History of economics - working groups
Working group 1: pre-classical economics and Adam Smith
Chapter 3, pp. 35-39; Chapter 4, pp. 58-61; Chapter 5, pp. 68-69; 72-88.
Knowledge clip: the invisible hand
Pre-classical economics: mercantilism, physiocratics
Adam Smith
Smith has four central ideas:
1. Specialisation: processes would be more efficient if splitted up and multiple careers
with specialization would arise. Bosses from the specialized workers have another
responsibility: remind them of their purpose, role and dignity of their labor.
2. Consumer capitalism: the surplus of wealth allowed societies to look after the
weakest members. Smith defended this on the basis that it did more good to the poor
than socieities devoted to high ideals. Smith also recognized people have higher needs
that lie outside of capitalist enterprise like education, self-understanding etc.
Capitalism shouldn’t just service our basic material needs, it should make money from
goods and services that deliver true fulfillment.
3. How to treat the rich? How to let them behave well?
Instead of raising taxes (which would only chase away the rich), Smith proposed
something else. The rich should get honour and respect. Governments should
understand the vanity at the heart of the rich and their motivations. Give them honor
and status in return for funding schools and hospitals,and paying their workers well.
4. Educate consumers
Consumers need to be taught to want better quality and pay a proper price for it. Good
capitalist society should exercise its consumer to choose in judicious ways. Capitalism
can be saved by elevating the quality of consumer demand.
Smith’s work is about how human values can be reconciled with the needs of businesses. He
was interested in the issue: how to create an economy that is at once profitable and civilized?
Knowledge clip: the invisible hand
The invisible hand is the single most important image in economics, attributed to Adam Smith
(1723-1790). What we learn from this clip is: what it is, whose hand it is, what does it do,
and why is matters.
What is a problem?
The initial problem it is trying to solve is to explain the social order (society as a whole) - the
stability and optimality of the common life.
The starting point of the argument is: Self-interested individuals who intend only their own
game, look only for their own interests.
These individuals interact with each other on the free market, and led by the invisible hand,
somehow promote the interest of others as well, and thus increase the wellbeing of the whole
society. There are unintended consequences of self-interested actions.
,Interestingly, this happens spontaneously in the market, without external governmental
intervention. Famous quote of Smith: ‘’It’s not from the benevolence of the butcher, the
brewer, or the baker that we expect our dinner, but from their regard to their own self-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.’’
Why does this idea is so important?
It demonstrates one of the key economic ideas, that the interaction of these self-interested
individuals can be social optimal (optimal for all). This social order emerges without
governmental intervention, and reproduces itself spontaneously. Still this society is stable,
people don’t kill each other, they instead interact to each other’s’ benefits.
Any doubts?
The concept is not without problems. If you leave the market to itself, it would produce
monopolies, this happens very often. The market may undermine itself. The market forces
being unstraight can create huge inequalities, which is also far from the idea of social
harmony. Often, people arguing for the invisible hand, in fact argue for their own interests,
which can take over and hide themselves behind the market rhetoric. Finally, the mechanism
of the self-interest is still unclear. The invisible hand of God: the invisible hand is interpreted
theologically.
So, invisible hand is an important concept in understanding market societies. But it is also
somewhat limited. We have to refer critically its potentials and limits.
Working group questions
1. Compare the value theories and policy prescriptions of mercantilists and physiocrats.
What are the differences and similarities both in theory and in policy?
Theory question: What is the source of the wealth for the state?
Mercantilists Money and gold, trade
Physiocrats Agricultural production
Physiocracy (‘rule by nature’) is about physics, democracy is about power. Physiocrats say the value
comes from the nature (abandoness and richness of nature), and you profit from that. Whereas, in the
industry you reproduce, and you don’t produce something new as in the nature. You get some value,
you process this, and reproduce.
Policy question:
Mercantilists Government should always intervene
Physiocrats Don’t intervene, economy works best if let by itself
Physiocrats
You’re paying taxes on your income, something on your own wealth. The same happens in micro
economics. This was direct consequence of physiocratic thought. Money (gold) doesn’t have value,
only nature has value. Money is only a sign of wealth, helping to transfer wealth, but not of itself. But
there is another reason why money matters. One sector with more money than another, becomes more
wealthier. It attracts more money, and then money becomes cheaper. But, in the long run, there comes
inflation, which means no real wealth is available. Everyone is richer, but no one is getting really
richer. Mercantilists believe money matters, because it gives you more dynamics. This is true, but only
in the short run.
, Adam Smith argues in his Wealth of Nations against the mercantilists and supports
free trade and markets.
2. Explain the idea of laissez-faire and why physiocrats supported this idea.
Laissez faire is a concept behind the neoclassical economics. It means that there is no
intervention from the government, as regulation, privileges and subsidies. It argues for a
separation of government and economics.
3. Describe the major contributions and shortcomings of the physiocratic doctrine.
Shortcoming: They only considered the agricultural side: ‘why only the nature?’.
Contributions: What can we say today about the value of nature? The value of nature is higher today,
because it is scarce. Nature is limited, and we can’t produce more. Now economists are going to think
about that. Another powerful contribution is ‘laissez faire’. It has become part of all economic
thinking. They clarified the conditions under which laissez faire works or not.
4. What were David Hume’s arguments against mercantilist theory and policy?
Another contemporarist is David Hume.
Mercantilists They believe trade is a zero-sum game (‘war’)
David Hume Trade is mutually beneficial
Prices species flow mechanism:
When Export is higher than Import Money increases inflation.
When prices are high, it means our goods cost relatively more than goods from abroad. Our goods are
not competitive on the international market anymore. Which means import increases. The
disequilibrium equals again. There is no gain in mercantilist policy: the economy is regulating itself.
Even if you follow this policy, all the additional money you get is useless.
5. What is the general theme of Adam Smith’s Theory of Moral Sentiments?
Self-interest and sympathy; justice, beneficence; virtue (self-command)
The theory is not a social theory, but a moral theory.
Smith investigated the other side of the self-interest: the interest of the greater good (sympathy). The
theory of moral sentiments advances ideas about conscience, moral judgment, and virtue. These
concepts have taken on renewed importance in business and politics.
Theory of Moral Sentiments:
It shows that our moral ideas and actions are a product of our very nature as social creatures. It
argues that this social psychology is a better guide to moral action than is reason. It identifies the
basic rules of prudence and justice that are needed for society to survive, and explains the
additional, beneficent, actions that enable it to flourish.
Self-interest and sympathy. Smith explains, that we as social creatures are endowed with a natural
sympathy. Smith has that meaning what we now call empathy (feeling for others, feel as if you were
the other person). For Smith, this is a powerful moral sentiment. That is, a feeling that has moral
significant, and some kind of normative power in regulating the relations between people, and in
stabilizing the society. Sympathy is important for society. So is also justice and beneficence. We have
to live alongside others without harming them.
For Smith, morality is not something we have to calculate but which is natural, built into social beings.
6. How does it relate to his Wealth of Nations? Explain the idea and the advantages of the
division of labor. What is the role of this concept in Smith's work? What could be the
shortcoming of the division of labor, according to Smith, and the possible remedy?
, Smith became famous because of his Wealth of Nations, which was to critique and offer an alternative
to the mercantilists. Smith thought this policy was foolish and limited the potential for ‘real wealth’,
which he defined as the ‘annual produce of the land and labor the society’.
The remedy is education. Education gives you options. If you don’t see the whole process, your
perspective becomes very limited. Education gives you more insights, in what to do. The division of
labor is a powerful concept, something which works all the time.
7. In what respects might Smith rightly be called an advocate of laissez-faire? On what
basis might one challenge this label?
He doesn’t want governmental regulation, because he wants free market trade. There is no need for
institutions to intervene. People know much better, than anyone who wants to regulate them.
Individuals strive for their own self-interest, while in doing this contributing to the whole society.
That’s because they need things from each other, then trade and overall compete which each other.
The free competition, when everyone pursues his own interest, leads to the whole to become greater.
Public goods (infrastructure, education) are provided by the state, where the state is responsible for.
For this, state intervention can be justified according to Smith. If your country is in war, then laissez
faire is not working, because then your country will be destroyed by the competitor.
8. What is the source of value for Adam Smith?
In mercantilism production is the source of value, while in physiocrats it’s exchange.
Adam Smith is closer to phsyiocrats, but the real source of value is ‘labour’. It’s called the labor
theory of value.
The labor theory of value (LTV) states that the value of economic goods derives from the
amount of labor necessary to produce them.
In LTV, relative prices between goods are explained by and expected to tend toward a
"natural price," which reflects the relative amount of labor that goes into producing them.
In economics, LTV became dominant over the subjective theory of value during the 18th to
19th centuries but was then replaced by it during the Subjectivist Revolution.
LTV suggested that two commodities will trade for the same price if they embody the same
amount of labor time, or else they will exchange at a ratio fixed by the relative differences
in the two labor times.
Best-known advocates of labor theory were Smith, Ricardo, and Marx.
9. What, according to Smith, determines exchange value in a primitive and in an advanced
economy?
In the primitive society (=society without capital) it’s only labor as a factor. Even given this, the prices
are defined by labor.
In the advanced society (=society with capital) it’s also about capital, rent, etc. Labor is part of the
product. Value is not defined by capital. The word value has two meanings: value to use (how you
value it yourself) and the value to exchange (price you can get for it). Smith was interested in the value
to exchange. Exchange value = wage + profit + rent
Primitive society Exchange value is defined by only labor
Advanced society Exchange value is defined by wage, capital (physical, financial), profit,
(interest rate) and land (rent).
10. Explain the meaning of Smith's 'invisible hand' doctrine.
Because everyone is aiming for its own wealth, and striving for self-interest, the collective interest is
also served, due to the unintended effects.
