1. Chapter 4: Adam Smith Questions for Review, Discussion and Research (pp. 105-06) 1, 2, 4, 7, 9

2. Overview The publication of the Wealth of Nations was a watershed in the development of Economic Thought Beginning of the “Classical” era

3. Breadth of Smith 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

4. 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

5. Breadth of Smith Cont’d 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

6. Natural Order Believed it was possible to discover the laws of market economy by means of rigorous analysis Scientific investigation could reveal cause and effect relationships

7. 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

8. Natural Order Cont’d 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

9. Key Role of Investment 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

10. 3. The level and pace of economic development 4. Optimal allocation of capital assets by capitalists

11. Key Role of Investment Cont’d 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

12. 1. Productivity of labour specialization division of labour Overhead pp. 88 2. Distinction between productive and unproductive labour Overhead pp. 90

13. International Trade 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

14. Confusion in Early Theory of Value Discussions 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

15. Confusion in Early Theory of Value Discussions Cont’d 1.Value in Exchange 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

16. 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

17. Smith’s Confusion in Explaining Relative Prices Cont’d 2.Labour Command Theory 3.Cost of Production Theory of Relative Prices 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

18. Smith’s Theory of Income Distribution 1.Determination of wages Identifies many influences I) Subsistence theory of wages II) Productivity theory of wages III) Bargaining theory of wages IV) Wage fund theory of wages

19. The latter was an important concept in classical writings Recognized that the production process yielded outputs long after inputs are applied in agricultural sector

20. Smith’s Theory of Income Distribution Cont’d 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

21. Smith’s Theory of Income Distribution Cont’d 2.Determination of (Normal) Profit 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 Smith predicted that the rate of profit would fall over time

22. Welfare and the General Level of Prices Read pp. 101-03 on your own

23. Summary 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

24. Smith primarily interested in questions of economic policy affecting economic growth and development Overhead pp. 104-05