Comparing Adam Smith and David Ricardo - Case Study Example

During the 18th and 19th century many economists advanced several theories as they sought to try and understand the science of economics as it applies to the market. Most of the classical writers tried to understand the nature of the economy in two discrete ways by defining the subject known as political economy that is the science of wealth and also advanced the nature of tat wealth with which economics is concerned. Economics was mostly described in terms of wealth in the classical times but however with developments the concept has narrowed down to material wealth. Economic theory has therefore evolved through feudalism to mercantilism in the renaissance period to the modern political economy as first put forward by Adam Smith in his Wealth of nations. Smith is regarded as the father of modern economics in that his works focused on free market economy and security and public education that had modest limitations of government. Smith’s interest rely on then ideology that an evolving capitalist system is likely to benefit society as a whole stating that the economic process had unlimited potential. The main issues raised in his wealth of nations include divisions of labor, value exchange, the invisible hand, wealth distribution and the role of government.

However economist such as David Ricardo had skeptical views about Smith’s advancement about market potential because events such as war, inflationary storms, the industrial revolution and population growth among others failed to confirm the unlimited market potential hypothesis prompting classical economists such as Ricardo to expound on the Smithian paradigm so as to deal with 19th century issues. Ricardo maintained that the economy actually grows towards an economic standstill and most of his arguments are rooted on the labor value theory. His work of principles follows the work of Smith in that he addresses the same issues such as labor, and wealth distribution but rather in a different view relative to issues of the time. As much as Ricardo mirrors Smith’s work there are however basic principles that differ in respect to market impacts and adjustment sequences. This paper therefore will focus on the economic theories of Adam smith and David Ricardo and the issues of value exchange and divisions of labor, the “invisible hand” and wealth distribution shall be discussed in depth and also the limitations to these theories.

Adam smith’s theories are based on individual profits as the main driving force behind economic activities. His Wealth of Nations explains that although strained and chaotic free markets are actually guided in production of the right amount of goods by an “invisible hand”. He holds that individual competition in free market benefits society by keeping prices low while at the same time it builds the incentive of a range of products. According to his theory the market economy always adjusts relative to demand and supply in an indirect way rather than not intensively although in a fully competitive market it adjust automatically. In this system supply is produced by demand in that an invisible hand brings the buyer to the product thus there is no direct demand for the product. Theoretically what Smith alludes is that if producers sold products at higher prices in the same market then more producers are going to enter the same market with the same good thus there is abundance of the good which lowers prices that is the invincible hand puts pressure in reduction of prices. The invisible hand causes expertise production resulting in market price adjustment and amendment in non economic societal behaviors. One of the most renowned texts from wealth of nations explaining the idea of invisible hand states;

“It is not from the benevolence of the butcher, the brewer or the baker we expect our dinner, but from regard to their self interests. We address ourselves not to humanity but to their self love and never talk to them of our own necessities but their advantages.” (Smith, 1776:18)

According to the theory economic growth is best spurred in an environment of free competition thus the government should not be involved in such a free economic system. Since supporting domestic industries creates monopoly smith believed that any government involvement has a likelihood of creating a monopolistic market devoid of competition thus prices are likely to increase which will impact negatively on welfare of people. Smith indicates that government’s role in economic life is negligible but could play part in enforcing contracts, and granting patents and copyrights to encourage new ideas and inventions. He also saw the role of government in provision of infrastructure such as roads which will have been otherwise difficult for an individual to provide.

Another classical theory by Adam smith is the Value exchange theory in which he says that the price of one thing is labor and the difficulty in acquiring it as a result of its scarcity. Naturally those goods with a high usage value are always low in value and sometimes without any value and equally those with high exchange value are almost with no usage value. According to this theory the main cause of prosperity is the increasing division of labor which has ripple effect on productivity as evidenced by the example of pins. In a day a worker could probably make twenty pins however according to smith if ten people divided up the steps of making a pin in a day they could achieve 48000 pins. Therefore labor is the factor that brings exchange value of goods of which smith believes the real natural price or value of a good for anyone in need of it is paramount to the inconvenience that the producer goes through in the process poof production. Hence when a producer wants to exchange a good for another then the price of the good is the amount of labor spent in producing it which makes labor the benchmark in the exchange of goods. In his Wealth of Nations Smith indicates that;

“The greatest improvement in the productive of powers of labor and the greater part of skill, dexterity and judgment with it is directed or applied seem to be the effects of division of labor.” (Smith, 1776).

In order to get the highest possible returns then an individual ought to invest resources such as land and labor and all the uses that the puts the resource into are supposed to yield equal return relative to the risks associated with each enterprise contrary to which will require reallocation. Smith employed the insight of equality of returns to explain the differences in wage rates. He argues that rates are likely to be higher for traders that would be considered difficult to learn since people will be unwilling to learn them if they are not properly compensated by means of higher wage rates. Similarly those individuals who are exposed to hazards or unsafe working conditions are likely to attract higher wages thus implying that different types of occupations are to be compensated differently. Therefore division of labor makes the workforce to be more effective in the production process and expertise which means les difficulty in performing tasks and time consumptions.

Adam smith argues that wealth distribution is determined by land rent, wages and profit. His theory on wages holds that wages should be subsistent in that they should at least be able to sustain the worker and somewhat more in other occasions. The theory of wages holds that the wages should not only meet the basic needs but is set as at some level of humanity. Nevertheless subsistence is a dynamic concept because economic development and progress prescribes that human necessity keeps changing. However the subsistence ideology seems to have setbacks because it is rare for wages to be regulated by the lowest rate and in most times the theory has demonstrated inverse relation. This however implies that when prices are high and money wages are low then the wage has to be in a given level of subsistence. Smith argues that subsistence wage does not however persist in reality which may be difficult for demand and supply approach of wage. Wage determination involves bargaining between worker and master and the employer holds the upper hand because of their unrestricted ability. Demand for labor however increases revenue and thus increasing competition between employers which thus increases the wage rate above subsistence. However when labor is in surplus and employment is limited the laborers are likely to bid against each other hence lowering the price of labor. Nevertheless in circumstances where market price for labor is significantly above or below the normal then the actions of the laborers will put it in check by turning to particular employment due to high wages or seeking other employers. Therefore economic growth keeps wages relatively high and in cases where the economy is stagnating even if it is a healthy one the lowest classes will always remain poor.

On profit smith holds that when a person has resources that exceed what is necessary for subsistence then they can put those resources to earn some extra income for them. However smith does not differentiate between profit and interest because he refers to interest as the gain including investment risk and profit. Increase in profits is dependent on the same causes as the fall and rise of labor and or the increase or decline of wealth in society although they have a different effect. An increase in stock according to Smith increases wages which leads to lower profits same way competition is likely to affect profits. In this sense therefore profit is deemed to be fluctuating thus it is not easy to determine the average annual profit because it is affected by price variations, competition and other liabilities. According to smith measuring stock over time is difficult thus interest is considered to be a good measure since it is paid with profits of the stock. Generally high interest rates correspond to high stock profits which are favorable for the coexistence of high stock profits and wages.

The rent from land Smith believes is the landowner’s share of domestic product and it is naturally the highest that the tenant can afford to pay. In the process of adjusting the terms of lease the landowner seeks to leave the tenant with no greater share of returns other than what is sufficient to maintain stock together with profits. However at times the tenant can pay less than the ordinary profits gained which nevertheless can be considered still the natural rent of land and it may not be higher than the normal profits or interest of the stock. Smith however argues that rent of the land is dependent of its productivity and the role of improving the land lies solely upon the tenant. Smith gives a classical example of land near a sea that is rich in fish thus if a farmer were to rent such land they cannot be charged according to what they can make from the land but rather what they can make from both the land and water. Essentially land is a form of monopoly since it is based on what a tenant can afford to pay rather than what the landowner may have spent developing it.

David Ricardo’s major concern on the other hand was the intellectual discourse of economics in the 19th century by expanding on the value theory in “Principles of Political Economy and Taxation”. Ricardo follows and expands smith’s concepts although he does not agree with smith on basic principles especially market impacts and adjustment sequences. He argues that although prices are set at the margins of demand and supply it is costs of supply that ultimately dictates market prices. Ricardo provided theoretical tools for handling economic problems and means of coming up with solutions for them through the law of diminishing returns.

According to Ricardo in the labor theory of value the price of two commodities is determined by the ratio of the amount of labor required in the production process. However Ricardo asserts that even the labor embodied in the goods fails to produce a clear way of determining the value of those goods. He preempted that all sectors have the same wage and profit rate and that capital incurred in production is comprised of wages only with the period of production equally being the same. However some of his assumptions were not realistic and hence he admitted to two exception in the labor theory in that the production process may comprise other instruments as capital apart from just wages in different quantities and also the period of production can equally differ.

Ricardo actually argues that value in exchange can be distinguished from value in use by equating wealth and riches distinctively with economic and use values. Just like Smith, Ricardo does not see need of trying to determine use value and he concludes that;

“A precise method of calculating value in commodities is impossible but the embodied labor is the best general measure.” (Ricardo, 1821)

Since labor determines value then in barter system if it takes twice labor to kill a beaver than a dear then one beaver exchanges for two deer. Therefore use values are subjective and variable to each other and in f air circumstances there is greater exchange value in the market because of bargaining which gives consumers more use value than they give up. Ricardo argues that unskilled basic labor is a variable value that can be measured proportionately to other factors of capital contrary to what smith holds that basic labor is constant because of its association to subsistence levels.

Supply and demand on the other hand interact to determine the exchange values and although he recognizes monopolies he looks at the factors that are in play in competitive markets. Thus in a competitive environment the exchange factors are always fluctuating relative to shift in demand and supply. Therefore for subsistence goods he believes that it is the supply of goods that determines price in market exchanges. Reduction in production cost will adjust prices hence reducing profits even if demand increases. To Ricardo rate of profit is dependent on the amount of labor required to support production and equally wages have a effect on profit. He differentiates labor in terms market and natural price in that in an economy that is not growing natural wages are expected to be higher because population growth is attuned to profit. Equally he argues contrary to smith that wages should not be taken just for subsistence purposes.

On land Ricardo argues that because of variation land pays differently thus it has a monopolistic feature of scarcity. Rent from land is an individual benefit that accrues from scarce resources such as land that is above and over any social exchange benefit. According to Ricardo if land was equally located regardless of scarcity one could determine the market exchange of the construct hence free and equal value of trade will be conveyed to interested parties. According to him land can be categorized depending on its productivity in that if land is more fertile it will attract higher rent whereas land that is poor will attract low rent. With population growth less productive land needs to put into use so as to meet the growing demand which puts more pressure on productive land.

The concept of rent according to Ricardo is confined to the indestructible power of the soil and whatever that shall be invested is a distinct subject thus his definition is precise compared to that of Smith because it permits a sharper analysis of the subject. Ricardo discusses rfent relative t agricultural lands and notes that an increase in rent absorbs all advantages of a particular property. He tends to agree with smith on this that profit rates will most probably be the same whether production is in less productive lands that attract no rent or more productive lands that attract substantial amount of rent. Therefore rent increases to absorb the advantages of capital investment in the land over the normal rate of capital and its return belongs to the capital provider be it the landlord or the tenant. Smith says that if capital improvement is permanent lie removal of rocks or trees or reclaiming wetlands then the rent of that piece increases to absorb such benefits.

According to Ricardo price margins of rents are set by considering the profitability of lands that are considered least productive. He argues that;

"The reason then, why raw produce rises in comparative value, is because more labor is employed in the production of the last portion obtained, rather than because of the rent paid.”(Ricardo, 1821)

Therefore the poor lands will require increased labor input so as to maintain output of falling profits at minimal and as a result population increase will gobble up profits due to the costs of rent. Ricardo holds that if there are more profits then it means more investment however the rising costs of rent are likely to deter economic growth and development indirectly.

On market prices Ricardo holds that they are influenced by and vary according to the natural prices as determined by labor. However market prices adjustments are sensitive to application of external factors that regulate the competitiveness of the market economic system. Capital flows will always be in line to the most profitable ventures thus affecting increase or decrease of profits through price fluctuations hence balancing the whole system. In so doing they drive the prices to return towards the natural levels. Therefore profits are impacted by many external factors such hardship and risk can deter investment till profits are considered to be relatively higher.

Ricardo says that the natural prices of labor tend to vary in respect to the rising and falling cost of living thus wages are left to be labor stuck and they will fluctuate around subsistence levels that are sufficient enough to reproduce a stable population. Ricardo agrees with Smith that an economic system that is continually growing can support wages above the subsistence period for an indefinite period. In periods of economic boom an increase in population will increase the labor force thus depressing wages back to subsistence levels provided the economy keeps growing. Increase in productivity of capitalistic market economies is a natural phenomenon according to Ricardo and it can provide continuous expansion of capital which support higher wages hence constant population growth. The law of diminishing returns and population increase will always drive wages back to subsistence levels and although productivity increases it can however not indefinitely outrun population growth. Ricardo notes that;

“Diminishing rate of increase in population can keep labor forces scarce and prosperous.”(Ricardo, 1821).

Therefore wages just like rent will tend to increase with the accumulation of wealth and growth in population. However prices of subsistence items tend to increase faster hence benefiting landlords because such situations will increase rent thus outrunning cost increases as labor lags behind.

Although Adam Smith is considered the father of economic his theories have some limitations and they have drawn critics from various economists including David Ricardo. For instance in his theory of invisible hand he allures of non interference an involvement by government although it is evident that in times of crisis government involvement is essential. Most proponents of the theory seek limited government oversight and reduced regulation but then this can lead to crisis such as the global financial crisis where the banking sector got it wrong by selling mortgages to customers who could not afford them knowingly.

Adam smith holds that labor that is not considered when determining prices of goods an idea that Ricardo disputes in that in real sense labor is part of the capital investment thus it should be factored in when determining the price of a product. Therefore Smith’s theory on labor is limited in a way that contemporary economists do not consider it viable because it excludes the concept of labor and the time used in production process. Equally his understanding of the wages shows an inverse relation since he argues that regardless of prices being high and thus more profits the wages should be kept at subsistence level which is contrary to market economics since high process and more profits means economic growth thus wages are deemed to increase just beyond subsistence level.

Although Ricardo criticized much work of Smith his theories have equally had some limitations in that to begin with the labor value theory in which he equates values it does not apply in modern world because value of products nowadays is expressed in units of money. His views about land actually oppose the general rule of society and that economic stagnation drives capitalistic societies falls short because the economy is always dynamic and it keeps growing each day. Most of his arguments are focused on the supply of goods which is not ideal in the real world where demand is also a factor that determines market prices. While Ricardo explains that there are external factors that influence markets and market adjustments some of them such as inflation are rare occurrences that cannot be applied on daily when defining market structures.

To conclude therefore it is we can say that both Adam smith and David Ricardo have played an important role in the understanding of modern day economics. Smith’s invisible hand explains the forces behind market economics that go beyond demand supply and prices that drive the economy. However the non involvement of the government should not be limited as explained because they are essential in creating the necessary infrastructure for the markets and also regulations that govern the business. Equally labor should be considered as a factor of production contrary to smith who writes it off. Ricardo explains how labor and time are very important factors in the production process and that they should be included in the price determination process.

Equally among the issues identified by the two economics is the issue of wages, profits and the main factor of production which is land. Although smith does not define profits distinctively because he fails to differentiate it with interest on the other hand Ricardo is very objective about the issue of profit explaining it as the amount that the tenant or landlord accrues in excess of investing his capital in the production process. They both agree on the issue of wages in that wages are determined through bargaining and whenever there is high demand for labor then wages are likely to be high although smith insists that they should be maintained at subsistence levels. Profit determination is dependent on wages and capital of which according to Smith rent is payable to the amount that can leave the tenant with what is sustainable for the business however for Ricardo rent is dependent on productivity of the land in that less productive land attracts relatively less rent compared to more productive land. Therefore modern day economics which is defined by labor, capital and land was born from the ideas of Smith and advanced by Ricardo.