit •  Competition plus imitation limit the incomes of

entrepreneurs, –  And raise the incomes of the poor


Regulation of Incomes

•  Endless cycle of innovation and short term profits, imitation, and return to normal profits – Constant improvements in the standard of living as a

result, •  Workers are the main beneficiary of innovations

– Prices tend towards the minimum price that allows firms to make an ordinary rate of profit

•  Which results in a nearly EQUAL DISTRIBUTION OF INCOME – This aspect of Smith is conveniently ignored by

many of those who quote him


The Invisible Hand

•  Free market is self-regulating – Consumers get the quantities they want at the

lowest possible price – Competition even regulates incomes:

•  If any one person makes too much money, new competitors will enter the market and drive down prices, eliminating excess profits

– Competition further insures that resources are allocated to their most productive use


Moral Sentiments

•  Smith thought that the existence of morality was also crucial in making the market system work – MORAL SENTIMENTS prevent people with

power from ruthlessly exploiting others


What (if any) role did Smith see the government playing in the economy?


Smith did believe some govt. was necessary (limited laissez-faire).

1.  Maintain order and defense 2.  Protect every member of society from injustice and

oppression, establish a system of justice 3.  Provide public goods, including roads, harbors,

education which all contribute to commerce. –  Smith wanted much greater investment in human capital.

•  Without such govt. efforts, Smith feared most people would be poor and would have mindless jobs.

•  Education should lead to more innovations, possibly by workers themselves, and increase productivity


Rise of Laissez-Faire after Smith

•  Say and others argued that unregulated markets will generate the most economic growth – Everyone will be better off, and – The economy will always function smoothly


Say’s Law: Supply creates its own demand (Circular Flow)

•  Producing goods generates the income which is used to purchase what is produced; –  The economy can never experience GLUTS for a long

period.

•  But the economy had regular gluts (recessions) where not everything was purchased –  (insufficient demand) –  And the poor did not benefit from capitalism as Smith said

they would •  There wasn’t enough work, working conditions were abominable,

wages were very low


FIGURE 3.1 The Flow of Economic Activity


Karl Marx on Capitalism

•  The laws of capitalism prevent it form working on behalf of workers

Chapter 3€¢ Smith was concerned with the wealth of ALL citizens, ... produce and consume goods...

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