The Wealth of Nations. The Theory of Moral Sentiments

Trade is the central component to a thriving economy. It is humans’ propensity to trade that gives rise to the division of labor and it is open trade between nations that makes them wealthy. Smith elaborates that the division of labor flows naturally from this propensity of humans to trade with each other to meet their needs, and consequently, over time, cultivate different skills, talents, and abilities.

In establishing the origins of specialization, Smith addresses the psychological roots of his theory, allowing its roots to be understood before progressing to more mundane economic arguments.

The size, or extent, of the market determines the benefit individuals receive from their mutual exchange, and consequently determines how specialized they can become in their tasks. Smith explains that certain trades must be conducted in an area of highly-concentrated population, while others can be conducted in a small town. He provides the example of a village carpenter, who must perform a variety of tasks, while a carpenter in a city may specialize in one component of the trade, such as cabinetry or house-framing. Smith extrapolates from this reasoning that access to navigable waters is essential to securing a large market. Smith explains that limitations in access to navigable waters are responsible for different rates of economic growth seen in different countries throughout the world:

As by means of water-carriage, a more extensive market is opened to every sort of industry than what land-carriage alone can afford it, so it is upon the sea-coast, and along the banks of navigable rivers, that industry of every kind naturally begins to subdivide and improve itself, and it is frequently not till a long time after that those improvements extend themselves to the inland parts of the country (9). 

Smith explains that the genius and principle value of money is to ensure people can obtain and retain maximum value for their labor:

When the division of labour has been once thoroughly established, it is but a very small part of a man’s wants which the produce of his own labour can supply. He supplies the far greater part of them by exchanging that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men’s labour as he has occasion for. Every man thus lives by exchanging, or becomes, in some measure, a merchant, and the society itself grows to be what is properly a commercial society (10).

He continues, “If, on the contrary, instead of sheep or oxen, he had metals to give in exchange for it, he could easily proportion the quantity of the metal to the precise quantity of the commodity which he had immediate occasion for” (11). Thus, money saves individuals the trouble of locating persons with the precise inverse of their needs and enables them to trade with and accumulate some other medium (currency) to then trade with a third, fourth, or fifth party.

Smith progresses to define “value” in two ways. Value determines the rate at which different products are exchanged. He defines value in use as the usefulness of a commodity and value in exchange as the power of purchasing other goods that the possession of an object conveys. For example, water has a high use value, but little exchange value, while gold has low use value, but high exchange value. This difference between use and exchange value is now taught in economics courses as the concept of marginal utility. The subjective value placed on having excess gold is high, while the subjective value of having excess water is low for all but those dying of thirst.

Smith begins by stating that a person’s wealth is determined by their ability to purchase “the necessaries, conveniences, and amusements of human life,” but that in a modern society, a person can only supply a small portion of the necessaries, conveniences, and amusements through their own labor (12). Consequently, Smith explains that people must trade with others to obtain what they want and need. This is commonly practiced through the exchange of money with various merchants for goods. Smith concludes that labor is the true measure of value, and that other measures, such as money, are merely estimates useful for conducting business. While labor may be described as cheap or expensive at different times, the value of labor remains constant. It is wages that are high or low, not the value of labor itself. Therefore, the real price of a commodity is the amount of labor it can purchase. This contrasts with the money price, which is how most interpret value. Smith explains that while the money price is useful in commerce, it is not accurate because gold and silver prices are in constant fluctuation. Because the value of labor is constant, it is a truer measure of value.

Smith will spend much time later criticizing the tendency to conflate money and wealth. Such criticism is central to his critique of the mercantile system and British colonies, and his analysis that colonies are a losing venture. Smith affords the money price of goods only a limited role in providing convenience of commerce. He cautions the wisdom of allowing money a more central role in determining both individual and national wealth. Because The Wealth of Nations is primarily a critique of the mercantile system, Smith’s critique of ascribing money value to commodities, instead of labor value, is central to the book.

Smith asserts that the price of every commodity is composed of three parts: labor, profit, and rent. He explains that in a primitive society, labour comprises the whole price because in such a society, no stock exists and land is free. However, when people acquire capital stock and begin to employ others, the price must be shared. In such a society, the laborers receive wages and the rest of the price goes to the employer as profit. Such profit does not reflect the work of the employer, but rather the value of the capital employed in production. When societies allow for the private ownership of land, a third group shares in the price of commodities- landlords. When privately-owned lands are used to produce value, landlords demand a rent for such use, which must be reflected in the commodity’s price.

Smith explains that the labor-component part of price determines the value of each of the other components of price (rent and profits of stock), because the other components are “measured by the quantity of labour which they can, each of them, purchase or command” (18). Therefore, the three components (labor, rent, and profits of stock) determine price, and labor determines the value of rent and profits of stock, so the value of labor ultimately determines the price of commodities. However, it is not always possible to separate the three components of price. For example, a farmer may supply the land, capital, and labor required to harvest crops. In such a situation, the three components of price are mixed.

While the distinction between the three components of price may seem artificial, they are in fact of real and profound consequence. Smith revisits the components throughout his work to illustrate the effects of policies that increase the profits of merchants at the expense of the wages of labor, or those which increase landlords’ rent at the expense of the profits of manufacturers. Smith illustrates that while these policies propose to grow the nation’s economy, their real effect is to reallocate wealth from one group to another. Further, these components of price represent the backbone of modern business finance. Every business, when calculating profit margins, forecasting financial projections, and determining price, utilizes a variation of these three components. A simple example is the restaurant industry, in which price is broadly composed of 30% wages, 30% product cost, 30% fixed cost, and 10% profit. In this model, capital stock is mixed between product cost (e.g., chicken, vegetables) and fixed cost (e.g., a grill), which also includes rent of land. It is imprecise and developed from Smith’s initial theory, but its root in Smith’s three components of price is clear.

Smith distinguishes between a commodity’s natural price, which is the price “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, according to their natural rates” and a commodity’s market price (20). The market price of a commodity is the actual price at which the commodity is sold. A commodity’s market price “may either be above, or below, or exactly the same with its natural price” (20). Smith elaborates that the market price of any commodity is regulated by the amount of the commodity in the marketplace and the demand for the commodity at its natural price. This concept is commonly known as supply and demand.

Smith goes on to explain concept of supply and demand in more detail: when the quantity of a commodity in a market is less than the demand for it, it will incite competition in the marketplace and raise the price above its natural value (which is comprised of the cost of labor, rent, and profits of stock). When the quantity of a commodity in a market exceeds the demand for it, it cannot be sold for the price of its natural value, but rather must be sold for less, in order to prevent forfeiting the exchange entirely.

In his explanation, Smith explains the idea of effectual demand—that is, the need for a commodity by the demographic or group that can truly afford to buy it. Smith also references trade secrets and monopolies as two factors that can artificially elevate prices. Smith asserts that by restricting the manufacture of goods, monopolists create an artificial shortage, ensuring there is not enough supply to meet effectual demand, and consequently increasing market prices.

Smith’s analysis of supply and demand, along with both market prices and arguments against monopolies, constitutes his first argument in favor of free trade. Smith asserts that a free market is self-regulating in that prices continually trend towards the cost of production under competition and producers continuously attempt to supply the amount of their product that matches demand. Intervention in free markets, by governments, lobbying, or through monopolies, artificially alters prices. Smith contends that such actions favor specific individuals but harm more individuals than they favor, as well as the economy of the nation as a whole.

Wages are the most basic component of commodity prices. Employers set wages, employers strive to pay the lowest possible wage, and employers have more bargaining power than their laborers. However, Smith observes that “there is […] a certain rate, below which it seems impossible to reduce, for any considerable time, the ordinary wages even of the lowest species of labour” (24).

Modern economists refer to this lowest rate as a substinence wage: the amount required for workers to supply themselves and their families with the bare essentials of life. Smith also reasons that wages rise with economic growth, that the demand for labor increases with the stock and wealth of a nation, and that without an increase of stock and wealth in a nation, there cannot be an increased demand for labor.

He explains further that it is not the amount of national wealth that allows for wage increase, but rather the rate of its increase. Therefore, it is not the richest countries that experience the best wage growth, but rather the most rapidly-developing countries: “Though the wealth of a country should be very great, yet if it has been long stationary, we must not expect to find the wages of labour very high in it” (25). When demand for labor is rising, workers have the negotiating advantage over employers. Conversely, when a country is experiencing economic decline, wages decline as well.

Smith concludes by observing that high wages are good for a nation. Because most citizens are laborers, high wages increase the standard of living for much of the population. Smith notes several other positive effects of high wages: high wages allow people to marry and reproduce, which increases the labor pool and furthers the division of labor, which in turn leads to technological innovation and cheaper, more plentiful goods. Inexpensive goods increase purchasing power, which further increases the value of wages. By this reasoning, Smith concludes that high wages benefit all members of society. 

Profits of stock are more variable and difficult to measure than wages of labor. Smith explains:

Profit is so very fluctuating, that the person who carries on a particular trade, cannot always tell you himself what is the average of his annual profit. It is affected, not only by every variation of price in the commodities which he deals in, but by the good or bad fortune both of his rivals and of his customers, and by a thousand other accidents, to which goods, when carried either by sea or by land, or even when stored in a warehouse, are liable. It varies, therefore, not only from year to year, but from day to day, and almost from hour to hour (30).

Smith reasons, however, that interest rates provide an approximate measure of profitability: “It may be laid down as a maxim, that wherever a great deal can be made by the use of money, a great deal will commonly be given for the use of it; and that, wherever little can be made by it, less will commonly be given for it” (31).

Therefore, ordinary profits of stock can be tracked alongside interest rates. Smith then makes observations concerning interest and profit: profits and interest are high in new economies because such situations create a greater demand for capital; legal defects, such as poor enforcement of contracts, can artificially raise interest rates by influencing cautious behavior. Smith concludes by noting that “high profits tend much more to raise the price of work than high wages,” because profits have an exponential effect on price as a commodity is repeatedly exchanged. (33). While the profits of stock are difficult to measure, their effect on the price of goods is profound.

Smith reasons that the wages and profits from stock in any locality should tend towards equality. If they did not, laborers and employers would flood the sector with the greatest financial return, and wages would consequently decrease. The varying financial returns of different industries can be explained by the non-pecuniary costs and benefits of those industries. In short, non-financial as well as financial returns must be considered.

Smith reasons that five factors account for pecuniary variation among different industries:

·       unpleasurable and pleasurable aspects of certain employments affects wages;

·       the skill required, and time spent learning such skill, for various employments affects wages;

·       the consistent or inconsistent nature (seasonal, etc.) of certain industries affects wages;

·       the trust required in the profession affects wages;

·       the probability of success in a given field affects wages.

The first factor simply states that financial return varies with the difficulty or easiness of the job. The second factor explains that the time, effort, and money spent qualifying oneself for a particular profession must be returned in increased wages or profits. The third factor accounts for seasonal demand of trades. The fourth factor asserts that a premium is paid where trust of expertise is part of the exchange. The fifth factor relates earnings to the probability of success in a given field, rewarding those who succeed where most do not with high wages.

Smith reasons that variation in wages is primarily due to differing levels of risk or uncertainty. Each of the factors to which he attributes wage and profit variation account for some level of risk, experienced in different ways. It is the risk after paying for schooling and spending years studying law, only to then not pass the bar exam, that permits attorneys to charge a premium. It is the trust one puts in their surgeon and the risk involved in hiring an unqualified surgeon that permits the surgeon to earn a high salary. It is the risk to one’s own body that permits other professions to earn a high wage. It is the risk of losing one’s entire investment that permits someone investing in an uncertain venture to demand a high rate of return. Without risk and uncertainty, Smith reasons, all industries would permit the same financial return.

Smith also notes wage inequality as the result of burdensome and nonsensical laws and regulations. Smith argues that these laws, which restrict specific trades by requiring licenses and apprenticeships, restrict the movement of people between trades and hinder the economy. Smith believes the only effective regulation on a business to be its fear of losing customers—that is, the market. He reasons that a competitive market governed by consumer choice is the best regulation of business.