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THE ORIGINS OF CAPITALISM
Adam Smith (1723-1790)
“Father of Capitalism”
Professor at University of Edinburgh
Advocate of free trade: flow of commerce in world market
without government regulation.
Author of “Wealth of Nations” (1776)
A forceful, systematic argument in favor of free
enterprise; intellectual justification for a system of
economic individualism.
Presented the Classical economic view (Laissez-faire
Capitalism).
Laissez‐faire Capitalism
Premise:
Economy would prosper by itself if left alone.
The best way of increasing the wealth of a nation: laissez‐faire approach (through individual decision making with minimal government interference.
Laissez‐faire: “let it happen” “leave alone” “allow them to do”
Government should be reduced to the smallest size and fewest functions possible.
Government has no positive role in helping the general welfare.
The Market Mechanisms
Defined: natural forces which keep the market moving .
Identified:
Law of Supply and Demand
Law of Self‐Interest
Law of Competition
Smith on the Law of Self Interest
Law of Self‐Interest in a Product Market
“Self‐interest is what motivates people to do things. Each individual knows much better than the government what is best for himself. To further his economic self‐interest each person sells his labor or produces goods that people want to buy. No one sells unless he feels he is getting the best (highest) price that he can get. No one buys unless he feels he is paying the lowest price under the circumstances. Therefore, every sale in the marketplace is a transaction in which both people feel they have increased their self‐interest. (If they did not, they would not have bought or sold.) Thus, the sum total of all the millions of sales is that millions of people have benefited. In this way, by each person doing what he thinks is best in the marketplace for his own self‐
interest, the general welfare of all the people in society is improved.”
According to Smith, individuals would naturally want to employ a capital to produce goods or provide services of the “greatest possible value” because “as the value of this produce is great or small, so will likewise be the profits” (profit=price‐cost).
Law of Self‐Interest in a Resource Market
“Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society, which he has in view….[self‐interest, however] leads him to prefer that employment which is most advantageous to the society….It is only for the sake of profit that any man employs a capital in the support of industry”
“The area of labor is also controlled by the market. An employer, to serve his self‐interest, will try to hire as cheaply as possible. A laborer, to serve his self‐interest, will attempt[t to get the highest wages he can. The price arrived at will be subject to the natural law of supply and demand.”
The Invisible Hand Doctrine
According to this doctrine, it is foolish to expect people to base their business dealings with others on benevolence, or the best interests of the other person. Rather, people carry on their business in a way that serves their own best interests. In a system of free and open competition, it is in the producers’ or sellers’ best interest to try to give the buyer what he or she wants on terms that are acceptable to both parties. In this way, by pursuing one’s own best interest, one is guided “as if by an invisible hand” to advance the interests of all society (self interest would inherently promote public interest). There is no need for government to oversee the operation of the economy since people working for their personal gain will achieve the most desired results.
No need for government intervention; people working for personal gain will achieve most desired results.
Smith declares that both profit incentive and income rewards would naturally guide our markets (like an invisible hand).
The sum of self‐interest in individual transactions is the total of the self‐interest of all members of society or the general welfare. The market’s “invisible hand” converts self‐interest to the benefit of the whole society. Law of Competition
Effect on prices (sellers must lower costs).
Both the law of self‐interest and the law of competition resulted in efficiency.
Smith:
“When the marketplace is left uncontrolled to work according to the laws of supply and demand, everyone’s economic freedom is assured since no one individual is in control of events. It is when the government interferes in the market that the economy becomes less efficient, freedom is restricted, and economic growth retarded.”
Because the marketplace reacts immediately to changes in demand and supply (shortages and surpluses), it is extremely efficient; Government can never adapt as fast enough to the millions of changes in the market which take place from day to day.
Society is too complex for rational thought by any person or group, which is what government is. Government can never react fast enough to all those transactions in the marketplace, so it is by nature inefficient, whereas the market is the transactions—it reacts immediately and constantly.
Smith believed the government, an artificial creation, would only impede a natural process; he felt government interference was inefficient and hurt economic growth.
“No regulation of commerce can increase the quantity of industry in any society beyond what it’s capital can maintain. It can only divert a part of it into a direction into which it might not otherwise have gone; and it is by no means certain that this artificial direction is likely to be more advantageous to the society that that into which it would have gone of its own accord. The statesman who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or Senate whatever, and which would nowhere be so dangerous as in the hands of a man, who had folly and presumption enough to fancy [consider] himself fit to exercise it.”
One interpretation of Smith’s ideas (which is contrary to mercantilist philosophy) Through the operation of the market mechanisms, supply creates it’s own demand. The way the market mechanism operates; producers actually create demand by paying for all the factors of production necessary to put a good or service on the market. That means every payment made by a producer is income for someone else. Once that income is obtained, it is spent (essentially becoming new demand).
Since supply creates its own demand, producers who are not encumbered by government rules (laissez faire) act in their own self‐interest to realize profits, and in doing so they stimulate growth.
Conclusion: the production of one good stimulates the creation and consumption of others; this means that economic growth is defined by an economy’s ability to produce (not consume); the more the economy produces, the wealthier it is.
Trade barriers (tariffs) actually result in economic depressions because they prevent the exchange of goods and services with other nations; output must have markets in which to be sold.
When the government prevents producers from accessing these markets, it causes depressions (overproduction cannot harm the economy if the market is free; only government interference with trade keeps goods and services from reaching world markets.
Conclusion: the production of one good stimulates the creation and consumption of others; this means that economic growth is defined by an economy’s ability to produce (not consume); the more the economy produces, the wealthier it is.
Trade barriers (tariffs) actually result in economic depressions because they prevent the exchange of goods and services with other nations; output must have markets in which to be sold.
When the government prevents producers from accessing these markets, it causes depressions (overproduction cannot harm the economy if the market is free; only government interference with trade keeps goods and services from reaching world markets.
The modified free enterprise system