Can self-interest be a good thing? What does it have to do with labor, embargoes, and taxation?
According to Adam Smith, self-interest in the context of a free market is what a nation needs in order to flourish. In The Wealth of Nations, he argues that free markets harness the power of rational self-interest to incentivize the production of useful goods while efficiently distributing surplus wealth.
Read more to understand Smith’s case for free markets and individual self-interest as the best ways to grow a nation’s economy.
Adam Smith on Self-Interest
According to Adam Smith, self-interest is the driving force behind a strong economy. Throughout his book, he argues that the individual pursuit of self-interest maximizes a nation’s capacity to produce wealth. We’ll define this concept, explain how it encourages the specialization of labor, and how this leads to greater prosperity in a large, market-based system.
Smith states that workers produce the goods that increase a nation’s wealth out of a desire for personal gain. Because they can make the most money for themselves by creating things that others want to use and buy, workers will naturally be drawn to create the goods that are most useful and desirable to others. Furthermore, self-interest will also direct workers to produce more goods at a higher quality because, the more and better goods they make, the more they earn selling them at market.
|“Common Sense” and the Scottish Enlightenment|
Smith’s economic theories were heavily influenced by the Scottish Enlightenment, an intellectual movement in which he was a major figure. This movement also included philosophers like David Hume, George Campbell, and Francis Hutcheson (Smith’s teacher).
The Scottish Enlightenment placed a heavy emphasis on “common sense” and the wisdom of ordinary people in making the right choices for their lives. These philosophers understood common sense as the ability to perceive and discern truth that is common to all and independent from reason or knowledge. The philosopher James Beattie described it as “that power of the mind which perceives truth, or commands belief, not by progressive argumentation, but by an instantaneous, instinctive, and irresistible impulse; derived neither from education nor from habit, but from nature.”
These ideas influenced Smith’s economic philosophy, as he asserts that governments ought to trust ordinary people’s instincts for personal gain and ability to discern their own interests as the guiding force in the economy—this will yield more prosperity than a reason-based government program to grow the economy by setting prices and prioritizing some industries over others.
The Specialization of Labor
Smith maintains that self-interest also leads to wealth production because it encourages the specialization of labor. Specialization of labor is the practice of dividing one complicated task done by one worker into a series of smaller, simpler tasks done by multiple workers. Specialization allows for much greater productivity overall.
Smith explains that a worker’s ability to specialize is determined by the size of the market in which they participate. The larger the market, the more workers can specialize.
Smith suggests that this is why the most economically developed societies usually have access to ports, canals, and other trading routes. They develop more advanced economies because their workers participate in larger markets and can therefore afford to specialize more.
Prices Regulate Markets
The fluctuation of price regulates markets to naturally create a balance between suppliers and customers. Smith states that, as long as there is free competition, and buyers and sellers pursue their own self-interests, the supply of goods will naturally balance itself out to meet the demand for those goods.
If the demand for a good outweighs the supply of that good, economic self-interest will give sellers a strong incentive to bring more of that good to market to take advantage of these high prices. However, if, in doing so the sellers then bring more of the good to market than customers want to buy, the sellers will then have to sell the good for less to compete. Economic self-interest will cause sellers to bring less of that good to market until supply meets demand. This allows market systems to efficiently balance the production of goods to their demand.
The principle of individual self-interest also governs labor markets, much like it governs markets for goods. Labor markets consist of a seller (the worker), trying to sell their labor for the highest price, and a buyer (the employer), trying to buy labor for the lowest price. The same principles of supply and demand apply: Anything that reduces the supply of workers in a given profession will drive up wages.
(Shortform note: Many economists have argued for an approach to labor markets that takes into account psychological behaviors besides rational self-interest.)
Smith identifies the cost of capital—all of the equipment, materials, and money (outside of wages and rent) required to run a business—as the third factor that influences the natural price of a good. He explains that capital is typically lent to businesses for a profit. Those who own a surplus of capital lend it out to interested businesses out of self-interest, and they’ll naturally expect a return on their investment. Therefore, the natural price of the good will include not only the cost of the capital itself but also the profit of the investor.
The cost of capital is also going to be influenced by the profit gained by the investor who lends out their capital. Smith states that capital lenders are also guided by their self-interest and invest to gain the most return.
Lending capital for profit plays an essential role in growing the wealth of nations. Smith identifies two main reasons: First, the self-interest of the lender encourages them to invest in productive labor. Second, the self-interest of the lender also guides them to invest in less-developed portions of the economy and help them develop.
Smith suggests that, when capital lenders are free to pursue their self-interest, they’ll naturally direct their wealth towards productive labor—which strengthens the nation’s economy and produces national wealth.
Smith also asserts that capital markets grow new sectors of the economy, boosting the national economy as a whole. The more capital that has already been invested in a given industry, the lower the profits for the investors. Therefore, the self-interest of the capital lender directs them to seek out industries with less capital investment. This process grows the economy.
Smith contends that an embargo has the effect of drastically restricting the supply while leaving the demand unchanged. This will drive up the price, as customers who want the illegal goods will now have to outbid each other to purchase from the diminished supply. The high prices will encourage merchants to pursue their self-interest by smuggling the tariffed or embargoed goods.
Smith views taxes largely as a necessary evil. He remarks that all taxation takes value out of the hands of private investors, whose self-interest encourages them to invest it in the industries that contribute most effectively to national growth.
Borrowing money pays for the same public works but redirects more private capital in doing so. Because self-interest directs the efficient investment of private capital, government debt becomes a burden on a nation’s economic growth by consuming more of this capital than regular taxation.
Exercise: Reflect on Economic Self-Interest
Smith argues that people specialize their labor out of self-interest. If you had to choose between two jobs—one where you completed a repetitive task over and over but made lots of money, or one where you frequently switched between tasks but made less money—which one would you choose and why?