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Note: The Cato University introduction to the Wealth of Nations incorrectly lists three authors. This was an error. The script was written by George H. Smith.

Adam Smith was both moral philosopher and social scientist. He sought to understand the wellsprings of morality as well as the regulating principles of social life. In seeking to understand the natural laws governing the regularities of economic life, Smith took the time to observe carefully how business enterprises operated, how markets were organized, and how the prices at which goods were exchanged were determined. Working out the relationships of “supply and demand” that determine prices in the market was one of his principal concerns. Despite a flawed theory of value, Smith did much to explain how the “higgling and haggling” of the market results in prices that coordinate complex economic and social undertakings. From barter, the important institution of money, in the form of precious metals that are “fit to be the instruments of commerce and circulation,” emerges, greatly increasing the possibilities of mutually beneficial exchange and social coordination.

In this module, the results of Smith’s investigations of the natural rules or laws of exchange are explained and then reinterpreted in light of the “marginal revolution” of the 1870s, which allowed Smith’s enterprise to be put on much more secure footing. An important insight that has survived unchanged, however, is Smith’s crucial distinction between “effectual demand” and “absolute demand.” When someone says, “I want X,” thereby expressing an “absolute demand,” we learn less than if he were to explain how much he is actually willing to give up for a unit of X, that is, his “effectual demand.” “More health and safety” are undoubtedly desirable, but the important question is, “How much convenience, pleasure, and other goods would you give up for another increment of health or safety?”

To overcome the natural poverty of mankind, Smith emphasized, there must be growth in the capital stock. Capital accumulation changes the ratio of labor to capital, meaning that an additional unit of labor can produce more wealth than before, thus raising the living standards of the working masses of the population. Those who are concerned about poverty must be concerned about increasing the stock of capital; increasing the stock of capital is the only way to increase living standards. As Adam Smith and subsequent generations of economists have shown, the free market is probably the most humanitarian institution the human race has ever produced.

What is necessary for wealth creation to proceed and for the attendant rise in living standards is not availability of more natural resources; many resource-poor places are inhabited by rich populations, while resource-rich places are inhabited by poor populations. Good institutions, such as a secure system of private property, freedom of contract, and the rule of law, are necessary for wealth to be produced, as Rosenberg and Birdzell show in the reading from their book.

Readings to Accompany The Audio

From The Libertarian Reader: Adam Smith, “Labor and Commerce” (pp. 258-59), “Free Trade” (pp. 260-62), “The Simple System of Natural Liberty” (pp. 263-64).

From How the West Grew Rich: Chapter 4, “The Evolution of Institutions Favorable to Commerce” (pp. 113-43).

Some Problems to Ponder & Discuss

• Why do humans bargain and trade? What is unique, among all the creatures of whom we have any knowledge, about humans that makes exchange both possible and a necessity of life?

• How does a barter economy evolve into an economy in which exchanges are mediated by money? What is the role of money in facilitating exchange and voluntary coordination of activities? What makes commodities “fit to be the instruments of commerce and circulation”?

• How does capital accumulation, or growth in the capital stock, increase the productivity and wages of labor?

• How did the contributors to the “marginal revolution” in economics improve on Adam Smith’s explanation of the workings of supply and demand? How does the focus on the marginal unit affect our understanding of public policy, for example, of how legally mandated increases in minumum wages can cause unemployment?

• A newspaper article on the boom in the construction industry in south Florida after a hurricane is headlined, “Hurricane Andrew Good News for South Florida Economy.” The boost for the construction industry is “seen.” What is not seen?

• In the 1960s it was popular to assert that Germany and Japan had become rich in the postwar era because all of their factories had been destroyed in the war, allowing them to rebuild new and more technologically advanced factories. The conclusion seemed to be that bombing American factories would make America richer. What is wrong with that argument?

• Are markets characterized only by competition? What about cooperation? What is the relationship between competition and cooperation?

Suggested Additional Reading

Joseph Schumpeter, History of Economic Analysis (Oxford: Oxford University Press, 1954). Schumpeter’s work is a magisterial treatment of its topic; it places Adam Smith in the context of other writers and of what they and Smith set out to explain.

Thomas Sowell, Classical Economics Reconsidered (Princeton: Princeton University Press, 1994). With scholarly precision Sowell sympathetically reconstructs the principle ideas of the classical economists, including Adam Smith. One of the more interesting parts of his treatment is the attention he devotes to the classical economists concern with promoting economic growth as the key to prosperity for the masses of the population.

For Further Study

Edwin G. West, Adam Smith and Modern Economics: From Market Behaviour to Public Choice (Cheltenham, U.K.: Edward Elgar, 1990). West places Adam Smith’s work in the context of modern economic science and demonstrates the continuing relevance of Smith’s work, two centuries after his death, with special emphasis on the inspiration he has given to economic research during the last two decades.

Carl Menger, Principles of Economics (1871; New York: New York University Press, 1981). This book was one of the three books published in the 1870s that revolutionized economics by focusing on the “marginal” unit as the unit of choice that determines exchange relationships (prices). While agreeing with much of what Smith had argued, Menger put economics on a more secure foundation than had Smith.

Adam Smith (1723-90) was not the first to try to understand the market economy, but he may have been the most influential and eloquent observer of economic life. His observation that a person may be “led by an invisible hand to promote an end that was no part of his intention” became the guiding star of an investigation of the beneficial unintended consequences of voluntary exchange, an investigation that still continues strong after more than two hundred years. (Others had reached that insight earlier, as the excerpt from the Tao Te Ching of Lao-tzu in the readings indicates; interestingly, the writings of Lao-tzu were distributed by the anti-Nazi “White Rose” group in Germany to undercut the National Socialist regime.)

In addition to seeking to explain how markets work and how order emerges spontaneously from the voluntary interactions of countless market participants, Smith was very concerned with understanding how virtue fares in commercial society. He saw how commercial relations tend to encourage probity, punctuality, and honesty in dealings. As he observed, “Of all the nations in Europe, the Dutch, the most commercial, are the most faithful to their word.” He argued that this was not due to some unique Dutch national characteristic or racial distinction but was “far more reduceable to self interest, that general principle which regulates the action of every man, and which leads men to act in a certain manner from views of advantage, and is as deeply planted in an Englishman as a Dutchman. A dealer is afraid of losing his character, and is scrupulous in observing every engagement. When a person makes perhaps twenty contracts in a day, he cannot gain so much by endeavouring to impose on his neighbors, as the very appearance of a cheat would make him lose. Where people seldom deal with one another, we find that they are somewhat disposed to cheat, because they can gain more by a smart trick than they can lose by the injury which it does their character.” Smith follows up this observation with a dry remark that certainly rings true: “They whom we call politicians are not the most remarkable men in the world for probity and punctuality.”

Enemies of free-market relationships tend to portray voluntary exchanges as “zero sum,” that is, a gain to one party can come only at a loss to the other. But Smith showed how trade is based on mutual benefit, rather than conflict over fixed resources. The division of labor, so bemoaned by socialists as the source of “alienation,” is seen as the foundation for an enormous system of social cooperation and wealth production. Among Adam Smith’s accomplishments in changing how people think about wealth was his redefinition of “nation”; not only privileged members of the court, but every human being counted as a part of a nation. Eliminating special privileges may be to the short-run detriment of special interests, but free markets and the attendant economic progress and growth are to the long-term benefit of all the members of society, including the least powerful, whose interests count as much as those of the powerful.

A common criticism of classical liberalism is that it focuses too much on the abstract rules of justice, which are, communitarian critics allege, the principles appropriate for abstract men. Benevolence, love, national identity, or some other principle, they believe, would be the proper foundation for a good human society. Smith responded to this criticism in The Theory of Moral Sentiments (excerpted in the readings), and David Boaz examines the issue in his chapter on “Civil Society” in Libertarianism: A Primer.

An Inquiry into the Nature and Causes of the Wealth of Nations, published in the same year as the American Declaration of Independence, is one of the great books of the classical liberal tradition, and one that continues to instruct us in the principles and functioning of the free society.

Readings to Accompany The Tapes

From Libertarianism: A Primer: Chapter 7, “Civil Society” (pp. 127-47); Chapter 8, “The Market Process” (pp. 148-85).

From The Libertarian Reader: Adam Smith, “Justice and Beneficence” (pp. 58-61), “The Man of System” (pp. 209-10), “The Division of Labor” (pp. 253-54), “Society and Self-Interest” (pp. 256-57); David Hume, “Justice and Property” (pp. 135-39); Lao-tzu, “Harmony” (pp. 207-8).

Some Problems to Ponder & Discuss

• If “nothing could be more absurd” than the doctrine of the “balance of trade,” as Smith noted, why has this doctrine persisted and continued to dominate most public discussions of trade policy?

• Which is of primary importance or absolutely necessary for the maintenance of society, benevolence or justice?

• Many people who are hostile to the free market assert that commerce undercuts or erodes moral relations; they believe that people are encouraged by market exchange to think of each other solely as competitors or as sources of benefits, rather than as friends and neighbors, so that “profits” replace affection, goodness, and morality. Smith argues, to the contrary, that commerce encourages the virtues of honesty and fair dealing and that those are the foundations for the flourishing of the other virtues. How could we determine which view is right?

• Adam Smith wrote An Inquiry into the Nature and Causes of the Wealth of Nations. What, for Adam Smith, is a nation?

• The nightly news reporter announces, “The administration today made major concessions in international trade negotiations by agreeing to open American markets to imports of foreign goods.” What might Adam Smith or other economists say about that way of understanding trade relations and policies?

Suggested Additional Reading

Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (many editions) and The Theory of Moral Sentiments (many editions). The most elegant and scholarly—and certainly the most affordable—editions of the works of Adam Smith are the paperback editions from Liberty Press. These two works reveal Smith the economist and Smith the moral philosopher and show the relationships between the two ways of viewing humanity.

David Hume, Essays: Moral, Political, and Literary (various editions). Hume was a close friend and collaborator of Adam Smith, and he expressed complementary views in his various books and essays. Of special relevance to this module are the essays “Of the Balance of Trade” and “Of the Jealousy of Trade.”

E. G. West, Adam Smith: The Man and His Works (Indianapolis: Liberty Fund, 1976). West offers a sympathetic and enlightening overview of Adam Smith’s ideas.

For Further Study

Ronald Hamowy, The Scottish Enlightenment and the Theory of Spontaneous Order (Carbondale: Southern Illinois University Press, 1987). Hamowy presents a general introduction to the Scottish Enlightenment, the period in the late eighteenth century when such Scottish luminaries as Adam Ferguson, Adam Smith, Francis Hutcheson, and David Hume dazzled the world with the brilliance of their thought, and the central role played in it by the idea of spontaneous order.

T. S. Ashton, The Industrial Revolution, 1760-1830 (Oxford: Oxford University Press, 1962). In a compact presentation, this distinguished economic historian documents the beneficial effects of the Industrial Revolution, which created widespread wealth on a scale never before imaginable, and refutes the many myths about how capitalism and industrialism made the masses miserable.

Neil McKendrick, John Brewer, and J. H. Plumb, The Birth of a Consumer Society: The Commercialization of Eighteenth-Century England (Bloomington: Indiana University Press, 1982). This brilliant work documents the rise of an economy oriented toward satisfying willing buyers, in which, as Neil McKendrick notes, “there were profits—even small fortunes—to be made from very modest artefacts indeed. It is no accident that Adam Smith’s famous example of the division of labour was taken from the manufacture of pins.”