Last Time: Late Pre-classical Economic Thought (1500 – 1750)

1. Last Time: Late Pre-classical Economic Thought (1500 – 1750) Mercantilists, Precursors of classical economic thought, Physiocrats. Q: What is the main contribution of the Mercantilists and Physiocrats? A: The idea that the economy could be formally studied.

2. History of Economic Thought Ch 4: Classical Economic Thought – Adam Smith Adam Smith (1723 - 1790)

3. Classical Economists Adam Smith (1723 - 1790)

4. Classical Economists Main question: what is “the Nature and Causes of the Wealth of Nations”? Associated the wealth of nations with its production, not with its gold. Studied how output and prices are determined in a market economy. Adam Smith (1723 - 1790)

5. Adam Smith (1723 – 1790) Adam Smith (1723 - 1790)

6. Background – Influenced by – Contributions – Impact - Critique Adam Smith was a Scottish Philosopher and Economist. Considered by many the father of economics. At age 14 he enrolled at Glasgow University to study moral philosophy, and later studied moral and political science in Oxford. Adam Smith (1723 - 1790)

7. Background – Influenced by – Contributions – Impact - Critique 17th century is “The Age of Enlightenment”. Enlightenment thinkers believed that reasoning might be applied to all areas of human activity, and carried into the governmental sphere, in their explorations of the individual, society and the state. Adam Smith (1723 - 1790)

8. Background – Influenced by – Contributions – Impact - Critique Francis Hutcheson (1694 –1746), his teacher of Moral Philosophy, inspired Adam Smith to be passionate about liberty, reason, and free speech. Adam Smith (1723 - 1790)

9. Background – Influenced by – Contributions – Impact - Critique Aristotle (384 – 322 BC), a student of Plato who supported private property. Adam Smith (1723 - 1790)

10. Background – Influenced by – Contributions – Impact - Critique Thomas Hobbes (1588 –1679), English Philosopher, famous for his book “Leviathan”, in which he studies the need for governments in a society. Adam Smith (1723 - 1790)

11. Background – Influenced by – Contributions – Impact - Critique John Locke, (1632 –1704), English Philosopher, considered private property as natural right, advocated a government with checks and balances, and had influence on the Constitution of the United States and its Declaration of Independence. Adam Smith (1723 - 1790)

12. Background – Influenced by – Contributions – Impact - Critique Bernard Mandeville (1670 – 1733), Argued that selfishness is a moral vice but social good could result from selfish acts if these actions were properly channeled by the government. Gave examples of division of labor: “But if one will wholly apply himself to the making of Bows and Arrows, whilst another provides Food, a third builds Huts, a fourth makes Garments… [the society will] receive much greater Improvements…” Adam Smith (1723 - 1790)

13. Background – Influenced by – Contributions – Impact - Critique Montesquieu (1689 – 1755), famous for his articulation of the theory of separation of powers (division of government into the Executive, the Legislative, and the Judicial branches). Adam Smith (1723 - 1790)

14. Background – Influenced by – Contributions – Impact - Critique David Hume (1711 – 1776), Scottish philosopher, historian and economist, close friend of Adam Smith, exchanged ideas, Adam Smith has been known to have added some of David Hume’s work in Wealth of Nations. Adam Smith (1723 - 1790)

15. Background – Influenced by – Contributions – Impact - Critique Richard Cantillon(c. 1680 – 1734), developed long run price equilibrium, and a two sector general equilibrium, quoted by Adam Smith in the Wealth of Nations. Adam Smith (1723 - 1790)

16. Background – Influenced by – Contributions – Impact - Critique • Mercantilists - The motivation to prove mercantilist theory wrong was one of his major efforts in Wealth of Nations. Adam Smith (1723 - 1790)

17. Contributions Division of Labor Invisible Hand The Role of Government Adam Smith (1723 - 1790)

18. Background – Influenced by – Contributions – Impact - Critique Division of Labor “One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into paper.” Adam Smith (1723 - 1790)

19. Background – Influenced by – Contributions – Impact - Critique Division of Labor He observed a production unit of 10 workers producing pins. If each of the 10 workers performed all the tasks, the daily output would be 200 pins. When the production is divided into 10 different tasks, the same workers make 48,000 pins in one day (240 times more!). Adam Smith (1723 - 1790)

20. Background – Influenced by – Contributions – Impact - Critique Division of Labor He concluded that division of labor can increase the output at the global level. Specialization and trade, is division of labor at the global level. Adam Smith (1723 - 1790)

21. Background – Influenced by – Contributions – Impact - Critique Invisible Hand “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 necessities but of their advantages.” The Invisible Hand is the quest for profit. Adam Smith (1723 - 1790)

22. Background – Influenced by – Contributions – Impact - Critique Invisible Hand – Modern Illustration Representative firm Market for Chinese Restaurants MC Costs Price S S1 AC profit PLR D1 D Quantity Quantity Adam Smith (1723 - 1790)

23. Background – Influenced by – Contributions – Impact - Critique Consequences of Invisible Hand Each firm will produce at minimum average costs. If for some reason the price is above PLR, then firms will enter the industry and reduce the price to minimum AC. Firms have incentive to innovate to improve quality and reduce costs, and thereby have above normal profit. Adam Smith (1723 - 1790)

24. Background – Influenced by – Contributions – Impact - Critique Consequences of Invisible Hand 3.Firms respond to changes in consumers’ tastes without government regulation. If the demand for some good drops, the price will decline below PLR, profits will be below normal, and the number of producers will decline. Similarly, if the demand for some good rises, its price will rise above PLR, increasing the profits above normal, which leads to entry of new firms. Adam Smith (1723 - 1790)

25. Background – Influenced by – Contributions – Impact - Critique Invisible Hand It is difficult to imagine any government being able to collect information on all the consumers’ preferences and all the firms’ technologies, and finding the optimal output level in each firm. It turns out that the Invisible Hand (or the desire of firms to increase their profit) makes everybody better off. Adam Smith (1723 - 1790)

26. Background – Influenced by – Contributions – Impact - Critique The Role of Government Adam Smith, although argued that markets are efficient, pointed out that sometimes there are market failures (public goods, monopolies). He argued that government intervention is justified in cases of market failure. Adam Smith (1723 - 1790)

27. Background – Influenced by – Contributions – Impact - Critique The Role of Government “The first duty of the sovereign, that of protecting the society from the violence and invasion of other independent societies” “The second duty of the sovereign, that of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it” Adam Smith (1723 - 1790)

28. Background – Influenced by – Contributions – Impact - Critique The Role of Government “The third and last duty of the sovereign or commonwealth is that of erecting and maintaining those public institutions and those public works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature that the profit could never repay the expence to any individual or small number of individuals, and which it therefore cannot be expected that any individual or small number of individuals should erect or maintain.” Adam Smith (1723 - 1790)

29. Background – Influenced by – Contributions – Impact - Critique The Role of Government “After the public institutions and public works necessary for the defence of the society, and for the administration of justice, both of which have already been mentioned, the other works and institutions of this kind are chiefly those for facilitating the commerce of the society, and those for promoting the instruction of the people. The institutions for instruction are of two kinds: those for the education of youth, and those for the instruction of people of all ages.” Adam Smith (1723 - 1790)

30. Background – Influenced by – Contributions – Impact - Critique • Adam Smith’s Contributions: • He helped make Political Economy into an “autonomous systematic discipline” • The invisible hand, division of labor, • Adam Smith has influenced many Economists • David Ricardo • David Ricardo became interested in Economics after reading Wealth of Nations. • All the other economists that followed. Adam Smith (1723 - 1790)

31. Background – Influenced by – Contributions – Impact - Critique • Adam Smith’s efforts arguing against Mercantilism paved way for Britain to engage in free trade. • Britain dropped some Mercantilist thought years after Wealth of Nations. • Adam Smith’s theories appear today in our microeconomic and macroeconomic text books • Some recognizable theories are: The Invisible Hand, Division of Labor, and the concept of Lassiez-faire. Adam Smith (1723 - 1790)

32. Background – Influenced by – Contributions – Impact - Critique • Adam Smith did not believe in the usefulness of statistics in economics, an approach proposed by William Petty (1623 – 1687). • His almost 1000 pages book, the wealth of nations, could have been much shorter and clearer had he used graphs and math. Adam Smith (1723 - 1790)

33. Questions and Discussion Give an example of division of labor from your everyday life. Give an example of the workings of the Invisible Handfrom your everyday life. These days we often hear a call for government intervention in the market for energy, environment and global warming, health care. How would Adam Smith propose to address these issues? In Wealth of Nations Smith emphasized how self interest, while in his previous work Moral Sentiments he emphasizes sympathy for others. How would you reconcile this apparent contradiction? Adam Smith (1723 - 1790)