Adam Smith's Theory on State Roles and Market Dynamics

The Three Indispensable Roles of the State

But that didn’t mean that the state is unimportant for Smith. He saw that it performed three indispensable roles in the commercial stage of society:

• First, the state should provide defense of the territory in order for perfect liberty to be exercised.
• Second, the state must uphold the rule of law. Without secure property rights over the use and disposal of goods and capital, the market cannot function. To cap the interest rate was very important. He realized that if the reward was too big, investors would forget the risk. But with the rate capped, people will take reasonable risks.
• Third, the state should provide certain “public goods” that it may never be profitable for individuals to produce privately. They should protect wage workers, keep banks honest, protect new industries, and establish education standards.

The Dangers of Mercantilism and Capitalist Influence

Big capitalists had enough political power to push for laws establishing subsidies and protective tariffs that guaranteed high profits—a system known as mercantilism. Those laws were bad for society, but no one was realizing it. So, Adam Smith didn’t think that government was inherently dangerous for the market, but rather that capitalists were tricking it in their favor. This leads to the core message of The Wealth of Nations: be aware of capitalists.

Balancing Profits and Wages for Social Benefit

He also thought that profits should be low, because you couldn’t have high profits and high wages at the same time. High wages weren’t just in workers’ interest but in society’s interest. However, capitalists followed their own interests and paid low wages.

The Invisible Hand and Price Mechanisms

And finally, according to Smith, inequality was produced by the impersonal and neutral mechanism of the invisible hand, and not by direct exploitation. He sought to locate the mechanism for the distribution of income among the factors of production and the specialized occupations in the actual structure of the division of labor.

Natural Price vs. Market Price

Smith distinguished between the natural price (the one that covers the costs of production) and the market price (which is determined by scarcity and the balance of supply and demand at any point in time). The two prices frequently diverge in the short term, but in the long run, the competitive market ensured their convergence, meaning the economy would move towards equilibrium.