Adam Smith's Economic Theories: Foundations of Free Markets

Adam Smith's Core Economic Principles

Adam Smith was a Scottish economist during the 18^th century. In 1776, he published his most influential book, The Wealth of Nations, where he made the first comprehensive examination of the emerging market capitalist system. He laid the foundations of classical free-market economic theory and developed the concept of division of labor. Smith explained how rational self-interest and competition can lead to economic prosperity.

Elements of Commercial Society

Adam Smith addressed two fundamental economic questions: the growth of wealth and its distribution. He provided an analysis of the relationship between three key elements of commercial society:

• Factors of production
• The market
• The state

From this framework, he identified a direct link between the expansion of the market and the division of labor. In commercial society, there are three primary factors of production:

• Land
• Capital
• Labor

The division of function among these factors leads to three constituent orders of society:

• Landlords
• Capitalists
• Laborers

Their mutual dependence is evident in the exchange relations between rents, profits, and wages, forming a circular flow of production, income, and expenditure. The capital stock provides wages for workers' expenditure and consumption of production, which in turn generates profit.

The Invisible Hand and Market Equilibrium

For Smith, a primary cause of wealth was the division of labor. He posited that each product brought to market should be sold at a fair price, as if guided by an "invisible hand." The price needed to be high enough to cover costs and labor, yet low enough to prevent competitors from "stealing" customers. Therefore, the product's price included the fair value of all the land, labor, and capital that went into its creation.

If consumers do not purchase a product, it signifies that its perceived value does not justify the cost of the resources used to make it. In such cases, the seller goes out of business, thereby freeing up the land, labor, and capital that were being inefficiently utilized. Thus, Smith argued that if left to itself, the market would naturally achieve equilibrium on its own.

Role of Money and the State

Smith relegated money to a secondary, passive role within his analytical system. For him, money should serve as nothing more than a medium to facilitate market exchange.

Similarly, Smith assigned politics and the state a minimal role in economic affairs. He insisted that economic coordination and wealth creation were the spontaneous and unintended consequences of a self-regulating market. He viewed the state's extensive involvement in economic activity as counterproductive.