Adam Smith

Adam Smith (16 June 1723 N.S. (5 June 1723 O.S.) – 17 July 1790), a Scottish economist, is popularly considered the founder of modern economic science.

Critique of Adam Smith
Some economists have called into question Smith's contributions. According to Rothbard, "Smith not only contributed nothing of value to economic thought; his economics was a grave deterioration from his predecessors" and much knowledge of previous economists was "blotted out". He was "almost solely responsible for the injection into economics of the labour theory of value," which later influenced Marx. Against the standards of his day, Smith acknowledge very few of the authors he quoted from.

Division of labor
For Smith had division of labor crucial and decisive importance.

The older and truer perception of the motive power for specialization and exchange was simply that each party to an exchange (which is necessarily two-party and two-commodity) benefits (or at least expects to benefit) from the exchange; otherwise the trade would not take place. But Smith unfortunately shifted the main focus from mutual benefit to an alleged irrational and innate 'propensity to truck, barter and exchange'. As Edwin Cannan pointed out, Smith did this because he rejected the idea of innate differences in natural talents and abilities, which would naturally seek out different specialized occupations. Smith instead took the egalitarian position, still dominant today in neoclassical economics, that all labourers are equal, and therefore that differences between them can only be the result rather than a cause of the system of the division of labour.

But if Smith had an undue appreciation of the importance of the division of labour, he paradoxically sowed great problems for the future by introducing the chronic modern sociological complaint about 'alienation', picked up quickly by Karl Marx and has been advanced to a high art by socialist gripers. In Book I of the Wealth of Nations, the division of labour alone accounts for the affluence of civilized society, and is repeatedly equated with 'civilization' throughout the book, expanding the alertness and intelligence of the population. In Book V it is condemned as leading to their intellectual as well as moral degeneration, to the loss of their 'intellectual, social and martial virtues'.

Productive vs. unproductive labor
One of the physiocrats' more dubious contributions to economic thought was their view that only agriculture was productive, that only agriculture contributed a surplus, a produit net, to the economy. Smith, heavily influenced by the physiocrats, retained the unfortunate concept of 'productive' labour, but expanded it from agriculture to material goods in general. For Smith, then, labour on material objects was 'productive'; but labour on, say, consumer services, on immaterial production, was 'unproductive'. In Book II of the Wealth of Nations, Smith opines that labour on material objects is productive, while other labour is not because it does not 'fix or realize itself in any particular subject which endures after that labour is past and for which an equal quantity of labour could afterward be purchased'.

The bias in favour of material objects amounted to a bias in favour of investment in capital goods, since a stock of capital goods by definition has to be embodied in material objects. Consumer goods, on the other hand, either consist of immaterial services, or they get used up, consumed in the process of consumption. Smith's imprimatur on material production, therefore, was an indirect way of advocating investment in an accumulation of capital goods as against the very goal of producing capital goods: increased consumption. When discussing exports and imports, Smith realized full well that there was no point to amassing intermediate objects except that they eventually be consumed, that the only goal of production is consumption. However, Adam Smith's Presbyterian conscience led him to value the expenditure of labour per se, for its own sake, and led him to balk at free market time-preferences between consumption and saving. Clearly, Smith wanted far more investment towards future production and less present consumption than the market was willing to choose. One of the contradictions of this position is that accumulating more capital goods at the expense of present consumption will eventually result in a higher standard of living unless Smith prepared to counsel a perpetual and accelerated shift toward more and more never-to-be-consumed means of production.

The lingering physiocratic bias was also shown in the assertion that agriculture is a far more productive industry than manufacturing, because in agriculture nature works alongside man and provides extra rent for landlords as well as profit for capitalists. Smith here failed to realize that nature in the form of ground land collaborates in all activities of man, not just agriculture, and that all activities, including manufacturing, will therefore yield ground rent to landowners.

But if Adam Smith was excessively in favour of capital investment as against consumption, he at least was sound in realizing that capital investment was important in economic development and that the only way to increase capital is by private savings or thrift. Thus, Smith wrote, 'Whoever saves money, as the phrase is, adds proportionately to the general mass of capital…. The world can augment its capital only in one way, by parsimony'. Savings, and not labour, is the cause of accumulation of capital, and such savings promptly 'puts into motion an additional quantity of industry [labour]'. The saver, then, spends as readily as the spendthrift, except that he does so to increase capital and eventually benefit the consumption of all; hence 'every frugal man is a public benefactor'. This was probably inspired by the creative work of Turgot, with his emphasis on time, the structure of production, and time-preference. But at least it was sound, and it stamped its imprint indelibly on classical economics.

The theory of value
Before the Wealth of Nations, economists had always concentrated on the market price, and had seen readily that it was determined by the forces of supply and demand, and hence of subjective utility and scarcity. The more abundant any given good, the lower its value; the scarcer the good, the higher its value.

In his lectures, Smith had solved the value paradox neatly, in much the same way as had Hutcheson and other economists for centuries. Why is water so useful and yet so cheap, while a frippery like diamonds is so expensive? The difference, said Smith in his lectures, was their relative scarcity: 'It is only on account of the plenty of water that it is so cheap as to be got for the lifting, and on account of the scarcity of diamonds… that they are so dear'. With different supply conditions, the value and price of a product would differ drastically. Thus Smith points out in his lectures that a rich merchant lost in the Arabian desert would value water very highly, and so its price would be very high. Similarly, if the quantity of diamonds could be multiplied, the price of diamonds on the market would fall rapidly.

But in the Wealth of Nations, Smith finds himself unable to solve the value paradox and separates utility from value and price, the crucial concept of scarcity is gone:

"The word value... has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called 'value in use': the other, 'value in exchange'. The things which have the greatest value in use have frequently little or no value in exchange; and on contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water; but it will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it."

Smith turned to another concept which for him took on overriding importance: the "natural price", or what might be called the "long-run normal" price. This concept, similar to Cantillon's "intrinsic value" or Hutcheson's "fundamental value", had appeared in Smith's lectures, but occupied a minor role as it did in the work of these other economists. But suddenly, it became more important, more truly "real" than the market price of the real world that had always been the prime focus of economists. Value and price theory shifts from prices in the real world to a mystical non-existent price in the never-never land of longrun equilibrium.

Not that the natural price, or as we now call it the equilibrium price, is nonsense. The equilibrium price is the long-run tendency of the market price. As Adam Smith indeed saw, if the market price is higher than the long-run equilibrium, then extra gains will be made and resources will flow into this particular industry, until the market price falls to reach equilibrium. Conversely, if the market price is lower than equilibrium, the resulting losses will drive resources out of the industry until the price rises to reach equilibrium. The equilibrium concept is highly useful in pointing to the direction in which the market will move. But equilibrium will only be reached in reality if the 'data' of the market are magically frozen: that is, if the values, resources, and technological knowledge on the market continue to remain precisely the same. In that case, equilibrium would be reached after a certain span of time. But since these data are always changing in the real world, equilibrium is never attained.