Lecture Notes: History of Thought
- I. Intro
- A. "History of Economic Thought" can be a course
in history (names, dates, who affected whom) or in thought. This is a course
- 1. Because we don't really know why people believed what
- 2. And even if we did, there is no reason for economists
to spend large amounts of time and effort on intellectual history.
- 3. And even if we wanted to, one cannot do a respectable
job of explaining people's beliefs without first understandingthem--and
in the case of the founders of economics, understanding their ideas is
hard work, and more than enough to fill the quarter.
- 4. So that the other sort of course is likely to end
up with superficial knowledge of the ideas, much of it wrong.
- 5. By the end of the quarter, you can decide for yourself
whether this highly biased view of how History of Thought should be taught
is correct or not.
- B. Three people: Smith, Ricardo and Marshall
1. We will mostly rely on three books they wrote
2. I may put a few other short things on reserve.
- 3. The course has a web page, I have an EMail address,
both arein the syllabus .
- 4. Office hours T 4:00-5:30, Wed 3-5, and by arrangement.
rm 204 5732
- C. Handouts.
- 1. You will get handouts consisting of a collection of
quotes from the book we are reading, along with a few questions.
- 2. Their primary purpose is to help you tell whether
you are really reading the book--i.e. absorbing the ideas, which is the
point of the exercise--or merely passing words through your mind, which
is easy to do, especially when you are tired and the ideas are hard.
- 3. If the quotes don't make sense, you are missing the
- 4. Some of the quotes will also be on the exams, as short
essay questions--explain what they mean.
- D. Two midterms, a final. They are weighted roughly 25/25/50
1. Mostly essay questions, explaining the quotes.
- 2. Might be a few numerical questions.
- 3. No historical questions.
- 4. But I hope you will remember that the important event
of the year 1776 was the publication of the Wealth of Nations
- 5. That Ricardo was a generation or two later
6. And Marshall at the end of the 19th century, beginning of the 20th.
- E. A few homework assignments, but most of the work is
reading and understanding. First assignment: Roughly estimate the ratio
of national income to national debt in England in the 18th century, entirely
from information in Smith. Compare to the current figure. Due just before
the first midterm.
- II. Who they are:
- A. Smith
- 1. The man who first assembled economics, although there
- 2. Tryed to understand questions such as:
- a. Why are some nations richer than others.
- b. What determines prices
c. What determines wages, profits and rent
d. Nature of money
e. How can you compare standards of living across time and space.
- 3. But also economic imperialist questions, such as:
- a. Why were barbarians dangerous to civilized nations
in antiquity, and the reverse now?
- b. Why did feudalism end?
- c. What are the advantages or disadvantages of an established
- 4. And policy questions such as:
- a. Should there be tariffs, export subsidies, etc.? His
analysis was not up to modern academic standards, since Ricardo had not
yet invented the theory of comparative advantage, but was well ahead of
modern newspaper discussions of such issues.
- b. Should schooling be public or private?
- c. How should universities be organized? Compulsory attendance?
- d. How should taxes be collected?
- 5. Enormous range of knowledge.
- a. Many of us us have a prejudice towards our own superiority
over people of the past.I know of no evidence of improvement in intelligence
over the long term.
- b. Not only was Smith smarter than most of us, he knew
- c. Not about physics and mathematics, but ...
- d. About history and contemporary institutions.
- 6. His book opens a window on a different world.
- a. If you want to know about the past, read primary sources--books
written then (selecting, of course, the interesting ones)--not just modern
- b. The Wealth of Nations is a good one.
- c. My other favorite for the 18th century is Casanova's
- d. And it turns out there is a connection between them.
The advertisement to Smith's 4th edn thanks a Mr. Henry Hope of Amsterdam
for information about the bank of Amsterdam. He is related to a woman Casanova
- 7. 18th century prose. If something doesn't makes sense,
check how he is using words. Usually the same meaning, but not always.
- B. Ricardo: In Marshall's words "His exposition
is as confused as his thought is profound."
- 1. He invented general equilibrium theory--without mathematics.
He did it by a c ombination of:
- a.Simplifying assumptions
b. simple numerical examples
c. and very good mathematical intuition.
- d. Marshall comments in one of the appendices that it
is risky to reason via numerical examples, because you may, without realizing
it, assume away part of the problem in drawing up your example. "Ricardo
himself had no mathematical training. But his instincts were unique; and
very few trained mathematicians could tread as safely as he over the most
perilous courses of reasoning." (Principles, Appendix L)
- 2. Disagreement with Smith: How prices are determined.
- a. Price of money: Smith says that the price of a good
is the sum of the price of the inputs. So if one input, say labor, goes
up, the price of all goods must rise. But money itself is a produced good,
and its (money) price cannot rise--it is one by definition (the price of
a dollar is--a dollar). Something is off--Smith has his (implicit) general
equilibrium theory wrong.
- b. Separate technological change from factor price change.
Consider, for the moment, only price changes due to changes in factor prices.
- c. Therefor when wages go up (measured in money), technology
held constant, profits must go down--in order that the price of money,
which must be the sum of the cost of its (unchanged) inputs, can stay the
- d. Implicitly, this is a world where money can be produced
instantly at a fixed input cost--not because the world is like that, but
because that makes it easier to think through the logic of this particular
- 3. Disagreement with Smith: Rent
- a. Is rent a cost? Not on marginal land.
- b. Marginal land must just cover production cost, so
- c. Rent on other land is the value of its output above
the output from the same inputs applied to marginal land.
- d. So rent is not a component of price. Rather price
is determined by labor + capital on marginal land.
- e. Or on the intensive margin--how much grain does one
more dose of labor and capital produce.
- f. This is not only the modern theory of rent ( "Ricardian"
but invented by Malthus)
- g. It is the first step towards the marginal revolution.
- h. Going from a constant returns world, to a constant
returns except for land world.
- i. Note that there are two "technology" changes
implicit in the model: changes in how we produce goods (what we think of
as technological change), and changes in what land is marginal.
- j. Which is ultimately determined (geography held constant)
- 4. Contrast with Smith:
- a. Smith is drawing on all the richness of his real world
knowledge, thinking through the logic somewhat imprecisely, and applying
- b. Ricardo knows a lot about the real world--he was disowned
by his parents at age 21 for marrying a woman of the wrong religion (Quaker--his
parents were Jewish) and in the next four years made a fortune on the stock
exchange, retired, and lived on it. but...
- c. He is interested in an abstract logical structure.
- d. Thus, for example, he finds it useful to hold technology
and capital fixed while letting population go to equilibrium. Then he lets
capital go to equilibrium--with the population at any instant at the level
implied by that amount of capital. Then ...
- e. While Smith is interested in how taxes can and should
be collected, Ricardo is using them to put his analytical engine through
its paces. If you impose this tax, what happens?
- f. Here and elsewhere, he uses brutal simplification
to see through to the fundamental relationships.
- g The first true economic theorist.
- C. Marshall
- 1. A number of different people invented the marginal
approach to economics at about the same time. Marshall is the one from
whom the main line of modern economic theory is chiefly descended--at least
- 2. So reading him shows you both the original derivation,the
big picture, and ...
- 3. Someone wrestling with the underlying problems--the
sort of criticisms that a very intelligent non-economist would make.
- 4. For example--how to define economic improvement.
- 5. I think Marshall's answer to that question is better
than the Paretian answer that is normally taught; for reasons see my Price
- 6. What assumptions about rationality do we need to do
- 7. In a way he combines the strengths of Smith and Ricardo--interested
in real world institutions and tryingto create a fully coherent theoretical
structure--built on the work of both Smith and Ricardo.
- III. Common issues considered by all three:
- A. Explaining relative prices.
- B. Measuring changes in human welfare.
- C. Solving the coordination problem. "Invisible
- D. Designing optimal institutions.
- IV. Hints on reading Smith:
- A. 18th century prose style. Words sometimes have different
- B. Fixed and circulating capital.
- 1. Fixed capital is what we think of as capital--machinery
and the like.
- 2. A farmer must pay his employees as they work, but
only gets the crop at the end of the year. So he needs capital with which
to advance them their wages, with which to buy fertilizer and seed corn,
etc. Similarly for a manufacture. This is the "circulating capital."
- C. Smith is Scottish, not English.
- D. Money in his world is government issued coinage, plus
privately issued paper convertible into government coinage on demand.
- V. Wealth of Nations, Book I
- A. Question: Economic growth and distribution of income.
- B. Division of labor
1. Inside the firm vs outside the firm (trifling vs not)
- a. Smith uses the example of a trifling manufacture (pin
b. Its division of labor is all under one roof, inside the firm, where
it is easy to see
c. While division of labor in more elaborate manufactures is largely outside
of the firm.
- 2. The possibility of improved output through division
of labor is greater in manufactures than in agriculture, hence ...
- 3. Output differences between more and less developed
countries are less, and poor nations specialize in agriculture.
- 4. The division of labor produces output increasse for
- a. Greater desterity
b. Eliminates changeover time
c. Tends to produce inventions
5. How many people does it take to make a woolen coat?
- a. Many--to herd sheep, shear them, process the wool,
spin it, weave it, make the tools that do all the things, produce the iron
and wood used to make the tools, ...
- 6. Or a pencil? Ditto.
- 7. Result--ordinary British peasant better off than African
king. Bigger difference than between European peasant and European prince!
- 8. Consider modern equivalent: Is the average worker
today better off than the rich of Smith's time? Is the difference more
than between the average now and the rich now?
- 9. Possibly true for material goods. Not for flattery,
status, service, ... .
- C. Division of labor arises from propensity to trade:
- 1. Situation among animals? Smith says no trade
a. But property exists without trade in the form of territory in some species.
- b. And some trade of services (grooming) apparently occurs
among primates. "I'll scratch your back, you scratch mine."
- 2. Among humans, trade lets us exploit self interest
of others. "Even a beggar." "It is not from the benevolence
- 3. Smith Argues for nurture over nature. He was not a
- 4. Trade makes diversity an asset to the group, since
individuals can specialize and exchange their product or services--unlike
the situation for animals.
- D. Division of labor is limited by the extent of the
- 1. To have division of labor requires either:
- a. Low transport costs or
b. High population density.
- 2. Hence civilization starts on coasts, rivers.
- 3. Nature of medieval economy--
- a. wheat doubles its price in 20 miles
b. The silk road from China across central asia.
- E. Money:
- 1. The problem with barter is the double coincidence
problem. The spontaneous solution is to use some good in part as a means
2. The money solution. Metal turns out to be the best good to use, and
almost all societies end up with some sort of metal money.
- a. It is easily subdividable, recombinable (try doing
that with a cow). Fairly high value to weight ratio, especially for precious
- b. Those were important characteristics in the past.
But today, we can exchange claims to goods rather than the goods themselves.
Commodity traders trade large quantities of pork bellies, wheat, etc. without
ever handling the real goods. If you are exchanging claims, these characteristics
of the goods don't matter much.
- c. A second crucial characteristic, so far, is that the
money you use is the money your neighbors use--otherwise you have to keep
going to the money exchange every time you want to buy anything.
- d. But that is changing to. I can put my money card into
a Canadian money machine and draw Canadian dollars from a U.S. dollar account.
As more and more transactions occur through computers, which can do exchange
calculations very fast and very inexpensively, the importance of using
the same money as your neighbor declines.
- 3. Pound--started out (France c. 800 A.D.) not as an
actual coin but as a money of account--the number of silver pennies that
weighed a pound (240).
- a. When the silver penny got debased, they could either
b. Keep redefining the number of pennies in a pound, or ..
- c. Use "pound" to mean "240 pennies, however
much they now weigh."
- d. They did the latter.
- 4. Debasing benefits debtors, esp the govt, at the expense
a. Consider the modern case. Our government inflated at a time when it
had large debts in the form of long term bonds--so it could inflate away
a lot of what it owes.
- b. Nowadays the debts are mostly short term--because
lenders require big interest rate premiums if the government is borrowing
long term and thus has a temptation to inflate. With short term debt, the
government can't gain much by inflation, short of very high rates.
- c. It is worth noting that Smith saw the logic of this--in
the context of the debasement of silver money--two hundred+ years ago.
- 5. Value has two meanings.
- a. Use value
b. Exchange value.
- c. Diamond water puzzle--not resolved here.
- 6. Three questions:
- a. What is the real measure of exchange value.
- b. The parts of which it is made up.
- c. Why the market price sometimes deviates from the natural
- d. Note that use value has dropped out of the discussion.
- e. And he recognizes that he has not fully solved the
- F. Real and nominal price.
- 1. Real price--number of hours to earn the money to buy.
Why is that the real price?
- a. Because ownership of something gives you command over
the amount of labor you can hire with the money you sell it for, or ...
- b. Because that is what it costs you in labor to buy
- c. Note that labor is the measure, not the determinant,
of value. So this is not a labor theory of value in the ordinary sense.
- d. He says that a good contains the value of a certain
amount of labor, not that it contains the labor.
- e. And he is going, in the next chapter, to argue that
the natural price is actually the sum of the costs of labor, profit and
- 2. Nominal price: In money. That is what we actually
buy stuff with--not goods or labor.
- 3. But the real value of gold and silver vary--New World
mines lowered it.
- 4. "Equal quantities of labour, at all times and
places, may be said to be of equal value to the labourer." So labor
is the real price of commodities!
- a. So what he is doing with "real price" is
using prices of goods measured in terms of wages, where we would use "real
wages" (wages measured in terms of prices of goods).
- b. Meaning that a fall in the value of goods is an improvement!
A fall in the value of goods means that you can get the goods with fewer
hours of work.
- c. One sort of "labor theory of value," but
- d. Turning it around, labour has a high real price if
it gets lots of commodities.
- e. He is using the use value of labor--toil and pain--to
measure the exchange value of commodities.
- 5. Sale with reservation of a perpetual rent:
- a. If the lease is set in nominal terms, it is vulnerable
to debasement (which always goes in one direction) and to variation in
the value of gold or silver, which currently, Smith thinks, is probably
- b. Better to set the rent in terms of corn.
- c. Empirical evidence from college leases. Apparently
Oxford et. al. had income from leasing land, and initially 1/3 was in Corn.
Now (almost 200 years later) that has become 2/3. It follows that the price
of corn has gone up four-fold [do the arithmetic yourself]--or, in Smith's
terms, the value of the money rents fallen to a quarter. Almost entirely
due to the change in value of silver.
- d. All of this assumes the inflation was unanticipated
--except by the clever guy who insisted on the corn rents.
- 6. Corn has a roughly constant value (in labor). Why?
But only in the long term.
- a. It fluctuates in the short term because annual output,
which varies, is large relative to the stock.
- b. Constant in the long term because corn is the input
to "producing" workers--an early version o f the "iron law
of wages." He does not say this here, but stay tuned.
- 7. Money has a roughly constant value in the short term,
not in the long term. Why?
- a. Roughly constant in the short term because annual
production and consumption is small compared to stock.
- b. But in the long term coins can be debased, the value
(measured in labor, remember) of silver and gold can change.
- 8. So short term fluctuations in the nominal price of
corn are due to changes in its real price, long term changes are due to
changes in the real price of money.
- 9. So prices in corn or a better measure century to century,
prices in silver year to year.
- 10. Real and nominal price are always in exact proportion
at a given time--the ratio being the wage rate!
- 11. And nominal, not real, price is relevant to a trader--because
silver is easier to transport than labor.
- a. If a trader can buy goods in London for 100 ounces
of gold, sell them in Calcutta for 200 ounces, and bring the gold back,
he is better off--quite aside from what the real price of the goods (measured
in local labor) may be.
- b. Suppose Smith had taken the argument one step farther.
Instead of bringing gold back, the trader (whose ship is coming back anyway,
and might as well fill its holds) uses the gold to buy goods in Calcutta.
- c. He would have discovered the principle of comparative
advantage--that the gain from trade depends on the ratio of prices of the
two goods (one transported London to Calcutta, one the other way) being
different in London than it is in Calcutta.
- 12. So people may more attention to nominal price--since
few of them are comparing conditions of life over long periods of time.
- 13. Corn is a proxy for wages in the long term, and better
recorded than wages, so useful for measuring economic change over time.
- 14. With two circulating moneys, we tend to think of
one of them as defining value.
- 15. With a fixed proportion, the value of the most precious
metal regulates the other! No.
- a. The one that is overpriced in the exchange is being
determined by the other, assuming no free coinage of it but of the other.
- b. And drives out the other if there is free coinage.
- c. Note that gold is being coined without seignorage.
Silver coinage is debased--and you can't coin debased coins, you have to
coin full weight ones.
- d. So debasement acts as rather like seignorage.
- 16. Why French coin comes home again.
- 17. Money price is defined by silver weight, not coins,
in Smith's usage.
G. An explanation of the economics of coinage.
- 1. Smith seems to understand it, despite his "most
precious." But he does not explain it clearly.
- 2. Simplest case: One metal, free coinage and melting.
You can convert silver freely into shillings, shillings into silver, so
a shilling is worth exactly its weight in silver.
- 3. Add seignorage, and some superior convenience of coin
over bullion. Now a shilling is worth a little more than its weight. If
its value gets up to the cost of having it coined (weight in silver plus
seignorage), people bring silver to the mint to be coined. If it gets below
the value of melting it--i.e. the value of its weight in silver--people
melt shillings. So the value of a shilling is normally somewhere between
the value of the silver in it and that plus seignorage.
- 4. Suppose we want two coinages, one silver and one gold,
with, free coinage (i.e. no seignorage) and melting (almost impossible
to prevent) of both, exchanging at a fixed ratio.
- a. We set their weights so that the value of the gold
in one is (say) ten times the value of the silver in the other.
- b. No problem--until the market ratio shifts.
- c. If the government does nothing, the coins no longer
exchange at 10:1, and their exchange rate changes from year to year with
the price of gold and silver--which is inconvenient.
- d. If the government guarantees the exchange rate--bring
in ten silver coins, they give you one gold, or vice versa..
- e. Now you can make a fortune (and bankrupt the mint)
arbitraging the two ratios. Suppose the gold in a gold dinar is worth the
silver in eleven silver dirhem. Start with 10 dirhem. Bring them to the
government, exchange for 1 dinar. Melt it. Sell the gold for 11 dirhem
weight of silver. Take it to the mint. Have it coined into 11 dirhem. You
are now one dirhem richer. Repeat.
- f. Seignorage reduces but does not eliminate the problem.
It stabilizes the system as long as the price ratio is witha limited range,
by (in effect) taxing the arbitrage loop described above, but it breaks
down if the price ratio of the metals shifts too far.
- 5. How do we solve this problem and keep both metals
in circulation? Make one a token coin.
- a. 21 shillings exchange for a guinea, whose gold is
worth more than their silver.
- b. You freely mint guineas from gold, but ...
- c. To get shillings, you pay in guineas, and government
mints dirhem as required and gives them to you.
- d. If people are, on net, bringing in shillings for guineas
the government melts (or hoards) the shillings, thus keeping them off the
- e. So the supply of shillings false when their price
drops below 21 to the guinea, rises when it goes above, ...
- f. Maintaining the fixed exchange ratio.
- g. And the value of both coins is determined by the value
- h. And you have to worry about people counterfeiting
- 6. Further complication--worn coins. Start with the mint
price slightly undervaluing silver.
- a. If the circulating silver is worn, weighs less than
its mint weight, then at a price where it doesn't quite pay to coin it
(at mint weight) it also does not quite pay to melt it--all the full weight
coins having already been melted.
- b. So you have an equilibrium with worn coins serving
as token coins.
- c. The situation Smith describes.
- d. I could take silver to the mint, have it minted, clip
the new coins--but presumably the cost of deliberately "wearing"
coins and reclaiming the silver is more than the small gain is worth.
H. What determines the natural price?
- 1. In a primitive society, with labor the only input,
ratio of labor inputs--deer/beaver
- a. Modified for unpleasantness of the labor.
- b. And dexterity. Why? Esteem? Human capital input.
- 2. As capital accumulates
- a. Workers become employees, and part of the price goes
to the capitalist.
- b. The capitalist must get enough to "more than
replace his stock"--remember that we are talking about circulating
capital. What he gets at the end must replace what he spent during the
year--his stock--with something over for profit.
- c. Profit is not the same thing as managerial income,
since it is determined by the amount of stock.
- d. So profits of stock are a separate term from wages
- 3. As land becomes scarce it becomes private property,
must pay rent to the landowner.
- 4. Labor still measures all three parts.
- 5. What about seed corn, wear and tear on the plow, etc?
- 6. That all goes back to rent, labor and profit input
to produce seed corn, plows, etc.
- 7. And sometimes (flour, linen), production involves
layer on layer of all three inputs. Land, labor, and capital to group the
wheat, then more to mill it, then ... .
- 8. In the progress of the manufacture, every subsequent
profit is greater than the forgoing, because the capital must be greater.
- a. Explain the argument--again remember this is circulating
capital. The company that spins the flax must advance both the price of
the flax and the wages of its workers. But the price of the flax is what
the grower of the flax got to replace his capital, plus provide profit.
So the spinning company must have advanced more capital than the farmer
who grew the flax.
- b. The argument is wrong because it implicitly assumes
a fixed turnover period. If growing flax takes a year and spinning it a
week, the spinning company gets to use its capital 52 times a year, the
farmer only once.
- c. If we wanted to consider fixed capital--machines and
such--we could incorporate it into the argument with a very long turnover
period--the ten years (or whatever) it takes to wear out a plow.
- 9. And from price you get distribution of income!
- 10. Being careful to note that one person, even one activity,
may draw income from two or three of wages/rent/profit.
- a. A gentleman who farms his own estate receives rent
and profit (he isn't doing the work). Note that a farmer, in Smith's terminology,
is the "capitalist" who rents land, hires labor, sells the crop.
- b. A common farmer, renting land, providing capital and
also doing some of his own labor.
- c. Gardener working his own land has all three.
- 11. Annual product split between industrious and idle,
which determines economic growth. Mandeville argued that vice and luxury
were good for the economy; Smith is going to argue that they are bad.
I. Natural and Market Price:
- 1. Start with ordinary rates of wages, profit, and rent--which
will be explained later.
- 2. Natural price of a commodity is then the sum of input
costs at their natural price.
- 3. Opportunity cost is brought in to show that the cost
to the seller must include his profit. Note that the war between the accountants
and the economists has already started. Smith sees cost as a modern economist
does but realizes that his readers may be thinking in terms of money actually
- 4. This is the lowest price at which he will sell for
a long period of time, if he is free to change his trade. In the short
term, he may sell for less (quasi rents are looming over the horizon, but
won't become clear until Marshall).
- 5. Market price might be above, below, or equal to natural
- 6. Depending on whether quantity demanded at natural
price is more or less than supply. "Effectual demand." He is
only using one point on the demand curve--which is all he needs for his
purpose, which is ...
- 7. A correct sign argument, which shows that market price
will tend towards the natural price. He doesn't take it the next step to
demand at other prices.
- 8. Similarly for supply--iron vs oranges. He see swhy
the price of oranges can drop much farther below its natural price than
the price of iron, but does not know how to formalize the idea. Marshall
- 9. So he shows why the price goes to its long term equilibrium--falls
when above, rises when below.
- 10. With fluctuations large or small according to incertainty
of annual output.
- 11. Fluctuations are mostly bsorbed by wages and profits,
because rent is set by contract in advance, in money or output.
- 12. Might stay out of equilibrium because:
- a. People in the business conceal shortage so as to make
money from it. Rarely for long.
- b. Trade secret.
- c. Rent on specially situated lands--good vinyard.
- d. Government granted monopoly.
- e. Apprenticeship, exclusive privilege, etc.
- f. Can be below cost briefly with freedom, only for a
generation at most with guilds, save in a caste system. Note his use of
"police." It means, roughly, government activity regulating internal
affairs (we will see the term again later). "Police" in our sense
are not going to exist in England for about another sixty years.
- 13. Next step: What determines the natural price of the
factors of production?
- 1. If labor were the only input, wages would have risen--i.e.
gsoods gotten cheaper--as productivity increased.
- 2. Wages are determined in part by a successful implicit
cartel of employers
- a. Supported by the state
- b. By the fact that employers can hold out longer
- c. By the fact that there are fewer of them.
- 3. Limited by what will maintain the laboring population.
- a. Why? Common humanity?
- b. Or--implicitly--because if population goes down, the
capital must bid against itself for the inadequate supply of workers.
- 4. But the employer monopsony cartel is broken by increasing
demand for labor, forcing employers to bid against each other.
- 5. Note that the amount of the capital is, roughly speaking,
the demand for labor, given the circulating capital model here.
- 6. It is the increase of wealth (stock) that gives high
wages, not the amount.
- 7. In North America wages are higher than in England.
- a. Lots of evidence.
- b. Widows with children are very marriageable--because
wages are so high that children are a net asset.
- c. People marry young. Because wages of children are
valuable, making it easier to support a family.
- d. Note that this is an early version of the work Becker
got the Nobel prize for--applying economics to the family.
- 8. In the stationary state, even ifa society is very
rich (lots of output per acre), wages are low.
- 9. In declining state it would be worse still.
- 10. So welfare of workers depends on the first derivative
of capital stock, wealth of country on level--roughly speaking.
- 11. Evidence that in England wages are above subsistence,
hence advancing economy.
- a. Summer vs winter wages
- b. Wages don't fluctuate with price of corn inthe short
- c. Wages vary by place--and not with price of subsistance.
- d. Grain was dearer and money wages lower in the previous
century. Yet people survived.
- 12. Are high real wages for the working class a good
thing or a bad thing?
- a. Consider what the fact that Smith has to ask that
question tells us about the difference between his world and ours?
- b. 18th c. England is a democracy, but with a limited
franchise, and parliament is dominated by the upper classes--land owning
gentry, aristocracy, etc.
- c. Who naturally enough see such questions in terms of
their self interest, not the workers' self interest.
- 13. A good thing on general grounds, and grounds of equity--the
sort of argument we would make.
- 14. The relation between standard of living of the workers
- a. Poverty does not lower, may even raise, the birth
- b. No explanation of why. My suspicion is that the upper
classes are using contraception of some sort or other, or possibly abortion.
Both exist--see Casanova's memoirs.
- c. But poverty drastically increases the mortality rate
- d. So increasing income increases the working population.
- e. Implicitly, employers are paying the cost of maintaining
the working class, just as slaveowners pay the cost of maintaining their
slave population--in the former case through the equilibrium wage rate.
If wages don't maintain the population, the population falls and wages
go back up.
- f. Maintanance of workers is cheaper than of slaves,
because the worker manages his budget in his own interest better than the
slave manager manages the slave's budget. Hence free labor is usually cheaper
than slave labor.
- 15. The relation between real wages and how long and
hard workers work:
- a. High wages make workers more productive, both for
biological reasons--better fed and healthier--and for incentive reasons.
- b. Smith is responding to arguments for what we would
call a backward bending supply curve for labor--when wages go up, workers
are richer, so choose to consumer more leisure.
- c. The argument matters, because if increased wages reduce
labor output, then it is in the interest of the employers to keep wages
low (real wages--i.e. money wages low and/or corn expensive). Smith wants
to persuade them of the opposite.
- d. He offers a variety of empirical evidence and oratorical
arguments, but can't eliminate the theoretical possibility of the opposite
- K. Profits
- 1. Increasing stock (but not high level of stock) raises
wages; high level of stock lowers profits. Merchants are competing with
- 2. What has actually happened in England in recent centuries?
- a. Measuring the rate of profit is hard, given the large
random component, but we can use the interest rate as a proxy, since higher
profits will result in higher market interest rates, ceteris paribus.
- b. Smith doesn't have good historical data on market
interest rates either, but he does have data on legal maximum rates and
believes that in England they tended to be at or a little above the market
rate. So he uses them to conclude that ...
- c. While wages have been rising, due to economic growth
at an increasing rate (i.e. the rate of growth of capital has been increasing),
profits have been going down.
3. What about variation over space?
- a. There is more stock relative to labor in large towns
than in villages, so rate of profit is lower, wages higher.
- b. But why? "It generally requires a greater stock
to carry on any sort of trade in a great town ..." Doesn't that reflect
a greater demand for capital, because a larger demand for goods? So why
is the profit rate lower? Not really explained.
- c. Similarly, Scotland is less developed than England,
interest rate higher, wages lower.
- d. France has higher profits (higher interest rates,
but hard to observe because of varying legal restrictions setting the interest
rate below its market level, which people evade in various ways) and lower
wages than England. French wages are lower than Scottish wages--because
although France is richer than Scotland, it is growing more slowly.
- e. Holland is richer than England, interest rate lower,
wages higher. Why high wages? Smith seems to be arguing that Holland is
not declining but not that it is growing faster than England, which is
what should be required to make its wages higher.
- f. In the colonies, profits are high because lots of
land etc.--opportunities for investment--and not much capital. Wages are
high because population is low relative to stock--and stock is increasing
rapidly because of the high rate of profit.
- g. So "rich" means something like "ratio
of capital to land" or "ratio of output to land," with land
apparently representing opportunities to invest capital.
- h. In the colonies, the profit rate has been declining
as stock accumulates--but wages are still high because stock is still accumulating.
- i. Smith seems to be arguing that a large stock with
low profits increases faster than a smaller stock with high profits. That
might be true if it means "the derivative of the capital stock is
higher." But isn't what matters the proportional growth rate--at how
many percent per annum the capital stock grows? If so, it will be lower
in the low profit case--independent of the amount of capital. But what
matters is ultimately the population growth rate necessary to meet the
growth of capital bidding for labor, since that determines how well off
the workers are in equilibrium--so it is the proportional growth rate of
capital that should matter.
- j. If new investment opportunities appear (new colonies,
for example) capital is pulled out of the old trades, and profits go up
- k. Smith has not yet explained why profits are not always
the same everywhere, due to just this mechanism.
4. In a fully developed country, wages should be low (no
increase in demand for labor) and profits low (all productive opportunities
for investment have been taken up). Lots of competition. But no known cases.
- a. China seems a candidate, but ...
- b. Bad laws (very limited foreign trade) and insecurity
of property rights keep it down.
- c. Which is supposed to explain why the interest rate
in China is high. Smith is trying to explain away a datum that seem inconsistent
with his theory--the fact that China is a very rich country with high interest
- d. But the bad laws don't explain that--they limit the
opportunities for investment.
- e. Insecurity of property rights would tend to keep down
both the supply of capital and the demand for it--why save if your savings
might get stolen, why invest if your factory/fertile field/whatever might
- f. It is unclear to me exactly what Smith's theory here
is--is "competition" of stock intended to mean "exhaustion
of good investment opportunities?"
5. If loans are risky because the contract is not enforceable,
the market interest rate will incorporate a large risk premium, so overestimate
the profit rate.
- 6. If interest is illegal, the actual interest rates
will be high to compensate for the risk.
- 7. Note that profit rate is profit above losses due to
- 8. In a fully developed country, the interest rate would
be so low that practically nobody could live on interest. Capitalists would
also be businessmen--as seems to be true in Holland.
- 9. Profit is normally more than the interest rate because
- a. The borrower is insuring the lender--this assumes
risk aversion (since Smith has already said that profit is net of loss
- b. And the borrower is actually managing the investment.
- c. But, as Smith already told us, the recompense for
that isn't really part of profit but of wages.
- d. In England, normal profit is about twice the interest
- e. But the ratio might change with the profit rate.
10. High profits tend more to raise costs than high wages.
- a. The argument is that an increase in the profit rate
acts as compound interest, since you have to pay a higher rate on the higher
amount from the earlier stage of production due to the higher rate on its
- b. So a one percent increase in the profit rate (from
10% to 10.1%, say) will increase the profit cost of goods by more than
a one percent increase in the wage rate (from 100 pence a week to 101 pence
- c. Provided the production period is more than a year,
so that the interest gets a chance to compound!
- d. But so what? Smith is saying nothing about how much
of the price is due to labor (most of it, given the interest rates he is
describing and a one year production cycle in agriculture) in the first
place, nor about how large the percentage changes in wages and profits
are that we can expect to see.
- e. So we don't actually know that the changes in profits
we observe in the real world have a larger effect on prices than the changes
in wages we observe in the real world.
- f. So this is rhetoric, designed to attack people who
blame high wages for the difficulty of selling their goods.
K. Chapter X part I. Wages and profits across employments,
where there is perfect liberty.
- 1. The principle of equal net advantage applies to both
wages and profits.
- a. If one job is, all things considered, more attractive
than another, people will move into the one and out of the other, driving
down the wage of the former and up the wage of the latter until they are
- b. Similarly if one line of business yields higher profits,
all things considered, than another.
- c. Note that this assumes that all workers are, in some
fundamental sense, identical--there is no premium for special talents.
All nurture, no nature.
2. Differences in money wages arise from:
- a. Pleasantness or unpleasantness of the employment.
- i. Smith says that this affects profits as well, as in
the case of a tavern keeper.
- ii. But this is wrong. It affects the wages of the tavern
keeper, which are being mistakenly included in his profit--a point Smith
b. How hard the business is to learn--Smith quite explicitly
introduces the idea of human capital here. He thinks that this has little
effect on the profit rate in different businesses. Here again, if it did
affect it, it would really be affecting managerial wages, not profits.
- c. Constancy of employment. If you can only practice
your trade half the year, you must make enough to make up for the days
- i. Plus a little extra to make up for risk aversion (or
- ii. But this ignores the benefit of the extra leisure.
- iii. He claims that this does not apply to profit--presumably
because profit is being calculated annually anyway.
d. Trust that may be reposed in the workmen.
- i. He puts this in terms of a link between social status
- ii. The modern version ("efficiency wages")
is that such people must get more than the opportunity cost of their labor,
in order that ...
- iii. Betraying their trust and losing their reputation
will injure them.
- iv. But sunk human capital can serve the same function--and
produces a better product; we should prefer the highly trained surgeon
over the less highly trained one who is getting an above market return
on his human capital. Both are in trouble if they lose their reputation--and
the former is a better surgeon.
e. Uncertainty of success.
- i. To first approximation, the expected return on all
investments, including investments in human capital, should be the same.
So a profession where many people fail should pay a very high salary to
- ii. But Smith believes that people tend to overestimate
their own ability and luck, especially young people at the point of choosing
a career, with the result that the expected return in very uncertain professions
is below that elsewhere.
- iii. Also, success in uncertain professions results in
status adn admiration, providing a non-pecuniary reward. Is this balanced
by the nonpecuniary costs of failure? He doesn't say.
f. Digression on opera singers, actors, and the like.
These are highly skilled activities but practicing them for money is considered
shameful--so they have to be paid enough extra money to make up for the
nonpecuniary cost. Probably not true nowadays.
- g. Evidence for risk preferring nature of people--aka
- i. The fact that people buy lottery tickets. Are there
alternative explanations? Is it true,as Smith claims, that the more tickets
you buy, the more likely you are to be a loser?
- ii. The fact that most houses and many ships are not
insured (he hasn't thought about moral hazard). He does allow for self
insurance by firms with lots of ships.
- iii. People enlist in the army.
h. What about the effect of risk on profit? He thinks
it is less than fully compensated--but the evidence he offers doesn't show
that. Even if it were fully compensated, there would still be more bankruptcies
in risky lines of endeavor (his evidence)--compensated by arger profits
for the firms that succeeded.
3. Difference in profit is also a result of confusing
profit with the wages of the proprietor.
- a. If the amount of capital one man can manage is small
(country grocer), including his wage in his profit results in a large overestimate
of the profit rate.
- b. Similarly if his labor is highly skilled and should
command a high wage (apothecary--who also has a small capital stock).
- c. This effect lowers the price of goods in big cities,
since the proprietor can operate on a much larger scale, requiring a lower
per unit markup to pay for his labor.
- d. Grocery goods have the same wholesale cost ("prime
cost") in cities (because they don't take a lot of land, being labor
intensive, so can be grown near the city?), so a lower retail cost in cities
than in towns.
- e. Corn and meat have a higher wholesale cost in cities
because they must be brought farther--and this is balanced by the lower
markup, making the retail price similar in towns and in cities.
4. In order for the principle of equal net advantage to
hold at a given instant, we require:
- a. That the employments are well known and long established.
In a new manufacture, a wage premium is needed to make up for the risk
that the job will vanish next year.
- b. That wages (and profits) are at long term equilibrium.
- c. That the profession is the chief employment of those
doing it. People who make their living doing something that sometimes leaves
them at leisure may be willing to spend that leisure working at something
that pays below the ordinary wage. Of course, one could say that part of
the net advantage of, say, spinning is that you can do it to fill in time
when you can't farm.
L. Chapter X part II. Inequalities due to government policy.
- 1. Guild regulations, requiring a fixed apprenticeship,
limiting the number of apprentices, etc.
- a. The real purpose is to benefit those in the trade
at the expense of their customers. In the short run the requirement of
apprenticeship injures the apprentice--but it raises his wage later, when
he becomes a journeyman or master.
- b. The pretended purpose is to protect the customers,
who are better protected by being free to buy from whom they please.
- c. Apprenticeship has bad consequences for the apprentices;
since they work for nothing during their apprenticeship they have no incentive
to learn to be productive.
- d. Each guild is willing to pay a high price for other
guilds' products in exchange for getting a high price for theirs. There
is a mistake in Smith's argument here. The high price reflects in part
artificially high costs (the inefficiency of apprenticeship, due to apprentices
not working hard). So the guildmaster produces less output per hour than
otherwise, and exchanges at the same rate as he would without guild restrictions
(both what he buys and what he sells being expensive because of guild regulations),
leaving him worse off.
- e. And the guilds together gain in their trade with the
countryside, which has no such monopolies.
- f. The argument may show that the towns are relatively
better off but doesn't show that they are absolutely better off as a result
of the restriction--you would have to know how much of the higher price
they get reflects higher costs.
- g. Note the wool-comber argument, which rebuts, a hundred
and fifty years in advance, what used to be a standard argument in anti-trust---that
if you had a monopoly in one stage of the production process you would
use it to get a monopoly in other stages (vertical integration). As Smith
points out, you don't have to.
- h. In fact, Smith argues, husbandry (what we call farming)
is a more skilled trade than most town trades, hence has more, not less,
need for apprenticeship (although he doesn't want any such requirement
for any trade).
- i. And dumb yokels, in his opinion, are on average smarter
than townies, due to the wider range of their activities--just less articulate.
2. Conspiracies in restraint of trade.
- a. "People of the same trade ... ."
- b. We cannot prevent such meetings by any law consistent
with liberty and justice (so presumably the Sherman act is inconsistent
with liberty and justice--or doesn't work).
- c. But should not encourage them--as we now do in a variety
- d. Nor provide legal enforcement of cartel agreements
which would otherwise be unstable.
- e. This is not just a historical issue. Barbers, physicians,
lawyers, and a host of less prominent professions currently use government
restrictions on licensing in just the way Smith describes.
3. Corporations (meaning here guilds, not joint stock
corporations) are unnecessary, since the real discipline on a producer
is exercised by his customers.
- 4. A second way in which public policy distorts relative
wages is by subsidizing the training of some professions, such as clergy,
either privately (by charity) or publicly.
- a. The result is not only to drive down the wages of
the clergy, but ...
- b. Of the learned professions, in large part populated
by unsuccessful aspirants for clerical office.
- c. In contrast, the top learned men in antiquity seem
to have done very well for themselves--before schooling for such activities
5. A third way is by keeping people from moving from
one trade or location to another in response to differences in relative
wages (or profits). Throughout Europe this is done by guilds
- a. Both because they may not permit someone from another
town to practice the craft in their town, and ...
- b. Because they will not permit skilled workers to switch
from a trade with a surplus of labor to one with a shortage--even if the
trades are so similar that most of the skill carries over.
6. In England, the poor laws create a further problem.
- a. Support of the poor is a local responsibility, so,
- b. Each parish is reluctant to allow people who might
need assistance to move there
- c. And has the legal right to send them away, unless
they meet conditions which ordinary workers normally cannot meet.
- d. Or have a certificate from the parish they came from
making it responsible for them--which that parish has little incentive
- e. With the result that labor mobility is seriously restricted.
7. There are also occasional attempts at price and wage
control, not very effective, and typically designed to favor of the employers,
not the employees.
M. Chapter XI part I: Rent
In Class Monday I said we were not covering Book II. I
was wrong. It is book III that is omitted on the syllabus; Book II is included,
you should read it, and you will be responsible for it.
- Chapter I: What is wrong with mercantilism
- A. Note that most of what Smith is attacking--17th and
18th century economics--is still alive and well everywhere except academic
- B. The obvious mistake--to confuse wealth and money.
- 1. Wealth is often measured in money, and if you have
money you can get other things, so it is tempting to suppose that the more
money a country has, the wealthier it is.
- 2. The Tartar error of identifying wealth with sheep
is closer to the truth than the Spanish error of identifying it with gold--sheep
being more useful than gold
- 3. Some people argue that money is crucial because a
nation needs it to carry on foreign wars.
C. Consequences of that mistake.
D. Why money is considered important.
E. Real gain from foreign trade:
F. The mercantilist error led to a lot of different sorts
of restraints, which Smith is about to analyze in the next few chapters.
- Chapter II: On restraints on imports that compete
with domestic produciton. (which we would call
protective tariffs and quotas)
- A. High duties or prohibitions give domestic industry
a monopoly of the home market; is this a good or bad thing?
- 1. Clearly it can benefit the protected industry, but
- 2. It is diverting capital there from somewhere else.
B. Why the national interest is usually best served by
letting people decide for themselves where to employ their capitals.
- 1. People prefer, for their own convenience, to employ
capital as near home as possible, which (Smith argues) is also in the national
- a. A modern economist would want a quantitative, not
just qualitative version of the argument
- b. Which, on Smith's terms, is not going to work, because
- c. The private incentives (easier supervision) for using
capital at home also count in the national interest calculation, but ...
- d. The national interest reason he believes exists does
not count in the private calculation, so...
- e. If the higher profit in foreign trade is just enough
to cancel the greater difficulty of supervision, the capitalist will be
indifferent between the two alternatives, but ...
- f. It will be, by Smith's account, in the interest of
the nation for him to invest at home.
2. In investing at home, each person tries to pick the
investments that produce the greatest value, which is good for both him
and the nation. This argument does work, although it is being made in a
simpler form than a modern economist would make it.
- 3. "those who affected to trade for the public good.
It is an affectation, indeed, not very common among merchants, and very
few words need be employed in dissuading them from it."
- George Stigler comments somewhere that Smith would
have done us a great favor if he had written down those very few words,
since Stigler finds dissuading businessmen from the belief that they are
doing busineess in the public interest harder than Smith did.
- 4. An individual capitalist is in a much better position
thatn a statesman or lawgiver to determine how best he should invest his
money. Great quote ending "and which would nowhere be so dangerous
as in the hands of a man who had folly and presumption enough to fancy
himself fit to exercise it."
- 5. And giving the monopoly of the home market to domestic
manfacturers is in some measure telling people how to direct their capital
- 6. Getting goods by importing them really means getting
goods by producing something else that costs less to produce than what
you are going to get, sending that something else abroad, and trading it
for the foreign goods you want. Hence a tariff is telling people to produce
the goods they would have imported in a more expensive way (at home) rather
than a less expensive way at home (produce export goods at home to trade
with foreigners for what they want).
- 7. Hence using the industry of the nation in a less productive
way, making us worse off.
- 8. Infant industry argument: Perhaps temporary protection
will result in an industry that can produce the goods we were importing
as cheap or cheaper, but ...
- a. In the meanwhile, we are making ourselves worse off,
hence reducing the capital stock (not necessarily--the higher cost in the
short run might be paid from reduced consumption), which makes us worse
off in the long run.
- b. This argument is inadequate, since if the new industry
can really produce the goods more cheaply than we can import them (in the
long run) that gain might be enough to make up for the loss.
- c. Smith may be being fooled here by thinking of the
value of output as proportional to the labor that goes into it (+capital
and rent), and forgetting that if the same goods become cheaper, measured
in labor, i.e. "less valuable," that is a benefit.
9. Benefits of trade and division of labor are likely
to be bigger in the international than interpersonal context, since nations
differ in natural advantages (climate etc.) whereas people only in acquired
advantages (again Smith assumes nurture is much more important than nature
as a cause of human differences).
C. Consequences of protection and of abolishing protection.
- 1. Most of the gain from protection goes to merchants
and manufacturers, since much of what they make has a high enough value
to weight ratio so that transport costs are not prohibitive and thus faces
potential competition from abroad.
- 2. Farmers and country gentlemen (i.e. landlords) are
at much less risk, since grain and cattle and butcher's meat all have a
low value to weight ratio and are therefore expensive to transport.
- 3. So only a very big price difference will result in
- 4. A conclusion Smith thinks is supported by recent evidence,
esp. with regard to imports of cattle from Ireland.
- 5. And for a well developed country, raising cattle would
be a wasteful use of land, so they would be better off importing them.
Note the distinction between raising, which can be done at a distance,
and fattening, which has to be done fairly close to where they will be
- 6. Also, the bounty on exporting corn means that smaller
stocks are carried over from year to year, so results in more imports in
a bad year, hence ...
- 7. The real gainers are the people who transport corn,
not the ones who grow it.
- 8. But doesn't the bounty also raise the price in both
good years and bad ones, benefitting the growers? The larger carryover
stocks without the bounty would keep down the price in bad years.
- 9. Farmers and country gentlemen are good guys, led astray
by the merchants and manufacturers into demanding trade protection.
- 10. And one reason they are good guys is that they are
dispersed, so cannot as easily organize against their customers. Note the
mix of "generosity which is natural to their station" on the
one hand and rational self interest arguments on the other.
D. Exceptions to laissez-faire: When is government
E. When is government interference possibly justified--or
- 1. Retaliatory duties
- a. if we really think they can be used to negotiate a
mutual reduction in trade barriers.
- b. If there is no likelihood of that, they merely add
a second injury imposed by our government to a first imposed by someone
2. If we have high duties and industries have adjusted
to them, and an immediate abolition will throw lots of people out of work
and cause a lot of trouble. but ...
- 3. Smith thinks this is less of a problem than generally
imagined, because ...
- a. In many industries, England is already an exporter
without a bounty, hence produces more cheaply than it could import, so
abolishing protection would have little effect--just a few imports by men
of fashion who liked foreign goods.
- b. The economy can absorb a lot of labor, as demonstrated
by what happened when the war was over and lots of soldiers and sailors
- c. Indeed, this is a harder problem than would result
from abolishing trade protection, both because the numbers of people were
bigger and because soldiers are less suited to be workers than workers
(shifting from one industry to another) are.
- d. And soldiers are more suited to be troublemakers.
"more than a hundred thousand men, all accustomed to the use of arms,
and many of them to rapine and plunder."
4. And it would be an even smaller problem if they repealed
guild regulations and the law of settlements, thus increasing labor mobility.
Note that it is the law of settlements, not the poor laws, he wants to
F. But it isn't going to happen--Smith thinks it is more
likely that Utopia would be established than that England will abolish
its trade restrictions (which in fact happened about seventy years after
Smith wrote, in part due to his influence).
- 1. Because the private interests of many (merchants and
manufacturers) oppose it
- 2. And they will fight to keep their privileges.
G. But the abolition of protectionist laws should be done
- 1. Which is an argument against creating them in the
first place, or extending them, ...
- 2. Since they are so hard to get rid of.
- Chapter III:
- Part i: Argues that the actual policies implemented do
not make sense even on mercantilist principles--an important (public choice)
point. "and smugglers are now the principal importers, either of British
goods into France, of of French goods into Great Britain."
- Part ii. And unreasonable on other (i.e. correct) principles.
- A. The argument assumes that a "trade deficit"
means the country is losing by trade, which is absurd.
- 1. If you believe that a country gains when it has a
trade surplus and loses when it has a trade deficit, it seems to follow
that a balanced trade is neither a gain nor a loss for either country.
But it lets both gain by employing their capitals in a more advantageous
way, increasing them
- 2. Smith assumes the commodities exchanged to be of roughly
equal value. He doesn't think about the ambiguity of his sense of "value"
--how many hours of work it takes to buy something--when wages are different
in the two countries.
- 3. It is easier not to stumble over the principle of
comparative advantage when you are in a gold standard world, where all
prices are comparable, than in a paper money world, where it is not obvious
how prices in yen can be compared to prices in dollars.
- 4. Smith runs through gains of trade, pointing out that
they apply if what is exported is gold just as if what is exported is something
- 5. "Losing trade with the alehouse?" No. (this
is apparently an argument about whether there should be import duties on
wine--and leads in the direction of questioning sin taxes, such as our
high taxes on alcohol and tobacco)
- a. The opportunity to buy anything can be abused if someone
acts foolishly, but ...
- b. That is not a good argument against institutions that
make it cheaper to buy things.
- c. Any way, inhabitants of wine countries are sober people,
being used to the stuff.
- d. And taxing wine makes it a luxury good, which makes
getting drunk a form of showing off.
- e. If it was untaxed and cheap, people would get a drunk
for a while, but once they adjusted to its being cheap would be as sober
as Frenchmen or Spaniards.
B. One implication of mercantilist doctrines is that everybody
else's prosperity is a threat to us.
- 1. The modern form of this dangerous mistake appears
in the word "competitiveness," which suggests that what matters
is not how well off we are, or how good at producing, but how well off
relative to other countries.
- 2. This makes commerce a source of international conflict
when it should be a source of international amity.
- 3. Quote on the "impertinant jealousy" of merchants
- 4. "And they who first taught it were by no means
such fools as they who believed it."
- 5. Because domestic manufactuers profit, and the rest
of us lose, through trade restrictions.
- 6. In fact, the wealth of our neighbors is a good thing
in time of peace, since it makes them better trading partners--although
it may be a threat to us when we are at war with them.
- 7. And their manufacturers may be enemies to our manfacturers,
but they are friends to the customers of our manufacturers--i.e. the mass
of the population.
- 8. Near neighbors are the best people to trade with because
the turnover is fast. England and France should be trading with each other
for their mutual benefit. And France is a much bigger economy than the
New World as well as much closer.
- 9. Predictions of national collapse due to unfavorable
balance of trade are often made and never fulfilled (sounds familiar--except
now it is due to overpopulation).
C. The balance that really matters is not between exports
and imports but between production and consumption--i.e. capital accumulation.
Chapter V: Bounties
- A. Export subsidies--not very common nowadays.
- B. Only necessary for industries that cannot make money
exporting without a bounty
- 1. Which means that the returns for what they produce
are less than the cost, so on net we are eating up capital by engaging
in those industries.
- 2. So we are forcing trade from a more to a less advantageous
C. Empirical evidence on the effect of the corn bounty.
- 1. The amount England has gotten for exporting corn has
exceeded what it has paid for importing it by more than the amount of the
- 2. But this confuses revenue with profit--the exported
corn cost something to produce.
- 3. Consider the argument in a simpler world where there
were no imports at all. If England exports £100,000 worth of corn
while spending £50,000 subsidizing the export, does that represent
a net gain?
- 4. The fact that the corn would not have been exported
without a bounty (if it is a fact--if not, we don't need the bounty) means
that cost of production was more than the price it could be exported for-say
a total production cost of £70,000-hence England lost by the bounty.
They got £100,000 of revenue in exchange for £120,000 of taxes
plus production cost.
- 5. The price of corn in England has inded been falling,
but that is in spite of the bounty.
- a. Happened in France, which has export restrictions,
not a bounty
- b. And presumably reflects the inflow of gold and silver
from the New World.
D. Theoretical argument:
- 1. A bounty tends to raise the price of corn in good
years (by encouraging exports) and in bad years (because less is carried
over from the previous good year).
- 2. This is clearly true if we hold output constant (
"in the actual state of the tillage"). Is the argument changed
if we allow for additional output due to the higher prices?
- 3. The bounty double taxes the population--to pay the
bounty, and to pay the resulting high price (a point the Agriculture department
was still missing c. 1966, when I was in Washington. They calculated the
cost of part of the farm program as equal to government expenditure on
it, ignoring the cost to consumers of having to pay more for food).
- 4. And the high home price reduces the population.
- 5. Ultimately, wages are proportional to the price of
corn, so the farmer is losing in higher wages what he makes in higher corn
- 6. And all prices rise accordingly.
E. Spain and Portugal and restraints on the export of
gold and silver.
- 1. In equilibrium, as much is smuggled out as is imported--a
flow always beats a stock (dam metaphor).
- 2. But what drives the (very expensive) smuggling is
the price difference between gold and silver in Spain and Portugal and
- 3. The result is to make goods more expensive in Spain
and Portugal than elsewhere. Every trade must pay the cost of smuggling.
F. Applied to the corn bounty
- 1. The bounty lets our competitors eat cheaper, ultimately
makes their labor cheaper, ours more expensive.
- 2. So we are exporting corn, turning it into workers,
turning it into goods, importing the goods--and using a bounty to force
that cycle when it would be cheaper to do it at home.
- 3. Only the corn merchants clearly gain.
- 4. "The nature of things has stamped upon corn ..."
G. Bounties on production (subsidies to production rather
than export) are much rarer.
- 1. Subsidy to fishing is an exception, perhaps justified
by considerations of national defense, but ...
- 2. Herring buss bounty makes little sense because ...
- a. Combining various subsidies, each barrel of herrings
exported cost the govt ...
- b. A tonnage bounty, not a herring bounty (paid in proportion
to the tonnage of the ship, not the quantity of herring caught), so ships
fit up to catch the bounty, not the herrings. Smith gives an extreme case
for a year when few herrings were caught.
- c. The bounty is subsidizing a shipping technology poorly
adapted to the circumstances of Scotland, over the boat fishery better
H. Justified bounties?
- 1. To keep militarily important industries in existence
in case of war.
- 2. Drawbacks (refunds of taxes on the import of the inputs)
- 3. Premiums--special prizes for artists, manufactuerers,
etc. are useful and cheap.
Digression on the corn trade
- A. Inland dealer--Smith is giving the argument that shows
speculation (in our sense) is a desirable activity. His inland merchant
is, among other things, what we would call a corn speculator.
- 1. A possible exception exists if there were a single
monopolist, who might destroy corn so as to raise the price.
- 2. Hirshleifer's stamp auction story: Someone buys the
only three copies in existence of a rare stamp, then publicly burns one--on
the theory that demand is inelastic, so the remaining two will be worth
more than the three were before.
- 3. But that can't happen with corn, since it is divided
among many merchants.
- 4. History of dearths and famines shows that dearths
are always due to a real shortage, not a conspiracy by the corn merchants--although
they often get blamed.
- 5. And the famines are due to government attempts to
interfere with a dearth.
- 6. For example, by holding prices down--with the result
that the corn is not produced or is consumed too fast.
- 7. Or old laws prohibiting middlemen in the corn trade.
- 8. Without middlemen, the farmer must provide the capital
that would have been provided by the corn merchant--and charge for it--so
eliminating middlemen doesn't save the customers money. The error he is
pointing out here is still around.
- 9. Indeed, by reduced division of labor, eliminating
corn merchants actually makes corn more expensive--it takes more work for
the farmers to do the corn merchants job, since they are not as good at
it as the corn merchants were.
- 10. And a merchant buys to sell--if he actually keeps
corn off the market when it is dear, he loses money--so merchants can only
cause famine if they make a mistake, in which case they are also losing
a lot of money.
- 11. The fear of speculators is like the fear of witchcraft.
B. Importer. Makes corn cheaper, so makes farmers and
landlords poorer in money, but not in value, since labor also gets cheaper.
And the lower price expands home industry, demand for corn.
- C. Exporter increases supply of corn in bad years by
providing a market for surplus in good.
- D. If all countries had free import and export of corn,
famine would be less of a problem.
- E. The merchant carrier of corn, with warehouses in Britain,
is a reserve in case of shortage.
- F. If the mercantilists were right, and prosperity occurred
because of such restrictions rather than in spite of them, why are Spain
and Portugal doing so badly?
- 1. Smith's explanation is that they are duing badly because
of the bad effects of importing gold and silver and trying to keep them
- 2. Plus insecurity of property rights.
Chapter 7 part i
- A. Gold mines are on average unprofitable for the same
reason as being a lawyer--investors are overoptimistic.
- 1. Hence should not be subsidized.
- 2. Should they be discouraged? He never says so, but
that is what the logic suggests.
...[the next bit is not in what you were
assigned to read, but you may find my summary interesting, especially if
you read part ii anyway]
- part iii What did Europe get out of its colonies in the
- A. General advantages:
B. Benefit to mother country of its colonies.
- 1. As of all its territory, provide military support
- 2. But the European countries have had to provide military
to defend their colonies, not the other way around--net loss to them.
- 3. And the British colonies usually cost Britain more
in peace, and always in war, than they bring in.
- 4. So the only benefit is the exclusive trade.
C. Effects of English monopoly over the trade of English
- 1. Benefits England relative to other European nations,
since English gets tobacco etc. cheaper, but ...
- 2. Smith thinks it might injure England absolutely.
- 3. Apparently he suspects tobacco production has a declining
industry cost curve, although ...
- 4. His own arguments about rent of specially suited lands
imply the opposite--larger demand should put more pressure on the limited
supply of special lands.
- 5. Note how Smith qualifies this whole argument-- "may."
- a. In judging how reliable a source of information is,
one of the things to look at is
- b. Whether it qualifies its statements carefully, so
as never to claim more than it really knows or can prove.
- c. Smith passes that test; many books and people fail
6. English monopoly in trade with her colonies pulls English
capital into that trade and out of domestic investment--which, Smith thinks,
is a bad thing. Now we see where he was going back when he argued that
investements closer to home were better for England. He was laying the
groundwork to argue that mercantilism made England worse off, by forcing
its capital out of home employments and into distant ones.
- 7. His conclusion that the profit rate must have been
higher as a result seems right, since foreign trade is a capital intensive
- 8. And the share of British capital in the colonial trade
continues to grow, because the colonies grow faster than England, hence
absorb an increasing amount of its capital.
- 9. And a further result is the decay in other parts of
English trade, as capital is pulled out of them into the colonial trade.
- 10. England was already a great naval power before the
legal restraints on trade with the colonies had had any effect, so they
cannot explain its naval power. Remember that Smith believes that military
strength is sometimes a legitimate basis for restrictions on trade.
- 11. Raising the profit rate in England makes it "less
competitive" in all other activities, since it raises costs.
- 12. Merchants complain of high wages as making it hard
to compete with foreigners, but ignore high profits.
- 13. Furthermore, driving other countries' capital out
of the British colonial trade lowers the profit rate in those countries
and thus their costs--for competing elsewhere.
- 14. And the long run effect is to move British capital
into an area where the turnover is slow, and where it thus supports less
British labor than it did before.
- 15. Another source of long turnover is that the colonists
pay their debts slowly, in order to, in effect, borrow capital.
- 16. Also, one long run effect is to put British capital
into the indirect carrying trade for other ultimate consumers--the worst
thing of all from Smith's standpoint, since it employs essentially no British
- 17. Furthermore, English industry is dependant on one
market when it could be on many, hence more at risk--like the risk of monocrop
- 18. What if the American colonies should revolt? As,
of course, they are just starting to do as Smith is finishing the book.
- 19. Conclusion: The colonial trade should be made free--but
D. Effects of the American Revolution (early stages)
- 1. The effects on the English economy were reduced somewhat
- a. Americans bought in advance what they would need from
England, anticipating an interruption of trade.
- b. A variety of temporary and accidental changes happened
which increased demands for British goods elsewhere.
E. Effects of the colony trade are good; effects of the
monopoly of it are bad. Net effect is still good.
- 1. Not so clear for Spain and Portugal, where a variety
of bad effects, including insecure property rights, make things worse.
- 2. But England has justice, secure property rights, freedom
to export, so survives and prospers despite some impediments.
- 3. Smith argues that the British monopoly on trade with
the British colonies reduces capital accumulation, because it reduces national
revenue, from which savings come--but it increases profits, which should
increase capital accumulation, both because profits can be reinvested and
because a higher profit rate makes saving and investing more attractive.
- 4. The monopoly reduces rent, because high profit rate
slows improvement of land.
- 5. And the high rate of profit makes merchants into spendthrifts!
- 6. And they set a bad example for everyone else.
- 7. Compare Spanish merchants to Dutch.
- p. 613 quote
- p. 616 quote
- F. What to do about the revolting colonies?
- 1. Best solution is to turn the colonies lose, but it
won't happen. How else might England resolve the matter--what terms might
it reach with the colonies?
- 2. England cannot expect the colonial legislatures either
to be willing to vote to pay their share of the expenses of the empire
or to know what it is.
- 3. Parliament could set, colony by colony, how much each
owed. Smith thinks they would set it low, not high, although he does not
explain why they would do so.
- 4. But that is not a reliable resource, because the colonies
would not cooperate
- 5. And if you did do it, that would wipe out the importance
of the colonial assemblies, which the colonial politicians would not tolerate.
- 6. But if you give the colonies representation in parliament
in proportion to the taxes they pay, then colonial politicians will hope
for imperial importance.
- 7. If you don't do that, the war is going to be very
difficult, because everyone in America feels himself important in consequence.
G. Consequences of mercantilism
- 1. British mercantalism may actually benefit foreign
countries--by forcing their capital into investments with faster turnaround
(so why not have government interference do the same thing for England?
Doesn't this argument imply that a reverse mercantilism would be even better
than laissez faire?)
- 2. While it injures England by the opposite effect.
- 3. Smith is struggling with the conflict between his
support for laissez-faire and his theory that some uses of capital are
more valuable to England than others. He tries to get out of the problem
by arguing that we may need the distant capital to keep the local capital
going. But at this point he no longer has a clear theory by which we can
evaluate the different uses of capital.
H. East India, Asia, ... The British East India Company
started as a trading company with a monopoly of trade between England and
India. It ended up ruling quite a lot of India. It was organized as a joint
Chapter VIII: Conclusion
Chapter 1a: Cost of defense
Chapter II: Sources of Revenue
- Part I: The Sovereign living of his own.
- A. In primitive societies, the sovereign lives on the
profit of his capital (herds etc.)
- B. In some small modern societies, a mercantile project,
such as a bank, is an important source of revenue.
- 1. It has been suggested for Britain, which could borrow
money cheaply to replace the Bank of England's capital, then get revenue
from the difference between its cost of capital and what the Bank lends
- 2. Smith thinks the English government is incompetent
to run a bank.
- 3. A post office has been run by many governments with
success--a simple business.
- a. Can't prove it by our Post Office, which has consistently
- b. But what Smith is describing is not exactly the same
- c. An 18th c. Post Office, in addition to carrying mail
(but not delivering it to houses, a 19th c. innovation, I think)
- d. Also provided a network of stables, such that somebody
"riding post" could keep changing horses.
C. Princes have tried many other businesses, and rarely
- 1. Their agents act like the servants of the rich, with
- 2. Making it a losing business.
- 3. Similarly, from the other direction, when the East
India Company became a sovereign it stopped being a competent trader.
D. States with a treasure may derive some income from
- 1. Typically lent to other states (because they operate
on a large enoughs scale)
- 2. Obvious risk in case of war between them.
E. Pennsylvania got income by lending on created money--bills
of credit backed by land.
- 1. Which works only if they are no more than the gold
and silver they replace
- 2. Successful for that moderate state, a failure for
other American colonies.
F. Rent of the public lands a larger and more reliable
source of income.
- G. Worked for Greek states (citizen soldiers, little
expense) and for medieval (King lived of his own).
- H. Nowadays, the whole rent of the kingdom would roughly
cover the peacetime revenue of government and be inadequate in wartime.
- 1. Some rough calculations of total rent
- 2. And the observation that it would be a fraction as
great if it all belonged to the government, and was mismanaged accordingly.
- 3. And in Europe there are typically large crown lands,
badly managed, producing almost no income. Consider the Bay area, where
land is very expensive, but most of the land is held out of use by government
ownership, zoning regulations, etc.
- 4. Government should sell off its land, both to get the
money to pay some of its debts, and
- 5. Because it would become much more productive as a
I. Conclusion: These sources are inadequate for a modern
society, so taxes are needed.
Part II: Taxes
Article I: Taxes upon rent
- A. Can be done as a fixed amount per year on any piece
B. or proportioned to the real rent year by year.
- 1. Which the physiocrats argue is proper.
- 2. The Venetian system is to tax rented lands at 10%
of the rent and self-farmed lands at 8% of the imputed rent.
- a. More equal than the English system, but ...
- b. Less certain
- c. More trouble to pay
- d. More costly to collect
3. These problems could be alleviated if (Smith's proposed
system for taxing rent):
- a. All leases must be publicly registered, with bounties
to either landlord or tenant informing on the other.
- b. Fines for renewal of leases (i.e. fixed payment rather
than annual) are a bad idea, could be discouraged by making the tax on
them higher than on rent.
- i. Bad for landlord, who is acting as a spendthrift
- ii. For tenant, who is capital poor, and can now cultivate
- iii. Why does it happen? Why doesn't landlord borrow
from someone else on better terms?
c. Restrictions on how the land is to be used should be
counted as further rent and also taxed at a higher rate, to discourage
- i. Because they are due to the foolish conceit of the
landlord, who thinks he knows how the land should be farmed better than
- ii. Why should he care? He is getting a fixed rent anyway.
- iii. Isn't a better explanation that the landlord wants
his land farmed in a way that maintains its value? There is an incentive
problem for the farmer, who can deplete the soil then go rent from someone
d. Rent in kind are a bad thing (why?) and can be discouraged
- e. Landlords should get a slightly lower tax if they
farm the land themselves, but only up to a maximum amount of land, because.
- i. Some cultivation by landlords, who have lots of capital,
permits experimentation, with benefits to all, but ...
- ii. Cultivating all of the land by landlords to get lower
taxes means by bailiffs, who are likely to be less competent than farmers
(if bailiffs are all that idle and profligate, will a moderate tax reduction
be a sufficient incentive for the landlord to use bailiffs, i.e. employees,
instead of renting out his land?)
f. Note the dirigiste tone of this passage. Smith should
reread his own discussion of people who think they are entitled to tell
other people how to use their capital.
4. Main argument against taxes proportioned to rent is
that they discourage improvement by taxing it.
- 5. The problem can be reduced by allowing a landlord,
before making improvements, to have his land valued and freeze the tax
at the old value for long enough to let him pay back the cost of the improvement
- a. But this assumes that the gain from the improvement
is known in advance.
- b. Which is unlikely.
6. Seen from the other side, the shift of part of the
gain from improvement to the sovereign is an advantage--the sovereign gets
a share in the gain from improving land, so has an incentive to encourage
it, but ...
- 7. Attention of the sovereign is a lot less important
than attention of the landlord, so better too long a term without raising
the tax than too short.
- 8. Such a tax has the virtue of varying with the state
of agriculture, value of money, etc. in an appropriate way.
C. Or proportioned to a survey and valuation
- 1. Might be equal at first, but ...
- 2. Becomes unequal
- 3. Unless you continually reassess
- 4. Something governments are incompetent to do
- 5. And a nuisance to the citizens.
D. Or by taxing output, not rent.
- 1. The tax will be passed on to the landlord.
- 2. Such taxes are really very unequal, since the relation
between output and rent is very different in rich and poor lands.
- 3. And they discourage improvement, by taxing its result.
- 4. And they discourage the growing of crops that are
valuable but expensive to grow. Madder.
- 5. When this is done by the sovereign rather than the
church (tithes), it at least gives him an incentive to maintain roads,
canals, etc. in order to keep up output. (would be true for the church
if it acted as a single body, as Smith earlier argued it can).
- 6. May be paid in cash or in kind
- a. Kind might be convenient for a small proprietor living
on his estate, but ...
- b. Leads to neglect and fraud if it is done for the owner
by agents, either of a rich gentleman or , still worse, a government.
7. If in cash, either proportioned to the real value of
the crop or at a fixed rate per bushel.
- a. Former varies in real value only with output
- b. Latter also with value of money.
8. If a tax on produce is commuted for a fixed sum, we
are back with the English land tax.
E. Or by taxing the rent of houses.
F. Better still, taxing ground rent.
- 1 Falls entirely upon the owner of the land.
- 2. Ground rent of houses, and rent of agricultural land,
come often with little attention by the owner, so taxing them does little
harm--in modern terms, the supply of land is almost perfectly inelastic.
- 3. And this is even more true of the ground rent of houses
than of agricultural rents.
- 4. Which is also fairer, since ground rents are due mainly
to external causes--good government.
- 5. Smith knows of no examples of straight ground rent
taxes, perhaps because of the problem of measuring it, but thinks it should
- 6. Various proxies for house value have been used, such
- a. Hearth tax. Odious because collector had to enter
every room. What would he think of modern building inspectors?
- b. Tax on houses, increasing with number of windows.
Could be counted from the outside.
- c. Unequal taxes, since the rich man in the capital pays
the same tax as the poorer man with the same number of windows in the countryside.
- d. All such taxes tend to reduce rent.
Article II: Taxes on profit
- A. Profit is divided into interest and what remains--compensation
to the entrepreneur.
B. Taxes on general profit that Smith knows of:
C. Taxes on profit in particular activities.
- 1. Can never fall ultimately on the dealers in that good,
since they must get their ordinary profit or they will go do something
- 2. If proportioned to the amount sold, the tax ultimately
falls on the consumer.
- 3. If a fixed tax on all dealers (such as license fee
for being in the business), it falls ultimately on consumers, but also
gives big dealers an advantage over small dealers
- 4. The tax on shops is the same amount on all shops;
it could not be proportioned to how much each shop sells
- 5. "without such an inquisition as would have been
altogether insupportable in a free country." In other words, a sales
tax cannot be collected in a free country, because it imposes an intolerable
violation of the seller's privacy.
- 6. If the tax was substantial (which it was not), it
would have given a significant advantage to large retail dealers, leading
to less competition and higher prices, so not only would the tax have been
paid by the consumers, they would have paid more than the tax, with the
extra going to increased profits to the dealers.
- 7. France has a tax on profits in agriculture
- a. The "real taille" was a tax on land held
by ignoble tenure (meaning not held by someone who held it as a nobleman).
- b. The "personal taille" was a tax on the (estimated)
profits of people who rented other people's lands (farmers in Smith's sense),
however the land itself was held.
- c. The former is unequal but need not be arbitrary--you
know by what tenure you hold the land, and may know the amount of taxes.
- d. The latter is both unequal and uncertain, since the
tax collector has no good measure of the farmer's profit.
8. A tax on profits in manufacture falls on the consumer;
a tax on profits in agriculture falls on the landlord--is paid by lowering
the rent the farmer pays. Why?
- a. Smith thinks the supply of agricultural output is
perfectly inelastic, so far as the tax is concerned
- b. Apparently because he believes that once you are renting
the land, there is a particular amount of capital necessary to cultivate
- c. But why doesn't the farmer pull stock out of the least
profitable parts of cultivation--not hire quite as many people to weed
the field, say, and accept a slightly lower output?
- d. I suspect we will hear more on this subject from Ricardo.
9. One effect of the personal taille is that, since the
tax collector will estimate your profit from how rich you seem to be, farmers
try to look poor--which sometimes means cultivating their land badly.
- a. Smith thinks they over do it, and lose more by farming
badly than they gain in reduced taxes.
- b. The result is to make everyone worse off.
10. Poll taxes in the New World are taxes on slaves, hence
taxes on the profit of a particular form of capital.
- 11. And should be distinguished from the kind of poll
tax that is paid by free men--i.e. a fixed amount per person.
- 12. Taxes on servants are really taxes on consumption.
They fall most heavily on the middling rank, since they have the highest
ratio of servants to income.
- 13. Taxes on profits in particular employments cannot
affect the interest rate (or so Smith thinks).
- a. The interest rate will have to be the same in the
taxed as in the untaxed industry, since otherwise nobody will invest capital
in the former. True, but ...
- b. That doesn't tell us if the overall interest rate
is or is not changed by the tax.
D. Taxes on the capital value of lands, houses and stock.
- 1. These are transfer taxes and inheritance taxes.
- 2. Inheritance, and transfers of lands and houses, are
public transactions, so may easily be taxed.
- 3. Transfer of moveable property, on the other hand,
can be kept secret, so cannot easily be taxed directly.
- 4. It can be taxed indirectly either by
- a. Requiring that agreements to repay be made on paper
that has paid a stamp duty in order to be enforceable.
- b. By requiring that such transfers be recorded, either
in a public register (i.e. one anyone can see) or a secret register (that
only the tax collector gets to see?), in order to be valid, and then taxing
5. The same method is also often used for inheritance
and transfers of real estate, although they could have been taxed directly
- a. Smith runs through historical examples, Roman and
medieval, in which
- b. The amount of the inheritance tax sometimes depended
on who was inheriting from whom.
6. The tax may or may not be proportional to the value
of what is being transferred. More historical examples.
- 7. Taxes by stamp duties and registration are a new invention,
but have spread very fast, since "There is no art which one government
sooner learns of another, than that of draining money from the pockets
of the people."
- 8. Taxes on inheritance fall on the heir.
- a. This sounds obvious, but it is neither obvious nor
- b. suppose I want to make sure my children have a particular
amount of money to support them, and so
- c. I compensate for the tax by saving more and consuming
less, thus making sure they will have enough after tax.
- d. I am then paying the inheritance tax out of my consumption,
and it is costing my children nothing.
9. Taxes on the sale of land fall on the seller because
(according to Smith):
- a. People usually sell land when they have to, and will
take whatever they can get (i.e. inelastic supply curve).
- b. While buyers are more flexible. So the buyer is willing
to pay a certain amount in tax plus price.
- c. Could be--but why does it have to be?
- d. Smith concludes that such taxes thus are often cruel
and oppressive, since they are falling on someone who is selling property
because he has to, and is thus presumably in a bad poisition already.
10. Taxes on the sale of houses fall on
- a. The buyer if the house is just being build, since
the builder must get his ordinary profit, but ...
- b. On the seller if it is an old house, for the same
reason as with land.
11. All of these taxes are unequal even if proportioned
to the value of the property, since some lands and houses change hands,
and thus get taxed, much more often than others.
- 12. All taxes on the transfer of property tend to reduce
the total amount of capital, shifting money from capital, which maintains
productive labor, to the government, which maintains unproductive labor.
- 13. Registering mortgages and other rights on real estate
is very useful, since it gives security to purchasers (who know what they
are buying, and whether it is encumbered) and lenders.
- 14. But making other transactions public is often inconvenient,
or even dangerous, to people (do you want everyone to know you bought lots
of valuable diamonds?). That you are deeply in debt to the bank?
- a. So registers of such transactions are kept secret.
- b. But a register that must be kept secret should not
be kept at all
- c. Since the people who are keeping them cannot be trusted
(do you want the IRS to know your secrets, and are you sure the local agent
Article III: Taxes on the wages of labor
Article IV: Taxes intended to fall on all sorts of revenue.
- A. Capitation tax (literally head tax, meaning a tax
B. Taxes on consumable commodities
- 1. Intended as a tax on consumption, hence an indirect
tax in income.
- 2. Smith distinguishes between necessaries and luxuries,
including in the former not only what you need to survive but what local
custom makes it indecent for you to go without (a shirt in England then
and California now, at least indoors).
- 3. A tax on necessaries works like a tax on labor--it
makes living and bringing up kids more expensive, which reduces the labor
force, which drives up wages, so the tax is eventually paid in higher wages.
- 4. Taxes on luxuries, even luxuries consumed by the poor
(beer, for example), do not increase wages.
- 5. This seems puzzling; one might think that if beer
gets more expensive and poor people still drink it, they will have less
money to buy necessaries, so the same sequence of events will occur and
wages will again rise.
- 6. But Smith has an answer. The laboring poor are divided
7. So taxes on necessaries raise wages, hence the price
of all manufactures, while ...
- 8. Taxes on luxuries are paid by the consumers of the
- 9. The upper and middle class ought to oppose taxes on
necessaries, and on the wages of labor, because they end up paying them,
with a considerable overcharge.
- a. His "overcharge" here seems to mean only
that, since the taxes on the poor are passed along in higher wages, they
all end up on the not poor--but so would any alternative tax, except for
a tax on the luxuries of the poor.
- b. He may also be thinking about his (mistaken) arguments
that taxes on wages end up costing more than they bring in.
10. He discusses actual taxes on necessaries in Britain:
salt, leather, soap and candles.
- 11. And abroad.
C. Taxes on consumables may be collected either:
- 1. As an annual fee for the right to consume certain
things, or ...
- 2. As a tax on the goods paid by the dealer before the
consumer gets them.
- 3. The former is more convenient for a good, such as
a coach, that lasts a long time, since the tax is spread out over its useful
- 4. But if such taxes were applied to all goods they would
be very unequal, since people who used very different quantities of the
taxed goods would all be paying the same amount of taxes for the right
to use them.
- 5. And would be less convenient for goods that were consumed
quickly, such as beer, since you would be paying a lump sum each year rather
than a little bit each time you bought beer.
- 6. And such a fixed fee would be less effective as a
sumptuary law--to discourage drinking, say--since the marginal tax on an
additional drink would be zero.
- 7. Of course, although Smith does not mention it, this
is an advantage if you are only trying to collect money not discourage
consumption, since it means that the dead weight cost of the tax is less.
D. Excises and Custom duties
E. Taxes on transport--tolls etc.
- 1. Presumably start as user fees for maintaining the
road, but ...
- 2. Get taken over by the sovereign and used as a source
- 3. Increasing the toll, and decreasing the upkeep of
the roads it was supposed to pay for.
- 4. Where the toll is on goods carried from country A
through B to C, they represent a tax B can collect that is paid by people
in A and C.
F. Taxes upon luxuries
- 1. Fall on all sources of revenue (i.e. on revenue, whether
from wages, rent, or profit) and are paid by the consumer of the luxury,
- 2. Not proportionally to revenue, since some people spend
more of their revenue than others
- 3. And someone whose revenue is in country A but who
lives, and consumes, in country B contributes nothing to the government
of A, which is protecting his source of revenue.
- 4. Such taxes can be made certain (i.e. predictable)
and convenient (we are back running through his four maxims of taxation,
and have just covered 1-3).
- 5. But they fail maxim 4--they cost the people much more
than what the government gets, for four reasons.
- a. Collecting them requires lots of customhouse and excise
officers. In England, the salaries of the customs officers are about 10%
of the net revenue of the customs, and their perquisites (non-cash benefits
of the job) are much more than their salaries, so the whole expense is
probably twenty or thirty percent.
- b. Discourage industry.
- i. Obvious if it is a domestic industry that is taxed,
- ii. If we tax import goods, since they are what producers
get in exchange for producing export goods, we make producing export goods
less attractive, so they produce fewer of them.
- iii. More generally, the taxes force the direction of
national industry in a different way than it would have naturally run.
c. Smuggling results in forfeitures and other penalties,
which ruin the smuggler
- i. Who, it is true, is breaking the law, but ...
- ii. A law that does not follow from natural justice,
so he may well be a good person.
- iii. And practically everyone is willing to smuggle when
he is sure he can get away with it.
- iv. And to claim scruples about buying smuggled goods
would in most countries be considered hypocrisy, and make the person claiming
it suspecedt of being a knave.
- v. When Smith became a commissioner of the customs, he
wrote one of his friends a letter saying that after checking the list of
commodities that could not be legally imported he had concluded that practically
everything he was wearing was illegal, and had destroyed his lace, etc.
- vi. He suggested that his friend avoid checking over
the list, for fear of having to do the same thing.
d. Expose the dealers in taxable commodities to harassment
by tax collection, vexation, trouble, ...
G. Smith argues that although the English system of taxation
is pretty bad, the taxation of most other countries is much worse, and
- H. Taxes on consumable commodities may be collected either
- 1. Government employees, in which case the revenue varies
year by year according to how much comes in, or ...
- 2. tax farmers, who agree to pay a fixed amount per year
in exchange for being permitted to collect the tax.
- 3. The latter is a mistake, because
- a. The farmer must make a profit on his advanced capital.
(But this is balanced by his paying earlier than he collects, which is
why he must make a profit on his capital)
- b. He must get paid for his expertise, work, etc.--but
so must the government tax collector. Hasn't Smith already answered these
arguments in his defense of the inland corn merchant some time back?
- c. But Smith thinks the competition for tax farming is
inadequate, due to the huge amount of capital (or credit) required, hence
tax farmers get overcompensated.
- d. And because the tax farmers are oppressive tax collectors,
since once their contract is over they don't care what condition the country
- e. And they lobby for more and more severe laws to force
people to pay taxes.
I. Smith discusses how to reform other countries' taxation
- 1. And observes that France, although richer in towns
etc. than Britain, collects only about half the per capita tax
- 2. And yet the French are much more oppressed by taxes
than the British.
J. He points out that when a country is sufficiently desperate,
and has imposed all the proper taxes, it may have to impose improper ones.
- 1. For example a country that had to spend a lot on warfare
to defend itself, or ...
- 2. Holland and Zealand, which are largely below sea level
and so have to spend a lot to simply stay in existence (dike repairs etc.).
- 3. They survive in part because the great mercantile
families have a share in the government and are therefore willing to stay
in the country even though their capital brings them less, and prices are
higher, than elsewhere.
- 4. If Holland should lose its republican form of government,
the capital would flee and the economy collapse.
Back to Class
Back to Home