How does a country make money? What separates a wealthy country from a poor country?
Many economists consider Adam Smith’s The Wealth of Nations one of the major foundational texts of their discipline. Writing in 1776, Smith argues that free markets are the best institution for cultivating a nation’s wealth.
Keep reading to learn the basics of how a country makes money.
How Nations Produce Wealth
How does a country make money? Smith states that a nation’s wealth is determined by the ratio of what it produces to what it consumes. Wealthy nations are able to satisfy all their citizens’ needs, either by producing the goods those citizens consume or by producing goods for export to other countries that can be exchanged for goods that are consumed at home. On the other hand, poor nations are unable to satisfy the needs of their citizens, either because they don’t produce enough goods directly to meet their citizens’ consumption needs or because they don’t export enough to other countries to receive sufficient goods for home consumption in exchange.
Throughout his book, Smith argues that the individual pursuit of self-interest maximizes a nation’s capacity to produce wealth. In this section, 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.
Self-Interest Promotes Wealth Production
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.
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. Smith provides three reasons why specialization increases greater overall productivity:
- The more a worker performs a task, the more skilled they will become at it.
- A specialized worker saves time by not switching between tasks.
- A specialized worker will be more likely to come up with more efficient ways of completing a task.
(Shortform note: Historians and archeologists have supported Smith’s claims about specialization increasing productivity, finding that the specialization of labor played an important role in developing the earliest civilizations during the neolithic period.)
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.
(Shortform note: In addition to higher degrees of specialization, economists have connected market size to increased rates of competition and innovation.)