The Formalization of Economics

Perhaps the best known contribution of the Scottish Enlightenment is the formalization of economics as a discipline. Adam Smith is rightly acknowledged as the "father of modern economics," and his work An Inquiry into the Nature and Causes of the Wealth of Nations is considered to be the foundational text of the discipline. While concentrating on this achievement, the legacy of Smith's teacher Francis Hutcheson will also be briefly discussed. It should be noted that both of these teachers presented topics related to economics in their moral philosophy classes, and Smith's book probably initiated out of his teaching experience on this subject.

Specialization and Industrialization

Our period saw the birth of the Industrial Revolution, propelled by the intensive use of machinery in production, but as Adam Smith observed, organized specialization was a prerequisite to this development: "invention of all those machines by which labour is so much facilitated and abridged, seems to have been originally owing to the division of labour."[1] Specialization and exchange is a basic element of human civilization, as noted in Hutcheson's lectures:

But 'tis plain that our acquisition by labour in any one sort of goods may extend far beyond our own present consumption and that of our families... as we may employ the surplus as matter of beneficence, or of barter for goods of different kinds which we may need. Otherways each one would be obliged to practice all sort of mechanic arts by turns, without attaining dexterity in any; which would be a public detriment.[2]

But Adam Smith was the first to extensively analyze the process:

The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour... owing to three different circumstances: First, the improvement of the dexterity of the workman necessarily increases the quantity of the work he can perform; and the division of labour, by reducing every man's business to some one simple operation, and by making this operation the sole employment of his life, necessarily increases very much the dexterity of the workman. Secondly, the advantage which is gained by saving the time commonly lost in passing from one sort of work to another, is much greater than we should at first view be apt to imagine it….  Thirdly, and lastly, every body must be sensible how much labour is facilitated and abridged by the application of proper machinery…[3]

Every workman has a great quantity of his own work to dispose of beyond what he himself has occasion for; and every other workman being exactly in the same situation, he is enabled to exchange a great quantity of his own goods for a great quantity, or, what comes to the same thing, for the price of a great quantity of theirs.[4]

But to make the process of extensive exchange work, the markets must be large enough,[5] and this requires efficient transportation, which was supported by improving technology and the growing British Empire.

Pricing and Production

The fact that the pricing of commodities is the result of the combination of supply and demand had been long understood, as acknowledged in Hutcheson's lectures

But when some aptitude to human use is presupposed, we shall find that the prices of goods depend on these two jointly, the demand on account of some use or other which many desire, and the difficulty of acquiring, or cultivating for human use. When goods are equal in these respects men are willing to interchange them with each other...[6]

But here again, Adam Smith was the first to study the pricing process in detail, and to describe its effect on allocating resources to production:

The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labour, and profit, which must be paid in order to bring it thither. Such people may be called the effectual demanders, and their demand the effectual demand… When the quantity of any commodity which is brought to market falls short of the effectual demand, all those who are willing to [buy it] cannot be supplied with the quantity which they want. Rather than want it altogether, some of them will be willing to give more. A competition will immediately begin among them, and the market price will rise more or less above the natural price… When the quantity brought to market exceeds the effectual demand, it cannot be all sold to those who are willing to pay the whole value... Some part must be sold to those who are willing to pay less, and the low price which they give for it must reduce the price of the whole.[7]

The quantity of every commodity brought to market naturally suits itself to the effectual demand... If at any time it exceeds the effectual demand, some of the component parts of its price must be paid below their natural rate. If it is rent, the interest of the landlords will immediately prompt them to withdraw a part of their land; and if it is wages or profit, the interest of the labourers in the one case, and of their employers in the other, will prompt them to withdraw a part of their labour or stock from this employment. The quantity brought to market will soon be no more than sufficient to supply the effectual demand... If, on the contrary, the quantity brought to market should at any time fall short of the effectual demand, some of the component parts of its price must rise above their natural rate. If it is rent, the interest of all other landlords will naturally prompt them to prepare more land for the raising of this commodity; if it is wages or profit, the interest of all other labourers and dealers will soon prompt them to employ more labour and stock in preparing and bringing it to market. The quantity brought thither will soon be sufficient to supply the effectual demand…The whole quantity of industry annually employed in order to bring any commodity to market, naturally suits itself in this manner to the effectual demand. It naturally aims at bringing always that precise quantity thither which may be sufficient to supply, and no more than supply, that demand.[8]

Recognizing the power of the market system to efficiently allocate resources, Smith warns against any type of interference, which may result from collusion or from privileges granted by the government:

The monopolies, by keeping the market constantly understocked, by never fully supplying the effectual demand, sell their commodities much above the natural price, and raise their emoluments, whether they consist in wages or profit, greatly above their natural rate... The exclusive privileges of corporations, statutes of apprenticeship, and all those laws which restrain, in particular employments, the competition to a smaller number than might otherwise go into them, have the same tendency, though in a less degree. They are a sort of enlarged monopolies, and may frequently, for ages together, and in whole classes of employments, keep up the market price of particular commodities above the natural price...[9]

Labor and Wages

In discussing the distribution of the wealth of a nation, Adam Smith discusses the roles played by those who own resources as capital for production, and those that labor. He would let the same forces of supply and demand regulate the negotiated value of each contribution and therefore the share of the product revenues that is provided to laborers:

What are the common wages of labour, depends every where upon the contract usually made between those two parties, whose interests are by no means the same. The workmen desire to get as much, the masters to give as little as possible. The former are disposed to combine in order to raise, the latter in order to lower the Wages of labour. [10]

But the negotiating powers of capital owners and laborers are very different:

A landlord, a farmer, a matter manufacturer, or merchant, though they did not employ a single workman, could generally live a year or two upon the stocks which they have already acquired. Many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment. In the long-run the workman may be as necessary to his master as his master is to him; but the necessity is not so immediate.[11]

But though in disputes with their workmen, masters must generally have the advantage, there is however a certain rate, below which it seems impossible to reduce, for any considerable time, the ordinary wages even of the lowest species of labour. A man must always live by his work, and his wages must at least be sufficient to maintain him. They must even upon most occasions be somewhat more; otherwise it would be impossible for him to bring up a family, and the race of such workmen could not last beyond the first generation.[12]

The above statements seems to treat laborers as nothing more than economic components, without reflecting on the human hardship of very low wages, which has caused modern societies to prescribe minimum wages. But in the following statement, Smith shows more human concern or social sensitivity:

Servants, labourers and workmen of different kinds, make up the far greater part of every great political society. But what improves the circumstances of the greater part can never be regarded as an inconveniency to the whole. No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable. It is but equity, besides, that they who feed, cloath and lodge the whole body of the people, should have such a share of the produce of their own labour as to be themselves tolerably well fed, cloathed and lodged.[13]

In fairness, it must be recognized that the worst human toll of the Industrial Revolution, with child labor and near-slavery working conditions, had not yet occurred.

Taxation and Social Order

Smith presents taxation as a responsibility of "shareholders" in the economic enterprise of the nation: "The expense of government to the individuals of a great nation, is like the expense of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate."[15] And he believes that the level of contribution should be: "in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state."[16] For the economy to function effectively, social order must be secured, and this, as Ferguson acknowledges, is part of the management role of the State:

The success of commercial arts, divided into parts, requires a certain order to be preserved by those who practice them, and implies a certain security of person and property, to which we give the name of civilization, although this distinction, both in the nature of the thing, and derivation of the word, belongs rather to the effects of law and political establishment... Property calls for the security of law; and prudence requires the trader to be fair in his dealing.[17]

[1] Adam Smith, "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776),  in The Works of Adam Smith  (London: T. Cadell and W. Davies, 1812) Vol II, 14  [Book 1, Chapter 1]

[2] Francis Hutcheson, A System of Moral Philosophy (Glasgow: A Foulis, 1755), Vol 1, 328-329.

[3] Adam Smith, "The Wealth of Nations" Vol 1, 12-14 [Book 1, Chapter 1]

[4] Ibid., 16-17.

[5] Ibid., 26-28 [Book 1, Chapter 3]

[6] Francis Hutcheson, A System of Moral Philosophy, Vol 2, 54.

[7] Adam Smith, "The Wealth of Nations" Vol I, 84-87 [Book 1, Chapter 7]

[8] Ibid., 86-87.

[9] Ibid., 92-93.

[10] Ibid., 99 [Book 1, Chapter 8]

[11] Ibid., 100.

[12] Ibid., 102.

[13] Ibid., 118 [Book 1, Chapter 9]

[14] Ibid., 119.

[15] Adam Smith, "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776), in The Works of Adam Smith  (London: T. Cadell and W. Davies, 1812) Vol IV,  256 [Book 4, Chapter 2]

[16] Ibid.

[17] Adam Ferguson, Principles of Moral and Political Science (Edinburgh: W. Creech, 1792), Vol 1,  252-253.