Structure of the Wealth of Nations Adam Smith's 1776 Inquiry into the Nature and Causes of the Wealth of Nations is divided into five books. Book I, on value and distribution, is doubtless the most important and most famous, Book II is on economic growth. Book III is an economic history of commercial revolution of the Middle Ages, Book IV a scathing exposition of 17th-18th C. Mercantilism and finally Book V a review of government spending and taxation in 18th C. Britain. Those with interest in economic theory usually confine themselves to Books I & II. But those with greater interest in economic history tend to proceed on to the remainder: BOOK I Division of Labor Adam Smith opens his treatise with a discussion of the division of labor. (ch.1). It is here that he gives his famous 'pin-factory' example, and explains how labor productivity (output per hour worked) is improved by dividing the production of a good into a series of smaller, simpler, specialized tasks. This increased productivity from division of labor comes about for three reasons - improved dexterity of workers, time saved by not switching to other tasks and because it allows the application of labor-saving machinery to specialized tasks. Although this detail of industrial technology may seem like a very unusual way of opening a general treatise, Smith quickly extends it as an analogy to society as a whole, explaining how society too is organized by division of labor. Everyone goes about their specialized task - butchers, bakers and candlestick-makers - thereby producing more goods overall. Labor productivity is the key to the 'wealth of nations'. Two countries may have the same sheer volume of resources - labor, land, etc. - but the more specialized society will end up with more goods and a greater standard of living. What allows this division of labor in society is exchange. (ch.2) Exchange permits shoemakers to specialize in making shoes, for they can trade shoes for their other necessities of life. Prevent exchange, and everyone will have to make everything himself, there would be no specialization and labor productivity - and consequently standards of living - will be low. This organization, Smith emphasizes, is spontaneous and not planned, it is driven by self-interest: "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." (p.26-27). As a result, division of labor, Smith famously notes, is "limited by the extent of the market" (ch.3). A shoemaker will not specialize in shoes if the market for shoes - consequently his ability to sell for his other requirements - is small or absent. At the industrial level, this phenomenon is captured by increasing returns to scale - that is, the ability to implement cost-saving technology at only large levels of production. The implementation of such technology is not worth it if the sales volume is low. The sales volume depends on demand which in turn depends on population size and improvements in transportation technology (which allow more markets to be reached). Smith does not really seize the opportunity to discuss the positive feedback of increasing returns. If division of labor improves productivity - and thus incomes - then those greater incomes should expand the 'extent of market' and thus allow more division of labor. Smith is not very explicit about this, and the identification of this feedback loop is due more to later writers commenting on Smith (e.g. Allyn Young, 1928) Smith goes on to explain how money facilitates exchange (ch.4). Bartering one good for another - shoes for meat, say - require a double coincidence of wants, i.e. that the butcher wants shoes and the shoemaker wants meat, a rare coincidence. As a result, societies tend to gravitate towards the use of a particular commodity as a general means of exchange. The gravitations towards precious metal - that is the use of gold, silver, copper, etc. as instruments of exchange - was natural, as the metals have the advantage of storability, divisibility, portability, etc. The adoption of currency was much assisted by the standardization (weights and fineness) enabled by government 'stamping'. Theory of Value (a) Value-in-Use and Value-in-Exchange Smith takes a sudden deviation at the end of ch.4 (p.45) to discuss the difference between 'value-in-use' and 'value-in-exchange'. It is meant to demolish the temptation to confuse usefulness with value. Smith applies the old water-diamond paradox (originally due to Davanzati and Law) to illustrate the difference: water, although immensely useful, has little or no value in exchange, whereas relatively useless diamonds have high value in exchange. So what determines value-in-exchange? Smith turns to that next. (b) Nominal and Real Prices Smith dedicates ch.5 to differentiating between real and nominal price. Intuitively, nominal price is merely the price of a good in terms of money (e.g. a ream of cloth sells for $8), while real price is the price of goods in terms of other goods (e.g. if a ream of cloth sells for $8 and a bushel of grain sells for $2, then the real price of cloth is four bushels of grain foregone to acquire it). But Smith doesn't take this route - at least not immediately. He doesn't express the real price of cloth in terms of grain, a commodity in terms of another commodity, via their monetary exchange values. Rather, he first attempts to normalize real values in terms of labor. Smith quickly confuses himself here by alternating between two definitions. At first, he starts off by saying "The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it." (p.47), implying the labor expended in production is real price. That is, that if a ream of cloth takes 12 labor hours to produce, and a bushel of grain takes 3 labor hours, then the 'real price' of cloth is four bushels of grain. Labor-expended is the normalizing device. There is no reference to dollar price in between. But then he immediately moves on to propose a different definition, that the real value of a good is "the quantity of labour which it can enable them to purchase or command" (p.48). This labor commanded measure brings dollar values back in as an intermediary device. If wages are $2 per hour, then cloth, which sells for $8 per ream, is worth 4 hours of labor commanded, whereas grain, which sells for $2 per bushel, is worth one hour of labor commanded. Thus, the relative price of a ream of cloth is four bushels of grain. Having thrown up that ambiguity, he goes on to dispense with labor-normalization: "It is more natural.... to estimate its exchangeable value by the quantity of some other commodity than by that of the labour which it can purchase." (p.49). The remainder of the Chapter 5 is focused on money prices, and we quickly realize why he has embraced the labor-commanded as the unit of normalization : because the value of money is altogether too susceptible to manipulation by government edicts and statutes, and so not always a reliable measure, certainly not over time. "Labour, therefore, it appears evidently, is the only universal, as well as the only accurate measure of value, or the only standard by which we can compare the values of different commodities at all times and at all places." (p.54). But here, again, Smith means labor-commanded. "From century to century, corn is a better measure than silver, because, from century to century, equal quantities of corn will command the same quantity of labour more nearly than equal quantities of silver." (p.54). It is a stunning statement, which cavalierly overlooks the difficulty of wages. Surely wages are as variable (and as manipulated) over time as the value of silver? If wages fall from $2 per hour to $1 per hour, then an $8 ream of cloth can command eight hours of labor - that is twice the amount of labor as before. It is not clear if Smith here is already assuming a constant long-run natural wage (see below), that is, that the labor commanded theory is implicitly assuming that wages don't vary over the long term. Commentators have puzzled over the meaning of Smith's recourse to the labor commanded. It is repeatedly appealed to throughout Chapter 5. But however ambiguously expressed, its purpose in this chapter seems clear. Labor commanded is just a normalization device to express real prices. He simply wants to use labor units - rather than dollars or bushels of grain - as the numeraire, the 'currency unit'. (c) Market and Natural Prices The next chapter (ch.6) is where he takes his bold leap into the theory of value. Here he dumps the labor-commanded theory and takes up the labor-embodied theory again. In order to understand what he is attempting here, it is best to go one chapter forward first. In (ch.7), Smith differentiates between natural and market price. Roughly and imperfectly speaking, the natural price is the average price that prevails in the long run, whereas the market price is what we see on the market at any moment. In a sense, it is a continuation of the previous theme about variability. Real prices vary over time and place. A ream of cloth may be $8 today, $6 tomorrow, $10 the day after, depending on the vicissitudes of the market, relative intensity of demand and momentary scarcity. If we 'normalize' in terms of labor-commanded, it still varies: .e.g. if wages are $2 per hour (and wages don't change), then the ream of cloth still varies from 4 labor units today, 3 labor units tomorrow, 5 labor units the day after. Labor commanded is of no help in ironing out these fluctuations. Why are we trying to ignore these fluctuations? Variation in prices is part of reality, why not embrace them and try to explain them? Why is the long run price any more interesting than the current market price? Here is where Smith appeals to his Newtonian analogy: the long run price is interesting because it serves as a natural gravitation center, a point of attraction for market prices. In the long run, market prices return, or have a tendency to return, or do not stray too far away from, the natural long-run price. It is sufficient to explain the natural price, and treat market price fluctuations as just aberrant, temporary deviations from the natural price.
Natural prices are the prices that emerge when the temporarily disturbing forces die away. It is important to note that unlike Scholastic predecessors, the natural price is not necessarily just nor reflective of the usefulness of the commodity. There is no telos, no inherent significance in natural prices other than the simple mechanical fact that they are centers of gravitation for market prices. (d) Labor Theory of Value But what actually determines the natural price? This is where we need to return to (ch.6), for here is where Smith outlines his labor theory of value (LTV). This is the labor-expended (not the labor-commanded) theory. The labor theory of value asserts that the natural value of a commodity reflects the labor that went into its production. Smith's own example is with hunters "in that early and rude state of society" (p.65). It takes two hours to hunt beaver and one hour to hunt a deer, so the natural price of one beaver is two deer. Why? Why is he so sure that this is the price that will prevail in the long run? Why not one beaver for one deer? Or one beaver for three deer? Smith offers two explanations. Firstly, it is just, the labor-embodied theory conforms somewhat to our rudimentary ethical idea of what the price should be. That is, if hunter Alphonse just spent two hours hunting beaver, and hunter Beatrice spent one hour hunting deer, it seems right and fair that Alphonse should receive two deer for one beaver - he put in twice the work - and will demand that of Beatrice, and Beatrice will agree, simply out of a sense of fairness. Of course, that is very 'Scholastic' thinking. So Smith offers a second, better, more mechanical explanation. If Beatrice offers him only one deer for his beaver, Alphonse will refuse the exchange simply because he can do better himself. Namely, in the same time (two hours) he spent hunting that beaver, he could have hunted two deer. If Beatrice doesn't offer him at least two deer, then he will refuse the exchange and switch to deer-hunting himself. Conversely, if Alphonse demands more than two deer from Beatrice, Beatrice will refuse the exchange and switch to beaver-hunting herself. The implication is that if the market price deviates from the labor-embodied price, then hunters will change their specializations and will drive the market price towards it. Again, if the price is 1 beaver: 1 deer, beaver-hunters will switch to deer-hunting, creating an abundance of deer relative to beaver, that will drive up the relative price of beaver to 1 beaver : 2 deer. If conversely, the price is 1 beaver : 3 deer, deer-hunters switch en masse to beaver hunting, creating a scarcity of deer that drives down the relative price of beaver to 1 beaver : 2 deer. So, if the price does not correspond to labor-embodied, people would behave in a manner that would bring it about. The labor-embodied price is the natural gravitation point. Smith must have felt tremendously pleased with this result. But he quickly realizes a complication. It is all very simple for a hunter to switch specializations in a primeval forest, but in a modern society switching industries is a bit more complicated. For starters, it doesn't boil down to one man's decision. In the forest, the hunter owns his bow, arrows and traps, and when he decides to switch from beaver-hunting to deer-hunting, he takes his tools along with him. But in a modern economy, labor and capital are owned by different people, laborers and capitalists, and they don't necessarily agree, i.e. the hunter may wish to move, but the owner of his arrows and traps may not. (e) Adding-Up Theory of Value Smith was quick to realize that in an advanced economy where labor, land and capital are owned by different people, laborers, landlords and capitalists have different lures for switching the employment of their resource: laborers chase wages, landlords rents and capitalists profits. The adjustment mechanics which made the labor theory of value true in a primeval forest did not seem to to hold here. So Smith went off to propose another theory of the natural price. This theory, sometimes called the adding-up theory of value (or the value-added theory of value). As a prelude, Smith dedicates the rest of ch.6 to a lesson in value-added accounting, explaining how the net product of a production process (Total Revenues minus Cost of Material Inputs) is distributed into the payment of wages to the laborer, rents to the landlord and profits to the capitalist. e.g. suppose it takes one year of labor and 10 bushels of seed corn to produce 100 bushels of corn. The net product is 90 bushels of corn. Suppose that laborer's wage is 30 bushels and rents are 25 bushels, then the remainder of the net product, 35 bushels, accrue to the capitalists as profits. [On a side note, notice that the 90 bushels of corn embody only one labor-year to make, but that same amount of corn can be used to hire three laborers for a year. So corn has one year of labor-embodied and thee years of labor-commanded. That is one of the important implications of the addition of land and capital into production: the measure of labor-commanded exceeds labor-embodied. Smith continues to use the labor-commanded theory as his numeraire; what he drops is the labor-embodied theory of value.] From the decomposition of net product into different payment categories, Smith goes on to argue that price of a commodity can be decomposed into the wages, rents and profits received by the people who participated in its production. In principle, that is not controversial - it is a mere accounting truism. What is controversial is the direction of causality. Smith proposes that wages, rents and profits determine price. So if wages rise, or rents rise or profits rise, then the price rises; if the components fall, then price falls. Price is determined by its cost of production. (Other economists, notably David Ricardo, go the other way. Price is determined first, the components deduced residually. In this case, an independent rise in wages will not raise price, but only reduce profits.) Smith's adding up theory of natural value follows (ch.7): the natural price of a commodity is determined by what he calls the 'natural wage', the 'natural rent' and the 'natural rate of profit'.
The labor-embodied theory of natural price has been jettisoned! What we have now is:
Assuming the amount of labor, land and capital per unit of output to be technologically determined, all we need to know is what the natural wage, rent and rate of profit in order to determine the natural price. The rest of chaper 7 is dedicated to discussing the difference between natural and market price (as outlined earlier). At the end of Chapter 7, Smith returns to the question of the determination of natural price. As his adding-up theory proposes that price is determined by wages, profit and rent, then to determine that 'natural price' one needs to know what determines the 'natural wage', the 'natural rate of profit' and 'natural rent'. Smith promises to present the theories on each of these components in the remainder of Book I.
But Smith's resulting performance falls a bit short of this promise. (f) Natural Wage Despite his promise, in Chapter 8 (ch.8), Smith does not present a theory of natural wage. Rather, he presents a set of very interesting theories which explain why wages in certain sectors may deviate from the average wage, but gives us no clear theory of what actually determines the average wage. He kicks off the chapter with a historical discussion with primordial man, tilling for himself, and the emergence of landlords and capitalist employers laying claim on his product. He proceeds to discuss relative bargaining power between employers and laborers (employers, being fewer in number, have the advantage), and a brief discussion about labor unions (combinations) and collusion among employers. He goes on to explain that, generally speaking, the resulting wage negotiated between employer and employees must not fall below the minimum subsistence level of workers. But he gives no reason why it might remain pinned there. Despite citing Cantillon, Smith does not systematically present a theory of endogenous population dynamics - that would be left for Malthus to add to the system. But it seems he does have something like that in mind, there are repeated suggestions linking high wages to fertility (e.g. p. 98) and low wages to population decline (e.g. p.90-91), although he falls short of explicitly tying it all together to determine the wage level. Like most other classicals, Smith seems to embrace the concept of a wages fund - that is, that wages are paid out of a pre-accumulated fund of capital that is set aside for that purpose. "The demand for those who live by wages, it is evident, cannot increase but in proportion to the increase of the funds which are destined for the payment of wages" (p.86) The implication is that wages are not paid out of current revenues, but past revenues, and thus the amount of labor hired is not determined by the demand for this year's output, but by last year's output (or rather, the portion of last year's surplus set aside to pay this year's wages). More precisely, labor demand is determined by the volume of this fund interacting with the wage rate, i.e. C = wL; if where C is the fund, w is the wage and L is labor employed; as C is pre-accumulated and w is pinned down by the 'natural wage', the implication is that the volume of labor employed is residually determined: L = C/w. Employment thus depends ultimately on the size of the capital fund (C) - which expands or decreases depending on past profits. From this, Smith goes on to argue (p.87) that it is possible for wages to be above normal if the economy is growing quickly. The implicit idea (not fully spelled out) seems to be that if an economy is growing, then it is accumulating capital at a faster rate than population (labor supply) is growing. If the wages fund is accumulating faster than labor available for hire, with the result that the fund gets distributed among a relatively small number of workers, thus wages are higher. [e.g. suppose wages are $5; if the fund is $100, then 20 workers can be hired. Assume for the moment that 20 is the entire workforce. If the fund increases to $150 (a 50% increase), then 30 workers can be hired. But if population does not grow as fast, and only 25 workers are available (a growth rate of 25%), then the $150 will be distributed among those 25, with the result that each worker earns a higher wage - $6 - than before. This, of course, assumes the capitalist must spend the entire $150 he has set aside on wages. Wage fund theorists usually assume just that.] This helps explain why Smith asserted high wages depend on growth and not size of the economy. An economy with $150 in the fund and 30 workers is larger than one with $100 in the fund and 20 workers. But the wages are the same: $150/30 = $100/20 = $5. It takes a growing economy, specifically one where the growth of the capital fund outstrips the growth of the labor force for wages to increase (e.g. as in our example, $150/25 = $6). So a country can have a larger fund stock than another, but wages will not be higher. It takes a rapidly growing economy (relative to labor supply) to deliver high wages, e.g.
As a result:
Smith can (and has been) criticized for providing only a theory of wage dynamics, explaining why wages might rise above normal or fall below it, rather than a theory that actually explains what is the normal, natural wage. It may very well be he had the Cantillon-Malthusian 'iron law of wages' in mind, but it would have been helpful to be a little more explicit and systematic. (g) Natural Profits In Chapter 9 (ch.9), Smith moves on to discuss his theory of a natural rate of profit. The only thing worth mentioning at this point is that natural price applies only to reproducible commodities, that is commodities which are not limited in supply in the long run. Grain is reproducible - if more grain is needed, more can be produced. Iron is reproducible - if more iron is needed, more can be produced. Van Gogh paintings are not reproducible - Vincent van Gogh is dead, he won't be making any more paintings, regardless of the demand for them. Immediately one must complain of this partition, as it seems to assume there are no resource constraints, that more corn and iron can always be produced regardless of finite amounts of labor, land and iron ore. In a sense, that is true. To produce more grain, one needs more labor to plant and harvest, and that labor may not be available. But labor is only temporarily constrained. Population grows in the long run (and, in classical theory, is actually endogenous to the production process). So labor is not a long-run constraint. What about land? There is a finite amount of land on earth, surely land does not grow (much) over time? That is indeed the case. And in the very long-run, we will run out of land and hit that upper limit. But Smith assumes we are still well before that point.. Land is not (yet) a constraint - one can always cultivate more. Similarly with iron ore deposits, etc. Book II Smith discusses here 1. the nature and divisions of stock, 2. the money portion of stock and how to economize it via banking; 3. accumulation of capital and connection with labor employment; 4. rise and fall of rate of interest; comparative advantage of different methods of employing stock. Book III Natural direction of capital is first to agriculture, then to manufactures, lastly to foreign commerce. But modern European states had reversed that order. Book IV Deals with (1) commence (mostly) then (2) agriculture. Under (1): i. - Absurdity of Mercantilist system, that wealth is dependent on balance of trade, ii-vi: absurd means by which Mercantilists attempted to reach this, e.g. protectionist tariffs, drawbacks, bounties, and treaties. vii - colonies (in chap 1 says colonies were est. to encourage export by monopolies; but this not mentioned here; here just history & progress of colonies for its own sake); viii - description of the Physiocratic system. Judgment pronounced on Mercantilists & Physiocrats. Proper system is natural liberty. Book V Reviews government expenses in the three areas (defense, justice and public infrastructure - e.g. details on military organizations, courts of law, public works, education and ecclesiastical establishments), revenues to meet those expenses, and the consequences of public debt. [Relative to Lectures on Jurisprudence's "Police" section: sanitation ('cleanliness') omitted, security of wealth moved to section on capital accumulation, 'natural wants of mankind' (consumption) omitted entirely. In LJ, Smith connects it to 'national opulence' arising from the division of labor. Opulence depends on div of labor and industry of people, not the quantity of gold & silver "as is foolishly imagined".. Policies to raise price above equilibrium e.g. sales taxes, monopolies, etc. are pernicious. So are policies to lower prices, e.g. corn bounty. "It is by far the best police to leave things to their natural course." In LJ, he jumps from div of labor to prices; in WN he discusses money first and its role in exchange & div of labor. Dumps Mississippi speculation and stock-jobbing entirely, moves banking from section on money and places it in section on capital (Bk II). LJ doesn't deal with profits and rent, and only slightly with wages. History of commerce is Bk III, although influence of commerce on manners is omitted in WN. New additions in WN: besides profits & rent & theory of distribution, also theory of stocks and unproductive labor (all evidently taken from the French); also wholly new are colonies, physiocrats, ecclesiastical establishments (maybe other part of lectures?)] |
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