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1.1.3 central statements

A summary of Wealth of Nations can be found as well on wikipedia: Wealth of Nations.

The author has preferred a different approach. Adam Smith describes quiet well the pillars of a market economy such as the homo oeconomicus, the role of competition, the function of prices a signals of scarcity, the risks of governmental intervention etc..

At the other side, Wealth of Nations is an illustrative example of how misleading concepts about the function of interest rates, capital, saving and money leads to a lot of errors. Concerning these issues, the author has preferred to confront them with the Keynesian theory.

Besides that, Wealth of Nations is very contradictory. The idea that the production factors are homogeneous and flow automatically in the most profitable use is incompatible with the function of prices as a signal of scarcity. To put it more clearly, the idea that labour is a homogeneous factor denies the necesity of prices in the labour market. If labour is considered a homogeneous factor, prices can't induce reallocation of labour, because there is no difference between the different kind of labours. To give an example, there are hundreds of contradictions like that which are both fundamental ones and smaller ones.

Murray Rothbard is an anarco capitalist. The anarco capitalists are the extreme version of neoliberals. The last ones don't want to abolish goverment at all, they just want to reduce its intervention. The first ones want to abolish it. This theory is so extreme that we don't discuss it in this manual. However, his statement about Wealth of Nations is correct.


It is not just that Smith's Wealth of Nations has had a terribly overblown reputation from his day to ours. The problem is that the Wealth of Nations was somehow able to blind all men, economists and layman alike, to the very knowledge that other economists, let alone better ones, had existed and written before 1776. The Wealth of Nations exerted such a colossal impact on the world that all knowledge of previous economists was blotted out, hence Smith's reputation as Founding Father. The historical problem is this: how could this phenomenon have taken place with a book so derivative, so deeply flawed, so much less worthy than its predecessors? The answer is surely not any lucidity or clarity of style or thought. For the much-revered Wealth of Nations is a huge, sprawling, inchoate, confused tome, rife with vagueness, ambiguity and deep inner contradictions. There is, of course, an advantage, in the history of social thought, to a work being huge, sprawling, ambivalent and confused. There is a sociological advantage to vagueness and obscurity. The bemused German Smithian, Christian J. Kraus, once referred to the Wealth of Nations as the 'Bible' of political economy. In a sense, Professor Kraus spoke wiser than he knew. For, in one way, the Wealth of Nations is like the Bible; it is possible to derive varying and contradictory interpretations from various – or even the same – parts of the book.

This statement is correct. Wealth of Nations is without any doubt the most contradictory book of economic theory. It is better to consider Wealth of Nations as a book that puts all the problems on the table instead of considering it as a book that resolves all the problems. It is more a basis of discussion than a book that explains how the economy works or should work.

However, all the lines of thinkings and schools, neoclassic theory, neoliberalism, ordoliberalism, social market economy, Austrian school, Marxism including the anarco capitalists like Murray Rothbard share the idea that capital, not just money, is the condition for investment. This is a fundamentally misleading concept. It is to assume that the idea is not from Adam Smith, but he was the first to write it down.

All these lines of thinking define capital for investment purposes as not consumed income of the past. The only difference is their definition of the source of the income. In Marxism, the income of the capitalists is the surplus squeezed out from the workers and the other lines of thinking simply didn't define exactly where this income comes from. However, that doesn't make a big difference because the whole concept is wrong. Capital is not a productive factor, is not scarce and has therefore no price. See interest rates. It is a strange kind of phenomenon that Marxism at one side, and the rest of the lines of thinking at the other side share the same ideas.

In Wealth of Nations, we found the more problematic version of the theory that capital is the condition for investment. In this version, radicalised by David Ricardo from where it was taken over by Karl Marx, only labour produces a value and the capitalist is able to accumulate this value squeezing out the workers. This leads to the concept that the value of an item is determined by the labour incorporated in this item. Demand doesn't play any role.

This contradicts his concept of natural price/market price. The natural price is the price paid for a productive resource, the wage for labour, interest rates for capital and the rent for the land, if the return on an item is the same in all uses and if there is therefore no need to reallocate it. For example, if a worker gets the same wage wherever he works, he has no incentive to change his work. The market price is the result of the demand. If a worker repairs cars and whatever he does, he will earn the same and he will continue to repair cars. However, if the economic structure changes and he can earn more money repairing computers, he will change his job. The natural price is an equilibrium price and nobody sees any need to reallocate resources. The market price is the result of change in the economic structure and induces people to reallocate resources. That means that the demand determines the price and not the incorporated work or the costs in general.

The more the demand side is neglected, the more we move away from a market economy. Changes in the demand side, whether they are due to a change in the production structure or a change in the preferences of consumers require a reallocation of resources induced by prices. The strength of the market economy consists in the fact that the decentral information processing through prices is more efficient than the central planning by a governmental planning commission.

If we assume like David Ricardo or Karl Marx that the demand side plays no role or if we assume, like Léon Walras, that resources move automatically in the optimal allocation, the development of the economy is predictable and can be planned. In this case, a planned economy would be better. What can be planned, should be planned. The problem is that the economic development can't be planned and market economies are the best system to deal with insecurity.

What Rothbard means with the sentence "The problem is that the Wealth of Nations was somehow able to blind all men, economists and layman alike, to the very knowledge that other economists, let alone better ones, had existed and written before 1776" the author doesn't know. It is to presume that Rothbard doesn't refer to the mercantilists because this theory, despite the somehow sophisticated arguments of Keynes, the mercantilists realised the function of money, is irrelevant.

Some authors are named by Adam Smith himself: His friend David Hume, John Locke (a little bit elder), Jean-Baptiste Colbert. Nowadays, no pre-classic author plays a role in academic economics.

Wealth of Nations is a microeconomic view focusing on the individual market player and it assumes that the individual interest agrees with the general interest. Saving, for instance, is not only good for the individual market player but for the economy as a whole. The more people save, the more capital is disposable for investment purposes. Something obviously wrong from a macroeconomic point of view. The more people save, the less they consume and the less there is an incentive for the investors to invest. We can even get into a downward spiral this way. Classic thinking assumes that if the interest rates are very low, people will stop saving. It can be doubted that this is true. If people save for well-defined purposes, for instance, to keep their living standard after having finished working, they will save more if interest rates are low, because, in this case, more saving is needed. If everybody does that, the problem gets still worse.

In other contexts, the idea that the individual interest agrees with the general interest is true. A baker wants to get rich; that's obvious. However, the only way to get rich is to deliver high-quality bread at a lower price than it's competitors. The result is that the consumer gets the best bread possible for the lowest price possible. That means as well that the baker has to buy the flour at the lowest price possible and therefore, the miller has to work efficiently. The miller has to buy the wheat at the lowest price possible and, therefore, the farmer has to work efficiently and so on. The market economy is a self-controlling system and doesn't require external control as it is the case in governmental activities, see governmental activities. The coordination between the different market players is realised through prices. If the baker realises that the consumer prefers rye bread, he will buy less flour, the miller will produce more rye flour if he gets more money for it, the farmer will cultivate more rye and so on.

In economics very often, it is not the really relevant concepts are canonised but the ones which are expressed in a spectacular form. The most famous illustration is the "destructive creation". Schumpeter assumes that the economic growth depends on charismatic figures like Bill Gates, Steve Jobs, Larry Page, etc. The reality is much more complicated than that. We will return to the topic when we talk about Joseph Schumpeter. Actually, the really relevant point in the Schumpeterian theory is his concept of money. A similar phenomenon is the comparative costs of David Ricardo. This concept became famous because it seems surprising at first glance that two countries will have commercial exchange even if one country is less efficient in all the items exchanged. The problem is that this is only a theoretical idea and irrelevant in reality.

The term which is most associated with Adam Smith is the invisible hand of the market. That's a nice expression but actually doesn't explain the basic idea. The basic idea is that the prices are signals of scarcity as well as an incentive to reduce this scarcity. High prices mean high demand, and therefore, people will produce the scarce item or offer the scarce service and reduce scarcity. At the other side, companies are obliged to react to the signals of the market. Market prices make therefore optimal allocation of resources possible and oblige the market players to adapt themselves. The invisible hand is therefore very visible. That why it works. People see the prices and react.

What people don't see is why prices raise or lower. If the price of petrol rises for whatever reason, the plastic bags become more expensive, and people will react. For instance, they will not throw away anymore the plastic bags, but use them several times. They don't know why the prices of plastic bags raised and there is no need to know that to react adequately.

The only alternative to this system is a planned economy. That means that a central planning commission allocates the resources. In order to that in an optimal way, this central planning commission must be as well informed as all the millions of individual market players. That's completely impossible. Besides that, the central planning commission has no incentive to change its decisions if the underlying structures changes or if it turns out that the decisions taken at the beginning were wrong.

All that seems very abstract to most of the people. Those who don't understand it can go to Cuba. Then they will understand it; there they can even smell and feel it. No abstract thinking needed. Rice, lentils and bread are almost free because highly subsidised, but marmalade, cheese, biscuits are more expensive than in Europe. Without subsidising rice, lentils and bread, it would be more expensive, but cheese, the marmalade, toothpaste, soap etc. would be obliged to subsidise the rice and the lentils. In planned economies basic needs like housing are very often cheap, most Cubans don't pay any rent. The problem is that there are no resources to maintain the houses, and, therefore, most Cubans live in ruins.

Most Cubans believe that their problems are due to the embargo, but this is only half of the truth. Cuba imports MARMELADE from Argentina, instead of producing it.

Similar problems could have been observed in East - Germany. In East-Germany, bread was more expensive than corn, with the result that the pigs were fed with bread and not with corn. If prices are not the result of the market process but arbitrarily determined by a central planning commission, they lose any kind of information.

The basic idea of market economies is much better illustrated by the concept of natural price/market price than by the invisible hand, which actually doesn't explain anything, It's just a nice term.

It is important to see what is correct in the thinking of Adam Smith and what is wrong. He describes quite well two pillars of a market economy. First, the fact that entrepreneurs have an incentive to produce the best product at the lowest price possible and that the personal interests of the market players agree related to this point with the interest of society. This is made possible by a decentral information processing through prices.

Concerning his ideas about capital, the function of interest rates, saving, money his theories are completely misleading and are refuted by Keynes.

Keynesian theory is often viewed as opposed to classic theory, neoliberalism, etc. This is only true on what concerns the ideas about capital, saving, interest rates, money, see interest rates. This is not true concerning the efficiency of market economies. Public debate would be more meaningful if people defined what they are talking about.

The widespread diffused opinion that Keynesianism is completely opposed to classic thinking is due in part to the way Keynesianism is presented in modern textbooks. If Keynesianism is reduced to expansive fiscal policy, to an increase in public demand no matter whether if public consumption is increased or public investment one could indeed believe that the allocation of resources is irrelevant in Keynesian theory, but this is a misleading interpretation of the Keynesian theory. See the booklet downloadable from the entry page of this website.

Wealth of Nations is not a blueprint for the ideal economic order. Something valid for any economic theory. It only explains some pillars of a market economy, although not really in a straightforward and easy to understand way. There is no equality of opportunities in Wealth of Nation. The misery of the masses is described as something natural, unavoidable. A system like that has no chance to be realised in a democratic decision-making process. The majority would overthrow a system like that.

Besides that, without equality of opportunities competition is low and innovations rare. The more people have a chance to realise their ideas, the better the chance to find a new solution to an existing problem, to create new products, to improve processes. If the growth of the economy would depend exclusively on the owners of capital, as Adam Smith assumed, we would have very little economic growth.

In modern societies equality of opportunities depends on the access to training, education and information. We will discuss this topic later, see training and education.

To a certain level, an unequal distribution is generally accepted, at least, no modern democracy have ever led to a system where taxes and social affairs have corrected the market result to the extent that everybody earns the same. An unequal distribution of income leads in general to social unrest. That's, by the way, obvious. If we want people to react and adapt themselves to the signals of prices, there must be an incentive to do that. If they earn all the same, there is no incentive to do that.

Besides that, many arguments are questioning the efficiency of the market. Very often not all the costs are priced in, in other words, prices can be lower than the real costs. This happens for instance if a company uses natural resources like the water or the air in the production of an item or these resources are needed when the item is used (external costs). This happens for instance in the production of leather where a large amount of poisoned water are released into the rivers or when the traffic pollutes the air.

At the other side, there are products which once produced can be consumed by everyone. If the police for instance by its mere presence makes a place safer, nobody can be excluded from this service. Public goods, like a monument in a public garden, can be seen by everyone without paying.

Merit goods are goods where the consumption is inferior to what it should be. (In the opinion of the government.) Some people believe for instance that better educated, trained, informed and critical people are more pacific and less inclined to resolve problems violently, that they are more willing to seek compromises and to consider an issue from all sides and not only from their perspective. In this case, the government will spend more money on education than would be needed for training for a particular need.

In all these cases, external costs, public goods, merit goods the prices don't represent the actual production costs. In cases like that, a tax can be levied on this items, for instance on cars, which pollute the environment or certain product can be subsidised, as for instance theatres.

In times of Adam Smith, the risks of governmental intervention were low because there was no governmental intervention. For Adam Smith, the principal menace to a free market economy was the free market economy itself. Entrepreneurs tend to avoid competition, and they prefer to agree on prices at charge of the consumer. Governmental interventions are considered inefficient by Adam Smith but were not a menace.

This changed in neoliberalism and the Austrian school. Governmental intervention is not only inefficient, in these lines of thinking, but a menace to liberty in general. A free market economy is, in these lines of thinking, not only the guarantor of the optimal allocation of resources but as well the guarantor of personal freedom. We will return to the topic in the chapters about Milton Friedman and Friedrich Hayek.

Anticipating a little bit of the debate, the Austrian school and neoliberalism have a simple point of view. Everything should be controlled through abstract and objective market mechanisms and what cannot be controlled through market mechanisms, shouldn't be controlled at all. In this world democratic decision making is not necessary and opposed to the assumed free cooperation of the market, because democracy means, in these lines of thinking, coercion. The minority have to accept the decisions of the majority. There are two main errors in this thinking and a lot of little ones. The first error is that there are a lot of issues that can't be controlled by the market. Education for instance, although Milton Friedman assumes the opposite. The second error is that Milton Friedman and Friedrich Hayek assumes that the only way to control the economy is by the mechanisms of the markets. The author would say that transparency has the same impact, see preliminaries, and that is the way to go, because there is no other choice, if some issues can't be controlled by the market.

There are differences between the classic authors like Adam Smith, Jean-Baptiste Say, David Ricardo, John Stuart Mill and the neoclassic authors like Alfred Marshall, Vilfredo Pareto, Léon Walras, Carl Menger although the difference is not, as we can read everywhere, the marginal revolution.

One difference between the classical authors and the neoclassical authors is that the first ones didn't reflect about the method to be used and didn't try to define what economics is about. The approach is more "intuitive" and a large range of topics, albeit in a "common sense" way, is addressed. (David Ricardo is the exception. His range of topics is very reduced.)

We find in Wealth of Nations an endless amount of psychological, sociological and philosophical observations, albeit they never pass the level of pure heuristic remarks.

This is better than the complete disregard for the impact on the economy of the political system, the educational system, the technological progress, the dynamic and interaction between the individual and society and vice-versa we find in modern textbook, where the issues belonging to economics have been canonised but is not what we actually need.

The political system and the economic system are for instance highly independent. It is, for instance, useless to say that the distribution of the national income depends on the marginal revenue of the productive factors, labour, capital and land. The income as a result of a market process can be changed at any moment by the government and is actually changed. Textbooks on microeconomics focus on the market result, but the most interesting question is whether and how this market result should be changed.

[The topic is actually discussed in modern economics in welfare economics from a narrow perspective: justice. This perspective is too narrow and leads nowhere. The interesting question is the impact of redistribution on incentive to work, saving, equality of chances, innovation.]

The way of thinking of Adam Smith is more "common sense" style. That is not really bad. Common sense style thinking very often leads to better results than mathematical modeling, which can lead to results that bluntly contradicts reality.

Common sense style thinking is more based on personal experience. The "ordinary man from the street" would for instance never take labour as a homogeneous factor as the neoclassic do. He knows very well that the qualification has a massive impact on wages.

Common sense style thinking takes into account everything it believes relevant without any kind of modeling. modeling means that some aspects considered irrelevant by the constructor of the modell are excluded. We get logical statements, but unfortunetaly only inside the modell. Beside that it is an illusion to believe that a modell is objective and only serve to reduce the complexity of reality in order to see the really relevant point of a problem. The neoclassical modell that wages depend on the marginal revenue for instance neglect the fact that wages are based on power. If it is assumed that high wages leads to unemployement, it can be said as well that high interest rates leads to unemployement. (For a more detailed discussion see interest rates.)

However, Wealth of Nations illustrates as well that common sense like thinking can be misleading. Common sense, for instance, believes that saving if a condition for investment. That is very true from the perspective of a single market player and very untrue if we focus on the economy as a whole.

If we regard the development from Adam Smith to nowadays textbooks, we can see an evolution. For Adam Smith, almost everything belonged to economy. Wealth of Nations addresses topics which nowadays would be considered to be social, political, philosophical or psychological problems. Adam Smith did not even feel any need to define the subject of economics.

That changed with Alfred Marshall, León Walras (or Schumpeter, who obviously doesn't belong to the neoclassics). All of them discussed the methods to be used and tried to define the object of economics with very different results.

Classic authors and neoclassic authors address, therefore, very different topics.

That's not the case in nowadays textbooks. For whatever reasons, some topics were canonised and others not. Nowadays any textbook on economics deals with the same issues in the same way.

We have already given some reasons, see mathematical modeling, that can in part explain what have been canonised and what fell into oblivion.

As a general rule, we can say, that concepts which can be modelled in a graphical or mathematical way survived, what can not be modelled was ignored. Therefore, we have almost no concepts from classical authors in textbooks, beside the comparative costs of David Ricardo, which can be presented in a modell, some authors like Joseph Schumpeter or the Austrian school is ignored, because they didn't use mathematical modeling at all. What we find in modern textbook of microeconomics are most of all concepts of neoclassical authors, which are allready presented in the original works with some kind of modeling.

There is no distinction between microeconomics and macroeconomics in Wealth of Nations. To be more precise: The two terms not even existed. If, as assumed in the pre-Keynes era, the maximation of individual benefit leads automatically to a maximation of the prosperity of the society this distinction is not needed.

The definition we find in textbooks that microeconomics focuses on the individual market player, for instance, individual demand, and macroeconomics deals with aggregate quantities, the demand of the whole society, is not wrong but is not useful. If we get to the same results by analysing the supply of a company, the demand of households, the saving of single market player etc. then by analysing the supply and demand of the whole economy or the saving of the whole economy, there is no need for macroeconomics. The point is that we don't get to the same result. A behaviour can be rational from the perspective of a single market player, but completely wrong from a macroeconomic perspective. In this sense, Keynes is the founder of macroeconomics.

It is true that Adam Smith didn't express his ideas in the clearest form possible, and the statement of Rothbard is correct. However, Adam Smith addresses all topics which are until nowadays in the center of public debate.

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Wealth of Nations:

As flexible as the bible?

Lines of thinking diametrally opposed refers to Adam Smith

Adam Smith describes some basic pillars of market economies

- Maximisation of the individual benefit agrees with the maximisation of the benefit of society

- The concept the natural prices / market prices describes quiet well the function of prices in a market economy

- Prices signals scarcity and are the basis of decentral information processing, but obliges the market playes as well to adapt themselves to a change of prices and the underlying changes the economic structures

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