Adam Smith (1723 1790)

Adam Smith was born in Kirkcaldy,

Scotland in 1723.
He was educated at the Universities of
Glasgow and Oxford and was a professor
at Glasgow from 1751 to 1764.
He is known for publishing two major
works The Theory of Moral Sentiments
(1759), a philosophical book, and more
famously An Inquiry into the Nature and
Causes of the Wealth of Nations (1776)
usually referred to simply as The Wealth
of Nations.
 Smith was one of the first economic
thinkers to develop a complete and
relatively consistent abstract model
of the nature, structure and workings
of the capitalist system. He is widely
regarded as being the founder of
modern economics.
Smith recognised interconnections
between social classes, various
sectors of production, wealth and
income distributions, commerce, the
circulation of money, price formation
 It is important to appreciate the
social and economic context of
Smiths writings.
Smith lived during a period when the
industrial revolution was taking root
in England and Scotland.
The main industries of the industrial
revolution were textiles and iron.
Indeed the wool industry of Britain
obtained a ban on the import of
Indian made calico (cotton) thereby
securing a monopoly for itself in the
home market.
 The industrial revolution was also
characterised by the development of a lot
of early technologies mainly based on
steam power.
During the time, growth in manufacturing
was remarkably high. It was accompanied
by the rise of major manufacturing cities,
notably Manchester and Glasgow.
In manufactories, the precursors of the
modern factory, the capitalist owned the
building, equipment and raw material and
hired wage labourers to do the work.
 Smith distinguished between profits
that accrued to industrial capital and
wages, rents and profits on merchant
capital.
He was also the first to recognise
that the three important functional
categories of income profits, rents
and wages, corresponded to the
three important social classes in the
capitalist system capitalists,
landlords and labourers (who had to
sell their labour power for a wage).
 Smith developed historical and
sociological theories which he used
to explain the evolution of the
capitalist form of class society and
the power relations between the
classes.
A persistent theme in Smiths
theories is that even though
individuals and indeed classes acted
in their own self interest, which
might even lead to individual or class
conflict, an invisible hand guided
these seemingly contradictory
 This invisible hand derived from the laws
of nature or divine providence and not
from the actions of human beings.
Smith believed that the way humans
produced and distributed the material
necessities of life was the most important
determinant of any societys social
institutions as well as of the personal and
class relationships among its members.
Smith identified four distinct stages of
economic and social development
hunting, pasturage, agriculture and
commerce.
 Hunting was the lowest state of society. In
such societies, poverty and the precariousness
of existence prevented the emergence of
institutionalised forms of power and privilege.
The next higher stage was that of pasturage.
Production was based on the domestication of
animals, while herding required a nomadic
existence. In pastoral societies the first form of
wealth that could be accumulated emerged,
namely cattle.
Ownership of cattle became the first form of
property relationship leading to the
establishment of institutionalised protection of
privilege and power.
 Agriculture, the third social state, was seen in
the medieval, feudal economy of western
Europe. Societies permanently settled in one
area and agriculture became the most
important economic activity.
Ownership of land thus became the most
significant property relationship and it acted to
differentiate classes according to their
privileges and power.
Ownership of large tracts of land gave social
and political power, leading to a class of rulers
who formed the nobility, deemed superior to the
ruled. However, the nobility were limited in the
ways in which they could use their wealth.
 In the absence of foreign trade or
manufacturing, a large landowner could
only use his surplus wealth to maintain
large numbers of staff or retainers who
owed their absolute loyalty to the
landlord.
The fourth stage of development,
commerce, came about as a result of the
rise of European cities.
Within the cities producers enjoyed
greater freedom relative to other stages
of economic development.
 Accompanying this freedom was a wider
extension the rights of property which
permitted producers to create wealth for
themselves rather than for an overlord.
Differing conditions of property ownership
formed the basis of major class divisions.
The division of the produce of labour
between wages and profits was
determined by the struggle between
labourers and capitalist over what the
wage rate would be.
The struggle was, however, unequal.
 Smiths value theory
While Smith never presented a
consistent theory of value, his ideas
formed the basis of more
sophisticated labour theories of value
provided by Ricardo and Marx.
Smiths insight was to recognise that
in all societies the process of
production can be reduced to a
series of human endeavours or
exertions.
 Over time, humans increased their
productivity by producing new tools.
Tools are used to produce other
products and are themselves
produced by humans. On their own
tools do nothing. All products are, in
the end, a manifestation of human
labour.
In contemporary economic thought,
tools are classified as capital
which, in conjunction with labour,
contribute to the production of
 Thus, in Smiths view, the necessary
prerequisite for any commodity to have value
was that it be the product of human labour.
The exchange value of a commodity is also
determined by the amount of labour
embodied in it and the relative allocation at
different points in time of indirect labour, i.e.
the labour embodied in tools or other means
of production.
However, Smith saw labour as the
determinant of exchange value only in pre-
capitalist economies, where there were
neither capitalists nor landlords.
 Once capitalists gained control over
the means of production and
landlords gained control over land
and natural resources, Smith
believed that exchange value or
price came to be a sum of three
components: wages, profits and
rents. Profits and rents must be
added to wages in order to
determine prices. Hence, Smiths
theory is sometimes called an
adding up theory.
 In contrast to pre-capitalist
economies, the profit component did
not necessarily have any relationship
to the labour embodied in the
commodity. Competition would tend
to equalise profits earned on capitals
of the same value.
In other words, if a capitalist received
(say) $30 profit on $100 worth of
owned capital, competition would
tend to lead to a situation in which
$100 of any other kind of capital
would also generate $30 worth of
 Under this principle, prices would only remain
proportional to the amounts of labour
contained in a commodity if the value of
capital per worker was the same in different
lines of production.
However, if this value was different in different
lines of production the proportionality would
not hold. Smith accepted this, or at least was
unable to incorporate it in a labour theory of
value that would hold more generally.
Later, Ricardo and Marx showed that the
relationship between embodied labour and
exchange value was much more general.
 Smith also distinguished between natural
price and market price.
The natural price was the price which just
covered the landlords, capitalists and
workers rent, profit and wages. Market price
fluctuated around natural price.
There were two major weaknesses in
Smiths theory of prices.
First, wages, profits and rents were
themselves either prices or derived from
prices. So, a theory which tries to explain
prices in general cannot be derived from
other prices.
 Smith also rejected the utility theory
of value (or use value) as the
foundation of a theory of price.
The second weakness of Smiths
cost-of-production theory of prices
was that it led to conclusions about
the general level of prices rather
than the relative value of different
commodities.
Smiths theory of economic
welfare
Smiths economic theory was normative, or
policy-oriented in nature. He was concerned
mainly with how to increase human welfare.
In Smiths view of history, laissez-faire
capitalism represented the highest stage of
civilisation.
The forces of supply and demand would
regulate all aspects of the economy without
any form of government restriction or
intervention.
 Smith rejected the ideas of the
mercantilists and the physiocrats.
He called laissez-faire capitalism the
obvious and simple system of natural
liberty the best possible economic
system.
Any form of government intervention would
prevent capital from being directed to its
most productive use.
Government can only have three broad
functions national defence, law and order,
provision of public goods and services.
 Smith naturally held that the obvious and
simple system of natural liberty would lead
to an economic system in which harmony
prevailed.
He admitted the possibility of selfish motive
but the invisible hand would, in the long run,
resolve all apparent conflicts.
However, there is an apparent contradiction
between Smiths vision of a conflict free
society and his labour theory of value, which
proponents argue would inevitably lead to
class conflict, which is also fundamental in
understanding capitalism.
 Smiths intellectual influence can be
seen in the two rival traditions which
form a major part of contemporary
economic thinking one that
emphasises the labour theory of
value and the other which
emphasises the utility theory of
value, social ahrmony and the
invisible hand.