Adam Smith Theory

  • Adam Smith, the father of Economics is regarded as the pioneer of classical economics and in his book “An Enquiry into the Nature and Causes of the Wealth of Nations” published in1776, focused on economic development.
  • Generally speaking, the classical theorists mainly focused on the ways market economies function and their studies are mostly on the dynamics of economic growth
  • Apart from Adam Smith, other classical theorists are David Ricardo and Thomas Malthus.

The Theory

In explaining Adam Smith’s theory of economic development, the concepts of Laissez-faire, division of labour, and capital accumulation are important.

Laissez –faire

Adam Smith’s theory is based on the principle of laissez-faire, where the economy is free from government intervention and the “invisible hand” guides the market mechanism.

According to Smith, people are the best judge when it comes to pursuing their self-interests, and allowing each individual to pursue his/her own interest, they end up achieving the aggregate interest of the society.

That is to say, each person’s self-interest leads him/her to serve the wants of his fellow man.

 For example, a food seller does not sell food because she is nice or kind hearted, but she does so because of her self- interest (probably trying to earn a living) and in so doing, she satisfies the wants of her customers leaving everyone better off.

In Smith’s opinion people should be left to pursue their own interests without any interference from the government as the invisible hand is there to automatically regulate the activities of the perfectly competitive markets in the overall interest of the whole economy.

Division of Labour

In Adam Smith’s book (The Wealth of Nations), focus was laid on the concept of economic growth and this growth, according to Smith, is rooted in increasing division of labour.

According to him, it is division of labour that results in the greatest improvement in the productive power of labour.

Stating further, he noted that the productive capacity of labour increases as a result of improved craftsmanship of workers which saves time and labour as there is also the invention of large number of labour-saving machines.

Division of labour is brought about by the human nature that tends to make people want to exchange one thing for another and it depends on the size of the market. So when market increases then division of labour would increase..

Division of labour means that people cooperate to do different works as these works are

broken down into small parts, each undertaken by different workers.

By cooperating with each other, craftsmanship is built, time is saved more goods are produced, people have enough to consume, innovation is promoted, market is enlarged; income increases and all these would give rise to increase in productivity.

However, division of labour according to smith depends on the size of the market which depends on the population.

Capital Accumulation

Smith viewed capital accumulation as a necessary condition for economic development.

He reasoned that the ability of people to save and invest (more) would lead to economic development.

Savings leads to investment and with higher savings comes higher investment.

In Smith’s theory, only the capitalist and the land owners could afford to save because of the investment capital or rent on land they possess, while the labourers on the other hand are unable to save because they earn wages only enough for consumption i.e. subsistence wage.

This idea is based on the belief of “Iron law of wage” (That is wages tend toward a level sufficient only to maintain a substance standard of living).

Smith noted that at any point, when total wages by workers increase, more labour will be supplied to the market and competition for employment will become tense and keener, this will therefore force wages down to its subsistence level making the workers unable to save and this according to Smith is what happens in the stationary state.

Smith believed that in periods of rapid capital accumulation, wage rates rise above the

subsistence level however the rate at which they rise will depend on the population growth and on the rate of accumulation.

Adam Smith also described the relationship that exists between wage and profit. According to him, profits fall as wages rise when an economy progresses.

When the rate of capital accumulation increases, increasing competition among capitalists raises wages and tends to lower profits.

The increasing difficulty in finding new profitable investment outlets is actually responsible for this fall in profits because the economy becomes stagnant as profit is pulled down.

The Agents and Process of Growth in Adam Smiths’s Theory

The theory identifies the farmers, producers and businessmen as the agents of economic progress.

 Noted that the functions of these agents are interrelated, as the development of one would lead to the development of others.

 He posited that it was free trade, the enterprise nature, and competition of these three agents that leads to development.

Smith assumed that in the growth process, institutional, political and national factors are

considered to remain unchanged and the growth process is steady and continuous because one development stage leads to the other.

Each situation grows out of the preceding one in a uniquely determined manner with each individual agent of growth performing their own bit in the process.

According to Smith, the growth process is thus cumulative.

The good performance of the agricultural sector, commerce, industrial and manufacturing sectors, would lead to capital accumulation, technical progress, population increase, expansion of

market, division of labour and a continuous rise in profit and hence the wealth of the nation.

In reality however, we know that there is limited supply of natural resources and the scarcity of this will eventually stop growth thereby leading the economy to a stationary state which is the end of capitalism.

In the stationary state, the competition for employment would reduce wages to subsistence level and competition among businessmen would bring profits as low as possible and investment will also decline.

As a result, Capital accumulation stops, population becomes stationary; profit is at the

lowest; wages are at the subsistence level; production and per capital income remain stationary and then also the economy reaches stagnation.

Weaknesses of the Theory

1) Erroneous notion of the role of wages and profit: According to the theory with rise in wage, profit goes down and economy stagnates and wages will fall to subsistence level.  In reality however, this is not true for a developed economy as wages and profits have been known to increase simultaneously.

2) The theory recognized technology but its importance was not stressed. The theory failed to see the role of technology in falsifying the stagnation stage of the classical system.

3) In real life situation, growth process is not smooth as the theory would have us believe. Development is never smooth or steady.

4) It assumes the existence of a rigid division of society between the rich capitalist and the poor labourers. In the theory, the middle class was not considered and that is not what is obtainable in our societies.

5) Smith’s theory focuses on the principles of laissez-faire where there is perfect competition. This is not found in any economy as there is nowhere in the world where a form of restriction is not imposed.

6) According to the theory, only the rich capitalist and landlords save because they have the capital to do so. This is not true because in modern society as we have today, the major source of

savings is usually from the income earners and not the capitalists who are always looking for opportunities to borrow and invest in one business or the other.

Despite all these criticisms, the theory can still be credited with having been able to make some good points as far as growth of an economy is concerned. For example, it emphasised on the importance of savings to capital accumulation; importance of division of labour and expansion of

markets in production. It also stressed on the importance of balanced growth in the process of growth.

IS the theory relevant to Less Developed Countries?

The following are the applicability of the theory to the developing countries:

1) The economies of the LDCs are characterized by low income, low savings, low investment and a high propensity to consume (every increase in income is consumed). All this makes the

market remain small and hence impede the growth of division of labour and further expansion of market for development.

2) Political, social and institution assumptions underlying Smith’s theory are not applicable in underdeveloped countries. Also, the principle of laissez-faire cannot be effective in allocating scarce resources because exploitation of the masses will be the order of the day. Therefore, for development to take place in a less developed country, government intervention is very necessary.

Despite all these, the theory can still be said to be relevant to the less developed countries because Smith gave some key points that can help any economy to achieve growth and examples are the agents of growth mentioned in the model, the promotion of balanced growth in an economy, and the emphasis laid on savings.

Brief Summary of the Classical Theory

Adam Smith, David Ricardo, Thomas Malthus and John Stuarts Mill are all proponents of the classical theory of development and their works put together can be briefly summarized as follows.

1) Laissez-faire policy- Free market perfectly competitive economy devoid from any government intervention where the ‘invisible hand’ guides the market mechanisms.

2) Capital is a key to economic progress- They Believed that capital is the key to progress and as such emphasis is laid on larger savings as it is believed that it would bring about capital

accumulation.

3) Profits as an Incentive to investment-The classicalist believed also that profits induce investment. The greater the profit the greater the capital accumulation and investment.

4) According to the classicalist, there is a tendency for profits to decline when there is an increase in competition for larger capital accumulation among capitalist.

5) Classicalist all agree upon the fact that there is a stationary state which is the end of the process of capital accumulation. According to them, as profits start declining, it continues to do so until it gets to zero, population and capital accumulation stop increasing and the wage rate gets to the subsistence level.

Leave a Reply

Your email address will not be published. Required fields are marked *