ADAM SMITH - HOW THE STATE MIGHT ENHANCE AND PROTECT THE WEALTH OF A NATION



Markets left purely to their own devices will not always achieve equilibrium 

Adam Smith (1723-1790) is well known as the father of the modern capitalist economic system -- especially with his emphasis on efficient manufacturing output and the benefits of the specialisation of labour (Splitting the production of pins into several component parts readily comes to mind). The pin factory example meant that ten people specialising in productive tasks could produce 48,000 pins a day - some 2,000 times more than if the 10 workers had not specialised at all. Firms could vastly increase their production and productivity but they would need to be in a position to sell that increased output. The latter might mean that the UK would need to expand its market for British goods and this would mean foreign trade without barriers. Smith was in favour of free trade as long as it did not increase the military might of the UK's competitors.

However there are some surprising conclusions within Smith's seminal work entitled," The Wealth of Nations"  (1776). For markets to allocate resources optimally some additional conditions must apply and in many popular discussions of Smith's work these are seldom if ever properly examined. The focus is on the laissez faire nature of Smith's thoughts, nevertheless these alternative perspectives do need to be considered by us in this modern day and age.

Smith was in favour of increased production and productivity which would increase a country's national output thus going hand in hand with expanding international trade. However he identified monopoly practises as the enemy of  a country's free trade and economic growth aspirations because monopoly:

1. Inevitably led to higher prices for consumers making them worse of than they could have been.

 

2. He viewed them as " a great enemy to good management." Competition forced managers to be more innovative and more efficient. Monopoly induces managers to stick with tried and trusted profit maximising approaches as they have no need to really do anything radically different. They will only innovate when their monopoly position is threatened by third parties.

 

3. Monopolies were more likely to be successful in pressurising governments to support the status quo in terms of maintaining the monopoly position (Unduly influencing or even corrupting governments) -- Sounds a bit familiar?

 

4. Monopolies lead to the mis-allocation of economic resources -- investment would go into monopolies precisely because they were monopolies not because the goods they produced were necessarily needed by the economy as a whole at the prices that the monopolies sold them at.

 

So whilst he was generally regarded as the father of modern capitalism that is not to say that he did not see a role for the state in guaranteeing economic freedoms . He viewed the role of the state in the following ways:

1. As a vigilant sentinel against the rise of monopoly power in the economy which would guarantee competition and a path towards the greater optimisation of the use of resources.

 

2. Defending the nation against external threats of aggression

 

3. Maintaining internal order and defence. The police and the judiciary and the rule of law. Without the rule of law economic and property rights in a competitive environment could not be protected.

 

4. Approving the provision of public goods where there were significant externalities.

 

The fourth point above is perhaps the most controversial. In a simple world the buyer buys a good or service from the seller. The buyer pays a price for the goods or services and consumes them whilst the producer receives payment for the goods and services which cover his costs of production and gives him a surplus to either consume and\or re-invest in his enterprise.

 

However such transactions are often not a purely private affair between the buyer and the seller. From certain types of transactions outsiders to the main transaction can themselves experience gains or losses and indeed the sum of these gains and losses can be argued to represent the gains and losses of society as a whole resulting from actions which were initially meant to just affect the two original contracting parties. The best examples of externalities are pollution - emanating from industrial processes (a negative externality) and  education\training (a positive externality).

 

The moral of externalities here is that without state intervention -- the market on its own could not hope to guarantee that nearly enough would be spent to properly combat pollution to ensure it does not critically affect our society nor can it guarantee that there will nearly be an adequate level of education\training for all in society. Poor children could not obtain the level of education commensurate with their needs and aspirations because their parents may not be able to pay the market rate for it. Pollution causes costs and dis-benefits which may not much affect the two initial parties to the transaction. These two parties do not have the incentive to, or the financial means of, ensuring that, society is safe from their polluting activities.

 

Hence in both these situations the state would need to ensure that the benefits of positive externalities were amplified as much as possible and the dis benefits  of negative externalities were similarly muted as much as possible.

 

The above four points and especially point four, describe the proper role that the state should play in a potentially thriving economy. Adam Smith recognised this and it is a shame that some people who purport to be his followers focus on laissez faire factors seeming to have forgotten what he said about the role of the state.