Transition to Smith: The Physiocrats

1. Transition to Smith: The Physiocrats Fixation on agriculture • Manufacturing & commerce sterile Champions of laissez – faire • François Quesnay (1694 – 1774) • Physician to Mme. de Pompadour: Economy Anatomy/Circular flow • Leader of group: disciples and associates including Mirabeau, Dupont, Turgot, … and Smith • Tableau Economique an Input-Output table Initially: Landlord has cash; farmer has grain; artisan has stock of goods Landlord buys and food and manufactures…Manufacturer buys food • Zig – zag to balance flows • Agriculture  increased wealth (counter to Colbert’s favoring mfg) • Taxes ultimately borne by landlords  tax land rents directly • Hoarding (of money) threatens economic stability…{Malthus/Keynes} • Free trade/free competition most profitable for the nation…{Smith} The tableau: http://www.newschool.edu/nssr/het/essays/youth/tableauoverview.htm#summary

2. The Visions of Adam Smith • Self – regulating system of markets • Virtuous circles … Progress • Rule of Law/Property Rights  Productivity  Rule of Law • Division of Labor  Extent of Market  Division of Labor Social interdependence  [Social science]—Invisible hand • Economy  Solar System  Social Physics • Self –regulating system of markets • Newtonian influence • Progress! • Material progress: HuntersShepherdsFarmersMerchants • Progress in governance: Increased liberty/security of property Feedback to material sphere

3. Glasgow University Student of Francis Hutcheson Greatest happiness of greatest number Friendship with David Hume Chair of Logic (1751),Moral Philosophy (1752) Theory of Moral Sentiments, 1759 Lectures on Jurisprudence, early 1760s Tutor of Townsend’s stepson  Continental travel, 1764 – 1766  Acquaintance with French Physiocrats  Generous pension Kirkcaldy, 1766 – 1776 The Wealth of Nations, 1776 Scotland Commissioner of Customs Scottish Enlightenment Adam Smith, 1723 – 1790 • Smith’ s Contacts • Hutcheson/Hume • Quesnay/Physiocrats • Burke/Johnson/Reynolds/ Gibbon/Franklin

4. From The Theory of Moral Sentiments, 1759 • How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it. • Lets translate the rest • It hurts to be the object of hatred and indignation; and there is satisfaction in being beloved [and respected]. This is more important to happiness than all the [material] advantage a person expects to get from it. The Wisdom of Adam Smith

5. Theory of Moral Sentiments • Because others sympathize more with our joy than with our sorrow, we show off our riches and conceal our poverty … it is from this regard to the sentiments of mankind that we pursue riches and avoid poverty. • We want to be respectable and respected…To deserve, get and enjoy the respect and admiration of others are the great objects of ambition. • There are two different ways to achieve this: • one, by the study of wisdom and the practice of virtue; • the other, by the acquisition of wealth and greatness. • Smith’s martial spirit

6. Saving hundreds of millions in China at the cost of our little finger: • … what is it which prompts the generous upon all occasions and the mean upon many to sacrifice their own interests to the greater interests of others, …counteracting the strongest impulses of self-love?. . . It is a stronger love, a more powerful affection, the love of what is honorable and noble … An affection more powerful than self – love!

7. Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 Division of labor Self Interest and Cooperation in Markets Role of government Foreign trade Labor theory of value Theory of distribution Accumulation and progress

8. Adam Smith Problems? • Inconsistency between Moral Sentiments and Wealth of Nations? • Skepticism of tradesmen • Important roles of government • Defense/Justice/Public Goods…Education • Plagiarism

9. Adam Smith Problems? • Inconsistency between Moral Sentiments and Wealth of Nations? Theory of Moral Sentiments as foundation of Wealth of Nations • Freedom within self-imposed ethical constraints • Moral Sentiments explains how self-interested “economic man” erects barriers against his own passion  generally accepted rules of behavior • Man is formed for society with an original desire to please • Desire for praise…and for praiseworthiness in own mind • Rules of Justice/System of Law: preconditions for social order

10. Smith: Stages of History/DevelopmentInteractions between rule of law and economic progress Rude State Hunter/Gatherer (American Indians) Personal Liberty + Lack of institutions to secure private property Small Communities Few Disputes Agriculture Farmer (Feudal Europe) Property in Land Feudal Authority (Landlord Rules) Commerce Merchants (City-States) City as counterwt to landed aristocracy Trade & Mfrs “Good Gov’t” GROWTH Pasture Shepherd (Arabs, Tartars) Private Property in Cattle Civil Government (Defend rich against poor) Nomadic K i n g C o n q u e s t

11. Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 Division of labor Increasing Returns to Scale

12. From An Inquiry Into the Nature and Causes of the Wealth of Nations …the division of labor is limited by the extent of the market • To take an example, the trade of the pin-maker; a workman not educated to this business could scarce, perhaps, with his utmost industry, make one pin in a day… But [pin making] is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head…Making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands… I have seen a small manufactory … but indifferently accommodated with the necessary machinery [where ten men could] make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size… Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day…

13. Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 Self Interest, Competition and Cooperation in Markets The invisible hand

14. Economic Man: Self – interest, competition and exchange • This division of labor…is not originally the effect of any human wisdom, which foresees and intends the general opulence to which it gives occasion. It is the necessary … consequence of a propensity in human nature …to truck, barter, and exchange one thing for another. • In civilized society [man] stands at all times in need of cooperation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons.... [M]an has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. • It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages... • [Value] is adjusted... by the higgling and bargaining of the market, according to that sort of rough equality which, though not exact, is sufficient for carrying on the business of common life. • …the rivalship of competitors, who are all endeavoring to jostle one another out of employment, obliges every man to execute his work with a certain degree of exactness.

15. Evils of monopoly • Monopoly...is a great enemy to good management. • People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. • As soon as the land of any country has all become private property the landlords, like other men, love to reap where they never sowed and demand a rent even for its natural produce. • The monopolists, by keeping the market constantly under-stocked…sell their commodities much above their natural price and raise their emoluments, whether they consist of wages or profits, greatly above their natural rate… Virtues of competition • [W]here competition is free, the rivalry of competitors, who are all trying to jostle one another out of employment, obliges each to work with a certain degree of exactness... • The natural price, or the price of free competition ... is the lowest which can be taken, not on every occasion, but for any considerable time ...[It] is the lowest price which sellers can commonly afford to take and stay in business.

16. Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 Limited role of government • Protect societyfrom invasion • Administer of justice • Public worksandpublic institutions

17. The Role of Government and Laissez – Faire • Every individual... neither intends to promote the public interest nor knows how much he is promoting it...[B]y directing [his] industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this … led by an invisible hand to promote an end which was no part of his intention. Social Physics: Newton in the Economic Universe

18. Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 Foreign trade (Absolute Advantage) Free trade Extended market Increased division of labor

19. Free trade • … never make at home what it costs more to make than to buy... If a foreign country can supply a commodity cheaper than we can make it, buy from them with goods where we have an advantage. • By means of glasses, hotbeds, and hotwalls, very good grapes can be raised in Scotland, and very good wine can be made of them at about thirty times the expense for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland? • A great empire [America] has been established for the sole purpose of raising up a nation of customers who are obliged to buy from our shops and producers all the goods we can supply. For the sake of that little enhancement of price which this monopoly might afford our producers, the home-consumers have been burdened with the whole expense of maintaining and defending that empire…The interest on the debt incurred is not only greater than the whole extraordinary profit made by the monopoly of the colony trade, but greater than the whole value of that trade...

20. Smith: Thoughts on the state of the contest with America Cost – benefit analysis: value of taxes vs. cost of defeating and policing the colonies • If retain colonies, should give them (and Ireland) representation in Parliament • Because of America’s growth potential, she would become the “seat of the empire” in line with her contribution to defense via taxes • Worst case scenario for Smith: • Lose the United Colonies • Retain Canada, which is expensive to defend

21. Themes in An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 Theories of value Labor theory of value (rude state) Place of profit

22. Smith’s Theory of Value “Every man lives by exchanging  becomes by some measure a merchant” Value in use—Value in exchange—Market price…not the same • Natural price: the central price, the price to which all prices are continually gravitating…this center of repose…neither more nor less than what is sufficient to pay the rent of land, the wages of labor, and the profits of stock employed in raising, preparing and bringing it to marke S—D interactions: market price reverts to natural price • {Labor} Theory of Value Labor cost theory / Labor command theory • The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toilandtrouble of acquiring it … What is bought with money or with goods is purchased by labor, as much as what we acquire by the toil of our own body. That money or those goods indeed save us this toil. They contain the value of a certain quantity of labor which we exchange for what is supposed at the time to contain the value of an equal quantity. Labor was the first price, the original purchase-money that was paid for all things … and its value to those … who want to exchange it for some new productions is precisely equal to the quantity of labor which it can enable them to purchase or command.

23. Smith’s Labor Theory of Value • At all times and places that is dear which it is difficult to come at, or which it costs much labor to acquire; and that cheap which is to be had easily, or with very little labor. Labor alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. It is their real price; money is their nominal price only. • Smith’s theory of money: just a convenience • Gold and silver’s values depend on the toil and trouble (labor) of mining them. Deer and beavers: 2 Deer = 1 Beaver • In that early and rude state of society which precedes both the accumulation of stock and the appropriation of land, the proportion between the quantities of labor necessary for acquiring different objects seems to be the only circumstance which can afford any rule for exchanging them for one another. If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer,one beaver should naturally exchange for or be worth two deer. • No return to capital? • Later, once land is appropriated, what about rent?

24. Smith’s Theory of Distribution • … the three great social classes  Alternative theory of value • Labor  wage • Capital  profit • Landlord  rent But if all value comes from labor, where do profit & rent come from? … Rent makes the first deduction from the produce of labor employed upon the land … and the produce of almost all other labor is liable to the like deduction of profit. • Exploitation? … Smith doesn’t go there Profit rate: a multiple of the interest rate on money … wherever a great deal can be made by the use of money, a great deal will be given for the use of it … The progress of interest therefore may lead us to form some notion of the progress of profit. Net Profit = Gross Profit – Interest {Both interest and profit fluctuate with investment opportunities} • Rent: … High and low wages and profits are causes of high or low prices; high or low rent is the effect of it (high or low prices). Progress  Increased Demand  Higher Prices  Higher Rent

25. Accumulation, Wages, and Profits(Accumulation: Saving and Investment by Capitalists) Accumulation Wage fund Wage (Iron Law of Wages) Population Productivity Profit

26. Smith’s Theory of Progress The division of labor is limited by the extent of the market • What extends the market and increases division of labor? Spatial factors: • Urbanization  agglomeration economies • Location on seashores and rivers • Improvements in transportation Colonial settlement … imperialism Foreign trade Free competition Increased domestic income • Higher wage • Increased population Extent of the market  Division of Labor  Productivity  Output Income Price

27. Smith’s Spiral of Growth National Wealth II National Wealth I Employment with increased Division of Labor Opportunity for division of labor Profit Expectations Increased Labor Supply (Reduced Mortality) Demand for Investment Higher Wage Increased interest rate Increased Demand for Labor Increased Saving Accumulation

28. More Adam Smith Problems • Division of labor  Alienation … The man whose whole life is spent in performing a few simple operations … has no occasion to exert his understanding or to exercise his invention … [He] becomes as stupid and ignorant as it is possible for a human creature to become. His dexterity at his own trade [is] acquired at the expense of his intellectual, social, and martial virtues. … It is otherwise in the barbarous societies … every man is a warrior. Economic progress  Moral decay & economic stagnation • Division of labor = Increasing Returns  Monopoly Industrial Age  concentration Globalization and information age  Agglomeration and networking, not concentration • Microsoft? • Google?

29. Spiraling progress … or stationary state? It is in the progressive state, while society is advancing toward further acquisition, rather than when it has acquired its full complement of riches, that the condition of the great body of people seems to be happiest and most comfortable. It is hard in the stationary state and miserable in the declining state. …that full complement of riches which the nature of its soil and climate and its situation with respect to other countries allows it to acquire. In a country fully peopled in proportion to what either its territory could maintain or its stock employ … In a country fully stocked in proportion to all the business it had to transact … the competition would be great and the ordinary profit as low as possible. An extinguished Sun … in the very long-run But until then, Smith prophesies progress for the commercial age (he does not see beyond that age). So…Don’t worry! Be happy! Also, Natural price of labor = “necessaries and conveniences” • “Convenience” component of subsistence can rise with attainment

30. Adam Smith: A Summation • Moral sentiments a first principle. • Market coordination of self – interested individuals “Economic man” led by an “invisible hand” Competition  Efficiency and Equity • Guard against monopoly • Laissez – faire! Restricted government trumps government restrictions • Labor theory of value … and beyond • Progress through specialization and exchange The division of labor is limited by the extent of the market. Spiraling progressRule of LawSpiraling Progress Stagnation and decline in the distant future