Harmony of interests

Adam Smith and the Wealth of Nations

 

Adam Smith (1723-1790)

 

Adam Smith is frequently called the father of modern economics. His best known work is An Inquiry into the Nature and Causes of the Wealth of Nations, which has been shortened by most people to Wealth of Nations, first published in 1776 (an easy date to remember). It is frequently cited as one of the three most quoted and least read books in modern times. (The other two are Alexis Tocquevilles Democracy in America and the Bible.) As part of your assignment this week Ive asked you to read some Smith so that you can appreciate him as an author (Warning! Reading this can induce drowsiness. Dont do this while operating heavy equipment). His work is amazing because of its breadth. He seems to have considered almost all the aspects of the market system and how it works.

To help you put his work in some context you should know a few things. It was written in England (he was a Scotsman) at the end of the period in European history known as Mercantilism (1500 to 1750 or so). At this time, there was robust growth in what we now call the middle class. Previously there were three classes in medieval society the nobility, the clergy and the peasantry. With the rise of the middle class we have a fairly wealthy group of people that was technically part of the peasantry but clearly much wealthier than most peasants and many of the nobility. (This is the period Jane Austin wrote about.) This new class of people wanted to break away from the restraints of the old social and political system. The market system was coming maturing and the new middle class benefited the most from it. There were many who advocated letting markets work free of government regulation the most famous being the Physiocrats of France who invented the phrase laissez-faire, or let it be. This phrase has become almost synonymous with Smiths position on government intervention. He thought that government should play a very limited role in regulating markets.

 

Harmony of Interest

Without government guiding them would markets meet the essential needs of society?

Smiths answer is very clear, and basically it goes like this:

1. People are self-interested.

2. People naturally trade as a means of getting what they want.

3. In a free markets people will not exchange unless both gain.

4. Self-interest will cause individuals to buy what they want and produce goods that others want.

5. Prices tell buyers and sellers the wants and needs of society.

6. People will unintentionally meet societys needs as they pursue their self-interest without government intervention.

You need to keep in mind that Smith was part of the philosophical movement called Enlightenment. A basic tenant of Enlightenment philosophers was that there were laws that God had set in place when the universe was created (natural laws). They maintained that these laws are knowable by humans and we should strive to understand them. Smith set about trying to understand the natural laws that make economic societies successful.

Smith (who was a Christian) was troubled by the fact that people appear to be selfish, a very un-Christian characteristic. Why would God create selfish people? Smith deduced that this characteristic must somehow serve the society as a whole. We now refer to this as a harmony of interests: when people follow their self-interest they inadvertently fill societys interest. The way that Smith put it is that people, in the act of following their self-interest, end up serving the social interest, as though they were being guided by an invisible hand.

This is a very important idea. Most of us like to think someone should be in charge in order to make sure that societys needs are being served. The mercantilist approach was based just on that kind of argument. Businesses needed to be regulated and monopolies had to be granted, to make sure that nations became prosperous. To just let everyone do his or her own thing seemed to be inviting chaos, mired in greed and selfishness. But Smith argued that the market was self-regulating, led as if by an invisible hand to meet societys needs.

For example, lets say that the members of society would like more wine and less mutton. As people bought more wine and less mutton the price of wine would increase and the price of mutton would decrease. Self-interested wine makers would plant more grapes and hire more workers while self-interested sheep ranchers would breed fewer sheep and put their land into more profitable areas of production. So by allowing individuals to follow their self-interest society ends up with what it wants. There ends up being a Harmony of Interest between individuals and society.

 

According to Smith, this harmony doesnt come about because businesses are concerned about meeting societys needs. Indeed, Smith was no great believer in the nobility of business owners. In fact, he was rather disdainful of their character, referring to them as mean and rapacious. He wrote that when they gathered together the results were always bad for the consumer and thus for society as a whole. The key for him was competition. What would keep the baker from charging too much for that essential loaf of bread? Other bakers. Competition keeps the avarice nature of individuals from exploiting society.

 

Specialization

A second important fact that Smith stressed (in fact he starts his book with this observation) was that specialization is the key to the wealth of nations. When we specialize, Smith argued, we divide up a task into smaller components. As individuals perform these sub-tasks it results in three benefits. First, we dont waste time moving from task to task. Second, repeating one task over and over allows one to gain a great deal of skill in one small area. Finally, as these tasks get smaller (narrower), it is easier to develop a machine that can help do the task faster. Here he cited a now famous observation of how a pin factory works and how it is so much more effective than an individual pin maker.

What should one specialize in? According to Smith we are endowed with small difference that gives us an absolute advantage. In other words we are the lowest cost producer. Late another classical economist (David Ricardo) will expand on this idea, calling it comparative advantage. Most economists still accept the idea of comparative advantage which states that we are all endowed with differences and that if resources specialize in their comparative advantage we will have lower opportunity costs. This is what you discovered in the three person economy. Whether we specialize in our absolute or comparative advantage we increase our total ability to produce.

The drawback of this is that as individuals become more specialized, the more they need to trade with other people to meet their daily needs. Or they become more interdependent. Go back to the island, in order to fish one needs a net. Not all fishermen are good at making nets. Thus, the task of fishing can be divided into fishing and making nets. If someone specializes in making nets they will become very good at it, in fact better than anyone else. If you allow this to happen, your society will catch a lot more fish (wealth). But, while the best net maker is doing his thing and the best fishermen go fishing at the end of the day, that net maker must be able to get some food. Markets really help that net maker do this. In fact, they reward the net maker by giving him more fish than if he fished himself. All of society is better off. Weve got more and better nets, leading to more fish.

All of this is done based on the self interest of the individual. But they need to be free to pursue their interest. Indeed, Smith pointed out that this specialization and capital accumulation (remember a net is capital) would cause the nation to become wealthy. This all can be done without government intervention. Wow, looks like the invisible hand strikes again!

Conclusion

Much of what Smith wrote about is still the core of what economists study. Here, we have only been able to skim over the surface of what he wrote. Those who tend to agree with his conclusions are now known as neoclassical economists. They have some important differences with Smiths analysis, but not with his basic conclusion: markets work best when they are unencumbered with governmental regulation. I think you should be able to see which political party is more likely to agree with his conclusions. Whether you agree with his conclusions or not, you should appreciate the impact of his work. His ideas changed the way that many people view how the world works.

 

 

 

, - (1801 1850 ):

We hold from God the gift which includes all others. This gift is life -- physical, intellectual, and moral life.

But life cannot maintain itself alone. The Creator of life has entrusted us with the responsibility of preserving, developing, and perfecting it. In order that we may accomplish this, He has provided us with a collection of marvelous faculties. And He has put us in the midst of a variety of natural resources. By the application of our faculties to these natural resources we convert them into products, and use them. This process is necessary in order that life may run its appointed course.

Life, faculties, production--in other words, individuality, liberty, property -- this is man. And in spite of the cunning of artful political leaders, these three gifts from God precede all human legislation, and are superior to it.

Life, liberty, and property do not exist because men have made laws. On the contrary, it was the fact that life, liberty, and property existed beforehand that caused men to make laws in the first place.

Frédéric Bastiat, The Law