Mercantilism
Adam Smith is seen as the founder of economics. His book “An inquiry into the Nature and Causes of the Wealth of Nations” was completed in 1776. It is a broad book touching on several subjects, with a part of it focused on economic growth and why some countries are rich. At the time, Smith’s native Britain was at the start of the industrial revolution and the relative economic output between the richest and poorest nations was not as large as it is today.
Europe was also dominated by an economic policy called Mercantilism, which aimed to increase national wealth by ensuring a trade surplus and accumulating precious metals like gold and silver. While having a trade surplus does increase national wealth — achieving it requires a high level of private or public savings. However, Adam Smith disagreed with this view of wealth. He understood that a trade and subsequently a countries wealth was not a zero-sum competition between nations measured by its gold, but instead should be measured by the real standard of living of the individuals living in it, and that trade can be mutually beneficial:
It is “the exchangeable value of the annual produce of its lands and labour which determines the standard of living” (p.489)
Money is not as only seen as a form of wealth but also as an object that facilitates trade. This allows for the true driver of increasing the standard of living — which is increasing productivity through the division of labour.
The division of labour
“It is the power of exchanging that gives occasion to the division of labour” (p.22)
“Men are much more likely to discover easier and readier methods of attaining any object when their whole attention of their minds is directed to that single object” (p.14)
The division of labour is the separation of production into smaller tasks, allowing each individual to specialise and leading to increased productivity. Smith used the example of a nail factory — with each worker doing a small part, resulting in an overall productivity that a single craftsman could never replicate. Here is Milton Friedman explaining how a seemingly simple object is created using trade and the labour of multiple individuals:
Smith gives three reasons why specialisation would increase productivity:
Firstly, individuals are more focused on each task. Complete focus on a single activity increases the time spent on it and ability — think of the Gladwell’s “10 000- hour rule”.
Secondly, time is saved from not having to switch between different tasks. This includes reducing the set-up costs.
And finally, specialisation allows the use of machines dedicated to a single task. The division of labour also increases the incentive to invest in these types of machines, further increasing productivity.
There are limits to which the division of labour can increase productivity, as the ability to specialise was dependent on the size of the market and the proximity to the market:
“The division of labour is limited by the extent of the market”(p.22)
In a small market or community, each member must contribute to multiple tasks and there is little room for specialisation. It is an environment that favours foxes rather than hedgehogs. As the local market grows, there is a greater demand for specific products or services, increasing the incentive to specialise and invest in machines.
Cities
“The greater the number of revenues of the town, the more extensive the market” (p.373)
Cities and towns facilitate markets by making it easier for individuals to interact and trade. The larger size of cities allows for a greater degree of specialisation and division of labour, leading to increased productivity. Cities are dependent on geography and trade as the costs of transporting products to where they can be traded limits the extent of market. Transport by water is cheaper than by land, thus large towns and markets tend be close to the coast or navigable rivers. Being closer to transport by water also encourages trade between countries. Furthermore, international trade further expands market size and facilitates specialization across countries, contributing to the division of labour and economic growth.
“Commerce and manufactures gradually introduce order and good government, and then the liberty and security of individuals. This is the most important of all effects” (p.402)
Growing commercial cities also have institutional effects. The idea is that merchants would prefer an improvement in institutions to conduct their business. These institutions include the security of property, the rule of law and the enforcement of contracts, all of which promote commerce and make merchants’ lives more secure.
Institutions and self-interest
“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 self-interest” (p.19)
Given the improvements of institutions driven by commercial cities, it is possible that personal interests and those of the public to align. This focus on self-interest is probably the most well-known idea from this book, with the general view that it focuses on material gain. What Smith means by self-interest is complicated. He wrote an entire book on this topic, “The Theory of Moral Sentiments”, in which Smith viewed people partly being driven by empathy and our social ties.
Smith is often characterised as a free market fundamentalist who did not see the risks of capital, however Smith also warned of the rent-seeking impulses of business:
“People of the same trade seldom meet together, even for merriment and diversion, but the conversation always ends in a conspiracy against the public or in a contrives to raise prices” (p.134)
Thus, for the division of labour to work was very much conditional on being in a “well-governed society” which sets the right structural framework for individuals’ self-interest and that of the public to align.
Agriculture and inheritance
The institutions and locations of cities effects agricultural productivity. Due to transports costs, land near cities and towns tend to have a greater degree of investment and productivity.
“Compare the cultivation of the lands in the neighbourhood of any considerable town, with that of those that lie of a distance from it, you see how the country has benefited from the commerce of the town” (p.374)
Another reason is that merchants in cities have ambitions to become “country gentlemen”. Smith argues that merchants have experience with profitable businesses and hence are very good farmers:
“Merchants are commonly ambitious of becoming country gentlemen, when they do, they are generally the best of improvers” (p.401)
Smith wrote about the right of primogeniture, in which the first-born child inherits the entire estate. In weak states without the rule of law, land was not only used as a form of wealth, but to also exert power for safety and security. Over time, this encourages the use of primogeniture. As states strengthened the rule of law and other political institutions, making use of land to hold power was not as useful and resulted in the decline of primogeniture.
This was, of course, before industrialisation, when working the land was highly labour-intensive, and large property owners could not work all the land that they owned. Given the nature of agriculture, it is harder to have some form of division of labour. Removing the right to primogeniture, resulting in property divided equally among the children of the family, has economic effects. Over time, this results in smaller properties and more equal land ownership — which Smith argues increases agricultural productivity as each property owner is more focused on every part:
“A small property owner knows every part of his little territory, and views it with all the affection which property naturally inspires and of all improvers is the most industries and successful” (p.409)
Conclusion
The overall theme of the book was a very classical liberal view of empowering the individual, to use the natural tendency of individuals to want to improve their own lives to align with that of the public interest. He also emphasized the role of commercial cities in allowing this to occur, by improving institutions and allowing for large markets. While Smith focused on limiting the role of government in terms of reducing trade and limiting entrepreneurs. He also understood the role of government to empower the individual — such as providing security and the rule of law and reducing the need for primogeniture. Smith made an error with agriculture; he had not seen the potential for increasing returns to scale due to the industrial revolution.
For such an old book, Smith got a lot right. I do think that Smith underestimated the role of capital accumulation in increasing productivity and reducing transport costs, and the vital role of the state in achieving this. This is understandable given that the industrial revolution was still in its infancy when this book was published.