Thursday, April 24, 2008

Adam Smith's Dynamic Equilibrium

Adam Smith’s intention in writing An Inquiry into the Nature and Causes of the Wealth of Nations was to explain the accumulation and definition of wealth of a society. In doing so, Smith described a liberated economic system in which a society could maintain internal balance while constantly changing and moving towards equilibrium and perfect justice. Smith’s portrait of a relatively stable economy would also have the tendency to grow its wealth and productivity.

Smith did not have the original idea of a self-maintaining society, but rather gave a clear voice to the concept of harnessing the power of a marketplace and of individual’s self interest to continually move toward this goal. The ancient Greek philosophers described an ideal state—of social and economic equilibria. This would be achieved through, for example, Plato’s caste system in which all occupations were decided at birth—a socially immobile division of labor. However, Plato’s system implies that men are naturally better or worse because of a preposition to a particular trade. Adam Smith’s ideal state gives more equality to the abilities of man, as most differences are developed through culture and education. The Greeks also held the belief that self interest was contrary to economic growth. Aristotle desired a system where a just price would be maintained through honesty of the purchaser and seller, not of their self-love. Similarly, the Mercantilists believed that self-interest was destructive to the wealth of the nation—for example, that certain personal luxuries should not be encouraged because it was against the well-being of the nation. Adam Smith expanded on previous political and economic philosophers by allowing self-interest to have a place in serving the greater good of the nation and establishing a societal balance which promoted relative harmony and morality.

This balance derived from self-interest is a product of an innate and universal desire for wealth and the dismantling of rules and regulations that hinder the potential of a free market system. With these two assumptions, competition is allowed to freely provision economic goods to all levels of society. Self-interest will lead to the division of labor. Each person cannot produce what he or she needs individually, and it is in each person’s best interest to truck, barter, and exchange the surplus of one’s products with another. This self-interest leads to unintended social cooperation. Due to the liberated market, the effectual demand of each good will ration the quantity of production of commodities. A relatively harmonious system is created in which people’s needs are met via the market mechanism. What Smith terms the “market” price of a good, its exchangeable value, will tend to converge with the “natural” price, its value in labor, in the long run as well. This occurs because if there is freedom to produce and to consume, it will be impossible to sell a good above its natural price for any amount of time, as there will always exist another producer offering a lower price, pushing the high seller out of the market. Both the natural and the market prices are constantly changing; the market price fluctuating greatly and the natural price theoretically decreasing in the long run because of increased productivity due to the expansion of the division of labor.

Wages and profits will tend to converge towards equilibrium levels in the long run. In the short run, Smith admits they may be “suspended a good deal” from natural levels, but this is only temporary. Therefore, individuals will not, in the long run, be working for more or less compensation than their counterparts in the same occupation. Smith argues this in Book I, Chapter 7 by stating that if in any area, there is an occupation that seems to be very attractive due to its high wages or profits, more people will crowd into it and will eventually balance the wages so that they are comparable to the levels of other similar occupations.

The market’s ability to ration economic goods and equalize occupations is under the assumption that actions do not violate natural laws of justice. These laws of justice are enforced by the government, whose only roles are to provide defense, public works, and a system of law and order. The government should not interfere with the market, not because politicians are inherently evil, but because they could not possibly do as much good as the market is capable of achieving. In this way, Smith’s economic welfare is contained by the government but also allowed to flourish within the dictates of justice. This maintains reasonable, but not perfect, order within the society. The society is constantly moving towards equilibrium, and may obtain it only briefly, but Smith was not describing a static system in which there will be a Utopian state through the division of labor and the free market mechanism. He was, however, describing a system of constant change under which relative order and justice exist.

Once this stability is achieved and maintained, the society may develop its division of labor into other sectors and continue to grow its wealth. The society moves from a primitive sort of society, where agriculture is the focus, to a manufacturing society, which will in turn eventually lead to commerce between other nations. This is also one of the functions of the market. With a liberated market, capital will flow into the appropriate areas—those with the most profit potential. Agriculture is the most “safe” investment, next being manufacturing, and so on: “…as the capital of the landlord or farmer is more secure than that of the manufacturer, so the capital of the manufacturer being at all times more within his view and command, is more secure than that of the foreign merchant” (Smith). In this way, the market may control the appropriate flows of capital due to expected returns and expected risk. As the society moves away from a primitive society, the extent of which the nation may specialize and divide labor increases. The most ideal society that Smith describes uses a sophisticated division of labor, in which there is professional differentiation of labor, and is the most effective. Therefore, productivity is increased and profits will be expected to increase. The growth of the nation cannot exceed the market capacity, keeping it within reasonable levels. Smith defines wealth as the amount of necessities and luxuries an individual has. The increased productivity will therefore lead to higher output and more “stuff” for each person. The market sparks growth that propels the economy forward towards, though never reaching, an optimum level of production and consumption.

As the society reaches a level where it can utilize the division of labor on an international level, the nations involved move continually towards an international equilibrium. Prices and wages begin to balance on a larger scale in the long run, and economic goods are provisioned to all levels of society for all countries involved in the trade. Just as the division of labor was beneficial to nations internally, it is also useful on a global scale. The benefits of trade are evident in Book II, Chapter IV in Wealth of Nations, as Smith notes the costs of production can be decreased by purchasing cheaper goods in foreign countries. The country’s total income is increased by allowing international commerce. Restricting trade only negatively affects the potential harmony that could be achieved through a liberated market by creating monopolies and unjust provisioning of economic goods.

Wealth is also created by the accumulation of capital from year to year. The productive class—mostly manufacturers, will produce more than what is necessary for the subsistence of both the productive and unproductive classes. What is set aside and saved for the next year may be used to generate more productive labor and to purchase new machinery and tools. This will maximize output and will continue to expand the nation’s productivity. Saving is natural, according to Smith in Book II, Chapter III of Wealth of Nations, because it betters one’s own condition and each person is constantly seeking to maximize their well-being: “the principle which prompts to save, is the desire of bettering our condition, a desire which, though generally calm and dispassionate, comes with us from the womb, and never leaves us till we go to the grave” (Smith). It is not, however, the accumulation of capital which expands wealth, but it is the connection that capital has to the division of labor as a nation is constantly moving towards its optimum productivity.

Adam Smith may have been arguing a direction for European economies of his time, but unintentionally set forth a self-sustaining economic system that could adapt to changes easily, contributing greatly to economic equilibrium analysis. Smith’s system had a tendency to align society’s needs and wants with what was produced, as well as providing relatively just prices, wages, and profits.


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Myers, ML. Adam Smith’s Concept of Equilibrium. Journal of Economic Issues: September 1976. Volume 3, Issue 3, pp 560.

Schumpeter, Joseph. History of Economic Analysis. Oxford University Press: New York, 1976.

Smith, Adam. An Inquiry Into the Nature and Causes of the Wealth of Nations. Liberty Fund: Indianapolis, 1981.

Vivenza, Gloria. Adam Smith and the Classics. Oxford University Press: New York, 2001.

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