Adam Smith and Laissez-faire Capitalism

Adam Smith, a Scottish economist, published his Wealth of Nations in 1776.  His economic theories proved to be the most popular, and perhaps the most useful, to the capitalists of the Industrial Revolution.  In his book, Smith analyzed society.  He asked the question, "How does society work?"  Looking at England in his time, he came to the conclusion that England would be best off if government stepped out of the business arena.  He felt that if the economy were left alone, three forces would come into play and be the most profitable for everyone.  These three forces were (1) self-interest, (2) competition, and (3) supply and demand. 

The following excerpt is from Robert Heilbroner, The Worldly Philosophers, New York: 1953, pp. 39-43 passim.

            Two great problems absorb Adam Smith's attention.  First he is interested in finding out the mechanism by which society hangs together.  How is it possible for a community in which everyone is busily following his self-interest not to fly apart?

            These questions led Smith to draw up laws of the market.  What he sought was "the invisible hand," as he called it, whereby "the private interests and passions of men" are led in the direction "which is most agreeable to the interest of the whole society."

            There is another question which interests him:  whither society?  To Smith, society is not a static achievement of mankind which will go on reproducing itself, unchanged and unchanging from one generation to the next.  On the contrary, society is seen as an organism that has its own life history.  To discover the shape of things to come -- this is the object of economics.

            We begin with a look at the market mechanism.  Adam Smith's laws of the market are basically simple.  They show us how the drive of an individual's self-interest in an environment of other individuals with the same motives will result in competition.  They further show how competition will result in providing those goods that society wants, in the quantities that society wants, and at the prices that society is prepared to pay.

            This comes about because in the first place, self-interest acts as a driving power to guide men.  It drives men to action.  But something else must prevent profit-hungry individuals from holding society up to exorbitant ransom.  A community moved only by self-interest would be a community of profiteers.  This regulator is competition.  A man who permits his self-interest to run away with him will find that competitors have slipped in to take his trade away.  If he charges too much for his wares or if he refuses to pay as much as everybody else for his workers, he will find himself without buyers in one case and without employees in the other.

            Consider, for example, the problem of high prices.  Suppose we have 100 manufacturers of gloves.  The self-interest of each one will cause him to wish to raise his price above his cost of production in order to make an extra profit.  But he cannot.  If he raises his price, his competitors will step in and take his market away by underselling him.  Only if all glove manufacturers combine and agree to maintain a solid front will too high a price be charged.  But in this case, this solid front could be broken by a manufacturer from another field -- say, shoemaking -- who decided to move his capital into glove manufacture where he could steal away the market by offering low prices.

            But the laws of the market not only make for competitive prices.  They also see to it that the producers pay attention to society's demands for the quantities of goods it wants.

            Let us suppose that consumers want more gloves than are being turned out, and fewer shoes.  The public will scramble for the gloves on the market and the shoe business will be dull.  As a result glove prices will tend to rise as consumers try to buy more gloves than there are for sale, and shoe prices will tend to fall as the public passes the shoe stores by.  But as glove prices rise, profits in the glove industry will rise too.  As shoe prices fall, profits in shoe manufacturing will slump.  Again self-interest will step in to right the balance.  Workers will be let go from the show business.  They will move into the glove business where business is booming.  The result is obvious: glove production will rise and shoe production will fall.

            As more gloves come on the market to meet demand, glove prices will fall back into line.  As fewer shoes are produced, the surplus of shoes will soon disappear and shoe prices will again rise up to normal.  Self-interest and competition, acting one against the other, have accomplished the transition.

            And one final accomplishment.  Just as the market regulates both prices and quantities of goods, so it also regulates the incomes of those who produce those goods.  If profits in one line of business are very large, there will be a rush of businessmen into that field until competition has lowered profits.  If wages are out of line in one kind of work, there will be a rush of men into the favored occupation until it pays no more than similar other jobs. 

            Adam Smith has found in the mechanism of the market a self-regulating system for society to provide the goods it needs.

            Does the world really work this way?  To a very real degree it did in the days of Adam Smith.  18th-century England approached Smith's model.  Business was competitive, the average factory was small, prices did rise and fall as demand ebbed and rose, and the process did bring changes in output and occupation.

Answer the reading questions below when you finish reading.

1.      What does Adam Smith mean by "the invisible hand"?

2.      What is self-interest?  Explain it.

3.      What purpose does self-interest serve in society?

4.      How are we protected from the evils of too much self-interest?

5.      What is competition?

6.      How does competition help all of us?

7.      How are the prices of goods decided?

8.      How does a manufacturer decide how much (the quantity) he ought to produce?

9.      How are the incomes of workers decided?