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Contribution of Adam Smith towards Economics

Adam Smith (1723-1790) is often thought as a founder of modern economics. His chief contribution was to build a coherent and logical theory of how the economy works by stating the law of the demand. His two main works are: The Theory of Moral Sentiments and An Inquiry Into the Nature and Causes of the Wealth of Nations.

In his book “Wealth of Nations”, Adam Smith puts his ideas of free market and examines the conditions, which lead to an industrial revolution. Two hundred – fifty years before he raised a question that still remains central in today’s world. Why do residents in one nation have higher incomes then those in other? Why do those incomes persistently rise in some countries and fluctuate around in others? According to him, in a free market a Government should have a limited proper well defined role in the society. Government should provide national defense, the administration of justice and public goods. In other words Government should provide only those goods and services which a free market cannot provide.

In “Wealth of Nations”, Smith talks about two important aspects of the economy, which are division of labor and Invisible hand. According to Smith division and specialization labor is very important. Unlike the modern approaches to technical advances linked to the capital investment process, Smith emphasizes the importance of the organization of production as representing the source of technical progress. The division of labor refers to the fresh forms of specialization separating the production process into compartments, each one performing different tasks with varying rates of profits for comparative advantages in the trade. Income level of any country depends on the level of degree of division of labor they have attained.

The method to run a free economy is competition, buyers and sellers striving against each other to gain more customers and profits. When sellers compete, they lower prices improve their products and offer specialized deals to gain more customers. The sellers are motivated by the self interest, they think about what is in there for me? The factor of self interest comes into play. Instead of being motivated by the fixed prices by the government, the sellers choose prices and run businesses to make as much profit as possible. Any product people demand will be supplied by someone ready to earn profit. Thus everything people need is fulfilled without Government getting involved in the business. This system was called “free market” by Smiths, which is run by an “Invisible Hand”. The self – interest is the invisible hand that runs the free – market, which means the markets are self regulated.

Even though Smith realized that free markets are not perfect, he understood that generally speaking, more than any other alternatives available free market concept is able to advance wealth and welfare. Instead of gains for both parties arising from each transaction, citizens must pay whatever service is offered in return. This leads to poorer lives. The simple truth is that, when free to do so, individual and families look after themselves than distant, too powerful government.

In Smith’s view of the workings of the market system, any short-run deviation of the market price from the long-run price would trigger the forces of competition—by which Smith meant profit-seeking entry and loss-avoiding exit—which would eventually take the market price to its long-run level.

Smith's theory of wages was a form of the Iron Law of Wages which held that wages are by and large equal to the subsistence level of wages. (If wages exceed the level that is just enough to keep the worker and his dependents alive, there will be an increase in population that will drive wages down to the subsistence level. If wages fall below what the workers need to stay alive, population will fall and wages will rise to the subsistence level.) This meant that any increase in total output went not to the workers but to capitalists who would save and invest in machinery that would make possible further division of labor and technological progress.

Smith thought of rent as a residual that is leftover after wages and profits had been paid out of total output. Wages would be reduced to the subsistence level, as I said before. Competition will gradually reduce the rate of profit to a low level that would also be uniform across all industries. Therefore, only those who earn rent income would benefit from progress.

In his book “the Theory of Moral Sentiments”, Smith argued that as people are able to imagine what others are going through, they are able to empathize with the sufferings of others. When the experiences of others are felt as our own experience, our instinctive pursuit of self-interest can lead us to pursue the interests of those others. So, it is perfectly consistent to believe that human beings pursue self-interest and are generous towards others. Moreover, apart from the human ability to empathize with the sorrows of others, the sheer practicality of peace—the fact that we realize that it is necessary for prosperity—may be enough to encourage good behavior.

As one might expect from Smith’s conviction that markets were extremely efficient, he was in favor of a government that did not hamper the working of the market. However, Smith emphasized the fact that the government should maintain law and order, ensure the defense of the nation from foreign enemies, erect and maintain public works that private citizens will not build, and subsidize the education of those who could not afford it.

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