The Wealth of Nations, by Adam Smith

An Enquiry into the Nature and Causes of the Wealth of Nations

By Adam Smith

Introduction & Context

An Enquiry into the nature and causes of the wealth of nations, often known by its shorter name “The Wealth of Nations,” is the seminal work of Adam Smith. Published in 1776, it is perhaps the most well-known book in classical economics and influenced economists and policymakers across the globe. The book is a critique of the mercantile system that governed economic policy in Great Britain during Smith's time. It explains how the obsession of mercantile groups over precious metals as wealth is wrong, and how the real wealth of a nation is the flow of goods and services which a nation creates. The book throws light upon topics such as: the division of labour, productivity, free markets, and the mercantile system.

About the Author

Adam Smith is one of the most well-known economists of all time. He is considered to be the founder of the free market economy. His magnum opus "The wealth of Nations" still remains one of the most influential works of classical economics.

What to Expect? Let the invisible hand guide you through the maze of classical economics.

In this book, the second work of Adam Smith, he investigates why certain countries have more wealth than others. In doing so, Smith presents a framework, which is now seen as a part of the modern economic theory.  This framework, glorifying free trade and free-market capitalism with minimum intervention of the government, stayed relevant till the coming of Great Depression when Keynesian economics replaced Classical economics. Even now, several of his principles remain important in the study of economics, and it remains a must read for all students of economics.

In this book, you will learn:

1. Why the division of labour is essential for increased efficiency

2. The natural price of a commodity consists of rent, wage, and profits. Market price is determined by the forces of demand and supply.

3. Why did the landowners did not take pains to improve land after the fall of the Roman Empire

4. What is the main function of the Sovereign

 The division of labor and the effects of specialization

The division of labour allows for increased efficiency in the production of goods. Due to such division, each worker develops specialized knowledge on a particular task. It also saves the worker time, since he or she doesn’t need to switch between different tasks requiring different tools and methods. Also, it allows for increased innovation in the methods and tools in the task that the labourer is concerned with. The increased productivity of each worker means that he or she will be left with surplus production, which can be exchanged for all the other goods he or she requires.

This exchange is called trade. Trade is not something which is artificial; rather it is in human nature to trade. It can be observed in even the most primitive societies. Through trade, both parties get what they were previously lacking, and thus are better off than before. The extent of trade is determined by the size of the market. A large market is needed to absorb the additional products made through increased efficiency. This means that the market must be enlarger, either through larger settlements or increased transport.

Another factor which increases trade is money. By being a universal medium of exchange, it eliminates the need for double coincidence of wants, which was a characteristic feature of the barter system.

Money and prices

To resolve the difficulties of the barter system, money was developed. The most commonly used item as money is metal coinage because it is compact and doesn’t perish.

A commodity’s price consists of three components: rent (earned by the landlord), wages (earned by the labourers) and profits (earned by the entrepreneurs).  However, often the landlord, labourer, and entrepreneur are the same person, and all three components accrue on him.

The natural price of a commodity is the sum of its components (rent, wage, and profits). The market price, however, is determined by the interplay of the forces of demand and supply. If demand exceeds supply, prices will rise, and vice versa. In such cases, the members of society bring the market price close to the natural price either by devoting more resources to its production or diverting resources elsewhere.

Wages, profits, and rent

Labourers get wages as remuneration for their work. The wage rate is determined by the supply and demand for labour. Where labourers are plenty but demand for labour is low, wages drop. On the other hand, if labourers are few but demand for labour is high, wage rate increases. Although labourers often form unions to further their interests, there is an invisible union between employers. Moreover, the increased wealth of employers gives them an advantage over labourers.

Entrepreneurs get profit as remuneration for the capital they invested. Profits on the stock are determined by competition among merchants who invest capital in a particular trade. When a large amount of stock is directed on the same trade, competition among merchants increases, resulting in lower profits.

Landowners get rent from their tenants as compensation for letting the tenants use the land. The landowner often charges the highest rent possible while allowing only a subsistence income for the tenant. In other words, any excess income of the tenant over and above the costs of labour, tools, and maintenance of farm animals is kept as rent by the landowners.

What is Capital and what is its use?

If a person owns enough money to maintain his expenses for only a few weeks, he will seek to use it sparingly while joining the labour force to get a steady income. This is the case for most of the labouring poor in the UK. However, if a person has enough money to sustain him for several years, he is likely to use a part of it to get revenue. This part of his wealth is called capital.

There are two ways through which the person can use his capital. The first is by raising, manufacturing, or purchasing goods that will be sold again at a profit. The sale of goods will bring in revenue, which can then be used for purchasing or manufacturing even more goods. Capital used in this manner is called circulating capital. On the other hand, capital may be used for the improvement of land, or for the purchase of tools and machinery (fixed assets). Capital used in this manner is called fixed capital. Different trades require different proportions of fixed and circulating capital.

Banking and paper money

The substitution of paper in the place of gold or silver as money is welcome, since it is much less costly but equally convenient. Among the several types of paper money, the most important is the ones issued by banks and bankers. If the people have confidence on a particular banker, that he may upon presenting before him, pay back the value of a promissory note, such note will have the same currency as gold or silver.

The system of banking is not only useful to the banker (since he gains interest), but also to merchants (since they can carry on trade without the need to keep much metal currency at hand all the times. However, the banks must use caution that the value of the paper currency they issue must never exceed the value of gold and silver they have in their coffers. If banks issue excess paper currency, they may fall short of metal coins when needed and thus would be required to purchase gold and mint coins, thus losing value.

Landownership and Agriculture

Since subsistence comes before luxury, thus the improvement of agriculture in the villages comes before the development of towns and cities. The natural way, then, should be first to devote sufficient capital for agriculture, followed by manufacturing, and finally to foreign commerce.

After the fall of the Roman Empire, the system of primogeniture became popular. Here, the eldest son inherited the land from his father. This meant that those who inherited the land often lived off its income without contributing to its improvement. The labourers who worked on this land were no better than serfs or slaves, and had neither the means nor the incentives to make improvements upon the land. The labourers, since they knew they would not get the fruits of increased productivity, never worked harder or more efficiently to generate a surplus. Thus, the system of serfdom is grossly inefficient for the purpose of greater agricultural output.

On the other hand, the system of peasants cultivating land and keeping the produce, while paying a fixed rent to the landlord, is much better. Since peasants get to keep the surplus production, there is an incentive for them to work harder and more efficiently.

Towns, cities and the growth of commerce

After the fall of the Roman Empire, the condition of townsmen and city dwellers was only slightly better than that of the countryside. The town was levied a fixed rent or fee by the sovereign, which was jointly paid by the residents. The people in town (burghers) were despised by the great lords, who were envious of the wealth of the urban merchants. The burghers, in turn, feared and hated the great lords. Common interests brought together the monarch and the burghers against the great lords, and the monarch granted the burghers their own magistrates and built walls for their security. Thus, law and order was enforced in the cities, whereas lawlessness and violence still prevailed in the countryside. This meant that the development of manufacturing and trade gained precedence over that of agriculture, in defiance of the natural order.

However, the development of manufacturing and commercial towns also led to improvements in the countryside. The towns provided a market for the surplus production of the countryside. This encouraged increased cultivation and improvements upon the land. Also, the wealthy inhabitants of the city often purchased uncultivated land in the countryside and brought them to cultivation. This increased the overall productivity of the rural areas.

Systems of Political economy

The theories of political economy expounded before by the mercantilists were fraught with error. One such theory is wealth lies in precious metals (gold and silver). This is false, since wealth lies in real commodities and labour, not in gold or silver. This has led to many governments prohibiting the export of gold or silver, which is a futile move since gold or silver could be easily smuggled. Rather the right move to discourage the export of precious metals is by taking care of the balance of trade.

Another false theory is that tariffs on imports help the country by promoting domestic industry. Foreign trade should rather be encouraged, since it provides a market for the surplus goods of one country and also provides a supply of those goods which are deficient. Thus, when two countries engage in free trade, the trade is advantageous to both. Imposition of tariffs by the government will only be a hindrance in most cases. The only exemption of this is if the development of a domestic industry is key to the defense of the nation, in which case suitable tariffs may be imposed to encourage the domestic industry. However, this is an exception, not the general rule.

The importance of colonies

The colonies established by Europeans in the New World were established out of curiosity and a sense of adventure by those seeking for mines of gold and silver. This usually a folly, since these ventures are usually unsuccessful. The reason these colonies were able to develop very quickly is that the colonists were able to bring new tools and techniques of agriculture to these lands, they also had huge amounts of land to cultivate and were not burdened by taxes or rent.

Colonies should be left to their devices and means for governance. For example, Portugal after stripping Brazil of all the gold, left it to its fate.  Subsequently, it became a powerful colony. Also, those colonies which are controlled by a single trading company are bound to have slower progress than those colonies where trade is free. This is why the English colonies in North America are so prosperous.

Colonisation has benefitted European countries in two ways. Firstly, it has provided a wide market for the goods of industrial Europe. Secondly, it has ensured a steady supply of raw materials for sustaining the industries of Europe.

Duties and functions of government and the sovereign

One of the primary duties of the sovereign is to ensure the security of realm from external aggression. Historically speaking, a mobile and nomadic society can enlist a larger proportion of its population into the fighting force. Once the population settles down, agricultural communities are better able to quickly and effectively prepare themselves for war than non-agricultural societies. For the purpose of defense, a professional standing army is far more effective than a militia. Another important duty of the sovereign is to maintain law and order, which is done through establishing magistracies.

Regarding education, it is seen that private educational institutions are in general superior to the public ones. Students who graduate out of private educational institutes will at least learn some useful skills, whereas that may not be the case for publicly funded institutions. It is also important to impart education to all, including the children of the labouring poor, who may not have the means to seek an education. The government should, in these cases, subsidize their education. The government should also develop infrastructure, such as roads and means of communication, since it is of benefit to the whole society.

Means of revenue for the government

In order to fulfill its various functions, the sovereign or the government must bring in revenue to cover its expenses. The most common way of doing this is through the imposition of taxes. There are mainly four kinds of taxes: those imposed on rent of land, those imposed on rent of houses, those imposed on profits and those imposed on income from employment.

The ideal way to impose a tax on land rentals is by fixing the tax as a proportion of the rent. This allows for the productivity level of the land to be captured in the tax, without being a hindrance to cultivation. As far as the tax on rent of houses is concerned, it is seen that a higher tax usually lowers the rent, since tenants will have to pay both the rent and the tax from a fixed budget. Taxes levied upon interest or profits are quite unsuitable compared to taxes on rent. This is so because people might try to conceal their profits and evade the tax, or move their capital to another country, where taxes are lower. As far as taxes on individuals are concerned, people try to conceal their income and wealth in order to avoid paying taxes.

During certain circumstances, such as during the war, the government is forced to go into debt to meet its expenditures. This is because, during periods of war, a vast amount of capital is directed towards destructive and not constructive purposes. During peacetime, the revenue is roughly equal to expenditure, and therefore no debt seems necessary. But the increased expenditure of wartime makes debt necessary. Fortunately, the government is usually able to borrow from individuals since people have an implicit faith in the government of repaying the debt.

Final Summary

The wealth of a nation is not dependent upon its reserves of silver or gold, but rather on its ability to produce a stream of goods and services. Increased efficiency through division of labour would mean the generation of surplus, which can then be sold in the foreign markets to buy those things a nation is deficient in. Thus, free trade is necessary for the economic development of a nation, as trade is mutually beneficial to both parties. Trading is natural to human beings, and putting restrictions on trade by the government is harmful.

Colonies have greatly helped the European nations in their economic development by providing a market for their finished goods and supplying raw materials for their industries. Those colonies which are left to their own devices generally develop faster than those with excessive control by the mother country.

The government has some functions, such as protecting the country from external attack, maintaining law and order and promoting education. To meet these expenditures, the government must raise revenues by imposing various taxes. During special circumstances such as during periods of war, the government might be forced to borrow money.

Standout sections

In the Chapter of Book 1, entitled “Of the Principle which gives occasion to the division of labour”, the author makes one of his most famous comments: “It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but their regard to their own interest.” What the author is trying to say is that when one engages in a productive activity, he is not doing it thinking of the good of the society, he does it for his own good. When everybody engages in economic activities for their own interest, the surplus generated by each, satisfies the needs of others, resulting in the good for all.