Brief review of Adam Smith's main concepts of growth.
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Adam Smith considered wealth of a nation to be its total output rather than just gold or agriculture. He believed economic growth increased total output, income, and standard of living. Smith argued growth occurs through increasing the division of labor, which raises productivity, and accumulating capital, which raises labor productivity by increasing the capital-labor ratio. This virtuous cycle of growth could eventually lead to a stationary state with zero growth.
Brief review of Adam Smith's main concepts of growth.
- 1. ADAM SMITH’S THEORY OF GROWTH Lecture 1
- 2. 23-Sep-13 P.Panth 1 Adam Smith’s model of growth Smith considered to be Father of Economics. His book: An Inquiry into Nature and Causes of the Wealth of Nations. (1776) He wanted to examine: Why some countries are richer and some poorer? What are the basic economic factors that can increase the wealth of an economy? Wealth of a country is not gold as assumed by Merchantalists. Or agriculture as assumed by Physiocrats.
- 3. 23-Sep-13 P.Panth 2 According to Adam Smith: Wealth of an economy is the Value of its Total Output – includes industrial and agricultural output. Growth increases wealth by increasing total output, income and wealth, and standard of living. How can growth increase? - If inputs increase, output will also increase. - Three factors (inputs) – land, labour and capital – owned by landlords, workers and capitalists.
- 4. 23-Sep-13 P.Panth 3 Assumptions: Supply of land cannot increase – it is finite. Labour is available in infinite quantity, so wage rate is at subsistence. Labour productivity increases through a) division of labour, b) increase in K/L Investment is endogenous – determined by savings. Market economy with Perfect competition, Diminishing returns Laissez faire, invisible hand allocates resources.
- 5. 23-Sep-13 P.Panth 4 Specialisation of Labour Labour specialisation increases output, by increasing productivity of labour. This leads to increasing returns to scale. So Growth is self-reinforcing He gives the example of a pin factory: If each worker produces entire pin, O/L is low, one worker produces only 20 pins a day. But if there is specialisation, with 18 sub processes, output per man increases to 4800 pins a day!
- 6. 23-Sep-13 P.Panth 5 Labour specialisation increases output because: Skill increases with repetition Time is saved, The worker can innovate and improve his performance. But increase in labour specialisation depends on demand (Market) for the product. So Adam Smith states: “Division of labour must always be limited by the extent of the market.”
- 7. 23-Sep-13 P.Panth 6 Capital Accumulation Capital accumulation is crucial for economic growth. As capital increases, capital per man (K/L) also increases, leading to increase in labour productivity, and growth. Investment capital formation Only capitalist class invests. Workers receive subsistence wages, cannot save, Landlords only consume, not save.
- 8. 23-Sep-13 P.Panth 7 The Virtuous Cycle Capital accumulation increases K/L Higher productivity of labour with higher K/L Higher productivity leads to higher incomes, Higher income leads to increased demand and bigger markets, Leads to specialisation of labour, with more division of labour. But more division of labour leads on to higher productivity This is Smith's Virtuous Circle.
- 9. 23-Sep-13 P.Panth 8 Smith’s Virtuous Cycle of Growth Division of labour Increase in Output, Income Increase in K/L Market increases Increase in Investment
- 10. 23-Sep-13 P.Panth 9 Stationary State Although there are increasing returns to labour specialisation, growth cannot go on forever. This is because: 1. Competition for labour increases, as K accumulation increases 2. Employment increases, and total wage payment increases 3. Profits decrease, investment falls, and growth levels fall. 4. Ultimately, rate of growth becomes zero. 5. This is the Stationary State.
- 11. 23-Sep-13 P.Panth 10 Stationary state S T 0 K g Features: 1.No increase in Investment 2.No increase in output – zero growth 3.No increase in wage rate, 4.No increase in standard of living
- 12. 23-Sep-13 P.Panth 11 Criticism Adam Smith was a pioneer in Economics, Crude theory of growth, profits and investment, Neglects the growth of agriculture, Based on “Iron Law” of wages, Stationary state – ignores the role of technical progress.