The Economics Book

THE AGE OF REASON 59

It is not from the

benevolence of the butcher,

the brewer, or the baker

that we expect our dinner,

but from their regard

to their self-interest.

Adam Smith

in which money paid in wages
circulates back into the economy
when the worker pays for goods,
only to be paid back out in wages
to repeat the process. Capital
invested in production facilities helps
to increase labor productivity,
which means that employers can
afford to pay higher wages. And if
employers can afford to pay more,
they will because they have to
compete with each other for workers.
Turning to capital, Smith
said that the amount of profit that
capital can expect to earn through
investments is roughly equal to
the rate of interest. This is because
employers compete with each other
to borrow funds to invest in profitable
opportunities. Over time the rate
of profit in any particular field
falls as capital accumulates and
opportunities for profit are exhausted.
Rents gradually rise as incomes
rise and more land is used.
Smith’s realization of the
interdependence of land, labor, and
capital was a real breakthrough. He
noted that workers and landowners
tend to consume their incomes,
while employers are more frugal,
investing their savings in capital
stock. He saw that wage rates vary,
depending on different levels of
“skill, dexterity, and judgment,”
and that there are two forms of
labor: productive (engaged in
agriculture or manufacturing) and
what he called “unproductive”
(supplying services needed to back
up the main work). The highly
unequal outcomes of today’s
market system are a long way
from what Smith envisioned.

Economic growth
Smith claimed that the invisible
hand itself stimulates economic
growth. The source of growth is
twofold. One is the efficiencies
gained through the division of

labor (pp.66–67). Economists

call this “Smithian growth.” As

more products are produced and

consumed, the economy grows,

and markets also grow. As markets

grow, there are more opportunities

for specialization of work.

The second engine of growth is

the accumulation of capital, driven

by saving and the opportunity for

profit. Smith said that growth can

be reduced by commercial failures,

a lack of resources required to

maintain the fixed capital stock,

an inadequate money system

(there is more growth with paper

money than with gold), and a ❯❯

Demand in a market can change for many reasons. As it does so,

the market responds by altering supply. This happens spontaneously—

there is no need for a guiding hand or plan in a market that encourages

competition among self-interested people.

... demand

for umbrellas

soars.

... demand for

sunglasses

drops.

During a rainy summer...

Umbrella firms

employ more

people and

enjoy profits

until other

firms enter the

market, forcing

prices back to a

“natural level.”

As prices

rise, so do

profits.

As prices

drop, so do

profits.

Self-interested

employers let

go of staff.

Staff go to work

in the booming

umbrella business.