Adam Smith on Growth and Economic Development

Abstract This paper is a contribution to the ‘Symposium: Perspectives on Adam Smith’, held at the University of Sydney on 26 May 2023 to mark the Tercentenary of Adam Smith’s birth. The paper provides a concise account of Smith’s analysis of growth and economic development in the Wealth of Nations. It shows that whilst the driving force of growth in Smith’s analysis is saving-cum-investment out of the net income of society, critical to achieving his policy objective of ‘universal opulence’, requiring higher wages for ‘common labour’, is technical progress and higher labour productivity stemming from the division of labour. From the perspective of the demand-led theory of growth, the paper identifies key insights from Smith’s analysis for understanding economic development in modern history, the most important being his notion that the division of labour is ‘limited by the extent of the market’.


Introduction
Central to Adam Smith's enquiry in the Wealth of Nations (1776 [1976]); hereafter WN) is the construction of a theoretical system for identifying the main drivers and causal processes of growth in their historical context by which to formulate and promote policies that could achieve the objective of 'universal opulence'being opulence 'which extends itself to the lowest ranks of the people' (WN: 22).While Smith's theory of prices, distribution, and resource allocation under conditions of free competition are mainly dealt with in Book I of WN, his theory of growth is largely set out in Book II together with the first three chapters of Book I on the 'division of labour'.In Book III of WN Smith identifies in history what he considers key factors promoting economic development and in Book IV the restraints on growth of mercantilist policies.
The main purpose of this paper is to provide a concise exposition of Adam Smith's theory of growth and economic development.In this exposition, we provide original insights into how technological progress promotes growth in Smith's theory as well as the relevance of some of his analysis for understanding contemporary economic development.Our exposition will follow the traditional approach of first expounding Adam Smith's theory of growth for a given technique of production, in Section 2.Then, in Section 3, we consider the role of technical progress in Smith's theory of growth.By way of conclusion in Section 4, we consider some key insights of Smith for an understanding of economic growth and development in modern history.

Adam Smith's Theory of Growth for a Given Technique of Production
The driving force of growth in Smith's theory is saving, what he referred to as 'parsimony ' (WN: 337-8).In Smith's analysis saving is the same as investmentor to put it another way, saving will lead to and be matched by equal levels of investment, involving the employment of stock (i.e.commodities) as capital in production, and which is necessary for capital accumulation.For Smith saving stems from the motive to better one-self materially: with the propensity to save standing alongside the propensities to 'truck' (i.e.trade) and to maximise profits as key aspects of human nature in the domain of economics in the WN.In the dynamic process of accumulation, the annual aggregate level of saving-cum-investment is conceived to come from what Smith called 'neat revenue', defined as the 'whole annual output' (equivalent to gross aggregate output) of the economic system less the replacement of capital employed to produce the gross output.While this 'neat revenue' consists of profit and rent, it is a wider concept than 'surplus product' as it includes wages of what Smith calls 'unproductive labour' associated with 'immediate consumption' of stock.The significance of Smith's conception of 'neat revenue' is that it constitutes maximum social income available after reproducing the capital stock inherited at the beginning of the annual cycle of production, which can be employed to expand the capital stock.
In Smith's analysis capital consists of two kinds. 1 Firstly, there is 'circulating capital', which is conceived to be commodity inputs that change form as they circulate in the production process from one owner to the next, consisting of 'money ',  'provisions', 'materials' and 'finished work' (WN: 279-3).Secondly, there is fixed capital used up in the production process, which is capital that affords revenue or profit by not circulating and not changing masters, and consists of 'all useful machines and instruments of trade which facilitate and abridge labour', 'profitable buildings' (not 'dwellings'), 'improvements of land' (i.e.irrigation, fencing etc.) and the acquisition of human capital (WN: 282). 2 But Smith is clear that fixed capital functions only with circulating capital, especially provisions for the necessary consumption of labour: Every fixed capital is both originally derived from and requires to be continually supported by circulating capital.All useful machines and instruments of trade are originally derived from a circulating capital, which furnishes the materials of which they are made, and the maintenance of the workmen who make them.They require too a capital of the same kind to keep them in constant repair.(WN: 283)   Two important points about Smith's conception of circulating capital need clarification here.First, as mentioned above, strangely it includes 'money', on the grounds of its role in circulating commodities and, thereby, the other circulating capitals, which indicates a confusion between the process of exchange and the circulation of commodities.Second, Smith's circulating capital includes the material inputs in the form of necessary wage goods to pay the wages of what he calls 'productive labour'.This means capital accumulation corresponds to the expansion in the necessary consumption of labour.Based on this analysis, Smith argues that the greater the proportion of neat revenue which goes towards saving, reflecting 'parsimony', and the less of it left for 'immediate consumption', reflecting 'prodigality', the greater the rate at which capital will accumulate through time.
This brings us to Smith's (WN: 330-36) distinction between 'productive labour' and 'unproductive labour'.'Productive labour' is conceived to be the employment of stock (as capital) directly and indirectly in the production of vendible commodities, adding value and contributing to the generation of commercial revenue in the form of profit and/or rent.By contrast, 'unproductive labour' is the employment of stock which is considered not to contribute to enlarging the capital stock, and, thereby, the reproduction of vendible commodities, and does not generate a commercial revenue in the form of profit and/or rent.Instead, it constitutes the consumption of neat revenue by consumption of luxury vendible commodities and/or services.By this conception, Smith argues that the larger the proportion of neat revenue employed as 'productive labour' relative to 'unproductive labour', stemming from a higher propensity to save-cum-invest by capitalists and landlords, the higher will be the rate of capital accumulation.Given the need to finance the 'unproductive labour' of government in providing the functions necessary to uphold a 'system of natural liberty', including necessary public expenditure on transport and communications infrastructure, in Smith's analysis it is the neat revenue after deducting his policy-determined taxes and public debt funding that sets the potential level of saving-cum-investment for maximising the rate of capital accumulation (see Appendix).After accounting for this policy aspect, in Smith an 'advancing country' with a high-growth rate occurs when saving-cum-investment is a high proportion of neat revenue; whilst a 'declining state' with negative growth occurs when prodigality causes 'immediate consumption' to exceed neat revenue. 3dam Smith's conceptual distinction between productive and unproductive labour is highly problematic and the source of inconsistencies in the WN (see Aspromourgos 2009, 164-73).Clearly, commercial services add value whether they 'generally perish in the very instant of their performance' or not (WN: 330).Indeed, many services are necessary inputs either directly or indirectly into the production of vendible commodities (for example, think of bankers, engineers and architects).Thus, Smith inconsistently treats transportation, wholesaling and distribution as productive activities though they are evidently services.The conception also misrepresents the role of government non-commercial services such as education and health as unproductive.These inconsistencies can be overcome to capture Smith's fundamental argument on accumulation if instead we adopt Sraffa's (1960, 7-8) distinction between basics and non-basics: basics are commodities or services which are employed as inputs in the system of production and non-basics are final commodities or services for consumption.This more precisely captures Smith's argument that the greater the proportion of aggregate net income, which is devoted to reproduction the higher the rate of capital accumulation: The proportion, therefore between the productive and unproductive hands, depends very much in every country upon the proportion between that part of the annual produce, which … destined for replacing a capital, and that which is destined for constituting a revenue, either as rent, or as profit (WN: 333-4). in which Parsimony, by increasing the fund which is destined for the maintenance of productive hands, tends to increase the number of those hands whose labour adds to the value of the subject upon which it is bestowed, it tends therefore to increase the exchangeable value of the annual produce of land and labour of the country (WN: 337).Adam Smith's analysis is entirely consistent with the 'surplus approach' of the classical economists developed prior to him.The 'neat revenue' is determined based on the datum: (1) Level of gross output (with industry outputs determined by the 'effectual demand' for their products); (2) The necessary consumption of the given real wage of labour; and (3) Technique of production (including normal capacity utilisation and depreciation rate of fixed capital).The annual level of output is itself determined in a dynamic way for a given technique of production by the capital stock laid out for reproduction according to saving-cum-investment out of neat revenue from the previous year.To determine the rate of capital accumulation in Smith's theory it is therefore necessary to know the proportion of neat revenue saved-andinvestedthat is, the saving-cum-investment ratio.
The fundamental nature of Smith's theory is illustrated by Hick's (1965, 36-8) simplified growth model, as based on the assumptions that land is not scarce so there is no rent and the only direct input of production is labour and only a single wagegood commodity (i.e.corn) is produced.The growth expression of this model is: where g is growth rate of output, measured in corn, k is the proportion of total employed labour as productive labour (equivalent to the saving ratio), q is output per worker measured in corn and w is the wage rate per worker, in corn (see Groenewegen 1977, 164). 4In absence of technical progress, universal opulence can only be achieved in an 'advancing country' in Smith's economic analysis by the rate of capital accumulation (and demand for labour) growing faster than population growth (and supply of labour) to an extent that strengthens the bargaining power of labour over 'masters' to establish a higher natural wage. 5However, as shown in Section 3 below, it is evident Smith believed that such universal opulence could only be achieved in an 'advancing country' with the accompaniment of technical progress through the division of labour.
A major deficiency of Smith's theory of growth is the absence of a saving-investment analysis with a co-ordination mechanism that brings aggregate demand and aggregate output into equality.As shown above Smith does not distinguish between aggregate saving and aggregate investment, though he appears to recognise that savers and investors are often different actors in a decentralised economic system (see WN: 320, 677).In absence of such an analysis Smith's theory is really based on assuming that aggregate demand is always sufficient to realise the supply-determined level of output, an assumption in classical economics, which was the basis of what, after Smith, was called Say's Law.What this means is that Smith's theory of capital accumulation in WN is really a theory of 'potential growth' as determined by the growth in productive capacity (i.e.capital stock).

The Role of Technical Progress in Smith's Theory of Growth
As is well known, Smith considered 'the division of labour' to be the most critical factor in promoting the growth process and in achieving the objective of universal opulence as measured by consumption per capita.Its importance is signified by being the subject of the first three chapters of Book 1 of the WN.In these chapters Smith contended the division of labour was a natural consequence of an exchange economy, which produced a surplus product, the division depending in large part on the 'power of exchanging' or 'the extent of the market'.According to Smith (WN: 17-22) the division of labour contributes to an increase in labour productivity in three main ways: (i) the increased dexterity of workers from specialisation of tasks and production processes; (ii) the saving of time from not having to shift from one kind of production activity to another; and (iii) to facilitate innovations, in particular, the invention of machines that replace labour power.In Smith's elaboration of them he captures most of the fundamental aspects of technical progress in a capitalist economic system (see Kurz 2010, 1188-90).By technical progress we mean innovation that reduces the normal cost of production of products overall, by reference to a composite product in a system of production, for a given distribution of income, involving a reduction in the technical requirements of inputs to production for a given output (or increase in output for given inputs).This is consistent with Smith's analysis of prices and distribution.
In the first place Smith understood the division of labour to operate both internal to firms as organised into factory-style production lines such as described in his pin-making example and external to firms in processes of production according to 'trades' and 'branches of trades' as described in his example of the production of a 'woollen coat' (WN: 14-15, 22-3).Hence, in Smith increasing returns to scale are both internal and external to firms, which means that extending the market corresponds to a higher rate of growth of industries in aggregate.Secondly, Smith (WN: 22-4) recognised that by breaking up the processes of production and distribution of products into more specialised stages the 'separation of different trades and employments from one another' tended to facilitate innovation, and, especially, the invention of more mechanised labour-saving techniques.It does so by enabling producers through experience to better identify what improvements in the production process can be made by innovation. 6urthermore, Smith's (WN: 22) division of labour comprises of specialised 'makers of machines' and 'philosophers or men of speculation' whose only trade is to invent and improve machinery.Remarkably, in only the early stages of industrialisation, he anticipated the key contributions to technical progress made by academic and scientific institutions, the machine tools and engineering industries and what today is called 'research and development' (Kurz 2010, 1189).Lastly, capitalistic competition plays an important role in the dissemination of improved techniques of production in Smith's economic thought.The 'advantage' of a higher labour productivity, which provides the motivation for the division of labour, takes the form of 'extra' profits above normal.It is free competition which causes the most productive techniques to be widely adopted in the establishment of a dominant technique of production corresponding to the gravitation towards a uniform normal (net) profit rate.
A feature of Adam Smith's growth theory is that technical progress is endogenous to the capital accumulation process.This is because in Smith's theory a requirement for the division of labour is that a stock of capital must have been previously accumulated to advance the wages of labour and supply the 'materials and tools' for production (WN: 276-7).A higher rate of capital accumulation therefore causally induces technical progress which increases the growth rate of labour productivity (Thus, by reference to Equation (1) above of Hick's Smithian model, q could be considered loosely a positive function of g in a 'system of natural liberty'; also see Eltis  1984, 68-73, 91-2).Moreover, Smith's theory strongly implies the growth process involves dynamic structural change in which the division of labour ever deepens with the progressive employment of machinery in production. 7There is also in Smith a causality running from technical progress to growth as the increase in the productivity of labour tends to increase 'neat revenue' from which saving is a driver of capital accumulation (This is reflected in Equation (1) above by the positive effect on g of any increase in the value of q).
A causal interaction between technical progress and capital accumulation therefore characterises Smith's theory of growth: what has subsequently been called 'cumulative causation' in the growth literature.In Smith (WN: 31-2) the main limit to this cumulative-causal growth process is the 'extent of the market' on the division of labour.The larger the size of the market for producers, and, therefore, of demand for potential final output, the greater the scope for the division of labour, economies of scale and technological progress.In this sense there is a conception of demand in aggregate playing an autonomous role in Smith's theory of growth (Aspromourgos 2009, 192-6).Aggregate demand itself though depends on the existing 'opulence' of the nation established by the prior accumulation of capital which, notably, builds the transport and communications infrastructure for urbanisation and foreign trade Smith considered important in extending the market that affords scale production conducive to specialisation.
Fundamental in our view to how technological progress promotes accumulation in Smith is its effect in lowering the 'real price' of commodities, especially manufactures.

As Smith argues:
It is the natural effect of improvement, however, to diminish gradually the real prices of almost all manufactures … In consequence of better machinery, of greater dexterity, and of a more proper division and distribution of work, all of which are the natural effects of improvement, a much smaller quantity of labour becomes requisite for executing any particular piece of work; and though, in consequence of the flourishing circumstances of the society, the real price of labour should rise very considerably, yet the great diminution of the quantity will generally much more than compensate for the greatest rise which can happen in the price (WN: 260).
It is by reducing the cost of capital, including the cost of employing labour, that technological progress which raises output per worker is conceived to increase the value of 'neat revenue' available for saving-cum-investment and accumulation in Smith's theory of growth.The reduction in prices, mainly of wage-goods, is conceived to be the major way by which a higher natural wage is attained necessary to achieve the policy goal of universal opulence, which Smith (WN: 22) categorically attributes to the division of labour. 8As Aspromourgos (2010) has argued, to maintain that accumulation in an 'advancing country' leads to a rising natural wage through time, Smith must suppose that the real wage can persistently exceed customary subsistence of labour for a rising customary subsistence real wage to become habitual necessary to establish an ever higher natural wage. 9A major way that this process of a rising natural wage may occur is through the persistent general reduction of the natural prices of wage goods in relation to money wages.Indeed, Smith highlights the prominent role played by the decline in the price of wage goods in relation to money wages in reference to rising living standards in eighteenth-century Britain: The real recompense of labour, the real quantity of the necessaries and conveniences of life which it can procure to the labourer, has, during the course of the present century, increased perhaps in a still greater proportion than its money price.Not only has grain become cheaper, but many other things from which the industrious poor derive an agreeable and wholesale variety of food, have become a great deal cheaper.Potatoes, for example, do not at present, through the greater part of the kingdom, cost half the price which they used to do 30 or 40 years ago.The same thing may be said of turnips, carrots, cabbages; things which were formerly never raised but by the spade, but which are commonly raised by the plough … The great improvements in the coarser manufactures of both linen and woollen cloth furnish the labourers with cheaper and better cloathing; and those in the manufactures of the coarser metals, with cheaper and better instruments of trade, as well as with many agreeable and convenient pieces of household furniture.Soap, salt, candles, leather and fermented liquors have, indeed, become a good deal dearer; chiefly from the taxes, which have been laid upon them.The quantity of these, however, which the labouring poor are under any necessity of consuming, is so very small, that the increase in their price does not compensate the diminution in that of so many other things.The common complaint that luxury extends itself even to the lowest ranks of the people, and that the labouring poor will not now be contented with the same food, clothing and lodging which satisfied them in former times, may convince us that it is not the money price of labour only, but its real recompense, which has augmented (WN: 95-96; my emphasis).
Since in Smith's analysis technical progress is the major force in reducing the price of wage goods, it can also be the major force in raising the real wage of the 'labouring poor' persistently above customary subsistence which, becoming habitual, then establishes a higher natural wage.However, as referred to in the above quotation and discussed above in Section 2, for Smith (WN: 85-7) the establishment of a higher natural wage will ultimately depend on the money wage determined by relative bargaining power between workers and 'masters' with workers' position strengthened in an 'advancing country' by the rate of capital accumulation (demand for labour) being greater than population growth (supply of labour).
Summarising our argument, Smith believed labour productivity growth stemming from the division of labour tended to generally reduce the real prices of commodities measured by labour commanded, and, thereby, raise real income, mainly of real wages, necessary to achieve universal opulence with an advancing rate of accumulation.Hence, consistent with Smith's theory is the notion of a social income dividend, which is generated from the labour productivity of technical progress endogenous to capital accumulation that tends to manifest itself in higher real wages through a lowering in the natural price of wage goods.In this theory fundamental to achieving economic development and a higher general living standard is the saving that drives capital accumulation and which Smith argued stems from the 'private frugality' and persistent 'effort' of individuals 'to better their own condition' (WN: 345; on the causality in Smith's theory, see Aspromourgos 2009, 206-7).
A question that begs itself is whether Smith conceived that the productivity dividend in real income generated in the accumulation process, in turn, tends to extend the size of the market?
From his history-based discussion of the concept Smith (WN: 31-6) clearly believed that the 'extent of the market' depended primarily on transport and communications infrastructure linking producers to urban populations which lowered the 'carriage' costs of tradable commodities so making them more competitive in a larger market. 10Moreover, technical progress which systematically reduces the cost of production of tradable commodities so as to overcome the competitive disadvantage of an existing cost of transport will contribute to the 'power of exchanging' and tend to expand the 'extent of the market' for a given transport and communications infrastructure.This causal effect could therefore be considered part of a cumulative-causation process in Smith's growth theory, in which the advancement of capital accumulation supposes there is usually ongoing improvement in transport and communications, partially met by the government, to extend the limit of the market and ensure sufficient aggregate demand to induce an ongoing division of labour necessary for greater universal opulence. 11This is in accord with Smith's (WN: 371-5, 450-72,  488-98, 642-62) policy advocacy of liberal foreign trade as a means of extending a country's market conducive to the division of labour and promoting accumulation.

Some Key insights of Smith into Explaining Economic Growth and Development
Adam Smith's theory of growth incorporating technical progress was a considerable advance in economic thought at the time and provided the foundation for nineteenth-century classical economists and Marx, who widely accepted the role of the division of labour (see Groenewegen 1977, 165).But as discussed above, Adam Smith, like the classical economists and Marx who followed him, failed to develop a robust theory of output and its growth because they failed to construct an analysis of how saving and investment are brought into equality necessary to explain the coordination of aggregate demand and aggregate output along any growth path.There are indeed only two theoretically robust approaches able to explain economic growth and development: the neoclassical supply-driven approach and the Keynesian demand-led approach.Our preference is for the Keynesian demand-led approach, which is also compatible with the approach of the classical economists to determining prices and distribution. 12From the standpoint of a 'Classical-Keynesian' demand-led approach, Smith provides some key insights into explaining growth and development historically. 13he most important insight of Smith's is his conception that 'the division of labour' is limited by the 'extent of the market', which, in a demand-led approach to growth, makes technical progress endogenous to the growth in effective demand.This insight is particularly significant in helping to explain why capitalist industrial development began first historically in Britain in the eighteenth century.From the perspective of the demand-led approach the problem of economic development is one of generating demand when income per capita of the nation is low.The challenge is to develop a complex of institutions that generate demand growth, which raises income per capita and, with it, increases the capacity of a nation to create demand.
By developing an 'empire economy' through colonialism and mercantilist policy, eighteenth century Britain was able to access raw materials for manufacturing industries and luxury 're-exports' which opened up trade in Europe as well as creating lucrative foreign markets, especially the north American colonies, in addition to its expanding domestic market.In this way the 'commercial revolution', as economic historians call it, of the eighteenth century acted to extend the market for British producers and generate growing demand conducive to the division of labour which increased labour productivity and raised income per capita (see Deane 1979, 69-70).As a pioneer with no other richer nation state to export to, industrialisation in Britain relied more so than any other in subsequent history on technological progress and productivity growth to generate the higher national income necessary to promote demand growth.Hence, in the division of labour, Smith identified not only the historical process by which technical innovation was developed for capitalist industrialisation but, also from a demand-led perspective of growth, that the resulting technical progress was the most important single cause of growth and economic development of Britain when he was writing.
Another key insight of Smith's, which is directly connected to the one above, is the importance he places on transport and communications to extend the market for producers, which enables them to potentially exploit economies of scale through the division of labour.Writing before the advent of railways, and referring to canal building in England, Smith maintains that 'by means of water carriage a more extensive market is opened to every sort of industry than what land-carriage alone can afford it, so it is upon the sea-coast, and along the banks of navigable rivers, that industry of every kind naturally begins to subdivide and improve itself, and it as frequently not till a long time after that those improvements extend themselves to the inland parts of the country' (WN: 32).In the eighteenth century, Britain in fact had a distinct natural advantage for developing water-carriage transport and communications towards creating a 'national' domestic market in that no part of the country was more than 70 miles from the sea and endowed with many navigable inland rivers (Deane 1979, 77).In addition, at Smith's time naval shipping and the construction of port facilities in Britain and its colonies were critical to both internal trade through coastal shipping and to a rapidly expanding foreign trade (see WN: 33-4).From the standpoint of our demand-led approach, the provision of transport and communications is conceived in the manner explained by Smith to play an important role in promoting demand growth and, thereby, advancing growth and economic development.
A further key insight stems from Smith's fundamental view, informed by eighteenth-century enlightenment on the emancipation of humans, that growth and capitalist development is best achieved by adopting policies which promote competition and the greater liberty of economic actors to pursue their best interests consistent with ascribed propensities of human nature to trade, to better one-self materially and to exploit profitable opportunities.In Book III of WN Smith argued that 'the natural progress of opulence' involved the development of agriculture before manufacturing industry could generally develop because the former provided the necessary subsistence of society and material inputs for manufacturing.In an account of the long historical development of agriculture in Europe Smith (WN: 385-8) argued that the feudal system of serfdom then in existence in much of Central and Eastern Europe was unproductive because there was no incentive for the peasantry to work beyond earning their subsistence. 14By contrast, Smith (WN: 387-96) argued that institutional arrangements, existing then in much of England, which provided free men with the incentive of making profits from farming brought about much greater productivity in agriculture, especially so when it facilitates long leaseholds for tenant farmers as an incentive to improve the land and adopt new techniques.The historical experience of nineteenth-century Germany and Japan clearly shows that fundamental to the development of an undeveloped nation is the abolishment of serfdom and adoption of land reform to commercialise farming as a necessary condition to increasing labour productivity in agriculture, itself a pre-condition for industrialisation. 15tes 1. Smith's treatment of capital in the development of his growth theory in WN owes much to the Physiocrats and Turgot, whom he met and discussed political economy with on an extensive stay in Paris as part of a European tour in 1764-1766 (see Aspromourgos 2009,  183-5).2. Smith (WN: 118-19) identifies 'human capital' as the 'extraordinary dexterity and skill' in some employments that are acquired through education and learning for which the wages earned are expected to be 'over and above the usual wages of common labour' by a magnitude that replaces the expense of education with 'at least the ordinary profits of an equally valuable capital'.3. On this reasoning Smith (WN: 337) contended that the 'proportion between capital and revenue, therefore, seems every where to regulate the proportion between industry and idleness' so that '[W]herever capital predominates, industry prevails; wherever revenue, idleness'.For other similar statements, see Smith (WN: 333-6).4. In this model positive growth requires k > 0 and q > w; while, for a given technique and real wage, maximum potential growth occurs when k ¼ k Ã , with all employed labour allocated to reproduction after accounting for the requirements of 'unproductive labour' to implement Smith's statecraft policy.For an elaboration of this point and derivation of our growth equation, see Appendix. 5.If we denote g n as population growth, then, by reference to Hick's model, Smith's 'advancing country' is characterised by g > g n , corresponding to higher output per person and a higher proportion of employed labour to the population.The latter implies a lower proportion of unutilised labour and a tighter labour market.