Loading...

Concepts: Free Trade, Pins and the Invisible Hand - An Inquiry into Adam Smith

Gunnar Jaerv
Gunnar Jaerv 19 February 2021

Adam Smith is the founder of modern economics. Before him, there was little effort to discover exactly how some countries became wealthier, some people more prosperous, than others. And in part this is because there was little need.

Prior to the sixteenth century, the process by which nations became wealthy was through farming, with some forestry, hunting, trapping, and fishing. England was famous for its wool, France for its agricultural produce. Samurai in Japan were paid a stipend in rice; officials in China were maintained in a similar way, with bushels of grain, though these were sometimes paid in equivalent value of coin.

This reflected an economic reality that was as obvious as it seemed unchangeable: wealth was control over land. The alternative source of wealth was conquest of land by force. There were ways for individuals and nations to acquire a greater share of such little wealth as existed. But there was little understanding of the process by which the total amount of wealth could be increased.

Agricultural land paid for everything and the price was work. Nearly everyone worked at agricultural production. By the beginning of the twentieth century Europe’s most backward country, Russia, had 85% of its population working on the land as peasant farmers.

But elsewhere a change had occurred: 85% of England’s population worked in industry, in factories and mines and mills. These new industrial workers were far from rich, especially by modern standards. But they were far better off than their Russian counterparts. And England was a far richer country than Russia, despite being far smaller.

Between the sixteenth century and the twentieth, at different times in different places, humanity broke free of the lock between the land and wealth. (Historians will quibble that the process began much earlier, and so it did; but it was essentially during the industrial revolution that the economy became self-stoking, free from the lock to land.)

We can see that all around us — compare Singapore, Japan, or Finland, all countries with little mineral wealth or tillable land, with chiefly agricultural nations or those with great mineral wealth. Land, ore or jewels do not determine wealth.

So, what does?

This was the question Smith set out to answer: An Inquiry into the Nature and Causes of the Wealth of Nations, which everyone now just calls Wealth of Nations, was the diary of his investigation and his answer. Published in the fateful year 1776, it became famous for espousing free trade and a happy kind of accident in which a free market would supply everyone’s wants without anybody’s being public-spirited.

Adam Smith’s free trade

Let’s start with free trade, the thing Smith is best remembered for. In Adam Smith’s time, trade was seen as something unproductive by most. Taking food across the country to sell it only meant some would rot; even selling nails to the man next door, by itself, produced no new nails. The best trade could do was break even. If this sounds short-sighted to us, we largely have Smith to thank.

Smith saw in trade the opportunity to massively increase both the availability and the desirability of goods at the point where they were sold, used or consumed. Prefiguring the insight of Hayek and others that an economy is not a calculation to be solved but the physical manifestation of human decisions based on needs, desires and availability — supply and demand — Smith saw that trade in high volumes could enrich everyone. The transport and sale of merchandise added, not new nails or more apples, but economic utility.

This was only possible if trade was encouraged. In Smith’s day, Mercantilism reigned. This was the belief that the state should protect its own interest, its own producers and exports, at the expense of competing nations’ producers. English apple farmers and blacksmiths should not have to compete with French and Dutch ones. England would charge what it liked for its apples and apply tariffs to foreign ones.

Smith showed that this was a kind of prisoner’s dilemma: the only advantage to be gained from mercantilism is if you are its sole practitioner. Generally applied it impoverishes everyone, because French imports are English exports and vise versa. What Smith hoped for instead was that:

“Every workman has a great quantity of his own work to dispose of, beyond what he himself has occasion for; and every other workman being exactly in the same situation, he is enabled to exchange a great quantity of his own goods for a great quantity, or, what comes to the same thing, for the price of a great quantity of theirs. He supplies them abundantly with what they have occasion for, and they accommodate him as amply with what he has occasion for, and a general plenty diffuses itself through all the different ranks of the society.” (Wealth of Nations Hackett 1993, p.9)

As for the individual so for the whole economy. National economies would grow and thrive under free trade as under mercantilism they could not; endeavors to protect the economy instead swaddled it, prevented it from moving and growing.

French imports made the British richer, so did British exports to France. Both should be left to function naturally. Prices should not be fixed.

Smith and prices

Prices, said Smith, should not be set by central authorities. Instead they should be set by the market. This is now absolutely commonplace economic boilerplate. In 1776 it was revolutionary. Smith held that every commodity had two prices, its natural price and its market price.

Natural price: “When the price of any commodity is neither more nor less than what is sufficient to pay the rent of the land, the wages of the labour, and the profits of the stock employed in raising, preparing, and bringing it to market…” (Wealth of Nations, p.23)

Market price: “The market price… is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity.” (Wealth of Nations, p.24)

This is a far cry from the idea that “a thing is worth what people are willing to pay for it”, though Smith does address this issue, and recognizes price elasticity based on fluctuating demand in quite sophisticated ways. Ultimately, though, Smith foresaw that “the quantity of every commodity…naturally suits itself to the effectual demand”, where “effectual demand” means those willing to pay more or less the natural price rather than some artificially low price.

But Smith addressed something much more vital and far-reaching too. Remember, he was interested not just in the nature of the wealth of nations but in its causes. How were some nations many times richer than others?

Smith and production

The dismal facts of the pre-industrial world looked at economics in terms of a present or likely shortage of food, taking for granted an absolute shortage of everything else — from the clothes that had to be hand-woven and hand-sewed to the metal so scarce that many agricultural instruments, from plows to spades, were mostly of (hand-carved) wood.

For Adam Smith, though, there was a clear difference between the wealth of some nations and others, and it required explanation. He sought his facts in the works of the French Encyclopedists, and gave the first chapter of Wealth of Nations to an examination of the effect of the division of labor on production.

His most famous test case is pins.

Pins were previously a specialist trade item. Making a pin involved several complex, skillful processes, each one requiring different tools. For one person to make a whole pin was an endeavor; skilled workers could make ten a day, while an unskilled person, as Smith points out, would be lucky to make one. Consequently the price of pins was high, driving up the price — and thus lowering the availability — of everything reliant on pins for manufacture and sale.

But Smith pointed to accounts from Diderot’s Encyclopedia as well as other sources to illustrate a change in productivity that was then in its infancy but would in time transform the world. Henry Ford is often credited with inventing specialization of labour; in fact it was an eighteenth-century innovation.

In the modern pin factory, one person drew the wire from which pins were to be made. Another cut it. Another attached the heads. Sharpening pins was a full-time job. “It is even”, reported Smith with some incredulity, “a trade by itself to put them into the paper [packets for sale]”.

The result of this method of working was an absolutely immense increase in productivity. Smith calculated that about 4,800 pins could be made per worker using this method; in modern terms, per-worker-hour productivity was increased by up to 4,800%.

But there would be little point making 4,800 pins an hour if you couldn’t sell them. Division of labour was most effective when markets were largest, meaning goods would be made cheaper by being sold more widely. Trade drove down prices and enriched producers simultaneously.

Smith used this observation to argue for greater use of specialized labour, a freer market economy, free trade, and the tendency for society to enrich itself when each member sought their most gainful employment.

Smith and pay

Adam Smith believed that people did their best work when they got paid for it, and their worst when it didn’t matter whether they worked or not. Farmers who grew wealthy on bountiful harvests and starved from weed-choked fields tilled and reaped energetically, engaging their full faculties; the national food production rose and everyone benefited. Put farmers on a stipend and they would take it easy. The same was true of university professors, industrial workers and pin-makers. (Smith was particularly negative toward the professors at Oxford who received a salary whether they taught or not, preferring the Scottish system which paid according to the number of students attracted — even when he was one, at Glasgow University.)

Pin-makers who chose to work in the new way were choosing to spend all day doing the same simple, repetitive task. We recognize this as the standard mode of industrial production, but in Smith’s day it was new and required explanation.

The obvious answer was that by doing so they could earn far more money. Given the chance, everyone would work in the job and in the way that would make them the most money for the least work. When people were insulated from the results of their decisions about work, as when they got paid whether they worked or not, they made bad decisions and paid less attention to their work. The result tended to impoverish all by diminishing work performance.

This analysis is at the root of one of Smith’s lesser-known enmities: he was opposed, quite strongly, to the “joint-stock company,” now known as the corporation, on the basis that its managers would be dealing with someone else’s money rather than their own. How could they be expected to be as diligent as they would be with their own fortunes?

Smith and the Invisible Hand

If Adam Smith is associated with one phrase, this is it. The term “invisible hand” appears in Wealth of Nations, where Smith explains how individual desire for gain improves the common lot:

“As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can.

He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it.

By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.

Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

(Book 4, Chapter 2 — my emphasis)

In this, as generally, Smith is very clear and doesn’t need much explanation. The invisible hand isn’t a kind of benevolent economic ghost, steering the ship while everyone attends to their own affairs; instead, by attending to their own affairs people improve the lot of their fellows in increased productivity and trade, improving the general welfare.

Smith’s argument in Wealth of Nations isn’t several separate pieces, and he didn’t advance it as an argument. Instead he reported on events, analysed the specifics and from this created nearly all the basic tenets of what we think of as classical economics. His theories have been sharply tested, and the work of John Maynard Keynes and his fellow thinkers arises out of the discovery that the invisible hand could slip or even fail entirely. But he remains one of economics’ clearest thinkers (and writers), and his conclusions are our assumptions: even now, Adam Smith is right until you prove him wrong.

Disclaimer:

Disclaimer: This publication is general in nature and is not intended to constitute any professional advice or an offer or solicitation to buy or sell any financial or investment products. You should seek separate professional advice before taking any action in relation to the matters dealt with in this publication. Please note our full disclaimer here.

Next Article