Download Chapter 4

Chapter 4: Adam
Smith
Questions for Review,
Discussion and Research
(pp. 105-06)
1, 2, 4, 7, 9
Overview
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
The publication of the Wealth
of Nations was a watershed
in the development of
Economic Thought
Beginning of the “Classical”
era
Breadth of Smith
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An academic in Edinburgh
with a high degree of
detachment and objectivity
Was a great synthesizer
Great insight into
interdependent relationships
emerging in the
economy
of 1770’s
Sought the same scientific
rigor that Newton
established in Physics

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Just as Newton found order
and harmony in the Physical
world, political economy
could discover the natural
laws governing society
Sought to explain the nature
and causes of economic
growth processes and wealth
of highly developed societies
Breadth of Smith
Cont’d
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Methodology combined deductive
theory with historical description
Arguments were rarely just
theoretical treatise
They were contextual and based
on observations of historical
situations and the institutions of
his era.
Overhead pp. 80
Contextual economic policy is
another way of expressing the
art of economics
Natural Order

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Believed it was possible to
discover the laws of market
economy by means of
rigorous analysis
Scientific investigation could
reveal cause and effect
relationships
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Natural process at work on a
market economy resolves
conflicts more effectively
than human arrangements.
Harmony and public benefits
could proceed from conflict
and self interest
Natural Order Cont’d
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Short-run prices -> “market”
prices
Long-run prices -> “natural”
prices
Government interference is
undesirable because it infringes
on the natural rights and liberties
of individuals
Roots of modern public-choice
theory extend back to Smith’s
perception of how business and
special interest groups use the
public sector to enrich
themselves
Key Role of
Investment

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Investment in real capital
assets is crucial to the
process of economic
development and growth
Capital accumulation is a
prerequisite for
1. The division of labour
2. Proportion of labour force
engaged in productive
labour
3. The level and pace of
economic development
4. Optimal allocation of
capital assets by
capitalists
Key Role of
Investment Cont’d

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It is beneficial to have an
unequal distribution of
income in favour of
capitalists
Wealth is often used to
describe national income
and is dependent on
1. Productivity of labour
specialization

division of labour

Overhead pp. 88
2. Distinction between
productive and
unproductive labour
Overhead pp. 90

International Trade
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Embedded in the analysis are
the dynamic effects over
time of larger markets
Rigorous proof of benefits
from trade requires evidence
that more goods and services
are produced after
international exchanges
occur
Confusion in Early
Theory of Value
Discussions

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No clear definitions
No distinction between
1. Determination of relative
prices
2. Determination of general
price level
3. Measures of social and
individual well being or
welfare

Smith uses two concepts
that become commonplace
in classical writings
Confusion in Early
Theory of Value
Discussions Cont’d
1. Value in Exchange
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The power of a product to
purchase other goods and
services
An objective measure
expressed in market prices
2. Value in Use

Ambiguous concept that has
ethical connotations
Smith’s Confusion in
Explaining Relative
Prices

He presents three (3) separate
theories in his analysis
1. Labour Cost Theory in a Primitive
Economy
 Overhead pp. 96
 Land and capital inputs are
either non-existent or free
 The price of a product is
determined by
I) Labour Hours
II) Ingenuity
III) Skill
IV) Hardship of tasks
Smith’s Confusion in
Explaining Relative Prices
Cont’d
2. Labour Command Theory
3. Cost of Production Theory of
Relative Prices
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Includes the cost of all factor
inputs
In a modern capitalist economy, it
would include
Labour – wages
Capital – “interest” or normal
profit
Land – (economic) rent
Entrepreneurs – (economic)
profit
Smith’s Theory of
Income Distribution
1. Determination of wages
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Identifies many influences
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I) Subsistence theory of
wages
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II) Productivity theory of
wages
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III) Bargaining theory of
wages
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IV) Wage fund theory of
wages
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The latter was an important
concept in classical writings
Recognized that the
production process yielded
outputs long after inputs
are applied in agricultural
sector
Smith’s Theory of
Income Distribution
Cont’d
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Cumulative savings of capitalists
in the form of
I) An inventory of consumption
goods to sustain labour between
the start of the production process
and its completion
II) An inventory of intermediate
inputs and/or capital inputs
Best illustrated in “Corn’ Model
where wheat is both a
consumption and investment good
Smith’s Theory of
Income Distribution
Cont’d
2. Determination of (Normal)
Profit
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Payment to capitalists for
performing the socially useful
function of providing labour
with
I) The necessities of life
II) Materials is used up in the
production process
III) Real capital assets
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Smith predicted that the rate of
profit would fall over time
Welfare and the
General Level of Prices
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Read pp. 101-03 on your
own
Summary

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Smith had insight into the
central ideas and forces that
govern a market economy
Failure to distinguish
between and create
separate theories for:
1.Relative prices
2.General price level
3.Measure changes in
wealth

Smith primarily interested in
questions of economic policy
affecting economic growth
and development
Overhead pp. 104-05