Adam Smith’s Theory of Economic Development | Economics

Adam Smith is known as father of economics. We get his ideas about economic development from his well-known book, “An Enquiry into the Nature and Causes of Wealth of Nations” (1976) which has tremendously influenced the thinking about economic growth and development.

We briefly explain below his ideas about economic development. We will study below that he advocated the policy of laissez faire, that is, non-intervention of government in economic activities of the individuals. He laid stress on individual freedom in conducting their economic affairs without any obstructions and restrictions by the Government. He advocated free trade among nations of the world and urged that all restrictions on foreign trade should be removed to promote international specialization so as to increase the incomes of the nations.

Aspects of Adam Smith’s Theory:

The crucial aspects of development theory as propounded by Adam Smith are – (1) division of labour and (2) capital accumulation. Productivity of labors increases through division of labour. The two factors that facilitate the use of more division of labour are capital accumulation and size of market. We explain below these factors in detail. Also learn about the relevance of Adam Smith’s Theory to developing countries.

1. Division of Labour:

A very important contribution made by Adam Smith to the analysis of the factors that bring about expansion of output is the division of labour. His treatment of this aspect of production is classic. He pointed out that there was a natural tendency among human beings “to truck, barter, and exchange one thing for another.” Among the benefits of division of labour he refers to increase in dexterity, saving in time, and invention of better machines and appliances. But Adam Smith points out that the degree of division of labour is limited by the extent of the market. Division of labour is profitable only if there is adequate market for the goods produced. He, thus, emphasized the expansion of international trade, which widens market for goods.

One of the most significant contributions to economics by Adam Smith was to introduce the idea of increasing returns caused by division of labour. He thought the gain from by division of labour or specialization was a basic feature of social economy otherwise everyone, like Robinson Crusoe, will produce everything they want for themselves. Thus Thirlwall writes, “It is the notion of increasing returns, based on division of labour that lay at the heart of Adam Smith’s optimistic vision of economic progress as a self-generating process, in contrast to later classical economists who believed that economies would end up in a stationary state owing to diminishing returns in agriculture.”

Given the crucial significance of increasing returns based on division of labour, productivity of labour rises with the increase in the size of market. Along with division of labour it is acceleration of investment or capital accumulation that leads to the increase in growth of output and living standards of people. It is worth noting that Adam Smith expressed the view that industry generally permitted greater scope for division of labour or specialization than agriculture and, therefore, in rich developed countries industrialization had taken place to a greater extent.

Another important related notion put forward by Adam Smith was that division of labour is limited by the size of market’. If the extent of market is small, it will not be profitable to produce on a large scale which requires introducing a higher degree of division of labour or specialization.

This is because if size of market for a good (i.e., the magnitude of demand for it) is quite small, it will not be profitable to introduce a higher degree of division of labour along with the use of large capital stock. In the absence of adequate demand, only a little degree of division of labour or specialization can be used and a good deal of capital stock is likely to remain underutilized. It is in this context that he advocated for free international trade which leads to the increase in the extent of market for goods and makes their production on a large scale profitable and induces the capitalist class to accumulate more capital.

2. Accumulation of Capital:

As a means of economic development, Adam Smith gave an important place to saving and accumulation of capital. To quote his words, “Capitalists are increased by parsimony and diminished by prodigality and misconduct parsimony and not industry is the immediate cause of the increase of capital. Industry indeed provides the subject which parsimony accumulates. But whatever industry might acquire, if parsimony did not save and store up, the capital would never be greater.” Here is a clear guideline and suggestion to the developing countries. Their greatest obstacle to economic development is the deficiency of capital. In this respect they are caught up in a vicious circle of poverty.

Productivity of people is low because the capital stock is small; capital stock is small because savings of the people are small and savings are low because incomes of the people are small due to the their low productivity. The way out of the vicious circle, according to Smith, is if capitalist class that saves most of their profits and invest in capital accumulation for accelerating economic growth. Thus, according to Adam Smith, saving of the society is increased by ‘parsimony’ (i.e., habit of frugality) of the capitalists. In fact, Adam Smith assumed that capitalist class behaves in such a manner and save a very large proportion of their profits.

Besides, capital accumulation, according to Smith, facilitates a greater degree of division of labour which causes productivity of labour to rise. Without capital accumulation the extent of division of labour cannot be increased much. Increase in capital formation leads to the production of different types of specialized equipment which are operated by different classes of workers who are skilled and specialized in various tasks. Thus, capital accumulation along with division of labour leads to the increase in industrial output and employment.

Development Process is Cumulative:

Adam Smith points out that the development process once started gathers momentum and becomes cumulative, that is, it feeds upon itself. This happens in the following ways. First, increase in saving causes more accumulation of capital which in turn facilitates a great degree of division of labour and thereby raising productivity of labour and levels of incomes of the people. Second, the higher incomes due to the capital accumulation and a higher degree of division of labour lead to the increase in the size of market or demand for goods. This expansion in demand for goods causes increase in national output and income which brings about more saving and further investment and capital accumulation. In this way spiral of economic growth rises higher and higher. Third, the increase in size of market and availability of capital induces improvement in technology.

This cumulative process of development provides a cheerful note for the developing countries. That is, if they start the development process in right earnest they can be sure of further and rapid economic development and can catch up with the presently advanced developed countries.

Sequence of Development:

According to Adam Smith, the natural course of development is first agriculture, then industry and finally commerce. Agriculture creates a surplus and increases the purchasing power of the people which generates demand for industrial products. It also supplies raw materials for industries. Agricultural growth thus provides a base for industrial development.

Stationary State:

Through his belief in increasing returns based on the increase in the extent of division of labour. Adam Smith was optimistic about economic growth in future. In fact, he emphasized the cumulative and self-propelling nature of development process. However, he also pointed out that there is limit to the economic development which ultimately lands a free market economy in a stationary state in which further capital accumulation ceases to take place and therefore there is no more growth of the economy. This happens because of two reasons. First, there is a limited amount of natural resources at the disposal of the economy and after passing through a phase of growth a point is reached when they are fully utilized and do not permit further growth of output.

The second factor responsible for occurrence of stationary state is fall in profits which reduces inducement to invest further. Profits tend to fall as a result of competition among the capitalists, i.e., investors. This results in decrease in demand for more capital accumulation. With slackening of capital accumulation, demand for labour decreases resulting in decline in wages. Thus, after a significant economic growth, stationary state of the economy is reached where further capital accumulation ceases and profits fall to a low level and with the further increase in population wages become equal to the subsistence level.

Policy of Laissez-Faire:

As an instrument of economic development, Adam Smith was a strong champion of the policy of laissez-faire or allowing economic freedom to every individual not hampered in any manner by State action. He believed that “there is a set of rules of rights or justice, and perhaps even of morality in general, which are, or may be known by all men by the help either of ‘reason’ or of a moral sense.” He was thus a strong believer in ‘natural reason’ guiding human affairs and he regarded State interference not only superfluous but positively harmful to economic progress.

Guided by enlightened self-interest, each individual was capable of promoting his own well-being and while promoting his own interests he promotes the welfare of the whole society in the process. It is, therefore, according to Adam Smith, the production by individuals is led as if by the ‘invisible hand’, to promote social welfare. Thus, though individual capitalists produce goods to make profits for them but in doing so they promote social welfare though it was no part of their intention. As a matter of policy, therefore, Adam Smith advocated the removal of all restrictions on trade, choice of occupation and the use of property by individuals.

Critical Evaluation of Adam Smith’s Theory of Development:

The great influence of Adam Smith on subsequent thinkers can be traced in the pattern he set for later discussion on development problems. The emphasis he laid on the accumulation of capital as fundamental to the development process finds a place in subsequent theories of development.

His idea of stationary state is also taken up and repeated in later writings on the subject. The policy of laissez-faire advocated by him is emphasized in the theories propounded by later classical writers. Similarly, his view that development was gradual and cumulative process was adopted by subsequent economists.

One of Smith’s significant contributions to the theory of development has been to introduce into economics the concept of increasing returns based on the division of labour. According to him, gains from division of labour or specialization are the basis of a social economy as without it man’s productivity will be very low. His model represents optimistic view of development in contrast to the pessimistic views of later classical economists such as Ricardo and Malthus and to Marx A.P. Thirlwall rightly writes, “It is the notion of increasing returns, based on the division of labour that lay at the heart of his optimistic version of economic progress as a self-generating process in contrast to later classical economists who believed that economies would end up in a stationary state owing to diminishing returns to agriculture and also in contrast to Marx who believed that capitalism would collapse through its own contradictions.” Increasing returns implies rising labour productivity and higher per capita income while diminishing returns means fall in labour productivity and therefore per capita income which set a limit to the growth of output and employment.

The most important contribution of Smith to the theory of economic development is his emphasis on capital accumulation and division of labour as the factors that determine economic growth of a country and further that capital accumulation or investment depends on savings out of profit generated by growth of industry and agriculture. This is very much relevant to the growth problem of present- day developing countries which requires acceleration of investment and capital formation.

Besides, Smith’s emphasis on division of labour for raising productivity of labour is a highly significant contribution to economic thought and to the theory of development. He uses the term ‘Division of Labour’ in a wider sense which incorporates technological progress though he does not say so explicitly. He also rightly pointed out that division of labour provides greater scope for capital accumulation and the use of machinery in the complex production processes in the production of commodities that result in higher labour productivity.

It is worth mentioning that Smith’s vision of development as a cumulative interactive process based on the division of labour and increasing returns remained neglected for a long time until an American economist, Allyn Young, revived it in 1928 in his important paper entitled “Increasing Returns and Economic Progress”. It may be noted that unlike Marshall, Young was not simply concerned with the factors that raise productivity or cost-reduction within an individual industry as it expands but explained the increase in productivities in interrelated industries of the economy as a whole. Therefore, the notion of increasing returns put forward by Young is sometimes called macroeconomics of scale.

Finally, it goes to the credit of Smith that he explained the gains from international trade based on specialization by various countries on the basis of greater efficiency in the production of different goods and then trade with each other. That is, he extended his division of labour to the international level. He advocated free trade as it would increase the size of market for goods produced by different countries to reap benefits of higher degree of division of labour.

Relevance of Adam Smith’s Theory to Developing Countries:

Adam Smith based his theory of development on the socio-economic conditions prevailing at his time in Europe. It was a period when the seeds of industrialization had already been dispersed in the economy. Industrial revolution was in its inception. Smith’s views on development are, therefore, an answer to the questions posed by the problems of economic transition from a pre-industrial to an industrial England.

Basically, he, like all other classicals, regarded that economic welfare of the society was roughly proportional to the volume of output and level of economic activity. The society was regarded to be composed of two classes—the capitalists and the labourers. The wages being at the subsistence level, the labouring class was incapable of saving. Only the capitalists were able to save.

The institution of private property, social attitudes and existence of perfect competition were considered congenial to economic growth. He believed in political liberalism and the philosophy of laissez-faire. He wanted that government should perform only those functions which individuals cannot. In his view the forces of competition were powerful enough to establish an optimum equilibrium in a society.

Division of labour symbolizes the core of Smith’s theory of development. It in turn depends on the ‘size of the subsistence fund with which to maintain labour, i.e., on the amount of savings’. As such, division of labour has got to be preceded by capital accumulation. Further, ‘capitals are increased by parsimony and diminished by prodigality and misconduct’. Division of labour is also dependent on the extent of market. So Smith favoured a widening of market through greater freedom of exchange.

Now, given adequate size of market, and sufficient amount of capital accumulation, division of labour would make its sway in pushing up the level of productivity. As such, with increased incomes, greater saving would be forthcoming. This goes to improve further the degree of specialization. The development proceeds ahead and becomes cumulative. Thus, in his theory, the economy grows like a tree in a steady and continuous way. It is this approach which forms the crux of Smith’s theory of development.

It is against this background that we have to estimate the relevance of Adam Smith’s theory to the socio-economic environment of presently developing countries. This theory has only limited relevance to the developing countries because of the following reasons. The size of market in these countries is quite small so that the effective demand for goods is low. Consequently, the inducement to invest is low. The size of market in turn depends on the level of income. Thus, the volume of production could be increased only if people’s incomes increased.

Again this can be possible only if productivity is increased. But productivity depends to a large extent on the degree to which capital is employed in the productive process. However, in the developing economies, small size of the market keeps productivity and hence income at a low level. This results in a small capacity to save and invest. This in turn reinforces the forces keeping the extent of market small.

Besides, the policy implications of Smith’s theory are quite inapplicable to the developing economies. His policy recommendations of laissez-faire, free trade and harmony of interests are unsuitable in the context of the development of developing economies. As it is, the market economy of developing economies has been distorted due to the emergence of various kinds of monopolistic elements. The monopolists inhibit technological progress on account of the fear that innovations might result into a devaluation of their investments in capital in their existing business.

In a free market competitive economy where prices perform parametric functions, the entrepreneurs have to submit themselves to the losses resulting from innovations, because there is no way out to counteract these innovations. But when monopoly in any of its forms exists, the prices lose their parametric functions and the possibilities of free entry of new firms into the industry becomes less effective, so that the tendency to resist the devaluation of the capital invested becomes stronger and stronger. This becomes a drag on technological progress.

The monopolists assume market powers to fix higher prices and obtain larger profits as compared to competitors. This not only accentuates economic inequality but also distorts the consumers’ preferences through sales promotion techniques. It is on these grounds that the governments of the developing economies have opted to intervene and exercise control on such undesirable forms of business activities. Besides, factors such as the loss of flexibility of wage rates, the unpredictable instability of demand and growth of mass production have all added to the impracticability of Smithian advice of laissez-faire. Even if competition was sought to be restored, there is no surety that efficiency in production would necessarily be increased. This is because of following reasons–

First, competitive prices generally fail to include social costs. As such, the possibility of a divergence between marginal social net product and marginal net private product in a competitive economy cannot be ruled out. The magnitude of this divergence might be so great that it becomes the responsibility of the government to intervene to make the desired adjustments.

Second, competition may also fail to achieve maximum social welfare. Demand price does not reflect relative urgency of demands or wants of different persons in an environment of inequality. As such, an allocation of resources sought to be determined by demand price that is offered for consumer goods may in fact give rise to distortions in the economy. In view of these arguments, we find that government intervention is desirable, be it monopoly or competition.

Apart from the above explained reasons, there are certain special grounds for the developing countries to necessitate greater intervention in the economic affairs by the government. It is only through rigorous and systematic planning and judicious government intervention that these economies can be lifted up from the depths of stagnation.

The developing countries are confronted with the colossal problems of:

(a) Acute inadequacy of capital resources in relation to their requirements,

(b) Open and disguised unemployment of a vast chunk of population and

(c) Low per capita productivity of the working force.

These stupendous problems cannot be surmounted unless the government steps in a big way to take positive steps to transform the traditional economies into the industrial ones.

Further, due to the ill-bred structure of the industry in the developing countries, the capacity to produce capital goods falls short of the availability of savings. What it really means is that even when the economy’s belt is tightened so as to extract larger savings, capital formation cannot be correspondingly increased to the same extent. This is because there is immobility of resources, plants and equipment are primitive and obsolete and there is huge capital wastage involved due to rapid depreciation. It is only the government which can undertake huge investments in plants and equipment and ensure mobility of resources for increasing capital formation through increased savings.

Besides, there is the need for building infrastructures and social overheads like roads, transport, communications, river valley projects, power, schools, hospitals and things like that. They involve huge investments with long gestation periods. The returns are uncertain and long delayed. As such, no private entrepreneur would come forward to undertake investments in these. Government must step in to provide these basic facilities. Furthermore, the developing countries are greatly ill-placed on account of their being consumption-oriented.

Due to the widespread poverty, the marginal propensity to consume of people is very high and thus the savings are very low. However, in case of a developing economy, the consumption would increase not only due to an increase in income but also due to the rise in the propensity to consume because the working of demonstration effect, both domestic and international. As such, it becomes incumbent for the government to take special measures to mobilise savings to step up capital formation.

The upshot of the discussion is that the government must play a positive role in accelerating the process of economic development in developing economies. It is, of course, very much true that the government machinery in developing countries is not that competent to bring about the desired rate of growth. But this should in no way be taken to mean that the government intervention has to be limited or eliminated. What is actually required is that the efficiency of the government be increased so that it can play its desired role to achieve the warranted rate of growth.

Nevertheless, some of the crucial variables of Smith’s model are as valid in the developing countries as they were for the economies that formed the basis of his theory of development. Capital accumulation and technology (i.e. division of labour) that played the strategic role in his model, are even today recognised as the key variables in the process of economic progress of the developing countries.

Further, for economies which are just on the threshold of take-off, Smith’s prescriptions in terms of division of labour, extension of the market, rational distribution of national income, anti- usury and anti-monopoly laws, furtherance of the interests of agriculturists, industrialists and those engaged in commerce by a proactive, promotional and developmental role of government, provide a comprehensive theory of economic development.

But it should always be kept in mind that this was a theory mainly formulated in the context of England with a view to tackle the problems involved in the process of transition from a pre-industrial to an industrial state. We should, therefore, not hope to get proper and direct solution to all the problems of development which are posed by the development and industrialisation of developing countries owing to the tremendous difference in the circumstances in the two cases.