Adam Smith and Modern Economic Thought

This is Adam Smith. Adam Smith was a Scottish philosopher and author who is probably best known for writing a book titled An Inquiry into the Nature and Causes of the Wealth of Nations. This book effectively marked the beginnings of economics as a separate academic discipline, as Adam Smith, now heralded as the father of economics, laid the foundation for economic rules and principles that guide the decision-making of nations. the world over today. It is likely you may have heard the name Adam Smith, but the impacts that this man and his writing has had on the modern world are truly hard to grasp. Before Adam Smith and his teaching rose to popularity, the world was dictated by an economic theory known as Mecantilism. Now, we have discussed Mecantilism before when we looked at the Dutch East India Company. But a big takeaway was that Adam Smith hated this theory, and this was probably a good time to shake things up a bit. You see, Adam Smith published The Wealth of Nations in 1776, just a few short years before the French Revolution, and during the height of the American Revolutionary War. The world had become obsessed with what good government went. The policies of the past were no longer working in the time of modern industry, and people were out to shake things up. But Adam Smith was not too concerned with what good government meant, but rather what wealth meant. He was effectively arguing that mercantilism, the theory that had dictated the decisions of nations for centuries, was as outdated as a monarchy. Mechanicalism was basically the idea that the world was a zero-sum game. If someone was getting richer, it meant someone somewhere else was getting poorer. If a nation increased its wealth, it's because it took that wealth directly or indirectly from another nation. The only thing that was actually seen as industry that produced growth was farming. And that's because it literally produced growth. Like right there, out in the paddocks. All of this was kind of easy to understand. especially in a world that was only just starting to embrace modern manufacturing. In feudal times, the ideologies of mechanicalism basically held true. Sure, there were blacksmiths and masons that would build basic tools and construct buildings, but that was extremely basic and lacked much in the way of value adding. Value adding is where you take component parts, say iron ore and coal and the skill hands of a blacksmith and turn it into something like a scythe or a sword or a piece of armor. This end product is more valuable than the sum of all of these individual parts, and therefore this whole process was said to have added value. And in economics, this process has a name. It's called production. Now production was so limited in feudal societies that it didn't really register in the overall wealth of the nation. So again, this theory of mechantalism held true. where a nation was only really as good as the grains it could grow and the gold it could hoard. Adam Smith realized there was more though. The advent of steam power and the popularization of industrial processes that was taking place during the inception of the industrial revolution in the United Kingdom made a lot of very smart people rethink how they saw wealth. Over the course of a After a decade of speculation, research and collaboration, Adam Smith and his contemporaries came to the conclusion that manufacturing was kind of the same as farming, in the sense that it grew things of value. In the same way that you contribute seeds, manure, labour and farmland to a crop of wheat, you can throw cotton, labour and a textile mill to grow fabrics. It's just that this process was entirely controlled by man. This was a revolutionary idea and it basically meant that nations were no longer limited with their lot in life. If they wanted to grow wealthier, they didn't need to invade their neighbours, they could just work on their own industry, improve on technologies, and educate their population. This understanding was potentially just as liberating for modernising nations at the time as the steam engines were. And this all also meant that people were incentivised to move from the farms and into the cities. Regular channel viewers would have heard me talk about the factors of production. That is land, labour and capital. Adam Smith in the wealth of nations was the person credited with recognising these factors. Alterations have been made over time to also include entrepreneurship, but what was true back then is just as true today. If you want to produce something you need these factors of production. Land and labour are easy to understand. You need space to harvest and assemble and store things and you also need people to toil the fields or hammer on the anvils or write code or whatever. This part of the equation actually wasn't anything new. People had known for generations that the key to a wealthy nation was having lots and lots of land and lots and lots of people to toil on that land. That's why wars were fought over good farmlands and nobility from across the globe tried to maintain a healthy population of peasants to reap the rewards of these lands. It's unknown if anybody actually wrote this down, but it was kind of something that was so obvious that it wasn't going to make anybody famous for pointing it out. In the same way that I wouldn't become a published academic by suggesting that Game of Thrones season 8 should not have happened. I mean, it's just so obvious that it doesn't count as cutting-edge research. Adam Smith's contribution, though, was this whole theory of capital, and what he decided capital was. Capital in finance normally just means cash, but capital in economics means basically anything that can contribute value, that isn't land or labor. Cash is capital, sure. but so is a pickaxe or a steam engine, a pair of work boots, or even a patent on some revolutionary social media algorithm. Any material or immaterial thing that assists with the production of goods is said to be capital. And this was a crazy, crazy idea for the time. And what made it even crazier was the way that Adam Smith laid out the logical progression of how people can create value. The wealth of nations basically said that there were key steps that a nation would take to grow its wealth. At first it would be an agrarian nation, pretty much because it's the easiest thing to do. Farming can be as simple as plowing some dirt and planting some seeds, and of course this is a massive oversimplification. But basically if a nation had spare arable land it just made sense to set up farmland there because farms literally grow wealth from the dirt. and require very very little capital investment. In this step nations might also make small scale efforts to extract precious metals like gold from basic mines as an easy way to supplement the wealth of their farmland. It was theorized by Adam Smith that this was the reason that the Americas had lagged behind European nations in developing modern industry. It's because they didn't really need to. Why on earth would a wealthy American in this time invest money into building a factory when they could instead just go and buy some land, or better yet just claim some land and turn it into a plantation. The upfront costs are way lower, and if it all goes terribly wrong, well at least you can still sell the land to someone else. This kind of reasoning was what formed the first step of Smith's progressions of the nation. But then, eventually a nation would hit a problem. Eventually it would run out of low hanging fruit of easy arable farmland and have to do something else to continue to grow. Historically, countries answered this problem by invading their neighbours or subjugating some poor colony on the other side of the world, and then using their farmland to continue the accumulation of wealth this way. But ultimately, this was limited, and what was potentially a better idea was to actually use that land you already had more efficiently by developing industry. You see, a factory that produces... Oh I don't know, let's say textiles take up much much less land than a farm but are able to produce the same amount of profit. But they take much much more of an investment. So they are not going to be the first choice of a nation to produce until they have absolutely exhausted the wealth they can harvest from their soil. Once a nation does start building these factories though they will get very very wealthy. Because you can pack a lot more wealth generation into a smaller space. To see this in action take the economies of China and the United Kingdom during the 1700s. China was a vast, lush and plentiful nation with a large population and extremely arable land. It had absolutely no incentive whatsoever to build factories at this point in time because it could easily support its population with the farmland it had available. If someone wanted to get richer, They would just work more farmland. England on the other hand was a tiny desolate rock that had farmland sure, but it was pretty lackluster in comparison, and almost every square mile of the nation that was usable had been used. So factories were the next logical step on getting wealthier. It's not necessarily that a nation like China wasn't able to embrace this technology, it's more that they had no real incentive to do so. To most people that hear this theory for the first time it seems pretty silly. In the 21st century we see nations that transition from agriculture to industry becoming very very wealthy in a short space of time. So it almost seems like this theory is wrong, but it isn't. Nations and individuals will naturally take the path of least resistance, which means Adam Smith's theory holds true even until this day. Nations start off farming because it is easy. Once they exhaust the potential of that they move on to industry and once they are finished with that they then begin to move on to a service based economy. This whole path of least resistance thing has also had a lot to do with the other major take away from Adam Smith's work. The wealth of nations highlighted above all else. Trade as a key driver that will increase wealth in any market and on any level. Adam Smith used the example of a worker in a pin factory and postulated that if a worker woke up one day and committed his entire working day to producing a pin from scratch, it is extremely unlikely that he would even be able to produce one pin. He would have to dig up the ore and fire the furnace, refine the metal and then machine it into a pin. And this would take a long, long time. It would also take a lot of expertise. What Adam Smith suggested instead was that one worker specialise in digging up the ore, another specialise in refining it, another specialise in machining it, and then even beyond that another worker specialising in going out and actually selling these pins. To you and I, this sounds like the most obvious thing ever, but it was a pretty new idea for the ages. On a local level people tended to be a jack of all trades. Peasants could toil fields but also build homes and do minor repairs as needed and the idea that someone would focus their entire work towards one specific task was pretty scary to a lot of people. But it worked. As industrial centers grew, so too did specialized roles. Now with specialized roles came the need to trade. If I worked in a newly created factory as a loom oiler or whatever, well I can't eat well-oiled looming machines. So I need to make money from my job as a loom oiler and then use that money to buy everything else that I need, as opposed to just doing it all myself. Now, because everybody else will be specialized in other roles, they will also need to trade their expertise to facilitate all their needs in life. And that is okay because people are becoming so specialized that they will get really, really good at what they are doing, meaning that we will have more stuff. overall. The act of trading also has its inherent benefits. You see people need certain things. You need food and water and shelter and clothing and if a whole lot of people are getting really good at building homes let's say but nobody is making clothes well then the supply of clothing will be lower than the demand for clothing and the price will rise. Savvy and logical participants in the economy will see this. and decide that it is a good idea to specialize in making clothes because it is a very profitable industry. And as more people move into that industry and produce more clothes, the price will fall back into line once again. Now the same is true on a larger level, between nations. Smith said that certain nations are inherently better at producing certain goods, and rather than nations trying to make everything themselves, they should instead specialize and trade with each other. This took a little bit longer to catch on though, because well, nations were still obsessed with the zero-sum ideology of mechanicalism, where every trade had a winner and a loser. And realistically, it took a while for nations to realize that hey, actually, trades that are a win-win do exist. This also sounds pretty logical to us today. This whole idea was really highlighted by Adam Smith and was dubbed the guiding hand of the free market. Smith loved this idea so much that he theorized that the best way to improve wealth was just to accommodate this market. Savvy individuals will logically do what is going to be most profitable for them. And the aggregate result of very profitable individuals is a very wealthy nation. To Smith, the role of government was only to make sure that markets were maintained. You know, by... Jailing scammers and enforcing contracts and making sure people were safe to actually conduct this business. But otherwise, they should stay out of it. Which again, was a very big deal. Feudal monarchies were basically command economies. People got what they were given and most people lived to produce grains for the state and were housed and protected by their representative lords. Suddenly, everybody having the ability to pick and choose what they wanted was starting to look a lot like some of the political movements at the time. At the same time the American Constitution was being penned outlining how men had the right to pick and choose their leaders, Adam Smith was outlining how men had the right to pick and choose their own products. Capitalism was democracy with dollars. Popular items got voted for with money and unpopular products faded into obscurity. So as hard as Smith tried to avoid getting political, he may have helped lay the foundation for the democratic movement that was taking over the modern world at this time. Smith's ideas sound so logical to us today because we live in a wealthy society that was afforded to us by these policies. We don't think twice about using a phone imported from overseas that was made of hundreds of components produced by thousands of people from dozens of countries, because we know this is the cheapest and most effective way to produce these kinds of products, thanks to Smith. That was not to say that Smith's ideas were perfect. Oh no, Smith basically invented economics, but he also put a lot of faith in people. You see the guiding hand of the free market and perfectly logical trades and rational participants, they are all nice theories, but Sharknado 5, the global swarming, would not exist in Adam Smith's reality. From this, a new brand of economics was created that accounted for people being dumb. So, in the next video in this series, we will be looking at behavioral economics and how it addresses and explains the shortcomings of us silly, silly people.

Before Adam Smith and his teaching rose to popularity, the world was dictated by an economic theory known as Mecantilism. Now, we have discussed Mecantilism before when we looked at the Dutch East India Company. But a big takeaway was that Adam Smith hated this theory, and this was probably a good time to shake things up a bit.

You see, Adam Smith published The Wealth of Nations in 1776, just a few short years before the French Revolution, and during the height of the American Revolutionary War. The world had become obsessed with what good government went. The policies of the past were no longer working in the time of modern industry, and people were out to shake things up.

But Adam Smith was not too concerned with what good government meant, but rather what wealth meant. He was effectively arguing that mercantilism, the theory that had dictated the decisions of nations for centuries, was as outdated as a monarchy. Mechanicalism was basically the idea that the world was a zero-sum game. If someone was getting richer, it meant someone somewhere else was getting poorer. If a nation increased its wealth, it's because it took that wealth directly or indirectly from another nation.

The only thing that was actually seen as industry that produced growth was farming. And that's because it literally produced growth. Like right there, out in the paddocks.

All of this was kind of easy to understand. especially in a world that was only just starting to embrace modern manufacturing. In feudal times, the ideologies of mechanicalism basically held true.

Sure, there were blacksmiths and masons that would build basic tools and construct buildings, but that was extremely basic and lacked much in the way of value adding. Value adding is where you take component parts, say iron ore and coal and the skill hands of a blacksmith and turn it into something like a scythe or a sword or a piece of armor. This end product is more valuable than the sum of all of these individual parts, and therefore this whole process was said to have added value.

And in economics, this process has a name. It's called production. Now production was so limited in feudal societies that it didn't really register in the overall wealth of the nation.

So again, this theory of mechantalism held true. where a nation was only really as good as the grains it could grow and the gold it could hoard. Adam Smith realized there was more though. The advent of steam power and the popularization of industrial processes that was taking place during the inception of the industrial revolution in the United Kingdom made a lot of very smart people rethink how they saw wealth. Over the course of a After a decade of speculation, research and collaboration, Adam Smith and his contemporaries came to the conclusion that manufacturing was kind of the same as farming, in the sense that it grew things of value.

In the same way that you contribute seeds, manure, labour and farmland to a crop of wheat, you can throw cotton, labour and a textile mill to grow fabrics. It's just that this process was entirely controlled by man. This was a revolutionary idea and it basically meant that nations were no longer limited with their lot in life.

If they wanted to grow wealthier, they didn't need to invade their neighbours, they could just work on their own industry, improve on technologies, and educate their population. This understanding was potentially just as liberating for modernising nations at the time as the steam engines were. And this all also meant that people were incentivised to move from the farms and into the cities.

Regular channel viewers would have heard me talk about the factors of production. That is land, labour and capital. Adam Smith in the wealth of nations was the person credited with recognising these factors. Alterations have been made over time to also include entrepreneurship, but what was true back then is just as true today.

If you want to produce something you need these factors of production. Land and labour are easy to understand. You need space to harvest and assemble and store things and you also need people to toil the fields or hammer on the anvils or write code or whatever. This part of the equation actually wasn't anything new. People had known for generations that the key to a wealthy nation was having lots and lots of land and lots and lots of people to toil on that land.

That's why wars were fought over good farmlands and nobility from across the globe tried to maintain a healthy population of peasants to reap the rewards of these lands. It's unknown if anybody actually wrote this down, but it was kind of something that was so obvious that it wasn't going to make anybody famous for pointing it out. In the same way that I wouldn't become a published academic by suggesting that Game of Thrones season 8 should not have happened.

I mean, it's just so obvious that it doesn't count as cutting-edge research. Adam Smith's contribution, though, was this whole theory of capital, and what he decided capital was. Capital in finance normally just means cash, but capital in economics means basically anything that can contribute value, that isn't land or labor.

Cash is capital, sure. but so is a pickaxe or a steam engine, a pair of work boots, or even a patent on some revolutionary social media algorithm. Any material or immaterial thing that assists with the production of goods is said to be capital. And this was a crazy, crazy idea for the time.

And what made it even crazier was the way that Adam Smith laid out the logical progression of how people can create value. The wealth of nations basically said that there were key steps that a nation would take to grow its wealth. At first it would be an agrarian nation, pretty much because it's the easiest thing to do. Farming can be as simple as plowing some dirt and planting some seeds, and of course this is a massive oversimplification.

But basically if a nation had spare arable land it just made sense to set up farmland there because farms literally grow wealth from the dirt. and require very very little capital investment. In this step nations might also make small scale efforts to extract precious metals like gold from basic mines as an easy way to supplement the wealth of their farmland.

It was theorized by Adam Smith that this was the reason that the Americas had lagged behind European nations in developing modern industry. It's because they didn't really need to. Why on earth would a wealthy American in this time invest money into building a factory when they could instead just go and buy some land, or better yet just claim some land and turn it into a plantation.

The upfront costs are way lower, and if it all goes terribly wrong, well at least you can still sell the land to someone else. This kind of reasoning was what formed the first step of Smith's progressions of the nation. But then, eventually a nation would hit a problem. Eventually it would run out of low hanging fruit of easy arable farmland and have to do something else to continue to grow. Historically, countries answered this problem by invading their neighbours or subjugating some poor colony on the other side of the world, and then using their farmland to continue the accumulation of wealth this way.

But ultimately, this was limited, and what was potentially a better idea was to actually use that land you already had more efficiently by developing industry. You see, a factory that produces... Oh I don't know, let's say textiles take up much much less land than a farm but are able to produce the same amount of profit. But they take much much more of an investment.

So they are not going to be the first choice of a nation to produce until they have absolutely exhausted the wealth they can harvest from their soil. Once a nation does start building these factories though they will get very very wealthy. Because you can pack a lot more wealth generation into a smaller space.

To see this in action take the economies of China and the United Kingdom during the 1700s. China was a vast, lush and plentiful nation with a large population and extremely arable land. It had absolutely no incentive whatsoever to build factories at this point in time because it could easily support its population with the farmland it had available. If someone wanted to get richer, They would just work more farmland.

England on the other hand was a tiny desolate rock that had farmland sure, but it was pretty lackluster in comparison, and almost every square mile of the nation that was usable had been used. So factories were the next logical step on getting wealthier. It's not necessarily that a nation like China wasn't able to embrace this technology, it's more that they had no real incentive to do so. To most people that hear this theory for the first time it seems pretty silly. In the 21st century we see nations that transition from agriculture to industry becoming very very wealthy in a short space of time.

So it almost seems like this theory is wrong, but it isn't. Nations and individuals will naturally take the path of least resistance, which means Adam Smith's theory holds true even until this day. Nations start off farming because it is easy. Once they exhaust the potential of that they move on to industry and once they are finished with that they then begin to move on to a service based economy.

This whole path of least resistance thing has also had a lot to do with the other major take away from Adam Smith's work. The wealth of nations highlighted above all else. Trade as a key driver that will increase wealth in any market and on any level. Adam Smith used the example of a worker in a pin factory and postulated that if a worker woke up one day and committed his entire working day to producing a pin from scratch, it is extremely unlikely that he would even be able to produce one pin. He would have to dig up the ore and fire the furnace, refine the metal and then machine it into a pin.

And this would take a long, long time. It would also take a lot of expertise. What Adam Smith suggested instead was that one worker specialise in digging up the ore, another specialise in refining it, another specialise in machining it, and then even beyond that another worker specialising in going out and actually selling these pins. To you and I, this sounds like the most obvious thing ever, but it was a pretty new idea for the ages.

On a local level people tended to be a jack of all trades. Peasants could toil fields but also build homes and do minor repairs as needed and the idea that someone would focus their entire work towards one specific task was pretty scary to a lot of people. But it worked. As industrial centers grew, so too did specialized roles.

Now with specialized roles came the need to trade. If I worked in a newly created factory as a loom oiler or whatever, well I can't eat well-oiled looming machines. So I need to make money from my job as a loom oiler and then use that money to buy everything else that I need, as opposed to just doing it all myself. Now, because everybody else will be specialized in other roles, they will also need to trade their expertise to facilitate all their needs in life. And that is okay because people are becoming so specialized that they will get really, really good at what they are doing, meaning that we will have more stuff.

overall. The act of trading also has its inherent benefits. You see people need certain things.

You need food and water and shelter and clothing and if a whole lot of people are getting really good at building homes let's say but nobody is making clothes well then the supply of clothing will be lower than the demand for clothing and the price will rise. Savvy and logical participants in the economy will see this. and decide that it is a good idea to specialize in making clothes because it is a very profitable industry. And as more people move into that industry and produce more clothes, the price will fall back into line once again.

Now the same is true on a larger level, between nations. Smith said that certain nations are inherently better at producing certain goods, and rather than nations trying to make everything themselves, they should instead specialize and trade with each other. This took a little bit longer to catch on though, because well, nations were still obsessed with the zero-sum ideology of mechanicalism, where every trade had a winner and a loser.

And realistically, it took a while for nations to realize that hey, actually, trades that are a win-win do exist. This also sounds pretty logical to us today. This whole idea was really highlighted by Adam Smith and was dubbed the guiding hand of the free market. Smith loved this idea so much that he theorized that the best way to improve wealth was just to accommodate this market. Savvy individuals will logically do what is going to be most profitable for them.

And the aggregate result of very profitable individuals is a very wealthy nation. To Smith, the role of government was only to make sure that markets were maintained. You know, by...

Jailing scammers and enforcing contracts and making sure people were safe to actually conduct this business. But otherwise, they should stay out of it. Which again, was a very big deal.

Feudal monarchies were basically command economies. People got what they were given and most people lived to produce grains for the state and were housed and protected by their representative lords. Suddenly, everybody having the ability to pick and choose what they wanted was starting to look a lot like some of the political movements at the time.

At the same time the American Constitution was being penned outlining how men had the right to pick and choose their leaders, Adam Smith was outlining how men had the right to pick and choose their own products. Capitalism was democracy with dollars. Popular items got voted for with money and unpopular products faded into obscurity. So as hard as Smith tried to avoid getting political, he may have helped lay the foundation for the democratic movement that was taking over the modern world at this time. Smith's ideas sound so logical to us today because we live in a wealthy society that was afforded to us by these policies.

We don't think twice about using a phone imported from overseas that was made of hundreds of components produced by thousands of people from dozens of countries, because we know this is the cheapest and most effective way to produce these kinds of products, thanks to Smith. That was not to say that Smith's ideas were perfect. Oh no, Smith basically invented economics, but he also put a lot of faith in people.

You see the guiding hand of the free market and perfectly logical trades and rational participants, they are all nice theories, but Sharknado 5, the global swarming, would not exist in Adam Smith's reality. From this, a new brand of economics was created that accounted for people being dumb. So, in the next video in this series, we will be looking at behavioral economics and how it addresses and explains the shortcomings of us silly, silly people.

Transcript for:Adam Smith and Modern Economic Thought

Transcript for:
Adam Smith and Modern Economic Thought