Economic Theories of Adam Smith - Research Paper Example

? Economic Theories of Adam Smith Economic Theories of Adam Smith Introduction Economics in general can be defined as a social science concerned with allocation of resources among competing users in the society (Lipsey & Chrystal, 2011). Productive resources are scarce as they do not exist in a sufficient quantity to satisfy human wants. The scarcity imposes a variety of constraints on both the choices of the society and the opportunities open to members. Economists, therefore, examine the activities of consumers, producers, suppliers of resources and the actions of the government in an attempt to examine how resources will be allocated efficiently. This report will discuss different economic theories by Adam Smith, a Scottish philosopher. Adam Smith is the founder of a free-market capitalism. He is also the father of modern classical economics and a proponent of laissez faire economic policies. His arguments against mercantilism made him the father of modern economics. The Scottish philosopher spent many years teaching and publishing some of his lectures in the “Theory of Moral Sentiments” in 1759. The material gained ground and laid the foundation for the publication of “The Wealth of Nations” in 1776 which cemented Smith’s place in history. However, many critics note that in his time Smith did not ‘invent’ the ideas he wrote about. He only popularized the ideas that became known as classical economy. Using his work other economists solidified the theories of classical economy which became dominant during the time of great depression or the global economic crisis. The report will also compare the current economic system with Smith’s and conclude whether he would agree with current policies of today if he was alive. Production Theory From the economists’ point of view, production simply means the creation of goods and services which consumers will buy. Companies are the units of production, and they convert input into output through a transformation process (Kurz & Salvadori, 1995). The theory of production then consists of how a company chooses and combines various inputs to produce an output at a given level in the most efficient manner. The assumption is that decision making is done with the view of maximizing profits. Production is all about creation of wealth which in turn adds to the society’s welfare. Resources are limited and must be efficiently utilized to create the maximum possible welfare. There are different inputs or resources of the society used in the production process. These inputs or resources are the factors of production. Adam Smith identified three factors of production which are land, labor and capital. In the economics the definition of land refers to all the natural resources which are used in production. The land notion includes farming and building land, forests, rivers, lakes, and mineral deposits. Therefore, land does not mean a piece of earth. Labor attributes to both mental and physical efforts used in the production of goods and services. Labor is distinct in that it is the services of labor that are bought and sold. Labor is also unique because it is the reason why economic activity takes place. The supply of labor is measured by the number of hours of work which is offered at a given wage rate over a given period of time (Kurz & Salvadori, 1995). Capital is a man-made input and can be classified as working or circulating capital referring to stocks of raw materials, partly finished goods, and finished goods held by producers. Alternatively, it can be classified as fixed capital which consists of all the equipment used in production. The aspect of specialization is important in the production process. It refers to the concentration of activity in those lines of production where the company or an individual has some natural or acquired advantage. Adam Smith drew attention to the importance of the labor division in his book “The Wealth of Nations”. He was fundamentally concerned with the division of labor of a particular industry where the manufacture of products was broken down into many specialized activities. He observed that making pins required 18 distinct operations; estimating that the production per day in the factory was about 5000 pins per person employed (Witzel & Warner, 2013). Specialization within plants can be of two types. A particular plant may be producing more than one item, thus regarded as two working sides. Then within every plant there is considerable specialization of labor. The following are the advantages of specialization by the labor division identified by Adam Smith: 1. Specialization improves the skill of workers given that once a person has established oneself in the job; they usually find that their skill increases with practice. 2. No time is wasted moving from one activity to another one, therefore, more is produced. 3. Since each person is endowed with different skills, an economic system that breaks down work into a variety of jobs, gives workers an opportunity to exploit their talents fully. 4. The fundamental advantage of the labor division is that there is an increased output. With the division of labor, a given set of factors of production can produce a far much greater volume of goods and services than it is possible without it. In an example given by Adam Smith, a factory employing 10 men could produce perhaps 48,000 pins per day by dividing work among them, whereas each might have difficulty in producing 20 pins a day if he had to do the entire task (Witzel & Warner, 2013). 5. Specialization reduces the cost per unit given that not all costs of production rise as output rises. Specifically, fixed costs remain constant at all levels of production. 6. However, the realization of the above benefits is limited by the market size since it is determined by specialization and division of labor (Witzel & Warner, 2013). Resource Allocation Theory In a market economy, resource allocation decisions are made by independent decision makers like producers and consumers and not by the central authority or government (Sampat, 2007). Therefore, the economy of a market is determined by markets and prices. In a market economy, all the decisions related to economic problems are taken by a decentralized price system. The forces of demand and supply coordinate decisions. The co-coordinating mechanism is the price system through which the decisions of the society are achieved. Therefore, in a market economy the problem of resource allocation is solved through the actions of producers and consumers. The price system is a signal to producers and, thus, helps with an efficient allocation of resources. The price of each factor is determined by the forces of demand and supply. The price is either at equilibrium or is constantly moving upward. In simple terms, prices are a kind of summary of all the decisions related to the allocation of resources. Adam Smith pointed out that the market economy is guided by the invisible hand (Kurz & Salvadori, 1995). According to Smith’s vision of the invisible hand, each individual makes various decisions related to production and consumption each day. Each seeks to maximize personal gain with no deliberate attempt to promote social welfare. However, the actions of various individuals lead to harmonious outcome. Such a harmony is coordinated by the price system. The invisible hand in a competitive market brings the market to some equilibrium. In other words, individuals maximize personal gains when left free. This brings into effect laissez faire system, a system that is free from the government intervention. The question of what is produced is concerned with the allocation of scarce resources. The answer can be found in commodity markets which offer some information to producers who make a decision on what to produce (Sampat, 2007). Individuals express their choice in the market through their spending trends, and, thus, enable the society to answer production questions. In the capitalist economy, the sovereign is the consumer, as it is the consumer who decides what is to be produced. The producer always compares the price of a product with its cost before making a decision what to produce. Producer’s aim is to shift resources to a more profitable branch of production. This means that output of some product will fail, and that of another one will rise in response to price changes. Such changes in production patterns lead to changes in the resource allocation and usage. The reallocation of resources is also influenced by changes of prices. For example, if demand for a resource such as capital or labor rises, the price for such a resource also rises. In summary, the price system enables the society to allocate resources efficiently and to have an effective view of the scarce resources (Sampat, 2007). Conclusion Adam Smith’s theories suggest that only the free-market exists. In reality market economies which are guided by laissez-faire philosophies do not exist in their pure form. Most economies are mixed economies in which some resources are allocated by the market system, while others are controlled by the central planning authorities. Therefore, if Smith was alive today, he would suggest for a mixed economy. He would have to agree with the current polices such as government intervention in resource allocation. Currently, economics is divided into macro- and micro-economics. Smith’s only concern was micro-economics which is how behavior and reactions of consumers and producers determine and are determined by the system of market prices. If he were alive today, he would accept the existence of macro-economics. References Kurz, H.D., & Salvadori, N. (1995). Theory of production: A long-period analysis. Cambridge, UK: Cambridge University Press. Lipsey, R. G., & Chrystal, K. A. (2011). Economics. Oxford, UK: Oxford University Press. Sampat, M. (2007). Modern economic theory. New Delhi, India: New Edge International (P) Ltd. Witzel, M., & Warner, M. (Eds.). (2013). The Oxford handbook of management theorists. Oxford, UK: Oxford University Press. Read More