Chapter 5, Book I

Historians of economic theory have wrestled with Chapter 5, Book I, of The Wealth of Nations, entitled "Of the Real and Nominal Price of Commodities, or of Their Price in Labour, and Their Price in Money." We believe that in this chapter Smith tried to answer several questions that, although related, create confusion when they are examined simultaneously. He attempted to discover, first, the factors determining the general level of prices, and second, the best measure of changes in welfare over time. The second question is the more difficult. How are we to define welfare in an unambiguous way so that changes in welfare can be measured? Suppose that an economy produces only one final product, deer. Welfare for the economy could be defined and measured in terms of the quantity of deer consumed. Consumption of larger quantities of deer would represent increased welfare for the society, and consumption of smaller quantities would represent decreased welfare or "illfare." The issue becomes more complex when we introduce a second final good, beaver. We can state unequivocally that more of both beaver and deer will increase welfare, and less of both will decrease it. But what if consumption of beaver increases and consumption of deer decreases? The welfare of the people in the society who place a high value on beaver would increase, and the welfare of those who value deer would decrease. Is it possible to define and measure changes in welfare for an economy of two or more products? Smith tried to answer this question.

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If welfare is defined as either the total consumption orlrtie output of society, the initial problem to be solved for a multiple-product eccmomy is to find a way to add the output or consumption of the products—for «example, beaver and deer. A possible solution to this problem is to convert al commodities to one common measure. If IB = 2D, then an increase in output off two beavers coupled with a decrease in output of two deer represents an increase in welfare. The new level of output can be said to be one beaver better off or two deer better off. However, if the relative prices of beaver and deer change as their outputs change, the problem of measuring welfare becomes much more complicated. In an economy with many products, the relative prices of commodities are expressed in a common measure, usually the monetary unit of the government. In theory, and occasionally in practice, this common measure (in the jargon of economics, the numeraire) could be any one of the commodities oof the economy—for example, cows, corn, or gold. In our economy, we measures output by adding up the money value of each commodity to obtain a sum we call the gross domestic product. If the gross domestic product increases from one year to the next, can we conclude that welfare has increased?

Measuring changes in output in a multiple-product ecconomy by this means presents difficulties, because the unit of measurement, ti«e yardstick money, is itself variable. The general level of prices changes; theretoore, the money value of output may not correctly reflect the true output. S-rnith considered the possibility of using gold or silver as a common measure, or numeraire, but concluded that because the prices of these commodities vary, they are unsatisfac­tory for this purpose. He then turned to labor but found rhat the price of labor also varies over time. In the end, the only invariant measure he could find to assess changes in welfare was the disutility of work, because "equal quantities of labour, at all times and places, may be said to be of equal vallue to the labourer."²³

Given Smith's conclusion that labor disutility can be unsed in computing an index of welfare, the problem of measuring changes in vedfare is easily solved. We first measure changes in total output in terms of the monetary unit; then we adjust for changes in the general level of prices accordingtoo changes in the price of either gold, silver, or corn. By this process, we have converted money income and nominal price into real income and real price. To measure changes in welfare, we then compare the amount of labor disutility involved in producing the different outputs. For example, if the money value of output increases 10 percent and the general level of prices as measured by the price of" gold also goes up 10 percent, the real value of output remains the same, ^leelfare increases if the disutility of producing this output decreases. Translated iffito everyday language, if we could produce the same quantity of output with less labor, we would have more leisure and be better off.

Measuring changes in welfare is much more complicated than Smith thought, however, and our discussion cannot touch on all the issue:s involved. Smith did not discuss how to define or measure the disutility of labor. This appears to be

²ⁱIbid., p. 33.

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etermining the long-run growth rate of a society, one of the main concerns of Adam Smith, has not al­ways been the primary focus of the discipline we now term economics. Analysis of growth was not a prime con­cern of the neoclassical writers, for ex­ample. As we enter the twenty-first century, however, economic growth and its causes and consequences have again come into focus. Somewhat ironically, modern economists, using high-powered econometric systems to test hypotheses, have succeeded in verify­ing empirically some of the factors that Smith, in his loosely constructed theo­retical framework, found to be key de­terminants of the wealth of a nation. One recent study looked at how the "extent of the market" influences eco­nomic growth. Another has found that secure property rights contribute sig­nificantly to the high rates of economic growth characteristic of Western devel-

oped economies. This work, called "new growth theory," is a major focus of mod­ern macroeconomics. Interestingly, many of its insights were anticipated in Smith's work (though careful scrutiny was needed to identify some of them), but during the intervening ages, they have been lost to economics, as the pro­fession focused on different issues.

A good summary of modern empiri­cal attempts to understand the causes of the wealth of nations is Robert Barro's Determinants of Economic Growth, MIT Press, 1998. See also Alberto F. Ades and Edward L. Glaeser, "Evidence on Growth, Increasing Returns, and the Ex­tent of the Market," The Quarterly journal of Economics, August 1999; and Charles I. Jones, "Was an Industrial Revolution In­evitable? Economic Growth Over the Very Long Run," National Bureau of Eco­nomic Research Working Paper No. W7375-

completely subjective. One of his assumptions that was not questioned by orthodox economists until the twentieth century was that more goods are better than fewer, or that increases in output that occur without increases in labor disutility must always result in increased welfare. The various goods that constitute total output are not an issue in his writing. Growth of output is an improvement in welfare even if the enlarged output includes goods of doubtful benefit to the society. Furthermore, Smith and the orthodox economists who followed did not consider the "quality of life" produced by this enlarged output. Little or no attention was given to the costs in the form of pollution or other harmful externalities that society might pay for ever-larger outputs.

SUMMARY

Smith's contribution to and influence on economic thought was tremendous. More than any other writer of his time, he saw the central ideas and forces that govern a market economy. However, his work is not without problems. Smith

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confused himself and generations of economists by failing to elaborate separate theories of, and distinguish clearly among, relative prices, the general level of prices, and changes in welfare. Historians of economic ideas have debated whether Smith propounded a labor theory of value. If this means a labor theory of relative prices, the answer is yes and no. He applied a labor theory of relative prices to a primitive economy, but for a modern economy he held to a cost of production theory. According to Smith, the general level of prices can best be measured by the price of gold, silver, or corn. To explain changes in welfare over time, he formulated a subjective labor-disutility theory. We must conclude that for a modern economy Smith did not accept a labor theory of value to explain relative prices. Once land and capital become economic goods, natural prices will depend mainly on costs of production—namely, wages, profits, and rents.

Smith was primarily interested in questions of economic policy affecting economic growth and development, specifically in determining policies that would best promote the wealth of the nation. His major recommendation was that the government follow a policy of laissez faire; this, he claimed, would effect a maximum rate of growth of per capita income in the economy. His analysis of the workings of markets (what today would be called the microeconomic aspects of the economy) must be viewed within the framework of his concern for economic development. His belief that laissez faire was the most effective policy available was based not primarily on its efficiency in allocating resources but on its beneficial effects on economic growth. His policy positions, for both laissez faire and government intervention, were always contextual. They were based on theoretical arguments combined with his observations of households, firms, politicians, and institutions. Nor was his methodological predilection that of a pure theorist; he also took into consideration political, historical, and institu­tional factors. This stance extended, moreover, from his analysis to his policy. The mercantilist regulation of domestic and foreign trade had been designed purportedly to increase the wealth of the nation, but Smith concluded that such regulation was misguided and that economic growth was best promoted by the free operation of markets. Smith's policy conclusions flowed not solely from his theoretical structure but in part from his application of the art of economics.

Although Smith was concerned chiefly with questions of economic develop­ment, it was in his investigation of the workings of competitive markets that he contributed most significantly to economic theory. In this endeavor he drew from the later mercantilists and the physiocrats and brought together in one book much of the solid analysis of his predecessors. He was able to describe the functioning of competitive markets with greater precision than previous writers. In the details of his theoretical structure, particularly in his attempts to formulate a value theory, he provided a necessary point of departure for Ricardo and other theorists who followed.

Smith was not a pure theorist. Rather, he was a political economist who was able to supplement a grand vision of the interrelatedness of the sectors of a market economy with descriptive and historical material and to influence economic policy for at least two hundred years. The pure theorist Ricardo was followed by J. S. Mill, and Mill by Alfred Marshall; both tried to return economics to Adam Smith's contextual analysis and policy. With few exceptions,

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the methodological position of orthodox economists since Marshall was one of almost exclusive focus on pure abstract theory, with little attention to historical and institutional material. In that focus, modern mainstream orthodox theory has rejected the Smithian methodology. However, it has been kept alive by heterodox economists who rejected Smith's laissez-faire policy conclusions.

Generally speaking, the history of economic analysis and policy discloses three major developments since Smith: (1) Microeconomic theorists have tried to fill in the details of Smith's grand vision of how markets work. Part of this activity has been technical, aimed at giving greater precision to Smith's vision, and part has attempted to develop areas that Smith failed to treat or to comprehend, including the development of the demand side of price analysis, the formulation of a theory of the economic forces determining the distribution of income, and the analysis of resource allocation in other than perfectly competitive markets. (2) After Smith, macroeconomic analysis received little attention from orthodox theorists until the 1930s, when Keynes returned to one of the mercantilists' concerns and attempted to explain the forces determining the level of income and employment. (3) Smithian economic policy remained virtually intact, despite the grumblings of Marx, Veblen, and others outside the orthodox camp, until the twentieth century, when theoretical developments (welfare economics and some parts of Keynesian theory) and events in the real world (revolutions that replaced some private property economies and severe depressions that shook the remaining ones) led to either rejection or reexamination of Smithian policy.

We turn now to the second great classical economist, David Ricardo. Like Smith, he was primarily interested in questions of macroeconomics; but in the course of developing a theory of distribution, he was instrumental in turning orthodox economics away from macroeconomic questions for more than a century.

Key Terms

advanced economy natural price

capital accumulation numeraire

contextual economic policy primitive society

cost of production theory of value productivity of labor

diamond-water paradox profits

division of labor Protestant ethic

early and rude state specialization and division of labor

extent of the market value in exchange

labor command theory of value value in use

labor cost theory of value value theory

laissez faire wages fund doctrine

market price wealth of nations

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