Chapter 3

Adam Smith• Big Ideas

– Free Market Capitalism– Free Trade

Biography Scotland 1723 – 1770 Studied

Glasgow Oxford

Professor at Edinburgh Tutor to Henry Scott Physiocrats

*Adam Smith - PHYSIOCRATS A philosophy that natural laws

govern human behaviour artificial laws created by humans

were unnecessary and ineffective Their doctrine of non interference

known as LAISSEZ-FAIRE leave to do leave it be

Times• Industrial Revolution• Mercantilism predominant

economic theory– Goal: increase a nations wealth

by increasing holding of gold and silver

– Achieved: increasing exports limiting imports through Tariffs and Taxes

– Result: decline in world trade

Big Ideas Published in the

book the WEALTH OF NATIONS

Big Idea 1- The Invisible Hand Self correcting system governed by

the laws of supply and demand People will act out of self interest Invisible hand: adjust prices and

output to meet the needs of the market

Key Assumption: Competitive Market place Argued against monopolies

Big Idea 2 Trade “What applies to the

individual applies to the nation with respect to division of labour”

All nations will benefit if each nations specializes in what they are best at Absolute advantage

Governments should not block trade

*Other ideas Division of Labour – specialization

of labour leads to increase in production and therefore greater profits and better economic efficiency

If people do what they do best in order to further their own self interest society will prosper

*Other ideas Law of Accumulation –

industrialists will increase profits and eventually reinvest profits in capital goods to further economic growth of society.

Socio Economic Spectrum Far right of spectrum Limited roll of government Businesses should satisfy needs and

wants

Strengths and WeaknessesStrengths

• Free market and trade policies = wealth creation

Weaknesses

• Laissez faire policies not perfect

• Great depression

• Credit Crunch

• Poor distribution of wealth

Application in Canada Canada has elements of the Smith’s

ideas Trade Free Market Capitalism

Much larger roll for public sector

Thomas Robert Malthus Big Idea:

Population and food production

THE DISMAL SCIENCE

Challenged Smith’s view of ever increasing prosperity Population and Food Production

Food – necessary to sustain human life

Sexual Instinct – constant From these 2 premises he

reasoned that Population would grow at a

Geometrical rate Food can only grow at a arithmetical

rate( law of diminishing returns)

“Malthus Dilemma” Humans will not be able to produce

enough food to meet needs – famine He recongnized 2 forms of

population checks Positive Check – increse of death rate

ex. War, famine disease Preventive Check – reduce birth rate

ex. Moral restraint, late marriage

So why has the world not self destructed? Was Malthus wrong?

Malthus was wrong… so far He failed at predicting two

developments Green Revolution – technological

breakthroughs in agriculture that increased production ex. Fertilizer, mechanization

Decrease in Industrialized Country Birth Rate Woman’s roll in the work force “The Pill” Education

Owners of the factors of production Identified 3 main groups in society

1. Working Class – wage labours

2. Industrialists – profits from factory ownership

3. Aristocrats – landlords who received money from landownership

He argued that group 3 could only prosper from exploitation of other two groups

David Ricardo (1772 – 1823)• Big Idea

– Wages– Trade

IRON LAW of WAGES Believed that higher wages would

increase population in working class but not standard of living because wage would have to be distributed amongst larger family

Therefore wage = surplus population Provided incentive and logic for

industrialist to keep wages low

Free Trade A firm believer in free trade he was the first to

compare Absolute and Comparative Advantage Absolute Advantage – when 1 community

produces wool more effieciently and another community produces wheat more efficiently – trade between both communities will be of absolute advantage (Adam Smith)

Comparative Advantage – the capacity of one economy to produce a good with comparatively fewer resources than another. ( e.g. having a lower opportunity cost) Rational for bigger countries to trade with smaller

countries

Example: You are a skilled cabinetmaker as well as a gifted painter. 1 day = 1 cabinet 1 day = 1 painting 1 cabinet =$400 1 Painting = $350

Your Neighbour shares the same skill set 1.5 days = 1 cabinet 3 days = 1 painting

What type of advantage do you have over your neighbour? Therefore it would make sense for you to out produce your

neighbour correct?

WRONG!!

Over a 6 day work week YOU: 3 paintings and 3 cabinets $2,250 Neighbour: 1 painting and 1 cabinet $1,100 Total: 4 paintings and 5 cabinets = 9 production units = $3,350

HOWEVER!!!

Say YOU focus on painting where you have the greatest comparative advantage and the most profit and leave the cabinet making to your neighbour.

YOU: produce 6 paintings = $2,400 Neighbour: produce 4 cabinets = $1,400 Total: 10 units of production = $3,800 Both you and your neighbour would be richer from specialization = 1

production unit more

Now that’s what I call EXCITING!!

Cabinet Production(over 6 day work week)

Painting Production(over 6 day work week)

You 6 6

Neighbour 4 2

Total 10 8

You have an absolute advantage in Cabinet production (1.5:1) and Painting (3:1)

You: 6 cabinets = opportunity cost of 6 paintingsNeighbour: 4 cabinets = opportunity cost of 2 paintings

You: Each cabinet you make will cost the community 1 paintingNeighbour: each cabinet he/she makes will cost the community ½ a painting?

Therefore your neighbour has a comparative advantage in cabinet making because it has a lower opportunity cost

Do You have a comparative advantage in this scenario?

Absolute Advantage Continued Examples:

BC has absolute advantage over Sask. in the manufacturing of wood products. Sask. Has an absolute advantage over BC in the production of wheat

NewFound. has a absolute advantage over Ontario in the production of seafood. Ontario has an absolute advantage over NewFound. in automobiles

Comparative Advantage California has an absolute advantage

over Texas in the production of both cars and computers.

California absolute advantage in computer production is 2:1 (ex. 200:100).

California absolute advantage in car production is 4:1 (ex. 400:100).

One Step furtherState Computer

Production (units produced in the

first 10 days)

Automobile Production

(units produced in the remaining 20

days)

California 200 40

Texas 100 10

Total 300 50

In California 600 computers = an opportunity cost of 60 cars

In Texas 300 computers = an opportunity cost of 15 cars

Therefore Texas has a comparative advantage in the production of computers because less cars will be lost

Does California have a comparative advantage?

Karl Marx• “From each

according to ability and to each according to need”

Biography Karl Heinrich Marx Born 1818 Born Jewish, chose to be baptised to not

loose his job as a lawyer Studies

Law at the University of Bonn University of Berlin

Exiled: Germany France Belgium London (Died 1883)

Times Young Hegelian movement which

opposed traditional religion and political structures

Industrial Revolution lead to destitution for working class (urban poor) Creation of massive slums Structurally unemployed artisans

(guilds)

Big Ideas1. Communist Revolution

2. Labour theory of value

3. Unemployment

Big Idea 1 – Communist Revolution Big Idea: Socialism and Communism

In Capitalist economies the working class is exploited by the ruling classes Aristocrats (land owners) Capitalists (capital owners)

Workers need to unite to overthrow the ruling class to create a just and humane society

Communism required a Revolution The revolution would be violent The revolution would lead to Socialism

Common ownership of land and capital STATE OWNED

Socialism would lead to Communism Worker Governed NO STATE Utopian society where everyone contributes

to the best of their ability and is taken care of by the contribution of others

Rational for the Communist Revolution The Capitalist system was morally

bankrupt and would inevitably self destruct

The industrial revolution in Western Europe showed the greatest degree of exploitation

Marx predicted this is where the Communist revolution would start Where did it start?

Russia 1917

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Big Idea 2 - Labour theory of valueCapitalist theory of value The value of item is governed by

supply and demand A Capitalist will purchase the factors

of production at the lowest price possible Land Labour Capital

Materials Machinery Money (Low interest rates)

Capitalist theory of value A Capitalist will then sell the resulting

product for more than what was paid for the factors of production

The difference being the profit Ex Shirt – Market Price $80

$40 – Labour $5 – Material $5 – Wear and tear on Machinery

(depreciation) $30 Profit

MARX’s Labour theory of value The value of item is governed by the

amount of labour that went into it Direct labour: labour spent making the

item Indirect labour: labour spent making

the items used in the manufacturing process

Profit = Surplus Value = Exploitation

MARX’s Labour theory of value Ex Shirt – Market Price $80

$5 – Indirect labour of Material $5 – Indirect labour of Machinery $70 Direct labour cost

All of that money should go to the workers who created the value

Big Idea 3 – Unemployment “The reserve army of the

unemployed” Capitalists always have the option of

hiring desperate unemployed workers at lower wages

Incentive in ensuring that wages stay at subsistence levels

Strengths and WeaknessesStrength

• It is a Utopian idea • Strives for equality

and justice– Wealth– Education– Health

• Allowed for rapid industrialisation

Weakness• Violent Revolution is not

justifiable• Does not encourage

entrepreneurship• Did not predict the rise of

middle class and welfare state

• Humans can’t be educated out of self interest (biology)

MAYNARD KEYNES (1883 – 1946) Big Idea

The invisible hand doesn't always work Government needs to play an active role

in the economy Counter Cyclical Spending

Business Cycles

Keynesian School of Economic Thought

Believe that government intervention in economy ( ex. Public works projects, interest rates) could stimulate employment, investment, consumer purchasing

Government needed to intervene in the free market to minimize business cycles

these ideas have been applied by many governments to fight recessions in the economy.

CRITICS Leading cause of inflation Higher government debts

Creation of structural deficits due to government programs that have no end date

Positive Side – unemployment rates have never dropped below levels seen during depression