What is Adam Smith's Economic Theory?

Adam Smith’s economic theory is like learning by trial and error…

Rather than dictating what you should or shouldn’t do, life has a way of giving you feedback and influencing your behavior. For instance, if you touch a hot surface, your body informs you not to do it again. Although the system doesn’t prevent you from getting burned once, it does provide some guidance so you can avoid repeating your mistakes.

Adam Smith’s economic theory is the idea that markets tend to work best when the government leaves them alone. Smith argued that rational people (aka acting in their own interest) would naturally find the best way to use the nation’s resources — He viewed government regulation as potentially detrimental to economic growth.

Smith’s laissez-faire (French for “let it/them do”) approach to economic policy in the 18th-century came at a time when governments discouraged international trade. Many believed that a nation’s wealth was measured by the amount of gold it had — And while imports meant bringing goods into a country, it also meant sending gold out. Domestic businesses (aka merchants) tended to support these policies because it eliminated foreign competition for their products. These merchant protection policies later became known as mercantilism.

In The Wealth of Nations, Smith showed that a nation’s wealth wasn’t determined by the precious metals it held in its vaults. Instead, he argued that wealth existed in the value a commercial society created through production and trade. Smith’s ideas formed the basis for how most countries determine their wealth to this day — By determining the market value of the products created within their borders (aka gross domestic product), or by their people (aka gross national product).

Adam Smith didn’t just contribute to economics, he basically invented it. In the early 18th century, moral philosophy was the closest thing to what we now think of as the field of economics. Smith grew up in Kirkcaldy, Scotland and studied moral philosophy at the University of Glasgow in the 1730s. One professor in particular, Francis Hutchinson (a notable Scottish philosopher of the time), had a profound impact on Smith’s training and seems to have guided his early work.

Smith continued his education at Oxford University in 1740, where he became close friends with David Hume — Another philosopher whose work would become well-known during this age of Scottish Enlightenment. Smith and Hume are rumored to have spent many hours in the Edinburgh taverns discussing their ideas.

Smith published his first notable body of work, The Theory of Moral Sentiments, in 1759. In it, Smith discussed the idea that self-interested people naturally end up working toward an outcome that benefits everyone. He described this idea as an “invisible hand” that guided individuals toward paths that simultaneously improve their lives and the lives of the people on the other side of a trade. This concept of natural liberty leading to optimal outcomes is perhaps the most significant contribution to what we now call economic theory.

In 1776, Smith published An Inquiry Into the Nature and Causes of the Wealth of Nations. Smith’s ideas in these works and others helped develop the foundation of political economics, inspired policies that shifted away from mercantilism, established the concepts of specialization and the division of labor, and laid the groundwork for macroeconomic theory. Because of his wide influence, Smith is often known as the father of economics.

Adam Smith was among the first philosophers of his time to declare that wealth is created through productive labor, and that self-interest motivates people to put their resources to the best use. He argued that profits flowed from capital investments, and that capital gets directed to where the most profit can be made. These ideas — That wealth follows capital, and that individuals own capital — are core to capitalism as we know it today. But at the time, Smith’s ideas were revolutionary.

Adam Smith is sometimes cited as an influential figure of the Industrial Revolution, which is usually described as beginning in 1760 in England. During that period, advances in technology changed the way that human society lived and worked. This was also the decade that Smith worked on his life’s work, The Wealth of Nations (1767-1776) — The timing suggests that Smith was working on his book just as industrialization began, and may be why Wealth of Nations makes little reference to the tectonic shifts that were starting to happen around him.

Before the Industrial Revolution, most of the population lived and worked on farms. Skilled artisans handcrafted most of the products that people used. These craftsmen were often part of a guild, which controlled the manufacturing and sale of products. Smith critiqued the monopoly power of the guild system, as well as the protectionist policies in which the government intervened to direct commerce. He pointed out that allowing individuals to decide how to use their money, land, equipment, and labor how they saw fit would generate the most benefit for the nation. His work suggested that allowing people to pursue their self-interest would result in a self-organizing system that was better for everyone.

At the same time, the Industrial Revolution turned manufacturing into a centralized process with the help of machinery and steam power. Factories could make products faster and cheaper than individuals could. Consequently, a significant portion of the population transitioned from cottage industries into new urban factories.

As Smith wrote about the theoretical benefits of the division of labor (having people specialize in specific tasks), and of allowing the free-market to guide the direction of an economy (as opposed to state intervention), his ideas were already playing out in real life.

It’s unclear to what degree Smith’s ideas influenced, observed, or predicted the way the world would change going into the 19th century. But his work did overlap with the expansion of the capitalist system that he described. The decades that followed are full of examples of countries adopting the free-market economy and laissez-faire policies that Smith promoted.

The main purpose of Adam Smith’s The Wealth of Nations was to further the understanding of political economy (the role of government in economic policy). He wanted to encourage governments to adopt a free-market approach to production and commerce.

At the time he wrote the book, the world was pre-industrial and largely ruled by empires with colonies. The working class relied on a system of journeymen and apprenticeship, managed by a network of guilds. In many places, kings and queens still ruled over the lands and measured the strength of their nations by the amount of gold and silver they owned.

Smith studied the motivations and natural tendencies of human beings. He observed that people were primarily driven by self-interest — Committing their resources to those things that most benefited them. He argued that all trade was mutually beneficial — If one person in the exchange didn’t come out better off, they’d simply decline the deal. Therefore, Smith observed, all voluntary trade resulted in increased wealth, and therefore regulating trade was unnecessary and potentially damaging.

Smith’s work showed how government policies that prevented trade reduced the amount of wealth that a country could create. (This idea included the mercantilist policies of England and France, but also the monopoly power exerted by the guilds.)

Smith wrote his book as a way to demonstrate that controlling free trade was unwarranted and unwanted. He showed that members of a society, each looking out for their own gain, embraced the natural competition that results from human nature. The forces of competition place a check on all activity, ensuring that everyone receives their value — Laborers earned wages, landlords received rents, and capitalists got profits, and so on. In Smith’s view, the best system ensured that resources would get exchanged until they resulted in the best possible allocation.

Adam Smith is considered the father of economics, but he did more than just write the book on the subject. His life’s work laid a framework of thinking that is widely believed to have changed the course of humanity. For example, Smith’s work pointed out the flaws in restricting international trade and encouraged governments to relax their protectionist policies.

As the world moved past mercantilism — Helped by improvements in transportation, communication, and commerce — Smith’s work inspired political leaders to adopt free enterprise principles. His crowning achievement was the completion of The Wealth of Nations, which revolutionized the way people thought about trade and laid the foundation for capitalism. Smith is widely considered one of the most influential people of the 18th century, and remains so to this day. In 2007, the United Kingdom commemorated him on its 20-pounds-sterling banknote.

Smith’s best-known ideas formed the basis of economic theory, including the invisible hand theory (the idea that free-markets coordinate themselves), the division of labor (the idea that people should specialize in specific tasks), and the measurement of economic activity (Gross Domestic Product). Smith was a strong advocate for individual freedom, free-market economics, competition, and capitalism.