The long-running Selected Papers series features notable work by University of Chicago faculty and other business leaders. This essay is an edited excerpt; the original was presented in 1976 at a meeting of the Mont Pelerin Society.
There is a game I sometimes play with children; I call it “Three Questions.” I promise a million dollars if all three questions are answered correctly; no doubt the Securities and Exchange Commission will eventually prohibit the game, or the Federal Reserve System will make it viable. The first two questions present no difficulty: perhaps the number of brothers and sisters the child has, and the city in which he or she lives. The third question is a different matter. Once I asked, “Who was Adam Smith’s best friend?” The reply from the child was, “You are, Uncle George.” I had someone such as David Hume or James Hutton or Joseph Black in mind, but I have long been a good friend of Smith. Still, I do not believe that my friendship distorts my ability to make a fair estimate of his triumphs and failures, and perhaps sufficient time has now passed—200 years since the appearance of The Wealth of Nations—to permit that estimate.
I’m not talking about the uninteresting task of praising or blaming Smith. The triumphs of any scholar are those of his doctrines that he persuades his contemporaries and successors to heed carefully. When David Ricardo or John Stuart Mill or Robert Torrens adopted a theory of Smith’s, it did not necessarily mean that they accepted it without qualifications, but that their work and thoughts were directed by the formulation of Smith. Smith’s failures were, correspondingly, those theories that his successors either ignored or rejected out of hand. It is the judgment of the science that is decisive in judging a scholar’s achievements.
The successes that deserved their success
A success or triumph is a proposition in economics that becomes a part of the working system (the so-called paradigm) of contemporary and subsequent economists. They accept and use the proposition, with heavy emphasis upon the word use, or they reject and dispute the proposition, with heavy emphasis upon dispute. In either event, their work is influenced by the successful proposition and, indeed, measures the success. So a success is ascribable to Smith if his formulation governs the later use of the theory, whether he invented it or not. Hence I shall not attempt to determine Smith’s debts to his predecessors; suffice to say they were large, but much smaller than our debts to him.
Smith had one overwhelmingly important triumph: he put into the center of economics the systematic analysis of the behavior of individuals pursuing their self-interest under conditions of competition. This theory was the crown jewel of The Wealth of Nations and it became, and remains to this day, the foundation of the theory of the allocation of resources. The proposition that resources seek their most profitable uses, so that in equilibrium the rates of return to a resource in various uses will be equal, is still the most important substantive proposition in all of economics.
I do not know whether to list as a second triumph one enormously successful application of this theory of competitive prices, namely Smith’s theory of the differentials in wage rates and profit among occupations. The famous list of cost factors that would generate apparent but not real differences in rates of wages and profits—training, hardships, unemployment, and trust—was accepted, and in fact usually quoted verbatim, by Smith’s successors for a century. So perhaps this special application of price theory deserves to be listed as his second success.
The third and final major success was his attack on mercantilism. I measure a success by the impact of a scholar on other scholars, not his impact upon public thinking or public policy. Smith’s attack on protectionism in all its basic forms—tariffs, subsidies, compulsory use of domestic shippers, limitations on colonial enterprise, and the like—rested squarely on his theory of competitive prices. The crucial argument for unfettered individual choice in public policy was the efficiency property of competition.
Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society.
This application of price theory was, again, a corollary of the main proposition, but its development was so extensive and its success so great that it clearly deserves to be called Smith’s third major triumph.
There is a fourth considerable success to be credited to Smith: the formulation of the wages-fund theory. This theory explained the short-term level of average wages by the ratio of funds for the payment of labor (the wages-fund) to the number of laborers employed. It was saved from being a tautology by the implicit condition that over moderate periods of time the wages-fund was approximately constant in size. Putting aside the question of whether it was a useful theory, there is no doubt that it dominated the next hundred years of English economics. The uncertainty is how clearly Smith formulated the theory. He definitely asserted the essence of the theory, but he did not explicitly define the contents of the wages-fund.
I am painting with a wide brush: insights and arguments of lesser scope, which would be a source of fierce pride to lesser economists, do not deserve inclusion here. The famous paradox of value concerning diamonds and water, for example, which posed in inescapable form the central problem for the marginal utility theory, would deserve attention in any lesser man’s work. But the first three of these four successes I distinguish have become a permanent part of economics.
The successes that should have been failures
An improper success is an error or an infertile and undevelopable subject or method of analysis—but one that is influential with contemporaries or successors. Most demonstrable errors, one hopes and believes, are soon ferreted out, but the analysis that somehow fails to identify and organize and exploit a useful body of knowledge can only be discovered with time.
I would propose only one significant topic in Smith’s work that meets this description: his theory of productive and unproductive labor.
There is one sort of labour which adds to the value of the subject upon which it is bestowed: There is another which has no such effect. The former, as it produces a value, may be called productive; the latter, unproductive labour. . . . (The) labour of the manufacturer fixes and realises itself in some particular subject or vendible commodity, which lasts for some time at least after that labour is past. It is, as it were, a certain quantity of labour stocked and stored up to be employed, if necessary, upon some other occasion. . . . The labour of the menial servant on the contrary, does not fix or realise itself in any particular subject or vendible commodity. His services generally perish in the very instant of their performance.
The purpose of the distinction is clear: if we identify productive labor by the characteristic that its product can be accumulated, capital formation can take place only out of the product of productive labor. The difficulties with the distinction are two. Even if Smith is correct, the extensive employment of productive labor merely permits the accumulation of capital, and the actual formation of new capital requires a wholly independent act of saving. Since most tangible products are not accumulated as capital but currently consumed, there could be the loosest of connections between the share of labor that is productive and the rate of capital growth.
There is a second difficulty: there are investment acts that are not the result of productive labor. Investments in what we now call “human capital” do not become incorporated in a tangible saleable commodity as commonly understood. Unless we include instruction and training as productive labor—and Smith lists “men of letters of all kinds” as unproductive labor—the existence of productive labor is not even necessary to capital formation.
The failures that rightly failed
Smith’s failures to persuade economics were, like his successes, of two sorts: failures that were proper, and failures that should have been successes. We consider first the proper failures. A proper failure contains an analytical error, or it presents an empirically trivial or mistaken view of the world.
The most conspicuous of Smith’s proper failures was the hierarchy of employments of capital presented in “Of the Different Employments of Capital.”
A capital may be employed in four different ways: either, first in procuring the rude produce annually required for the use and consumption of society; or secondly, in manufacturing and preparing that rude produce for immediate use and consumption; or thirdly, in transporting either the rude or manufactured produce from the places where they abound to those where they are wanted; or lastly, in dividing particular portions of either into such small parcels as suit the occasional demands of those who want them.
Although all four activities are essential to one another or to “the general convenience of the society,” capital is more productive—that is, sets more labor to work, and augments more the annual produce of the society—if applied earlier in this sequence of operations than if applied later. The argument is simple: the capital of a retailer employs only himself and possibly a clerk—the remainder of the capital goes to purchase the goods he sells, and therefore to replace the capitals of earlier stages. At the other end, Smith says, “no equal capital puts into motion a greater quantity of productive labour than that of the farmer,” for all of his capital goes to support labor, and in addition the fertility of nature is enlisted.
That Smith was in error is unequivocal. He allowed a system of financing to conceal the facts of economic life.
That Smith was in error is unequivocal. He allowed a system of financing to conceal the facts of economic life. If the consumer, instead of paying the retailer for the corn, had paid the farmer for raising it, the millwright for grinding it, the ship’s captain for transporting it, and the retailer for stocking it, everyone’s capital would have gone exclusively to the direct support of production, but nothing essential would have changed.
If Smith had really incorporated this error into his theoretical system, the effects would have been disastrous: as one important example, the argument for private control over investment would have been damaged beyond repair. But it remained a local blemish.
A related error, and one to which Smith attached greater importance if measured by the number of times it recurs in The Wealth of Nations, is the assignment of a hierarchy of social usefulness to domestic trade, foreign trade, and the carrying trade for foreign nations. The internal trade, he argues, by the act of buying Scottish manufactured goods, carrying them to London, selling them, and buying English corn to return to Edinburgh, replaces two British capitals, whereas the foreign trade replaces only one British capital and the carrying trade none. In addition, the returns of local trade are quicker than those of distant trade. At this level of discourse, Smith is surely mistaken. If these various trades are yielding equal annual rates of return on capital, a shift from foreign to domestic trade would reduce aggregate national output (although the export of capital can of course affect wages). This error received no greater approval from Smith’s successors.
A very different error, and possibly not an error at all, is Smith’s measure of value—which came from the same source as that which may have led him to overvalue agriculture. Smith was acutely sensitive to the instability of monetary measures of value, and an appreciable fraction of The Wealth of Nations is devoted to the chronicle of currency debasement and inflation. He proposes as the ultimate measure of value the disutility of an hour of ordinary labor:
Equal quantities of labour, at all times and places, may be said to be of equal value to the labourer. In his ordinary state of health, strength and spirits; in the ordinary degree of his skill and dexterity, he must always lay down the same portion of his ease, his liberty, and his happiness.
The price which he pays must always be the same, whatever may be the quantity of goods which he receives in return for it. . . . Labour alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared.
Smith’s error, if indeed it is an error, is to assume that the psychological cost of performing an hour of labor is more stable, in its significance to a person, than the psychological pleasure from the consumption of some bundle of goods. The instability of labor disutility arises from at least three circumstances:
- It varies with the conditions of technology—for example, the lifting of heavy weights has been almost eliminated in a modern society.
- It varies with the degree of training of the worker: the disutility of acquiring labor skills must be added to that of performing the work, and this addition was already increasing secularly with the progressive division of labor.
- It varies with the hours of labor, and hence with income.
The corresponding view of a bundle of consumer goods yielding constant satisfaction as the unit of value is free of the second difficulty, possibly free of the first (depending how one views new commodities), but of course not free of the third.
Smith’s rejection of consumption in fixing on a measure of value is attributable to his belief that luxuries are frivolous and yield illusory pleasures that vanish in the act of realization. That Smith should attribute to almost all economic factors an illusion that greater wealth yields greater satisfactions, an illusion that is perhaps never pierced, is one of his greatest idiosyncrasies.
Smith’s third error, and again perhaps we should label it a misdirection, is his monetary theory, as presented in “On Money.” Smith believes that there is a fixed demand for money in a society, in the special sense that only a certain quantity of money will circulate and excessive sums will be exported (if the money is gold or silver) or be presented for redemption in gold (if the money is bank notes). The theory is tenable as a first approximation if, as Smith assumes, the foreign exchanges are fixed, and the paper currency is fully convertible: the theory, then, is implicitly a simple purchasing power parity theory.
The complaint about Smith’s theory is not that it is formally erroneous but that it represents a retrogression from the generality and predictive power of the monetary theory in Hume’s essays.
The failures that should have been successes
There remain the successes that Smith should have achieved, but did not. It will appear paradoxical that Smith’s immense prestige and vast powers of persuasion should have failed to obtain acceptance of ideas that were correct, profound, and fecund.
The first of these superior theories was a rejection of the subsistence theory of wages. Smith, it will be recalled, gave four explicit reasons for believing wages were not generally at subsistence level in Great Britain:
- Summer wages exceed winter wages, but the cost of subsistence varies inversely.
- Subsistence varies substantially in cost from year to year, but some wages change very slowly.
- Subsistence varies substantially from place to place, but wages vary less by place.
- Variations over time and place in the cost of subsistence are often inverse to those of wages.
All of these proofs, particularly the first two, suffer from a concentration on short-term correspondences of wages and the cost of subsistence, but they carry considerable weight. In addition, Smith offers the powerful long-term example of the differences in real wages between England and the American colonies, an example whose persistence made it stronger with each passing year.
A second of Smith’s theories took slightly more than a century to achieve currency—it was his theory of rent. He consistently treated the rent of land as it should be treated: any one use of land had to pay a rent, which was a cost of production, to draw the land away from other uses; whereas for all uses combined, rent was a residual. This theory is present in “The Rent of Land,” with hardly any ambiguity but with hardly any explicitness. It is difficult in retrospect to see how the many recognitions of the alternative cost theory received so little attention, as when Smith says:
As an acre of land, therefore, will produce a much smaller quantity of the one species of food (meat) than of the other (corn), the inferiority of the quantity must be compensated by the superiority of the price. If it is more than compensated, more corn land would be turned into pasture; and if it was not compensated, part of what was in pasture would be brought back into corn.
Unlike the other theories of Smith under discussion, the correct theory here is only partly explicit, and it was fragmented in presentation, so Smith, rather than his successors, deserves the larger blame for its neglect.
The last of Smith’s regrettable failures is one for which he is overwhelmingly famous, the division of labor. How can it be that the famous opening chapters of his book, and the pin factory he gave immortality, can be considered a failure? Are they not cited as often as any passages in all economics? Indeed, over the generations they are.
The failure is different: almost no one used or now uses the theory of division of labor, for the excellent reason that there is scarcely such a theory—no standard, operable theory to describe what Smith argued to be the mainspring of economic progress. Smith gave the division of labor an immensely convincing presentation: it seems to me as persuasive a case for the power of specialization today as it appeared to Smith. Yet there is no evidence, so far as I know, of any serious advance in the theory of the subject since his time, and specialization is not an integral part of the modern theory of production.
Smith was successful where he deserved to be successful—above all in providing a theorem of almost unlimited power on the behavior of man. His construct of the self-interest-seeking individual in a competitive environment is Newtonian in its universality. That we are today busily extending this construct into areas of economic and social behavior to which Smith himself gave only unsystematic study is tribute to both the grandeur and the durability of his achievement.
George J. Stigler was the Charles R. Walgreen Distinguished Service Professor of American Institutions at Chicago Booth. He died in 1991.