The Cato Home Study Course, Vol. 5: Adam Smith’s The Wealth of Nations, Part 2

George H. Smith

George H. Smith was formerly Senior Research Fellow for the Institute for Humane Studies, a lecturer on American History for Cato Summer Seminars, and Executive Editor of Knowledge Products. Smith’s fourth and most recent book, The System of Liberty, was published by Cambridge University Press in 2013.

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.