Final Lecture on Smith
- I. Equilibrium across employments of land, labor and
capital: Smith gets it right.
- A. Equal net advantage in employment--with room for a
little irrationality by optimistic youngsters.
- B. Equal net advantage in agriculture implies that all
equally fertile land receives the same rent, whatever it is growing--save
for specially good vinyards etc.
- C. Equal returns to capital--with a nonpecuniary return
associated with the advantage of having your capital under your own eye.
- D. Smith sees that there is a coordination problem to
explain--and this is part of his explanation. Woolen shirt, invisible hand,
- II. Price Theory:
- A. The normal case is constant cost of production, perfectly
elastic supply curves (our terminology, not his).
- 1. Where cost is the sum of wages, rent, and profit .
- 2. Wages tend towards a natural wage-the level at which
the working class just reproduces itself.
- a. Which depends not merely on what it costs to stay
alive but on how much workers must be getting to be willing and able to
marry and bring up children.
- b. Wages will be above the natural wage if the demand
for labor (which is roughly proportional to the amount of capital, although
a little more complicated than that) is increasing, below if it is decreasing,
at if it is constant.
- c. Since a major input to workers is food, the natural
wage is roughly equal to the price of some fixed amount of corn.
- d. Smith is somewhat unclear as to whether the reason
for the natural wage is
- i. an implicit conspiracy among employers, which cannot
force wages below the natural wage for long, due to common humanity and
(perhaps) running out of workers, and ...
- ii. Breaks down when the demand for workers is increasing
and employers are bidding against each other. Or ...
- iii. population equilibrium--wage below natural wage
means fewer workers means higher capital/labor ratio, means higher wages--etc.
3. Rent is a "monopoly price"--meaning that
it is not determined by the cost of production of land.
- a. What is it determined by?
- b. What is left of the return from selling the output
of the land after paying for agricultural inputs, profit of the farmer,
- c. But that depends on the price of corn, which is itself
supposed to be partly determined by rent! The argument appears circular.
- d. It becomes less circular if we remember that wages,
in Smith's system, are at least roughly proportional to the price of corn-i.e.
equal to the price of a particular amount of corn, so ...
- e. If you take the amount of corn a piece of land produces,
subtract the amount necessary to pay the workers, subtract the profit rate
times the amount necessary to pay the workers (since the farmer's circulating
capital will largely go to advance the workers' wages), what is left is
roughly equal to rent.
- f. Here and elsewhere, Smith is not thinking very carefully
about what determines how much corn it is worth producing from a given
piece of land or which land is worth farming--both of which, as Ricardo
will point out, depend on the price of corn.
- g. Implicitly, much of his argument takes both of those
as fixed--which he signals with the phrase "in the state of the tillage,"
meaning that the amount of land being cultivated and the intensity of cultivation
are held fixed.
4. Capital is mostly circulating capital--the stock that
a merchant or farmer must have available so as to pay his employees now
when he is not going to be able to sell his output until some future date
- a. Smith sometimes takes it for granted that all production
periods are one year--presumably because that is the production period
in agriculture--and occasionally makes mistakes as a result.
- b. The more (circulating) capital there is, the more
prices are driven down and wages up by competition, hence the lower the
- c. Smith has a theory of capital market equilibrium,
but not a very clear theory of what determines how productive capital is.
- d. Oddly enough, he doesn't seem to think of capital
increasing or decreasing in response to the interest rate. At one point
he even argues that high profit rates turn merchants into spendthrifts,
reducing the amount of capital accumulation!
- e. Although he does think of capital accumulation as
a central force determing what happens to a society--improving, stationary,
or declining state.
B. So everything has a natural price equal to cost of
- 1. If effectual demand--i.e. quantity demanded at the
natural price--is greater than quantity produced, the price will rise above
the natural price, quantity produced will increase, until equilibrium is
reached at the natural price.
- 2. Similarly the other way if effectual demand is lower
- 3. Smith recognizes that these processes take time, so
prices may be out of equilibrium when there are sudden changes--such as
the demand for black cloth during a public mourning.
- 4. Notice that Smith is using qualitative arguments,
not quantitative ones--one point on the demand curve is sufficient for
his purpose, since all he has to establish is the equilibrium.
C. All of this is taking technology--i.e. division of
labor, specialized machinery, etc.--as fixed.
- 1. In the longer run, Smith believes that typically production
cost falls as quantity increases.
- 2. In part because of increased division of labor, invention
of machinery, etc., and ...
- 3. In part because of increased competition.
- 4. Which sometimes means "competitive price instead
of cartel price"
- 5. And sometimes means "excess supply driving down
prices"--in this case the former meaning.
- IV. Trade Theory:
- A. Smith has an absolute advantage trade theory, which
isn't so odd if you remember that he is living in a gold and silver standard
world, where prices really are directly comparable across countries.
- B. So "Britain has a comparative advantage in producing
wool" and "the cost in gold of producing wool in Britain is lower"
- C. Gold being a good with a very low transport cost.
- D. The essential point in Smith's position is that the
ultimate objective is getting goods to consume, not accumulating gold and
silver. Hence we normally want to buy wherever we can do so at the lowest
- E. With some exceptions for the need to raise revenue,
maintain military preparedness, and the like.
- V. We have to be careful about understanding Smith's
terminology, in big matters and small:
- VI: Applications of the theory
- A. To an attack on restrictions of economic freedom at
- 1. the guild system.
- 2. The settlement laws--restrictions on internal migration
associated with the local welfare system.
B. To an attack on mercantilism-
- 1. Which was the doctrine that a nation was rich or poor
according to how much gold and silver it had,
- a. And that government should therefore intervene in
order to produce a "favorable" balance of trade, meaning ...
- b. Exporting a greater value of goods than you import,
thus bringing gold into the country (since foreigners pay you with gold,
you pay them with gold, and they are paying you more than you are paying
2. It seems overdone to a modern economists, since none
of us take mercantilism seriously, but it was the dominant position when
Smith wrote, although being challenged both by Smith and the Physiocrats
(what Smith calls the Agricultural System).
- 3. And it is still a dominant position outside of the
- a. Because simple arguments are better than complicated
arguments when what matters is sounding smart not getting the right answer,
- b. Because mercantilism provides arguments for policies
that are politically attractive as ways of transferring money to well organized
interest groups--a point Smith clearly saw when he wrote that
- c. Those who made these arguments were by no means such
fools as those who believed them.
4. Smith's attack on mercantilism demonstrates several
- a. That mercantilism makes no sense as a way of making
a country rich.
- b. That it does not work on its own terms, since the
amount of gold and silver in a country, like the amount of pots, automatically
adjusts to the need for them, so that ...
- c. Keeping more in requires enormous and costly efforts
(Spain and Portugal) and makes the country poorer, not richer (ditto).
- d. That it makes little sense as a source of military
power, since wars are not paid for out of stored up treasure nowadays but
out of current export surpluses--which happen automatically when the government
is taxing money and spending it abroad on the war.
- e. That many of the policies adopted make no sense even
on mercantilist terms, and ...
- f. That their real effect is to make the country poorer,
largely by causing a misallocation of capital.
5. Most of this is right--the one weak point is Smith's
argument that the natural allocation of capital among differnet sorts of
activities is also the optimal allocation for the nation.
- a. He wants capital used in ways that employ as much
English labor as possible.
- b. Which means a preference for home over foreign use
(and for short production periods--a point he notes in foreign trade but
not in home manufacturing)
- c. And capitalists have such a preference--because they
want the money under their eye, but ...
- d. That doesn't give you that particular allocation that
employs the maximum of English labor, so ...
- e. While Smith's argument implies that mercantilist policy
pushes us in the wrong direction, by encouraging English capital to go
into foreign trade (for instance, by giving England a monopoly in dealing
with its colonies) it also suggests that we should have a reverse mercantilist
policy to push capital in the opposite direction.
- f. He tries to get out of this by noting that a certain
amount of the more distant uses is needed to support the nearer uses (foreign
trade to export the local manufactures, for example), but at this point
the theoretical structure breaks down--how do we know we are getting the
right amount for that purpose naturally, and ...
- g. Why not force English capital to home uses, and pull
in some Dutch capital (can get it cheap) for the carrying trade?
C. To an analysis of what government ought to do
- 1. For the most part, leave people alone to act in the
general interest from self interested motives, but ...
- 2. Provide national defense, some highways and canals,
forts in Africa, ...
- 3. A few interventions to make up for glitches in the
- a. usury laws--to encourage!!! capital accumulation
- b. Limits on the issue of small paper money.
- c. Requiring firewalls between houses, ...
4. Charter joint stock corporations for a very few limited
purposes, occasionally give temporary monopolies (patents, merchant company
opening up new markets), but not long term ones.
- 5. Maybe subsidize basic schooling for the poor, while
maintaining a school system largely paid for by the customers.
D. How it ought to do it.
- 1. Take advantage of self interest when possible, as
in having a canal run by someone who gets to pocket the tolls.
- 2. Use user fees when practical--for both justice and
- 3. And local taxes when user fees are not an option for
E. And pay for it.
- 1. Smith tries to use his theoretical structure to figure
out the effect of different taxes, with varying degrees of success.
- 2. The crucial element he has and our theories don't
is the population equilibrium/natural wage argument, which implies
- 3. That taxes on subsistence get passed on in wages and
- VII. In applying his theory, he often gets the details
- VIII: Occasionally wrong:
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