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ADAM SMITH AND THE THEORY OF LAISSEZ-FAIRE

This lesson will begin with a short review of the material that was presented in earlier lessons. This review will focus on the information in lesson 6, World Economy 1500 to the present and the two lessons on the history of the American economy.

Remember to use your economic spectrum ECONOMIC APPLICATION TOOL.

Remember to use your political spectrum ECONOMIC APPLICATION TOOLS.

It is very important that you understand the Theory of Classical Capitalism, which is the basis of the American economy today.

Adam Smith first proposed the Theory of Classical Capitalism in 1776.

All of the economists and social theorists we will study in this lesson and the next, took Smith's model and either added to it or changed it.

Adam Smith (1723-90) lived at a time when England's economy was undergoing a significant transitional period.

There had been a number of significant social and political events during the 17th century in England. (see graphic)

Early in the 17th century, James I of Scotland became the King of England.

This event ushered in a period of political unrest that culminated in a Civil War that lasted from 1642 to 1649.

In 1849, Charles I was executed, making England a republic. This was the historical background for the economic theory of Adam Smith.

During the 18th century, the economic philosophy dominant among the nations of western Europe was mercantilism.

This system, designed to increase a nation's supply of precious metals and raw materials, required extensive government controls.

In order to encourage investment in the colonies, the English allowed only certain companies to trade with the colonies.

These companies had stockholders much like a modern corporation.

Please recall the monopolies that were created in the United States at the end of the 19th century, when corporations controlled their competition.

By the middle of the 18th century, the conditions on which the mercantile system was based had begun to change in England.

As businesses grew in power with the increase of trade and manufacturing, government protection was no longer so essential.

At the same time, the Industrial Revolution was shaping a new era of production.

It was on these new conditions that Adam Smith based his theories of laissez-faire.

Smith believed that individual initiative, motivated by the desire for profits, could result in a healthier national economy.

If the economy were freed from the restraints of government interference, the factors of production (land, labor, capital, and management) could seek their maximum return.

With supply and demand operating in a free competitive market, the problems of production and distribution could be solved most effectively.

This was also true because Britain was stronger than her neighbors and more efficient in production.

Great Britain could afford to encourage free competition at home and overseas.

Adam Smith is usually referred to as the father of modern economics.

In giving meaning and order to the environment he lived in, Smith reflected the changes taking place in his day. His ideas influenced the direction of future change and development.

Point To Ponder!

It is important to remember that the events of their day, and also the past history of their country influenced the economists and social theorists we will study.

The history of economics can be compared to set of encyclopedia yearbooks.

In these yearbooks, the encyclopedia writers summarize all the events of the previous year.

For example, a scholar such as yourself could take the information in the yearbook from 1991 and compare it to 1990, or any other year.

This is how the academic subject we call Economics was created.

The system Smith described, which became the basis of our economic system, depends on the market to answer the basic economic questions.

The market is the place where buyers and sellers meet and where prices placed on the goods we want to sell and buy determine how we allocate our resources.

An "invisible hand" that was responsible for guiding all goods and services to the places and people that needed it the most is what directed the market.

Remember that the government would not control any part of the economy.

We refer to this type of system as laissez-faire, a French expression meaning "hands off."

The first economist to challenge the views of Smith was David Ricardo (1772-1823).

At the heart of the Ricardian system is the notion that economic growth must sooner or later be slowed down or stopped altogether.

Ricardo developed the "law of comparative costs" which basically stated that countries that had the most efficient factors of production could produce goods.

The cost of growing wheat in Great Britain had risen rapidly because of limited farmland.

Ricardo believed that Great Britain would be better off to import the cheaper wheat from other countries that had more efficient factors of production.

In other words, regions and countries should do what they do best.

Do you recall the West, South and the North in the United States before the Civil War? Each of these regions specialized in certain products that they could produce more efficiently that the other sections.

An essential ingredient of the Ricardian argument is the Malthusian principle that was developed by the Reverend T. R. Malthus.

Malthus believed that population tends to increase up to the limits set by the existing supply of food, thus holding down wages.

As the labor force increases, the food needed to feed the extra mouths can only be produced by extending farming to less fertile soil.

Although wages are held down, profits do not rise proportionately because farmers will outbid each other for the best land.

New ECONOMIC APPLICATION TOOL: The law of diminishing returns, when additional units of one factor of production are added to a constant quantity of other factors, eventually each additional unit will yield less than the preceding unit.

In simple terms, the law of diminishing returns means that if you overuse a factor of production it will not be as efficient as before.

This is what Malthus was explaining when he believed that overpopulation would cause labor to overwork the land.

We will see other examples of the law of diminishing returns in many of the lessons.

What was wrong with Malthus' ideas concerning scarce land?

Malthus failed to realize how technical innovation would offset the law of diminishing returns.

The new farm machinery that was developed during the 19th century meant that fewer farmers were needed to feed the people.

Forty-two years after Malthus published his ideas, England had less than half of its population engaged in farming.

Thus far we have stressed the classical economists' preoccupation with scarce land.

However, the history of economic growth since the early 19th century has been one in which capital, not land, was the most important factor of production.

We have already studied this information in previous lessons.

The introduction of power-driven machines, the spread of railroads, the rise of the iron and steel industries, the inventions of electricity and automobile are examples of capital.

Land came to be less important as labor and capital battled for political and economic power.

The influence of Ricardo's theory was felt almost as soon as it was published, and for over half a century the Ricardian system dominated economic thinking in Great Britain.

Ricardo also presented a careful analysis of the labor theory of value.

This theory will be discussed later in this lesson.

In 1848, John Stuart Mill restated Ricardo's economic thoughts, especially calling for free trade among countries.

In the middle of the 19th century, the study of economics was divided into two distinct branches.

One branch grew from the writings of Karl Marx, who advocated socialism that eventually led to the development of the communist states in Russia and China in the 20th century.

The other branch, the Neoclassical economists, were led by John Maynard Keynes.

We will study the neoclassical economists in the next lesson.

The socialist (communist) model was developed by Karl Marx. Marx was born in Trier, in the German Rhineland in 1818, the son of a middle class family.

Marx saw history not as a meaningless succession of events, but as a social change resulting from the struggle of classes.

Marx argued that all wealth is produced by labor, with the other factors of production either passive or also the result of labor.

In other words, the factors of raw materials, capital, and management could not exist or be used without the labor of the workers.

Before you go on, please reread this page.

The factor of labor is what would give something its value.

Because workers are not paid the full value of what they produce, capitalists are able to accumulate this large amount of surplus value.

Surplus value, in the opinion of Marx, is the difference between what the workers produce and what they earn.

As this process continues, the middle class disappears and society becomes divided between capitalists (the people who take advantage of the workers) and the workers.

For most socialists, social progress should be the result of peaceful evolution.

Marx believed the transition from capitalism to communism would follow a particular pattern and would be accompanied by a violent revolution.

This revolution would take place in the following stages:

The first stage is marked by the workers' overthrow of capitalism, (business owners) and is followed by the seizure of the government.

The second stage is characterized by the establishment of a small centralized authority that will govern in the name of the workers.

In the third stage, the dictatorship of the proletariat is replaced by the establishment of a "socialist" society. The political state will still exist, and because there may still be opposition, it will have considerable power. Economic production is to be controlled by the workers.

The fourth and highest stage is that of the true "communistic" society. Production will be in such abundance that work and payment will be made to everyone according to his/her need.

The communist economy seeks to end capitalism by revolution, whereas the socialists wish to do it through the ballot box.

In both economic systems of socialism and communism, the government will have a large influence on the economy.

There will be a difference in the amount of freedom the people have to choose what they want to buy.

Around 1870, three scholars working independently (Stanley Jevons, an Englishman; Anton Menger, an Austrian; and Leon Walras, a Frenchman) developed the economic theories of marginalism, utility and general equilibrium.

One of the key elements of the neoclassical revolution was to understand how utility (or consumer preferences) enters into the demand for commodities.

Marginal utility (or how utility affects the prices and quantities of goods) provided the missing link in a complete theory of the market mechanism.

In other words, marginal utility explains why people buy what they buy.

Recall the lesson in which you were asked why you had purchased the clothes you were wearing. Apply the statement above to that thought.

In the development of general equilibrium, Walras discovered how to analyze and measure the economy as a whole (macroeconomics).

This process enabled countries to measure all factors of production, land, labor, and also product markets, making it possible to develop long-range economic plans.

Summary

This concludes our study of the classical and neoclassical economic theorists of the 18th and 19th century. We will now turn our attention to the modern period of the 20th Century.

Here is a hint before we begin the next chapter:

Macroeconomics will be very important during the Great Depression.