ECS3705 ESSAY BASED QUESTIONS AND ANSWERS

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” This statement was made by Adam Smith who was one of the major contributors of the Classical School. The consumer looks to find the lowest price for a good, given its quality. The worker tires to find the highest pay, given the nonwage aspects of the job. Each of these members of the market look out for themselves (self-interest) by first meeting their own needs but still give the client a fair deal. Thus they are still being moral and everyone is better off in the end. But hidden within the apparent chaos of economic activity is a natural order. There is an invisible hand that channels self-interested behaviour in such a way that the social good emerges. 2. Smith on self-interest Smith’s self-interest refers to the desire to meet one’s own needs – earn your own money, pay your own food. This type of self-interest is entirely moral and can even go a step further where one is concerned with the interests of others. Self-interest as the dire to meet one’s own needs is thus not inherently immoral, selfish or greedy. It only becomes theses when done at the exclusion of a concern for the interests of others, when it is pushed so far that it squeezes out any generosity or any desire to see others get a fair deal to. 3. The key to understanding Smith’s invisible hand is the concept of competition. The action of each producer or merchant who is attempting to garner profit is restrained by the other producers or merchants who are likewise attempting to make money. Competition drives down the prices of goods and in so doing reduces the profit received by each seller. In situations in which there is initially only a single seller, extraordinary profit attracts new competitors who increase supply and erase the excessive profit. In an analogous way, employers compete with one another for the best workers, workers compete with each other for the best jobs, and consumers compete with one another for the right to consume products. Stated in contemporary economic terms, the result is that resources get allocated to their highest valued uses; economic efficiency prevails. Furthermore, because business persons save and invest—again out of their self-interest—capital accumulates and the economy grows. The pursuit of self-interest, restrained by competition, thus tends to produce Smith’s social good—maximum output and economic growth. 4. The division of labour Division of labour is whereby a job is divided into a number of distinct operations (number of branches). For example a Pin maker who doesn’t employ machinery or other employees can make only one pin per day, but if its divided into a number of branches; 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 and so forth. In the case they might make 20 pins a day. Smith said the division of labour increased the quantity of output produced for 3 reasons: – First, each worker develops increased dexterity in performing one single task repeatedly. – Second, time is saved if the worker need not go from one kind of work to another. – Third, machinery can be invented to increase productivity once tasks have been simplified and made routine through the division of labour. 5. Smith on the role of government Adam Smith believed in an invisible hand that channels self-interested behaviour in such a way that the social good emerges. The pursuit of self-interest, restrained by competition, thus tends to produce Smith’s social good – max output & economic growth. This harmony of interests implies that intrusion by Government into the economy is unneeded & undesirable. According to Smith governments are wasteful, corrupt, and inefficient and the grantors of monopoly privileges to the detriment of the society as a whole. He also argued that governments should not interfere in international trade. He did however see 3 major roles of government – 1 to protect society from foreign attack, 2 – to establish the administration of justice and 3 – to erect & maintain public works and institutions that private entrepreneurs cannot undertake profitable. 6. How the size of the market limits the division of labour. The size of the market limits the scope for labour specialisation, because increased specialisation, whether in product or in productive operation, always involves dividing up the market into smaller sub-markets – one for each specialised product or productive operation. In short: the division of labour implies a division of the market too. As a result, only when the market is initially large enough can its division into these sub-markets keep these sub-markets large enough for a specialist to make a living. That is why the growth of a market, say of the population of a town, leads to the establishment of more specialised shops in that town. When a town is really small, only a single general store can make a living there. As the town grows, however, a specialised bakery, butchery and clothing shop may be able to establish themselves, offering better quality, a wider selection and better prices than the general store previously could. That general store, therefore, goes out of business unless it specialises itself. As the town grows even further, there may even be space for a watch-maker, a tobacco shop and a dentist. 7. The two main reasons why, according to Smith, state interference is likely to be ineffective in furthering the common good. – First, people know their own interest better than government officials do: “[E]very individual, it is evident, can, in his local situation judge [his own economic interest] much better than any statesman or lawgiver can do for him. It is the highest impertinence and presumption in kings and ministers to pretend to watch over the economy of private people” (textbook, p. 68). – Second, government officials tend to waste public resources: “They are themselves always, and without any exception, the greatest spendthrifts in the society. Let them look after their own expense and they may safely trust private people with heirs.” (Textbook, ibid). Take note, however, that Smith is not entirely against government involvement and interference. Government still plays an important role in Smithian liberal capitalism and he still assigns some essential functions to it (2007:70-71). Make sure you know what these functions are. 8. In a statement in which he poses the “water-diamond paradox,” Smith observed that there are two kinds of value. The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called “value in use;” the other, “value in exchange.” The things which have the greatest value in use have frequently little or no value in exchange; those which have the greatest value in exchange have frequently little or no use value. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it. Smith did not solve the paradox of value. This had to await later economists who clearly saw the distinction between a good’s total utility and its marginal utility. Smith directed his attention toward exchange value, the power that the possession of a commodity provides to purchase other goods—its “natural” price. 9. The distinction between natural prices and market prices Natural prices: In every society there is average or natural rate (wages, profit and rent). When a good is sold at the natural price there will be exactly enough revenue to pay these natural rates. This is the long run price below which the entrepreneur would no longer continue to sell the goods. Market prices: Actual price at which a good is sold. Depends on the short run supply & demand workings and it will fluctuate around the natural price. If it is above the natural price, more goods will come to market, depressing the price. If it is below the natural price, some productive factors will be withdrawn, the quantity supplied will fall, and the market price will rise toward the natural price. 10. “Do pearls have value because people dive for them, or do people dive for pearls because pearls have value?” Smith stated that pearls have value because people need to dive to get them, that is, that the cost of production determines a good’s exchange value or relative price. Labour was the only resource in a primitive society and thus the time it took to dive the pearl was the element that gave it the value. Smith basically answered that pearls (goods) have value because people need to dive to get them; that is, that the costs of production determine a good’s exchange value or relative price. 11. Smith’s labour theory of value Smith first examined exchange value in an economy in which labour is the only scarce resource (capital and land are either non-existent or are free goods. “Labour theory of value in a primitive society”). Then he developed a theory of value for an advanced economy, in which capital had accumulated, and both it and land commanded a positive price. Labour theory of value in a primitive society - Smith argued that in a society in which labour was the only resource, the relative value of a good would be determined by the amount of labour necessary to produce it. Example, suppose that it took two hours to trap a beaver and one hour to hunt and shoot a deer. What is the value in exchange of the beaver? Answer: two deer or two hours of labour. That is, a person could either exchange the beaver for two deer (because each deer requires only one hour of labour to harvest) or could use the beaver to command two hours of labour services. In a primitive economy, according to Smith, labour is both the source (labour cost theory) and the measure (labour commanded theory) of exchange value. Value theory in an advanced economy - In a society where capital investments and land resources become important, said Smith, goods will normally be exchanged for other goods, for money, or for labour at a figure high enough to cover wages, rent, and profits. Moreover, profits will depend on the whole value of the capital advanced by the employer. The real value of commodities can no longer be measured by the labour contained in them. They still, however, can be measured by “the quantity of labour which they can, each of them, purchase or command”. The quantity of labour that a commodity can buy exceeds the quantity of labour embodied in its production by the total profits and rents. Demand, according to Smith, does not influence the value of commodities; the cost of production—wages, rent, and profits—are the only determinants of value in the long run. (E.g. let us assume that each commodity takes two hours to produce. But commodity A—say, potatoes grown where good land is abundant—requires virtually no capital to produce. Commodity B—cotton yarn—on the other hand requires intricate and expensive machinery in the production process. If one pound of cotton yarn and ten pounds of potatoes, each containing two hours of labour, could be exchanged for each other in the market, which would people produce? Potatoes, of course, because they could avoid investing large amounts of capital, and they would get the same return for their labour.) According to Smith, demand does not influence the value of commodities, the cost of production – wages, rent and profits – are the only determinants of value in the long run. Smith assumed that production will expand or shrink at constant cost per unit of output. Competition will drive prices down to costs, including a normal profit. Any increase in demand will not increase value because the costs of producing each unit of commodity remain unchanged. If we assume either increasing or decreasing costs, Smith’s principle becomes untenable. 12. Wages fund theory Smith addressed three facets of wages: the aggregate level of wages, the growth of wages over time, and the wage structure. With respect to the first two, he employed the wages fund theory: The wages fund idea implies that there is a stock of circulating capital out of which present wages are paid. This stock consists of the savings of the capitalists and is dependent on the revenue from previous production and sales. Consequently, this fund is fixed in the short run, but it can be increased from one year to the next. Average annual wage = Wages fund / Number of labourers The minimum rate of wages must be that which will enable a worker with a family to survive and perpetuate the labour supply. But when the demand for labour rises, wages will rise above this minimum. The rate of increase of national wealth determines the demand for labour and the wage by influencing the size of the wages fund. If the wealth of a country were great but stationary, population and thus labour supply would eventually multiply beyond the employment opportunities, and wages would fall. This explains Smith’s emphasis on capital accumulation and economic growth. Smith applauded the rise of wages that accompanied economic growth, thus opposing the low wage doctrine of mercantilism. 13. Smith’s theory of economic growth. page 86