What’s so great about the free market? Does self-interest benefit everyone? How should taxes be used?
Many economists consider The Wealth of Nations by Adam Smith to be 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.
Continue reading for an overview of this important classic work.
An Overview of The Wealth of Nations by Adam Smith
The Wealth of Nations by Adam Smith argues that free markets harness the power of rational self-interest to incentivize the production of useful goods while efficiently distributing surplus wealth. Because of this, Smith makes a case against heavy-handed market regulations that interfere with the natural wealth-generating processes of uninhibited markets.
Adam Smith was a philosopher who lived in 18th-century Scotland. At the time, the field of economics existed primarily as a hobby for philosophers in other disciplines. Smith’s theories helped lay the groundwork for the development of economics into an established field of study. Though radical in their time, many of Smith’s ideas have informed the economic policies of nations all over the world.
We’ll explore Smith’s arguments by first discussing how markets work and some of the factors that influence them. We’ll explain the benefits of workforce specialization, the purposes of money, and the natural costs of goods. Then, we’ll cover the role of capital in developing a nation’s economy. Finally, we’ll consider the role of government, including regulations, public spending, and revenue. Throughout this guide, we’ll compare Smith’s ideas to contemporary economics, while shedding light on his arguments by providing historical context.
(Shortform note: We’ve tried to highlight the core mechanics of Smith’s macroeconomic theory for contemporary readers—modernizing terms when applicable and focusing less on Smith’s analysis of specific market conditions and economic policies of the 18th century. However, we’ve still generalized his critiques to provide readers with a clear sense of the types of policies Smith opposed and his arguments against them.)
Part 1: How Nations Produce Wealth
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.
Throughout his book, Smith argues that the individual pursuit of self-interest maximizes a nation’s capacity to produce wealth.
How 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.
Specialization allows for much greater productivity overall. Here’s why:
- 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.
Large Markets Enable Specialization
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.
Part 2: How Markets Exchange Wealth
In a capitalist society, everyone’s a merchant. Smith contends that you cannot meet your needs without purchasing goods produced by others. Workers sell their labor in exchange for wages just as merchants sell goods in exchange for profits.
What Do Markets Exchange?
Markets exchange the value of labor. Smith explains that the value of every good is derived from the work people put into producing it. When you trade your labor for wages and then spend those wages on goods, you’re really exchanging your labor for the labor of others. You gain wealth by contributing labor to society, and your wealth gives you the power to command labor from others.
How Do Markets Exchange?
Smith asserts that markets can exchange labor only if there’s a shared medium of exchange. This is because there’s a problem with exchanging labor for labor. Not everyone’s work produces something everyone else wants. However, if you have a shared medium of exchange, such as a currency, you have a much smoother and more efficient functioning of markets.
Part 3: How Markets Regulate Themselves
Smith argues that free markets are the most efficient way of directing the production and exchange of goods to grow a nation’s wealth (and thereby enable the specialization of labor).
How Markets Regulate Price
The ratio between supply and demand regulates the price of any good. Smith explains that, if demand is higher than supply, the customers will have to compete with each other. However, if supply outweighs demand, then the sellers will have to compete with each other by lowering prices.
How 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.
Part 4: The Natural Price of Goods
When supply and demand are in equilibrium, goods will be sold for their natural price. Smith explains that the natural price is the cost of bringing a good to market. A business can continue bringing goods to market only if it’s able to sell them for more than its cost of production. Therefore, the natural price of a good will change in accordance with changes in any of the costs of production. Smith identifies three main costs that determine a good’s natural price.
Cost #1: Wages and Labor Markets
Smith identifies two factors that determine the cost of wages: labor markets and workers’ living conditions.
1) Labor Markets
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.
2) Workers’ Living Conditions
Wages must be enough so that workers can furnish themselves with food and housing. Furthermore, there is greater regional variety in the rate of wages than there is for the cost of goods. There isn’t likely to be much variety in the price of the same good from one region to the next. Workers tend to accept the prevailing local wage rather than constantly moving from town to town in search of better markets. This means that labor markets tend to operate across a smaller geographical radius than markets for goods, which makes it harder to bring different regional wages into a closer state of equality.
Cost #2: The Rent of Land
Every industry has to take place somewhere, and, if that land is privately owned, then the good’s price will include rent to the land’s owner. This is especially true in land-intensive industries. However, landlords still must operate with some constraints. If they charge so much as to bankrupt the businesses, then the business on their land will cease and the landlord won’t be able to charge any more rent.
Cost #3: Capital
Capital is all of the equipment, materials, and money (outside of wages and rent) required to run a business. Smith explains that capital is typically lent to businesses for a profit. Therefore, the natural price of the good will include not only the cost of the capital itself but also the profit of the investor.
When the supply of capital exceeds the demand, capital lenders will have to lower their profit margins to compete with each other. When the demand for capital exceeds the supply, businesses will compete with each other for investment and therefore capital lenders will be able to raise their profits.
Smith identifies three key factors that influence the markets for capital.
- Risk to the investor: The cost capital adds to the natural price will change from industry to industry depending on the risk to the investor.
- Profit on capital: The cost of capital is also going to be influenced by the profit gained by the investor who lends out their capital. Much like labor, the profits of capital are impacted by a nation’s overall economic growth. However, Smith explains that they have the exact inverse relationship.
- Changes in supply chains: Any change in the price of supplies or equipment will find its way into the natural price of goods.
Part 5: How Capital Grows a Nation’s Wealth
Lending capital for profit plays an essential role in growing the wealth of nations. Smith identifies two main reasons.
Reason #1: Capital Naturally Seeks Productive Labor
Smith first contends that capital naturally seeks productive labor: labor that can generate surplus goods. Surplus goods add to a nation’s overall wealth because they enter a nation’s overall supply of circulating capital.
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. This is because work that generates surplus goods can create greater profit than work that does not.
Reason #2: Capital Markets Seek Out Undeveloped Industries
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.
Part 6: The Effects of Trying to Regulate Markets
Throughout The Wealth of Nations, Smith identifies government policies—often intended to grow a nation’s wealth—that actually interfere with the free market and slow down economic growth.
Harmful Government Policy #1: Restrictions on International Trade
Many governments try to grow their nation’s wealth by preventing the import of foreign goods that would out-compete domestic manufacturers. Either the country bans importing foreign goods completely (an embargo), or it imposes high taxes on the foreign goods to prevent them from being competitive in domestic markets (tariffs).
Smith disagrees with restricting international trade for three reasons:
- Restricting international trade incentivizes smuggling. An embargo has the effect of drastically restricting the supply while leaving the demand unchanged. This will drive up the price, which will encourage smuggling.
- Restricting international trade misdirects domestic capital. Smith cautions that restricting international trade will slow economic growth by redirecting capital away from efficient industries and toward inefficient ones. By restricting international trade, governments artificially prop up unprofitable industries while making consumers pay a higher price for the goods these industries produce. This results in lower economic growth
- Restricting international trade prevents growth for both countries. Workers can devote more of their time to focusing on a single task if they have access to the customer base and the supplies to support high levels of production. Thus, by trading with each other, countries are able to access larger markets, supporting greater specialization of labor in each country.
Harmful Government Policy #2: Subsidies
Subsidies are policies in which governments directly give money to a particular industry or business. Smith explains that subsidies misdirect investment capital in two ways.
First, subsidies move capital directly by collecting it through taxes and giving it to the subsidized industry. This redirects capital by taking it out of the hands of private investors who would otherwise naturally seek out the most productive labor and grow the economy.
Second, subsidies encourage capital investors to prioritize an artificially profitable industry over others that are truly profitable.
Part 7: The Proper Role of Public Spending
Smith recommends that governments should collect taxes and spend public money only if it’s on something that’s important for society as a whole and can’t be handled better by the free market. Smith contends that only four expenditures meet these criteria.
State Expenditure #1: Defense
Smith provides three arguments for the benefits of public investment in standing armies:
- It’s difficult to imagine another funding source that could actually cover the expense and keep the nation well-defended against national security threats.
- Without a standing army, governments will have to move laborers out of their existing professions to fight for the duration of the war. This will disrupt the economy.
- It’s better in wartime to have a core of soldiers that are already trained to fight rather than taking the resources to train new soldiers.
State Expenditure #2: Justice
Governments have an obligation to provide justice and enforce the laws. Smith cites two benefits of having a judiciary funded by the government:
- The wealthier a society becomes, the higher the incentives to commit property crimes. Therefore, wealthier societies need strong courts and legal systems.
- If judges were paid by the parties involved in the trial, they may be tempted to judge in favor of those that could afford to pay them the most.
State Expenditure #3: Education
Smith explains that public education provides an important service to society as a whole, as it not only benefits the students but also promotes social harmony and order. Thus, it’s a proper investment for public spending.
State Expenditure #4: Transportation Infrastructure
Smith contends that everyone in a society benefits from transportation infrastructure that facilitates commerce because this expands the size of the market.
Part 8: How Governments Raise Revenue
Smith identifies two principal sources of revenue: taxation and borrowing.
Revenue Source #1: Taxation
Smith views taxes largely as a necessary evil. He remarks that all taxation takes value out of the hands of private investors that drive the economy. Therefore, much of his discussion of tax policy is directed toward finding the least disruptive system of taxation.
Guidelines for Taxation
Smith outlines four guidelines for ethical taxation:
- Taxation is proportionate to income.
- Taxes ought to be predictable.
- Taxes ought to be collected at convenient times.
- Levying and collecting taxes ought to be cost-efficient.
The Difficulty of Fairly Levying Taxes
Smith analyzes three common tax policies:
- Taxes on land: Taxing the rent of land provides a challenge for proportionality and cost efficiency.
- Taxes on profit: Businesses will raise the prices of their goods to recoup their losses. Therefore, a tax on profits is actually a sales tax on consumers. These taxes also aren’t cost-efficient because of how hard they are to determine and enforce.
- Taxing wages: Taxing wages will drive up labor costs for employers. These employers will then try to recoup their costs by raising the price of their goods, thus passing the tax on to their customers.
Revenue Source #2: Borrowing
Smith maintains that government borrowing is a drain on a nation’s economic growth. Because governments will have to pay off this money eventually, borrowed revenue is still paid for by taxation, but in the future. However, it will be paid off at a higher rate. Government debt becomes a burden on a nation’s economic growth by consuming more of this capital than regular taxation.
Exercise: Consider the Ideas of The Wealth of Nations
This exercise will give you a chance to reflect on Smith’s main ideas and develop your own economic thinking.
- 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?
- Smith divides the natural price of goods into three components: labor, land, and capital. Let’s reflect on which of these you consider most important for an economy. Imagine three countries.
- The first has abundant capital and land but is short on labor.
- The second has abundant labor and land but is short on capital.
- The third has abundant labor and capital but is short on land.
- Which one of these countries do you think would be the wealthiest and why?
- Smith states that the four appropriate expenses for public investment are: defense, justice, education, and transportation infrastructure. Of these four, which one do you think is most important for growing the economy? Explain why.
- Imagine that you are tasked with designing a new tax to pay for a government initiative and that your goal is to disrupt the market as little as possible. Would you rather tax wages, land, or profits? Explain your reasoning.
- Smith’s central contention throughout The Wealth of Nations is that the best way to grow a nation’s economy is by trusting the market to guide itself without government interference. Do you agree with this philosophy? Why or why not?