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Home Theories of Economic Growth Adam Smith's Model of Economic Growth

 

Adam Smith's Model of Economic Growth:

 

Definition and Explanation:

 

Adam Smith's model of economic growth is more or less available in the different parts of Smith's well reputed book "Wealth of Nations" written in 1776. This model primarily deals with capitalistic economies and their process of economic growth. In other words, this theory of economic growth portrays that process which enabled the developed and the rich nations of the world to attain economic growth.

 

In this model of economic growth we shall discuss the followings:

 

(i) Production Function, (ii) Natural Resources, (iii) Institutions, (iv) Labor Force and (v) Capital Accumulation.

 

(i) Production Function:

 

The classical economics is based upon 'Labor Theory of Value' which states that labor is the only factor of production and the costs of production entirely depend upon labor costs.

 

But Adam Smith includes land and capital, in addition to labor (because growth is a long run phenomenon) in the production function. Thus Smith's production function shows that the production of the economy depends upon labor, land and capital. It is as:

 

Y = f (L, K, N)

 

Where Y = national product, K = capital, L = labor and N = natural resources.

 

The Smith's production function is not subject to diminishing returns, rather it is subject to increasing returns. Smith says that as that:

 

Production increases the economies of scale are attained, both internal as well as external The market will be extended and real costs of production will decrease. He says that due to economies of scale not only division of labor is permitted, but the improvement in machinery also takes place. He further says that the difference in productivity of labor in different nations is attributed to difference in degree of division of labor. Smith says that the division of labor is limited by the extent of market. And the size of market is affected by the amount of capital and institutional framework. He further says that the size of the market and productivity of labor are influenced by regulation of domestic and international trade. This is the reason that Smith was in favor of domestic and international division of labor and specialization. As we presented earlier the Adam Smith's production function, it is as:

Y= f (K, L, N) ............. (1)

 

We also told that the productivity of labor (MPL) and land (MPN) are affected by stock of capital (K) and institutional framework (U). Therefore, following restrictions are placed on the above production function:

 

 

(ii) & (iii) Natural Resources and Institution:

 

According to Smith dU/dt is exogenously determined. Therefore, he considers such factor of production as given or fixed. It is as:

 

U = U (t) ........................ (7)

 

Regarding land Smith says that land is also fixed. In other words, there occurs no change in the supply of land with the passage of time, as:

 

dN/dt = 0 ..................... (8)

 

Now the growth rate of the economy will be expressed as:

 

 

From the equation (9), we find that there are only two independent variables in Smith's model:

 

They are = dL/dt and dK/dt

 

Therefore, to understand this model we will discuss the determinants of labor force (dL/dt) and capital accumulation (dK/dt).

 

(iv) Labor Force in Smith's Model:

  

Here we consider the demand for labor as well as supply of labor. Regarding supply of labor. Smith says, it is related to the population. While in long run the population is affected by the wages given over to the labor. If the labor are given more actual wages (W) than the subsistence wages (W), then the marriages will take place leading to increase the population. On the other hand, if the actual wages are less than the subsistence wages the marriages will be postponed leading to decrease the population. If both the actual wages and subsistence wages are equal the population will remain constant. Therefore, the supply of labor will be expressed as:

 

dLs/dt = q (W - W) ................ (10)

 

Here q > 0

 

Whereas the demand for labor is determined by wage fund. In other words, according to Smith there is a specific amount of 'Wage fund' in the economy Such wage fund determines the demand for labor. It is shown by the following equation:

 

dLD/dt = a . dK/dt + b . dY/dt ............... (11)

 

According to equation (11) the demand for labor (dLD) depends upon changes in capital (dK/dt), changes in income (dY/dt) and the parameters 'a' and 'b'.

 

Smith says that in long run because of perfect competition in the labor market demand for labor will be equal to supply of labor. It is as:

 

dLs/dt = dLD/dt .............. (12)

 

Rewriting the equation (11), the labor market theory in Smith's model is as:

 

dL/dt = a . dK/dt + b . dY/dt .............. (13)

 

According to equation (13) the growth of labor force is determined by the growth of income (dY/dt) and growth of capital (dK/dt). Now we substitute the equation (13) into growth equation of the economy. In other words, we shall like to see the effects of labor market and its determinants on the rate of change in national product.

 

 

The equation (15) throws light on the importance of capital accumulation in growth process. Now we discuss it.

 

(v) Capital Accumulation in Smith's Model:

 

According to Smith the capital accumulation depends upon investment whereas the investment is determined by savings. As Smith says:

 

"Capitals are increased by parsimony and diminished by misconduct".

 

Now we see what are the determinants of savings in Smith's model. According to Smith it is the consideration of private profit which determines the saving. In other words, the desire to save and invest is determined by profit. He further says that as long as the rate of profit is more than the amount of compensation for the risk from the investment capital accumulation will continue taking place. It is expressed as:

 

dK/dt = v (r - r . Y) ............... (15a)

 

where (r - r) denotes the way whereby capital accumulation takes place. 'r' shows the rate of profit while r shows the minimum risk compensation from investment.

 

In the course of economic development as capital stock grows in the economy the rate of profit comes down. Smith says that the rate of profit is also determined by the institutional framework. In other words the degree of commerce, control over monopoly or competition and the restrictions over international trade also influence the rate of profit.

 

He further says that the minimum rate of profit (r) is also affected by institutional framework. That is the security of the property and legality of lending operations also influence the minimum rate of profit. Thus the theory of profit in Smith's model is as:

 

r - r = m {K, U (t)} ................ (16)

 

Smith says that rate of interest also affects capital accumulation. As the rate of interest falls the people will find that they can no longer live on property income, they will force to turn to business. As a result, the capital accumulation will increase. He says if social changes occur in the society even with no change in rate of interest, the capital accumulation will increase. It has been described in Smith's model that as capital

accumulation increases the rate of profit falls till it becomes r . Here there will be no risk from investment. The capital accumulation will stop. The population will become constant and the economy will enter into "Stationary State".

 

(vi) Dynamic Path of Economy:

 

Combining the equations (15a) and (16) we are in a position to describe the dynamic process as presented by Smith.

 

dY/dt = f [r {K, U (t)}] ............... (17)

 

This equation shows that in a Growing Economy national product (dY/dt) increases, as the capital accumulation (dK/dt) increases. Therefore, the dY/dt is a positive term. But along with increase in stock of capital the rate of profit comes down. Whereas the capital accumulation increases along with fall in rate of interest. Thus in Smithian model the capital accumulation will increase in a growing economy, which in a turn will lead to increase the level of output of the economy. In this way, the process of economic development will become cumulative. It will proceed at an accelerated rate until the capital stock becomes so large that the rate of profit falls to r. After this the stationary state of the economy starts. This is shown by the Fig.

 

Figure/Diagram:

 

 

It is clarified that the stationary state does not mean the case of under development. Rather it means that here there is no growth, the per capita output becomes stagnant, profits are minimum, wages are subsistence, population remains constant and there is no change in the output of the economy. From the above discussion we conclude that in Smith's model economic growth depends upon followings:

 

Y = f [Ko, Lo, No, a ........ aN; U (T)]

 

Where Ko = basic capital, Lo = basic labor, No = basic land, a .......... aN are parameters of the model, while    U (T) represents institutional changes which occur with the passage of time.

 

The last equation shows that the development (growth) of the Smithian Economy depends upon initial amounts of K, L and N; structural parameters a............ aN; and the

institutional framework (U) of the economy.

 

Criticism:

 

The beauty of Smith's model lies in this fact that it identifies that how economic development takes place and what are growth inhibiting factors. The model stresses upon the role of saving and parsimony in the capital accumulation. The technology, division of labor, specialization and extended markets are important pillars of economic growth, according to Smith's model. Despite those merits, followings are the demerits of Smith's theory of economic growth.

 

(i) Smith in his model includes just two segments of the economy, i.e., the capitalists (landlords) and laboring class. But it is not true, in addition to these two classes, there is also a middle class which plays an important role, in the economic growth. The savings are not just made by the rich class, the middle class also saves.

 

(ii) The Smith's model is based upon Laisseze-Fair. But the non-intervention system is possible just in dreams. Each govt. has to intervene to tackle both internal and external matters.

 

(iii) In Smith's 'model, we do not find the role of entrepreneurs. While according to Schumpeter, it is the entrepreneur which combines other factors of production and it starts the process of production.

 

(iv) The Smith's hypothesis regarding stationary state is also misleading, because economic growth is not a smooth process. It is furnished with jumps and shocks. As in this regards John Hicks says that Smith's model is a static model.

 

Smith's Model and UDCs:

 

(i) Smith's model is least applicable in case of UDCs. Here the size of market is limited. As the size of market is determined by the volume of output, while the level of output is determined by level of national income. As far as UDCs are concerned they have low level of national income. Consequently, they lack the power to save and invest. The low saving and investment generate low incomes. Hence, in the next round the size of market again, remains limited.

 

(ii) In Smith's model greater stress has been laid upon social, political and institutional changes. But as far UDCs are concerned they are backward socially as well politically.

 

(iii) Smith's model is based upon laisseze-fair. But UDCs are furnished with monopolies and other market imperfections. Therefore, they have to depend upon state intervention.

 

Inspite of these Smith's model conveys a good message for the UDCs that they should raise savings for capital accumulation. If the poor countries wish to attain economic growth they will have to extend the markets; they should follow the principle of division of labor and specialization. Smith's slogan of Free Market economies has been re-popularized both in UDCs and DCs under the disguise of privatization.

 

Relevant Articles:

 

Adam Smith's Model of Economic Growth
Ricardo's Model of Economic Growth
Classical Model of Economic Growth
Marxian Model of Economic Growth
J.E. Meade's Model of Economic Growth
Schumpeter Model of Economic Growth
Secular Stagnation - Hansen's Thesis
Kaldor - Mirrlees Model of Economic Growth
Golden Rule of Economic Growth
Neo-Classical Theory of Economic Growth

 

 

Principles and Theories of Micro Economics
Definition and Explanation of Economics
Theory of Consumer Behavior
Indifference Curve Analysis of Consumer's Equilibrium
Theory of Demand
Theory of Supply
Elasticity of Demand
Elasticity of Supply
Equilibrium of Demand and Supply
Economic Resources
Scale of Production
Laws of Returns
Production Function
Cost Analysis
Various Revenue Concepts
Price and output Determination Under Perfect Competition
Price and Output Determination Under Monopoly
Price and Output Determination Under Monopolistic/Imperfect Competition
Theory of Factor Pricing OR Theory of Distribution
Rent
Wages
Interest
Profits
Principles and Theories of Macro Economics
National Income and Its Measurement
Principles of Public Finance
Public Revenue and Taxation
National Debt and Income Determination
Fiscal Policy
Determinants of the Level of National Income and Employment
Determination of National Income
Theories of Employment
Theory of International Trade
Balance of Payments
Commercial Policy
Development and Planning Economics
Introduction to Development Economics
Features of Developing Countries
Economic Development and Economic Growth
Theories of Under Development
Theories of Economic Growth
Agriculture and Economic Development
Monetary Economics and Public Finance

History of Money
 

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