Economist Guide: 3 Lessons Adam Smith Teaches Us

For all the attention Adam Smith receives as the father of modern economics, most of his lasting influences are best classified as moral and social – maybe even anthropological. Smith was a Scottish professor of moral philosophy at Glasgow, and most of his economic insights were byproducts of this pursuit. Smith championed self-interest as enlightening and beneficial, and he viewed political or business power with contempt.

Smith was wrong on many of the details of his economic theory; like Karl Marx after him, Smith operated under the assumption of the now-defunct labor theory of value, for example. Smith either ignored or never fully addressed other aspects; he lacked a full-bodied theory of prices and made virtually no mention of time factors. Still, there are some valuable economic lessons left to be learned from his classic book, “An Inquiry into the Nature and Causes of the Wealth of Nations.”

1. The Main Causes of Economic Growth Are Division of Labor and Accumulation of Capital

“Each individual becomes more expert in his own peculiar branch, more work is done upon the whole, and the quantity of science is considerably increased by it.”

Adam Smith begins “The Wealth of Nations” with a simple discussion of the division of labor within a pin factory. From that point forward, his focus never really deviates; in some ways, “The Wealth of Nations” is a tribute to the nearly endless applications of this fundamental economic concept.

The division of labor increases productivity for three reasons: it saves time and reduces setup costs, repetition and specialized education lead to increased dexterity and productivity, and it encourages the invention of machines or automation in the specialized areas. Smith didn’t discover these truths, but he did bring them together.

Smith also makes frequent reference to the stock of an economy, meaning savings and accumulated capital. Without pre-existing capital, businesses and entrepreneurs can’t hire workers, build factories or begin production. Smith understood that an economy requires savings to grow, for savings fuel investment and credit.

1. Voluntary Exchange Will Not Take Place Unless Both Parties Believe They Will Benefit

“Give me that which I want, and you shall this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of.”

It’s inaccurate to think of economics as a science about market gains and losses. What economics really studies is how separate individuals benefit each other; namely that they do so unintentionally. Smith’s crucial insight is that markets and society improve naturally when people are allowed to trade freely.

Basic deductive logic proves that people do not enter into a trades voluntarily when they don’t expect to gain; otherwise they would not make the trade and would be better off staying put. Each successful trade sends a signal in the market that a certain good or service has value; if this happens enough, greater forces will be mobilized to bring about that good or service in greater abundance.

Nobel-winning economist Milton Friedman once said, “Most economic fallacies derive from the neglect of this simple insight, that market participants trade to benefit themselves.” Friedman and Smith also knew that interfering with voluntary exchanges has the opposite effect.

1. Government Intervention Disrupts the Efficient Distribution of Resources on the Market

“But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies, much less to render them necessary.”

Though Smith believed in a functional, limited government, he didn’t want governments interfering with trade. Smith most famously used this argument against the prevailing economic theory of his time, something he labeled as “mercantilism,” because it favored subsidies and tariffs. Smith showed that free moving markets maximize the efficient flow of resources, which maximized the public good. Overreach by bureaucrats only hinders this process because it interrupts with crucial market signals.

Even though two trading partners accidentally create greater value by voluntarily exchanging, no third party can create additional value by forcing an exchange to take place – nor can a third party create additional value by forcefully interfering with the exchange of two separate parties. Rather, Smith felt that politicians and crony businessmen would likely use power to enrich themselves at the expense of the poor.

Source: Investopedia