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Adam Smith (1723-1790)

Adam Smith is probably the single-most famous economist in history. Interestingly, though, he never received a Ph.D in economics, and wasn't even a professor of economics -- he actually got paid to be a "moral philosopher."

ADAM SMITH WAS A "CHOKE POINT" IN THE HISTORY OF ECONOMICS

· although he "borrowed" extensively from the previous works of others, he was extremely successful at marketing his unified and internally consistent analytical framework. Smith was not the "first" writer to present a whole host of concepts, but was the author who popularized those ideas. [Although Smith was the author of many clever and highly original applications of economic theory.]

· he has been the principal subject of ~2000 books, articles, and notes. He or his works have been mentioned (favorably or unfavorably) in ~50,000 books and articles

· --- Trgve Haavelmo won the 1989 Nobel Prize in economics. Haavelmo was one of the founders of modern econometric, and did pioneering work in the 40s on "regression analysis." In 1988 (the year before his Nobel award) the works of Haavelmo were cited by other economists 15 times. That is a solid performance, qualifying Haavelmo as in the top 1% of the economics profession in terms of influence. But in 1988 -- not a significant anniversary of anything -- Adam Smith's works were cited by economists 122 times -- over 8 times more than Haavelmo. And Adam Smith had been dead for 198 years at the time. [FOR SOME REASON, ADAM SMITH'S CITATION RATE HAS BEEN INCREASING AT A RAPID CLIP IN THE LAST DECADE; IN 1999 IT WAS ~165.]

· One of the major factors in the ongoing professional influence of economists in particular and thinkers in general is Dead Men Tell No Tales. If you are dead, you are no longer around to promote your ideas, and your citation count should fall as a result. Therefore, 122 cites to the work of a dead guy is pretty impressive.

[Of course, Gary Becker blew Adam Smith out of the water in 1999. But I predict that Becker's citation count will fall drastically after he dies.]

This demonstrates that Adam Smith is extremely important in the history of economics. This does not necessarily mean he "deserves" to be important. Lots of modern economists think that Smith has been grossly overrated for writing about things other people actually discovered earlier. We can argue about how original he actually was, or how valid (or invalid) his ideas were. But his enormous influence on economics, even today, is beyond dispute.

During his lifetime, he did not look particularly remarkable.

-- nowadays we think of Smith as the Godfather of Economics. But during most of his lifetime, he was famous not as an economist but as a moralist. He wrote Wealth of Nations in 1776, but was already acclaimed for his Theory of Moral Sentiments (1759).

--- incidentally, there has long been a debate about how Smith could be the author of both WN AND TMS, based on the assessment that the themes of the two books are so radically different. In fact, the books are different, not inconsistent: in WN Smith set out the principles of economics, while in TMS he was concerned with defining the nature of the Good Life for an individual.

Flash back to Bernard Mandeville: In arguing that to have an orderly, productive market you did not need to assume that all market participants were sweethearts, he got a bit carried away. For example, in the Fable of the Bees, at one point Jove (i.e., God) gets sick of all of the rotten, immoral behavior in the Bee-hive, and forces all the bees to be virtuous, frugal, and honest. Mandeville wrote that this destroyed the Bee-hive economy, as trade virtually stopped.

· While this part of his poem is funny, it also implies that dishonesty, fraud, and general ill-motives made the Bee-hive economy more productive. Mandeville ends up arguing that the free market is productive, but inspires rotten behavior. In other words, economic growth tends to be inversely correlated with moral virtue.

Part of the problem is definitional. What do we mean by "vice"? Mandeville does not mean that robbery, theft, and initiated violence increase the rate of economic growth. [In a number of passages of the Fable, Mandeville notes that the Bee-hive economy depends on the security of property rights, so he clearly understood the role for incentives as guarantors of productivity.]

TO ADAM SMITH, CONTRA MANDEVILLE, SELF-INTEREST WAS NOT A "VICE."

· rational, selfish individuals will behave honestly, politely, and industriously because only by such behavior will they maximize their well-being. Bluntly stated, rudeness and dishonesty are bad for an individual's business.

· THEORY OF REPUTATIONAL HUMAN CAPITAL: the perception that an individual is a reliable and honest transactor is a valuable commodity. In the free market, individuals can expect to do well by being Good.

· However, he was probably influenced by Mandeville's account of the market as a "spontaneous order." But Smith focused in on the core proposition, that social coordination did not depend on the interdependency of utility functions.

"IT IS NOT FROM THE BENEVOLENCE OF THE BUTCHER, THE BREWER, OR THE BAKER, THAT WE EXPECT OUR DINNER, BUT FROM THEIR REGARD TO THEIR OWN INTEREST. WE ADDRESS OURSELVES, NOT TO THEIR HUMANITY BUT TO THEIR SELF-LOVE, AND NEVER TALK TO THEM OF OUR OWN NECESSITIES BUT OF THEIR ADVANTAGES." (WN, V.1, P. 18).

The selfish pursuit of profit leads to a variety of good things.

-- Commerce encourages various indirect benefits for society. In other words, greed leads to ethical behavior. In Smith's words, as a consequence of the expansion of commercial exchange:

"a general probity of manners takes place through the whole country. Nobody will be so mad as to expose himself upon the highway, when he can make better bread in an honest and industrious manner" (Early Draft of WN, cited in Cannan, p. xxvi).

These advantages were partly a function of repeat transactions:

-- "politicians are not the most remarkable men in the world for probity and punctuality. Ambassadors from different nations are still less so," the reason being that nations treat with one another much more seldom than merchants (Cannan, p. xxx).

· Smith was not the first writer to suggest that the appropriate role for government in the economy was extremely limited.

· But Smith employed the efficiency of markets as his core theme.

· Also, previous writers had usually tended to view government as if it was a Force of Nature: Government could "correct" market failures, and did so for the Good of Society. Smith argued that government was another organization, populated by ordinary people with individual economic interests like everybody else.

THE DIVISION OF LABOR (WN, Book I, Chapter 1; Cannan, 7-16)

-- Smith was not the first writer to discover the "division of labor":

Xenophon, Mandeville, Tucker, some others, had previously noted the advantages of the division of labor. Smith surely borrowed from earlier writers.

- He was unique, however, it making the Division of Labor the centerpiece of his economic system.

- The very first line of text in WN reads:

"The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgement with which it is any where directed, or applied, seem to have been the effects of the division of labor" (Bk. I, Ch. 1, p. 7).

The Division of Labor is a Fourth Factor of Production: Land, Labor, Time, and Division of Labor (Capital is not an ultimate factor, but a result of combining land, labor, time, and -- to Smith -- the Division of Labor).

- The pin factory: 18 different steps; specialization increases average output per worker 240 times!

- "In every other art and manufacture, the effects of the division of labor are similar to what they are in this very trifling one..."; unfortunately, the costs of employing the division of labor differ across industries (p. 9).

- technology improves a) through the efforts of common workmen, and b) through the specialization of "philosophers". TECHNOLOGICAL CHANGE IS MARKET-DRIVEN.

· In Bk. I, Ch. 2 ("Of the Principle which gives Occasion to the Division of Labour," WN 17-21), he argues that the Division of Labor, not any significant difference in natural talents, accounts for differences in incomes and abilities.

· Smith assumed that all individuals were fundamentally equal in mental endowments, and that variations in economic success were purely the result of different levels of investment of human capital.

ADAM SMITH ON THE DIVISION OF LABOR

The basic idea behind the Division of Labor is simply that the marginal productivity per worker increases with specialization. By implication, this marginal productivity increases at an increasing rate. But this definition does not explain why.

In Bk. I, Ch. 1, Smith attributes the advantages of the Division of Labor to three circumstances (which, incidentally, were the same as those listed in the French Encyclopedie [Diderot] by "Art", published in 1751):

1) improved dexterity of labor when specialized to one particular task [HE DID NOT EMPHASIZE THE ROLE OF MARGINAL OPPORTUNITY COST, BUT RATHER THAT SPECIALIZATION DIRECTLY LED TO IMPROVEMENT IN THE SKILL OF THE WORKER. SMITH DID NOT GRASP THE IDEA OF COMPARATIVE ADVANTAGE AS EXPLAINING THE ADVANTAGES OF SPECIALIZATION];

2) the time saved by specialization, which eliminates the need to spend time shifting from one task to another [THIS IS SURELY NOT GENERALLY TRUE; SMITH HIMSELF, ELSEWHERE IN WN, TALKS ABOUT HOW EXTREME SPECIALIZATION IN JOBS CAN LEAD THE WORKER TO BECOME DULL. SOMETIMES, SHIFTING FROM ONE TASK TO ANOTHER CAN INCREASE TOTAL OUTPUT PER WORKER BY REDUCING BOREDOM]; and

3) the application of machinery (i.e., technology).

Oddly, Smith did not argue that technological advance led to greater gains from specialization that the other two categories. This is "odd" because of the three factors listed, technological development is far-and-away the greatest in its effect on the increase in Division of Labor.

-- Smith did not see technological change as increasing at an increasing rate, which it was clearly beginning to do in the late 18th century.

Nevertheless, Smith recognized that technology ("application of machinery") played a major role in increasing the extent of the Division of Labor. Machinery was not portrayed as productive in itself, but as indirectly productive insofar as it reduced the need for labor, and increased the Division of Labor.

[SMITH DOES NOT SEEM TO HAVE NOTED THAT ADVANCES IN TECHNOLOGY LEAD TO NEW PRODUCTS, AND TO QUALITATIVE IMPROVEMENTS IN NEW DIMENSIONS. YOU CAN ARGUE THAT A COMPUTER IS JUST A DEVICE THAT REPLACES HUNDREDS OF SWEATING ACCOUNTANTS WITH ABACUSES; BUT COMPUTER TECHNOLOGY HAS LED TO SPACEFLIGHT AND MICROSURGERY, NOT JUST INCREASED OUTPUT IN THE PIN FACTORY.]

Smith's account of how technology improved is interesting and unusual.

- technology improves:

a) through the efforts of common workmen, and

b) through the specialization of "philosophers".

-- As workmen become more highly specialized in their tasks, they devote more time and attention to the same machinery, and find more and more ways to get the machinery to work better. Thus, as the Division of Labor increases, machinery gets better through "knowing-by-doing"; and this, in turn, causes the Division of Labor to expand.

-- As particular individuals specialize in developing new and improving old "machines" and production techniques, technology improves and with it the Division of Labor.

He makes a related argument in Chapter iii: The Division of Labor is Limited by the Extent of the Market. As exchange becomes more important, and more complicated, the Division of Labor tends to increase -- and productivity tends to increase. But as the Division of Labor increases, this means that the Market is Extended. Therefore, An increase in the size and complexity of the Market leads to greater Division of Labor -- which causes a further expansion of the Market, and which in turn leads to a greater increase in the Division of Labor. Although this might sound like circular reasoning -- I work to pay for my car, and I need a car so I can drive to work -- Smith is really positing a process of positive feedback, or "mutual determination". Put differently, the Division of Labor begets more Division of Labor. The Division of Labor tends to grow and expand, ceteris paribus. This implies that progress is the long-term trend. - In Ch. 2, he argues that the Division of Labor, not any significant difference in natural talents, accounts for differences in incomes and abilities. [Notice the surprising egalitarianism.]

The difference of natural talents in different men is, in reality, much less than we are aware of; and the very different genius which appears to distinguish men of different professions, when grown up to maturity, is not upon many occasions so much the cause, as the effect of the division of labor. The difference between the most dissimilar characters, between a philosopher and a common street porter, for example, seems to arise not so much from nature, as from habit, custom, and education. When they came into the world, and for the first six or eight years of their existence, they were perhaps, very much alike, and neither their parents nor playfellows could perceive any remarkable difference...

[COMPARE THIS WITH EARLIER MERCANTILIST WRITERS, WHO ALMOST SEEM TO HAVE CONSIDERED THE POOR SUBHUMAN, AND MANDEVILLE, WHO THOUGHT EDUCATION WAS POINTLESS. SMITH WAS ABOUT AS FAR FROM THE STEREOTYPE OF THE REACTIONARY PHILOSOPHER AS YOU CAN GET. EVERYBODY WAS BORN WITH THE ABILITY TO DO ANYTHING -- THAT IS, ANYTHING A HUMAN COULD DO.]

HE CONTINUES:

Among men, on the contrary, the most dissimilar geniuses are of use to one another; the different produces of their respective talents, by the general disposition to truck, barter, and exchange, being brought, as it were, into a common stock, where every man may purchase whatever part of the produce of other men's talents he has occasion for (Bk i, Ch.ii, pp. 19-20).

TRUCK, BARTER, AND EXCHANGE: the division of labor is a byproduct of the propensity of humans to trade with each other. A person makes his or her services more valuable to others by becoming more specialized, by determining what others desire and providing it to them. The butcher, the brewer and the baker specialize and produce quality goods for consumers because they can earn a profit by so doing. According to Smith, humans are the only beings who can cooperate in such a manner. THE UNIQUE MARK OF HUMANITY IS TRADING.

[In fact, Smith probably "undersold" the abilities of animals. Modern behavioral research has shown that many animal species engage in "economizing"; rats have been found to behave according to the basic elements of price theory; and modern biology views the biosphere as a "competitive market."]

Competition (among grocers, or any other suppliers) tends to lead to lower prices, and better quality goods for consumers. The more competitive a given marketplace, the greater the welfare of society, ceteris paribus. BUT "EFFICIENCY" IS NOT GOING TO MAKE EVERYBODY HAPPY, ALL TIME.

A lot of modern writers get this simple point confused. Adam Smith did not. Competition (what he called "rivalry") in WN is acknowledged to not benefit everybody, all the time -- just most people, most of the time.

A number of earlier writers had said that mechanization was terrible for workers because it led to boring, dead-end jobs, but these writers had generally neglected to point out that increasing mechanization also, at the same time, led to huge advantages for society.

ADAM SMITH ON ENDOWMENTS

With Smith, the concept took on a swollen and gigantic importance, putting into the shade such crucial matters as capital accumulation and the growth of technological knowledge. As Schumpeter has pointed out, never for any economist before or since did the division of labor assume such a position of commanding importance.

But there are more troubles in the Smithian division of labor than his exaggerating its importance. The older perception of the motive power for specialization and exchange was simply that each party to an exchange expects to benefit from the exchange; otherwise trade would not take place. Smith, by contrast, shifts the main focus from this "mutual benefit" to an alleged and irrational and innate "propensity to truck, barter, and exchange"; human beings are like lemmings , determined by forces external to their own chosen purposes. today in neoclassical economics that all laborers are equal, and that therefore differences between them can only be the result rather than a cause of the system of the division of labor.

Smith failed to apply his analysis of the division of labor to international trade, where it would have provided powerful support for the free-trade policies he advocated. It remained for James Mill to make such an application in his theory of comparative advantage in 1805. One other odd feature of Smith's treatment of the division of labor [domestically] was that Smith placed overwhelming emphasis on the importance of the Division of labor within a particular factory or industry, while pretty much neglecting the more significant division of labor among industries.

Smith, the ardent defender of the system of natural liberty, paradoxically sowed great problems for the future by introducing the concept of "alienation" in Book V of the WN. A number of scholars have concluded that Smith totally contradicted himself between Bk I, where he argues that the division of labor is the biggest factor in creating economic progress, and Bk V, where he characterizes the division of labor as the source of much misery to the bulk of the working population. In the former, the division of labor alone accounts for the affluence of civilized society [in fact the div. of lab. Is repeatedly equated with 'civilization' throughout the book]. But while in Bk I the div. of labor is hailed as expanding the alertness and intelligence of the general population, in Bk V it is condemned as leading to their intellectual as well as moral degeneration, to the loss of their "intellectual, social and martial virtues".

At several points in WN, Smith's enthusiasm for the Division of Labor is tempered by a concern for its ill effects on some workers:

The man whose whole life is spent in performing a few simple operations, of which the effects are, perhaps, always the same...has no occasion to exert his understanding, of to exercise his invention in finding out expedients for removing difficulties which never occur. He naturally loses, therefore, the habit of such exertion, and generally becomes as stupid and ignorant as it is possible for a human creature to become...unless government takes some pains to prevent it (Bk.V, Ch. i,

pp. 302-303).

[One form of "market failure" noted by Smith was the purported loss of qualities in the population of industrial societies which made for effective soldiering; the advance of the div. of lab. Allegedly reduced the quality of the bulk of the population as soldiers, given that the "alienation" caused by the div. of lab. Reduced the initiative, courage, and general fortitude of citizen soldiers. This was a major reason why smith favored a standing army, a professional military comprised of highly trained professionals who were available day-in, day-out, at a time when many writers supported the concept of a citizen militia (amateur soldiers who were only going to bear arms during wartime); Smith believed that the advance of the div. of lab. reduced the military quality of those who would form the militia, rendering this highly idealized system inefficient .]

However, when read in context, Smith was not contradicting himself, but simply admitting that no change will ever please everybody. The Division of Labor in society does not lead to Utopia, just to an increase in output.

without resources"; and so on Smith was, in part, just pointing out that we have to compare alternative arrangements which are realistic and possible. Increasing the Division of Labor led to a net benefit to society, but there were costs. The benefits outweighed the costs.

Smith places primary emphasis on the role of ordinary individual people, trying to make their own jobs easier, in stimulating the advance of technology. Technological advances are not Lightning Bolts from God, but the result of small, marginal improvements by ordinary people who are trying to make their own jobs just a bit easier.

- In Ch. 2, he argues that the Division of Labor, not any significant difference in natural talents, accounts for differences in incomes and abilities. [Notice the surprising egalitarianism.]

Smith, is clearly asserting that this "equal mental endowment" story is literally true. And while it sounds crazy in today's world, it probably 'fit' the circumstances of the late 18th century fairly well. Mobility was quite low; there were few decent roads, education was very costly, information flow was severely impacted, and the "Poor Law" restricted the movement of labor. The upshot was that a kid born to average parents (who were living on the edge of starvation) had few opportunities to exploit her "genius". Being endowed with a high IQ from birth was not a major advantage, at least not for people of the "lower orders" of society.

The Division of Labor led to a more complex society, in which individuals became more (not less) dependent upon one another: as specialization increases, the economy becomes more intricately interrelated, and more complicated. As specialization grows, the number of relationships in the economy increases. An accidental (meaning unintended) consequence of the expansion of the division of labor was that society became more stable and harmonious, because the returns to peaceful intercourse increased.

Because of the benefits of the increase in the Division of Labor, even the worst-off people in a developed country are much better off than the best-off people in a primitive country:

Compared...with the more extravagant luxury of the great, [the average worker's] accommodation must...appear extremely simple...yet...the accommodation of an European prince does not...exceed that of an industrious and frugal peasant, as the accommodation of the latter exceeds that of many an African king, the absolute master of the lives and liberties of ten thousand naked savages (Bk.i, Ch.i, p. 16).

Note also that Smith claims that inequality of income FALLS as the Division of Labor increases. As the rich get richer, the poor get richer, too, and faster.

Was Smith right? The "Gini coefficient" fluctuates in the short term, but the long-term trend appears to be towards greater income equality (i.e., over time the Gini coefficient falls). When we take into account the rise in democratic institutions, the rule of law, and the vast expansion of the opportunity set available to consumers -- who have, over time, a greater range of choice, even holding income constant -- this increase in equality becomes more pronounced. The political power of the rich falls while the political security of the poor rises, the upshot being that the real income of the "poor" grows faster than that of the rich if we control for the improved political/legal position of society generally. With economic development the King becomes transformed into an elected Prime Minister, who can only fantasize about becoming the "absolute master" of the citizenry; the reality is that that Prime Minister has become the agent of the median voter, and can be turned out of office rather suddenly if he neglects the interests of his principal.

Plagiarism or Just Slovenly Cites?

There is abundant evidence that Adam Smith simply copied earlier works when he discussed the same problems in WN; curiously, smith doesn't seem to have done this very much in writing his TMS. Yet this didn't stop him from frequently accusing others of plagiarizing from his stuff. For example, in 1755 he claimed to be the inventor of the concept of the system of natural liberty (he insisted that he had taught this principle since his Edinburgh lectures in 1749; unfortunately, no class notes from these lectures have survived, so it is impossible to assess this claim). This particular assertion is truly strange, because while Smith probably did invent the term "system of nat. lib.," the basic idea had been written up by a variety of writers {e.g., Grotius and Pufendorf a century earlier, and Boisguilbert and many other French physiocrats in the late 17th century).

Smith repeatedly attacked fellow scholars, not merely economic writers but even thinkers who seemingly had no interest in economics, accusing them of lifting his ideas. For example, in 1769 Smith accused William Robertson of stealing his (Smith's) ideas. What makes this claim so ludicrous is the fact that Robertson supposedly committed plagiarism in a book entitled History of the Reign of Charles V, about as unrelated to WN as you can get.

This all ties in to the div. of labor in the form of Smith's accusation of plagiarism on the part of Adam Ferguson, smith's friend who published a book entitled Essay on the History of Civil Society in 1767.

Smith accused Ferguson of lifting the idea of the div. of lab. from smith's lectures Smith was especially P.O.ed about Ferguson's use of the exact same "pin factory" example that Smith had been using in his lectures for years. Smith bitterly complained, but Ferguson merely replied that he had borrowed not from Smith but that both he and Smith had lifted the "pin factory" illustration from the article on Epingles (pins) in the Encyclopedie of Diderot, published in 1755. [That article mentions 18 distinct operations in manufacturing pins, exactly the same # claimed by Smith; however, in English pin factories the usual # of operations was 25. This pretty much proves that Smith lifted the example from this source.]

What's important about this minor incident is that it demonstrates a curious fact: Adam Smith, the founder of modern economics, seems to have had no inkling about the Industrial Revolution that was happening all around him! Here he is, lifting examples from 30-year old books when the economy was being radically transformed under his very nose. And this had nothing to do with his being cloistered in some dreary closet as he furiously scribbled the WN. He was friends with John Carron, the owner of the Carron Iron Works, the opening of which (in 1760) is often noted by modern economic historians as marking the beginning of the Industrial Revolution in Scotland. Weirder still, Smith was an acquaintance of the great James Watt (the inventor of the reciprocating steam engine and numerous other important technological innovations that played vital roles in the Industrial Revolution) yet made no mention of any of these developments in WN (while finding time to discourse on a bevy of trivial tangents, many of which wandered off into Nowhere. And it gets worse. He made no mention in WN of the canal boom which had begun in the early 1760s, or of the exploding cotton textile industry that dominated the early Industrial revolution in Britain, or of the rapid expansion of the pottery industry or even of the rapid development of new methods of making beer. He talks about many far away lands and peoples (and by his own admission frittered much of his time away while a student at Oxford reading travel brochures) but makes absolutely no reference to the enormous drop in travel costs that the new turnpikes were bringing about.

Smith on "Productive vs. Unproductive Labor"

One of the French Physiocrat's more dubious contributions to economic thought was the view that only agriculture was productive, that only farming contributed a "surplus" (produit net) to the economy. In other words, only agriculture added to economic growth and added to the real wealth of the economy. This is a plain stupid idea, that many of the smarter physiocrats basically ignored. Smith latched onto the idea, or actually a variant of the idea. He expanded the concept of "productive labor" from agriculture to material goods in general . This meant that labor allocated to the production of stuff was "productive", while labor devoted to, say, consumer services or "immaterial" production (e.g., a legal brief) was "unproductive".

This was a goofy idea. However, in Smith's defense, he never advocated that government policy be oriented towards reducing "unproductive" undertakings , and may have had a good idea that was poorly presented.

Smith really shoves his foot into the back of his throat in Bk II of WN. He says that labor on material objects is "productive" while other labor is not because it does not "fix or realize itself in any particular subject? which endures after that labor is past and for which an equal quantity of labor could afterward be purchased". Included in "immaterial" and hence "unproductive" labor are servants, churchmen, lawyers, physicians, men of letters of all kinds; players, buffoons, musicians, opera-singers, opera dancers, etc; the crucial point to Smith was that work done by "unproductive labor" "perishes in the very instant of its employment". Labor invested in the creation of durable capital goods wasn't just dissipated, but hung around in the form of that physical ? stuff.

This strange position is ridiculous; the service sector becomes increasingly important as the economy develops and whether or not output is physical and tangible or non-physical and intangible (read: costly to measure ) is of virtually no interest. But Smith may have been trying (badly) to make a different point. That is, labor effort is either allocated to production for the market, and the creation of wealth, or else devoted to influence peddling in the political arena, where the effort is devoted to affecting the coercive redistribution of privately created wealth. This latter form of activity subtracts value from the wealth stock available to society. In short, resources poured into political lobbying is a social "waste", what Jagdish Bhagwati has called "directly unproductive activities" (or, DUP). Smith was very much aware of the process by which interest groups seek to lobby government , and influence public policy to the benefit of their members. Smith was simply wrong when he characterized maids, butlers, priests, and bankers as "unproductive" in the sense that they do not contribute net value. But when he mentioned "lawyers, men of letters?" and so on, it should be noted that many of those individuals worked for or were chiefly concerned with influencing the policies of the government. The efforts of those guys were DUP, responsible for rent seeking waste.

Smith's classic quote on rent-seeking:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the publick, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary (Bk. I, Ch. X, Pt. II, p. 144).

HE GOES ON TO ARGUE THAT REGULATIONS ARE ACTIVELY SOUGHT BY INTEREST GROUPS WHO WANT TO USE GOVERNMENT FORCE TO PROTECT THEIR MEMBERS FROM COMPETITION.

- Smith endogenized the formulation of economic policy by government.: that is, he explained it as a rational outgrowth of his model of the response by individuals to incentives, and didn't just assume it some kind of external force whose motives were beyond understanding.

· Smith, like modern economists, assumed methodological individualism: the ultimate causative factor in the economy was the choices made by individual agents.

Richard Cantillon

The classical school is distinguished by its focus on the macroeconomic interconnections between different sectors of the economy, such as farmers, landowners and manufacturers. This orientation was derived not from pre-classical economics but from early (that is, pre-Adam Smith) classical writers, foremost among whom was Richard Cantillon (c. 1680-90—1734).

I will now list some of Cantillon’s main contributions.

1. Cantillon was the one who came up with the Land Theory of Value. (A theory of value is an explanation of how prices reach whatever levels they reach. Such a theory is of the utmost importance because your analysis of pretty much any economic issue will very likely depend in the end on the theory of value that you use.)

Before Cantillon, Sir William Petty (1623-1687) had formulated a Land-and-Labor Theory of Value. In all classical theories of value, the short-run price of a commodity fluctuated around its long-run level; sudden changes in demand or supply could make prices diverge from the long-run level. The long-run price itself was equal to the cost of production, which in turn was the cost of the labor, land, capital goods (such as machines) and other raw materials used in production. But, argued Petty, capital goods and raw materials were themselves made out of land and labor and could be regarded as labor and land in disguised form. So the (long-run) price of a good really is the cost of the land and labor used directly in the production of the good and the land and labor used to make the capital goods and raw materials that were used to make the good.

This is as far as Petty got. It was not good enough because he could not explain how the cost of the land and the labor embodied in, say, a shirt was to be measured.

Cantillon solved the problem by going further and arguing that (a) labor is a produced good too; just like any other produced good such as a shirt, and that (b) labor is made out of land. Therefore, in Cantillon’s theory, the labor, the capital goods and the raw materials used in the manufacture of, say, a shirt are really all disguised forms of land alone. The shirt is seen to be made out of just one resource: land. Since the (long-run) price of a shirt is equal to its cost of production, that price can then be measured by the amount of land used in the making of the shirt. This was Cantillon’s Land Theory of Value.

Cantillon’s argument that labor is made out of land relied on a theory of population stated earlier by Giovanni Botero and made famous later by the classical economist Sir Thomas Malthus. To understand this theory, let’s say that, at a minimum, a worker needs 2 tons of wheat a year to survive. According to Botero’s theory, if workers earn less than 2 tons of wheat a year, they will start dying of hunger, workers will become scarce and their wages will rise. On the other hand, if they earn more than 2 tons of wheat a year, they will start multiplying like rabbits, there will be a surplus of workers and wages will fall. So, in the long run workers will earn a wage of precisely 2 tons of wheat a year, not more, not less. (This wage is called the subsistence wage and the theory that workers will earn a subsistence wage, a wage that is barely enough to keep you alive, is called the iron law of wages.) Let’s assume that half an acre of land is needed for a year to make 2 tons of wheat a year. One could then say that the cost of a year’s labor by a worker is half an acre of land. And since the price of any commodity is in the long run equal to its cost of production, the price of a year’s labor by a worker is half an acre of land.

2. Cantillon began the classical school’s efforts at constructing a macroeconomic theory by imagining an economy with two sectors—agriculture and manufacturing—and three social classes—landowners, entrepreneurs and hired workers—and describing how the output of each sector ends up distributed among the three social classes as their consumption and among the two sectors as their raw materials. Cantillon’s analysis amounts to the circular flow of income model that almost every economics textbook of today starts out with. The notion that income equals expenditure or that each person earns what others must have spent is clear in Cantillon’s description. This idea is important in national income accounting.

Also, Cantillon informally argued that the way an economy with many households and businesses would produce the same outcome as an economy run by a benevolent, all-powerful dictator. This idea was further developed by Adam Smith who went on to solidify the idea in our consciousness through his metaphor of the ‘invisible hand’.

3. A monetary theory is supposed to say what would happen if the quantity of money circulating in the economy were to change. In Cantillon’s monetary theory, the purchasing power of money (that is, the value of money) does not change when the quantity of money changes. In Cantillon’s time, money consisted of gold and silver coins. This is called commodity money. Since gold is a commodity like any other commodity, its value, according to Cantillon’s Land Theory of Value, is measured by the amount of land embodied in the production of a unit of gold. As long as the way gold is produced does not change, its value in terms of land cannot change and therefore its purchasing power (measured in terms of the amount of any good that a gold coin can buy) cannot change.

However, all that is true in the long run. Cantillon argued that in the short run, the discovery of gold would lead to increased spending by those who mine the gold. This would create jobs and the economy would grow. But eventually the economy will reach a limit to what it is able to produce. When that point is reached, the increased spending by those who have the newly mined gold will simply drive up prices (remember that Cantillon agreed that while the land theory of value applied to the long run, prices in the short run would fluctuate around the long run level due to changes in supply and demand). This would reduce exports and increase imports. The resulting trade deficit would be accompanied by an outflow of gold to foreign countries. In the long run, the additional gold that was discovered would simply flow out of the country and the value or purchasing power of gold (that is, money) would return to its original level. This result is a version of the price specie-flow mechanism that David Hume (1711-1776) later became famous for.

François Quesnay

Returning to Cantillon’s story of how the circular flow of income worked, note that Cantillon was describing an economy at a specified point in time. In other words, his theory was static. A Frenchman named François Quesnay (1694-1774) gave a dynamic twist to Cantillon’s static theory. Suppose the agriculture sector produces some additional output for whatever reason. This sets in motion a series of effects, each leading to further rounds of output increases. Since the farmers are sharecroppers, a fixed proportion of the additional output goes to their landlords as rent. The landlords will spend part of their rent income on manufactured goods. The manufacturing sector will therefore need additional agricultural raw materials. This will require further production in the agricultural sector. This will mean further rental payments to the landlords. This will mean further purchases of manufactures by the landlords. And so on and on. This way of thinking reappeared in the multiplier analysis of John Maynard Keynes (1883-1946).

Quesnay also contributed to our understanding of the economic incidence of a tax. He argued that the multitude of taxes in France of his time should be replaced by one tax on agricultural income. As it was, all taxes were in the end being paid by the agricultural sector anyway because, according to Quesnay, it was the only sector in the economy that produced a surplus (which is the excess of production over the minimum amount of output needed to maintain the resources used in production). Therefore, the single tax would not change the economic outcome in any way; it would only have the added advantage of making the tax system simpler.

Early Classical Ideas on Paper Money

John Law (1671-1729) was a banker and writer on financial issues who brought about the emergence of paper money in Europe. Law pointed out that if a bank issues a paper note and promises to exchange that piece of paper into a specified amount of gold or silver and as long as that promise can be enforced by the law or otherwise deemed reliable, people would be perfectly happy to use that note as paper money instead of using gold and silver coins.

Law then went further and argued that paper money should not be redeemable into a fixed amount of gold. Sporadic discoveries of new gold mines caused great fluctuations in the availability of gold. These changes in the availability of gold change the purchasing power of gold. So, if each unit of paper money were tied to a specific amount of gold, the purchasing power of paper money would also fluctuate a lot. If paper money was de-linked to gold and properly managed, its purchasing power could be kept more stable than the purchasing power of gold.

So far, so good. But Law went still farther and set up a bank that issued paper money that could be exchanged for a specified value of land. He thought this was an improvement on gold-backed money because the purchasing power of land fluctuated less. But things did not work out that way. His scheme was a dressed up form of inconvertible paper money or fiat money. There was nothing to restrain his bank from printing as much money as it liked. Predictably, too much money was printed. This lead to ruinous inflation, after an initial period of economic growth. This experience taught classical economists that the mercantilist idea that an increase in the quantity of money led to an expansion of output and jobs was true only in the short run; in the long run all that an increase in the quantity of (paper) money does is raise prices.

David Hume (1711-1776) clearly described this main lesson of John Law’s disastrous schemes: in the long run money does not raise output and increase the number of jobs, it only raises prices. The word ‘only’ makes Hume’s statement sharper than the previously well-known idea that in the long run an increase in money raises prices.

Similarly, while the mercantilists knew that an increase in the quantity of money stimulated production and employment, they did not say clearly whether the monetary stimulus applied in the short run or the long run. Hume made it clear that that effect existed only in the short run and was completely absent in the long run.

The problem, however, was that everybody understood that money did make a difference, that a barter economy (that is, an economy without money) was far less efficient than an economy in which people used money. How then could one claim that in the long run the quantity of money did not matter? Hume addressed this issue by likening money to grease that makes a wheel turn smoother: although the application of grease was essential for the proper rotation of the wheel, it did not matter whether a lot of grease was used or a little.

Hume also gave a clear description of the specie flow mechanism. Cantillon had explained this much earlier, but Cantillon’s book was published after Hume had published his analysis.

Pehr Niclas Christiernin (1725-1799) argued that for an economy with inconvertible paper money (or, fiat money), the quantity theory of money was applicable. Cristiernin argued that the overall price level was proportional to the quantity of money in circulation, as long as the velocity of money (a concept discussed earlier by Cantillon) was constant. This was sharper than Hume’s statement that an increase in the quantity of money led to an increase in prices.

Christiernin was also first to make the point that an increase in the quantity of (fiat) money in a country reduced the foreign exchange rate of that country’s currency. This relied on an already well-known idea called purchasing power parity. According to this idea, the exchange rate of the currency of country B in terms of the currency of country A would be equal to the level of prices in country A divided by the level of prices in country B. That is, if prices were high in a particular country its currency would not only buy fewer goods, it would also buy fewer units of other currencies. Christiernin used the quantity theory idea that prices were proportional to the quantity of money and reached the conclusion that the exchange rate of the currency of country B in terms of the currency of country A would be proportional to the quantity of money in country A divided by the quantity of money in country B.

[INSERT DISCUSSION OF PETTY, MANDEVILLE, TUCKER, AND STEUART]

We are now all set to begin our discussion of Adam Smith.

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