I decided to start writing a series of diaries on History of Economic Thought as people had expressed interest in a number of discussions from the classical period. Moreover, some of its discussions (usually the worst parts) are still in use today. So, I thought I would introduce people to some ideas in the context of which they were written, discuss some of the policy issues (some of which underlie modern discussions for example of poverty), and have fun at the same time (I clearly have a strange idea of fun ...).
I am going to begin my examination of classical economic theory on the Daily kos with the study of Smith's seminal work The Wealth of Nations, written in 1776.
I want to begin this discussion by addressing some ideas of the Physiocrats and then move to Smith's notions concerning wealth, revenue and economic growth.
Simple reproduction and the Tableau Economique
In the Tableau Economique, Francois Quesnay (one of the pre-eminent members of the French Physiocratic school) articulated the first model examining the reproduction of a capitalist economy -- it described the flows of commodities and inputs necessary to sustain the economy at the level its is current level -- this is called a simple reproduction model, it describes the situation in the economy and shows how that situation can be maintained.
Why do we worry about the reproduction of the society at a certain level? First of all, if we just produced one time and consumed all the commodities, how can we ensure that there will be commodities to feed the population at its current level? Second, the non-labour inputs used in the production of commodities are either used up in one production period (these are called circulating capital) or wear out over time (the capital goods that last for many production periods, are called fixed capital). Not only do we have to produce inputs for the next period of production, we have to replace those capital goods which wear out over time -- these fixed capital goods are said to depreciate, that is they slowly wear out and the producers have to make provisions to replace them with new versions of the same capital. If we can understand how to maintain or reproduce the same level, we can then use this knowledge to increase the output or productive capacity of the economy -- this question concerns what is called economic growth or accumulation.
Increasing productive capacity usually entails the use of different techniques or methods of production. Changes in the methods of production enabling the increase in the output of the producers require a restructuring of the economic process. The introduction of technology which increases the productiveness of labour, that is, less units of labour are required to produce the same level of output, will enable the increase in the level of output and the size of the economy (or the same amount of labour produces greater amounts of amount). These questions are the primary concerns of the British classical economists. Adam Smith's primary preoccupation was to understand and encourage the increase of wealth in Great Britain.
Wealth and Revenue in Smith
The definitions used by Smith for the terms wealth and revenue are very important to comprehend his argument. For Smith, wealth is defined by the quantity of commodities produced in your country and brought to market; it is not production for home-use that is relevant to his (and the classical school's) discussion of economic growth. Like the Physiocrats, it is not just the production of commodities that is relevant it is the fact that they are produced for sale in the market. This introduces an important topic to the discussion, that of their exchange value or prices, as since goods are produced for sale, their prices and their determination become a rather important question.
What is revenue? In Smith and in all Classical economists, revenue is the quantity of surplus product, the product over and above what is needed to reproduce the economy at the same level; that part that is freely disposable without damaging the current level of the economy, that part that can be used to ensure economic growth. What would be part of the commodities needed for simple reproduction? We need to replace capital used up in the production process (at least its value, if not its exact physical replacement) and we need to make sure that the workers have their portion to ensure not only survival, but the reproduction of the class as a whole. This does not mean that wages are limited to this level it means that this is the floor below which wages cannot fall unless the whole process of production and circulation is breaking down.
Mercantilism and Populationism and the Physiocrats
This discussion seems a bit obvious, let’s go back a bit before to understand the context in which Smith’s argument developed. Let’s return to the Physiocrats and their opponents the mercantilists. It is rather important to note that their 2 main opponents in terms of the analysis of the economy were the mercantilists and the "populationnistes." The mercantilists argued that the wealth of a nation was dependent on the size of its international trade; they held that the primary aim of trade or commerce was that of "buying low and selling high," as such they believed that the wealth of the nation would be increased through selling commodities for as much as they were able. They believed that the surplus or the net product was created through this process -- as such, the "profits" that they were saying were created through the process of exchange resulted from buying the products from producers for as low as possible and then selling it overseas for as high as possible. This idea that profits were created through the exchange process was soundly rejected by the classical authors and Marx who argued that profits were created in the production process itself and then realised if, and when, the product was sold.
The "if" in the previous sentence refers to those classical economists who did not assume Say's Law and were concerned with the possibility of the product not being sold and hence the profits not realised. This has serious implications for economic growth and accumulation as an unrealised surplus is not available to be used invest in production, or to create and buy capital goods, which is what underlies economic growth.
The other main opponents to the Physiocrats were the populationnistes who held that the only true wealth of a nation was the number of its inhabitants; they argued that it was people that made a country rich and opulent. Accordingly, the main way that France could increase its economic power, according to this school of thought, was by adopting policies and laws designed to increase its population.
Quesnay maintained that the quantities of consumable agricultural products, and not money and people, were what could bring prosperity to a country. The Physiocrats argued that the first preoccupation of rulers was to implement policies which would increase the physical quantities of agricultural commodities produced and consumed each year. However, not only should France increase output of the agricultural sector, but in order to raise the level of the surplus this had to be combined with measure to reduce the quantities of products needed as means of production of that output. The physiocrats put forward an alternative notion to that of the mercantilists and the populationnistes with respect to the creation of wealth of nations and of revenue; they argued that wealth and revenue (i.e., the surplus) was created in the production process through the use of land in production. What this means is that they argued that the use of land in production enabled the creation of a product that not only replaced what was used to produce the current level of output (which included the wages of labour and the inputs to production), but created an additional product over and above that. As such, the gross product, the total product, minus that used to replace what was used in production, gives us the net product or the surplus product in the economy.
The Physiocrats believed that the surplus product or the net product derived from solely from the use of land in the production process -- this argument is called a land source of value. Accordingly, they argued that the surplus product derived from the "benevolence of nature." From this notion, comes the idea that if a surplus is to be created it will have to come from the sector which utilises land in production. This sector, which they termed called the primary sector, is clearly that of agriculture.
Wealth is envisaged by the Physiocrats to be the amount of consumable agricultural products, wealth is seen as agricultural use values or physical output. However, they realised that only the value magnitude of wealth can be used to compare the economic power of France to that of other countries. In order to become part of the nation's wealth products must pass through markets, where they are exchanged according to certain monetary prices. The wealth of a country depends on the size of its total consumable agricultural surplus, that is the product over and above what is needed for reproduction, as that provides an indication of the growth potential of the nation. The size of the surplus is measured by the difference between the value of agricultural output minus the value of its inputs.
The division of labour and the supply side of economic growth
One of the most important things that Smith is known for is his analysis concerning the causes of the improvement in the productive powers of labour. This addresses the question I raised earlier concerning economic growth. I had said there were two primary ways in which to increase the level of output in the economy: 1) the first way was to change the methods of production, that is to alter or restructure the process of production; 2) is to change the technological conditions, through improvement in the technology used by the workers, such that less workers are needed to produce the same units of output. Smith was one of the first to address these questions in a systematic manner.
Smith argued that the greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity and judgement with which that labour is applied, are the effects of the division of labour. The division of labour takes two forms: 1) the first is to separate the different trades and employments that enter into the production of a final commodity from one another; in this case, the same worker no longer is responsible for all the different stages of the production process. As an example we could examine the textile industry. The division of labour in textiles began with the separation of the industry into carding, spinning, weaving and dyeing of cloth. What is the work of one man in an underdeveloped economy is the work of several men or different firms in a capitalist economy. Prior to the industry being done in a factory, textile production was done at home in the spare time of agricultural workers as a putting-out system. What was done originally by one person, began to be broken down even at this stage: children carded, women spun the cloth and men were weavers. The first part of this industry that entered the factory system was spinning due to the invention of the spinning jenny as the blockage for meeting the demand at that time lay in the spinning portion; 2) the second form of the division of labour concerns the rationalisation of work within a firm, that is, the separation of the production process within the same firm. In this case, let's look at the auto industry: the production process is broken down, and each individual on an assembly line merely does one step in the process of each part.
According to Smith, the division of labour enables the increase in the productive powers of labour leading to a massive increase in the output produced in society in three ways: first, the division of labour enables the increase in the dexterity of every particular worker as they are only concentrated upon one aspect of the production process, their ability to do that aspect efficiently and properly is developed; second, the division of labour enables the saving of time which is lost in passing from one type of work to another; and third, the division of labour will lead to the invention of machinery which facilitates and reduces the amount of labour used in the process of production, this enables one worker to do the work which was formerly done by many.
The role of Demand in Economic Growth: the extension of the market
Although the division of labour massively increases the productive capacity of the economy, Smith was aware that if this produce was to be produced there had to be a market for it. In other words, what purpose does it serve to increase the amount of output produced, if there is no one to buy it or there is no market for the increased output? Smith argued that the division of labour is limited by the extent of the market. What Smith argued, was that since it is the power of exchanging commodities that gives rise to the division of labour, the extent of this division of labour is limited by the size of the market for this output. When a market is small, no one person would want to dedicate him/herself entirely to one employment. He argued that in a small market, he/she has no power to exchange all the surplus part of the product of their own labour (that is that part of the produce over and above their own consumption) for such parts of the product of other people's labour which he/she wants. Commodities will not be produced if there is no market for them -- there is a constraint on the growth of the economy which is based upon the ability of the population to purchase and consume the product. This issue touches upon limits to the economic growth of nations, the question of distribution, and the question of international trade. This has several implications: if in order for your economy to grow someone has to buy the product that you produce, that means the workers' wage has to be high enough for them to consume a varied wage basket, and the surplus over what the worker's themselves consume has to be bought by someone, either the capitalists, the landlords or people in another country.
- PY = wL + (1+r)K+ tT
- PY = wL + K + rk +tT
(Where P = price, Y = output, w = wage, L = quantity of labour, K= value of capital, rK is the rate of profits over the value of capital, t = rents, T =quantity of land)
Think of this question in another way: if you produce a level of output in the society, the workers will only consume the value of products equal to the wage, and capitalists will put aside the value of capital (K) used up in production that must be replaced. The surplus portion (or the net product portion) of the value of output has to be sold in order to realise the profits and rents contained in the value of output, thus, either the landlords and the capitalists must buy a portion of the product or the excess above the value of wages must be sold internationally or traded for commodities produced internationally that the landlords and the capitalists will buy. Otherwise, you have what Marx calls a realisation crisis.
Clearly, the assumption of Say's Law eliminates this question from economic analysis, as Say's law means that whatever is produced will be consumed. However, this is not the case in the analysis of Smith or the Physiocrats and it was one of Malthus's criticisms against Ricardo's theory.
Smith argued that the proper development of the economy was first to develop agriculture (which will feed the working population), then manufactures, and then to develop commerce or international trade. However, we need to take into account, that in the context of Smith's discussion, he is talking about the manner in which the system developed as a capitalist system. He always stresses the importance of the development of the domestic market for commodities. When he does address international trade, it is in the context of its relation to the economic growth of nations both in terms of what goods are to be traded internationally and purchased for consumption or production to achieve economic growth. Smith's argument, like that of the Physiocrats stressed the idea that production is what enabled the growth of nations, and his arguments should be seen as a critique of the mercantilist position, that wealth derives from commerce or trade, where the more money you had, the richer was the nation. Smith argued that the more you produced and the larger your market, the richer was your nation. Smith's analysis on the division of labour is in the first 3 chapters of Book I of The Wealth of Nations. What should be clear is that if commodities are to be produced that there must be a market for them, is that the commodities have to be exchanged.
Why consider Smith's discussion, what is its relevance today? Is it just old theory, after all it was written in 1776? I would argue that Smith's discussion on growth and the importance of a domestic market for commodities produced (and consumed) is relevant not only for developing economies due to the fact that he raises points that many contemporary economists ignore (due to the nature of the theory they are utilising). The need for high wages to sustain domestic (and international) demand for commodities to ensure growth is diametrically opposed to mainstream economic arguments from 1870 onwards, the fact that he does not assume realisation (purchase at a price which will enable economic growth) and argues that it is demand which drives the system, recognises the interconnectedness of the different aspects of the economic system to enable economic growth and he puts his finger on that exact point at which problems can arise. Consider that he wrote the Wealth of Nations at a point where the things he was discussing had not advanced to the point that they were obvious so as to make his treatise a description rather than a theory.
A last point
As I am planning on doing a series on classical economic theory and policy, I need to know some things that will help me teach this, how is the level (too high or low), are people interested in the discussions of prices in Smith and Ricardo, is more direct information helpful, shall I quote more from the authors themselves in addition to my lecture notes, do you want suggested readings? Thanks for any input.