The Wealth of Nations, written by Adam Smith, is truly a masterpiece. Billionaires such as Warren Buffett and Charlie Munger have admired and praised Adam Smith’s writing. Here’s a video form Berkshire Hathaway’s 2015 shareholder meeting, where Warren Buffett and Charlie Munger discuss the philosophical framework they took from Adam Smith’s 1776 economics classic, The Wealth of Nations. It is difficult to condense a 1200+ page book into one blog post, so in this week’s blog post, I will talk about the 5 key takeaways from the Wealth of Nations. Let’s dive in.
- The price of any goods or services is composed of wages of labor, profit of stock, and rent of land.
From the price of a cup of Starbucks’ coffee to the price of gasoline, there are only 3 components that determine the price of anything: labor, profit, and rent. For example – if you live in a city where the local government consistently increases the minimum wages, then the prices of goods/services in that area are bound to increase along with it. This is because the prices of goods/services are tied to the wages of labor. Now, if the price of goods/services in that region remains the same after the wage increase, that means that either the profit margin or cost of rent has dropped, or that labor/job has been outsourced all together. Similarly, if government decides to increase taxes on businesses, then to maintain businesses’ existing profit margin, the prices of goods have to increase. If the government decides to increase individual income tax, then the wages of labor must increase to compensate for the decreased net pay; with the increase in wages, the price of goods increases proportionally. In conclusion, price of goods = wages of labor + profit of stock + rent of land. - The relationship between the country’s wealth and its productive versus unproductive labor force.
Productive labor adds value and helps a business achieve profit. Unproductive labor, on the other hand, is an expense i.e. it takes money away and does not help generate profit. Examples of unproductive labor are public servants, military, politicians, etc.
A country’s GDP can be increased by increasing the number of productive laborers, or by increasing the productive powers (efficiency). In either case, additional capital needs to be employed. That additional capital is sucked away by unproductive (idle) labors, which prevents the economy from growing.
The overarching idea is this: the more capital that’s left over, the more can be re-invested into industries/factors, which can employ more productive hands/laborers, which leads to a greater exchangeable value of the produce of a country i.e. greater profit/capital, which makes a country wealthier.
In short, investing capital in productive labor increases the capital available to reinvest, which drives up the GDP; and investing in unproductive labor diminishes the capital available to re-invest, which drives down the GDP. You can tie this concept to why Universal Basic Income (UBI) would not be a good idea, which I blogged about a couple weeks ago –here. - Taxes, wages, and the invisible hand.
Restraint (i.e. taxes) on imports provides benefit to some sectors/industries by giving domestic producers an advantage. For example – the tariffs imposed by United States on Chinese Steel helps the domestic (US) steel industry prosper. Tax on imports makes those imported goods more expensive for the consumers, so demand for those imports would drop, and with decreased imports, government makes less import tax revenue. Adam Smith says that if it is cheaper to import than manufacture that product domestically, then the country should import and allocate the saved capital/revenue in places where profit can be achieved and society can be helped. At the same time, Smith argues that taxes on imports is a must if a country is trying to guard a domestic industry that is crucial to the country’s existence.
Smith points out that the wages of labor increase as the price of the laborers’ subsistence increases. So, if wages do not increase with the increased cost of living, then laborers would re-locate. With the shortage of labor, the wages of labor would increase.
Adam Smith’s invisible hand theory states that the job/work that brings the most value to the society is the most profitable, and capital will flow in that direction where profit can be maximized. Smith points out that self serving motives end up helping the society grow and prosper. He also shows that whenever the government tries to do something beneficial for the society, it always backfires; Smith provides the example of bounties, and how bounties increase taxes for the populous, raise the prices of commodities, and incentives inexperienced traders to take on risks and venture into unknown businesses. - What is money, and the relationship between money and goods?
Smith says that money is the known and established instrument of commerce, for which every thing is readily given in exchange, but money is not always with equal readiness to be got in exchange for every thing. Wealth does not consist in money, or in gold and silver; but in what money purchases.
Smith says, “Goods can serve many other purposes besides purchasing money, but money can serve no other purpose besides purchasing goods. Money, therefore, necessarily runs after goods, but goods do not always or necessarily run after money. The man who buys does not always mean to sell again, but frequently to use or to consume; whereas he who sells always means to buy again. It is not for its own sake that men desire money, but for the sake of what they can purchase with it.” (Book IV, Chapter 1) - Supply, demand, prices, currencies, metals, and value.
In the first bullet point, we talked about how prices of goods are made up of 3 components: wages of labor, profit of stock, and rent of land. The increase or decrease in supply and demand of goods will increase or decrease the margins of the 3 components, which will eventually determine the price of that good/service. For example – if a kid’s toy is in very high demand, then that business will demand a greater profit margin, which will cause the price of that toy to go up.
Adam Smith talks about how expansion of a country’s currency will lead to an economic expansion; paper money increases the money supply, which increases money available for materials, tools, and maintenance. However, Smith also talks about how continued devaluation of the currency is detrimental for the society as it leads to inflation and people lose trust in that currency. He describes inflation by saying, “The increase of paper money, it has been said, by augmenting the quantity, and consequently diminishing the value of the whole currently, necessarily augments the money price of commodities.” Smith talks about how metals play a role in the economy; money backed by precious metals is favored over common currency payments. Smith states that the prices of precious metals are governed by the qualities of utility, beauty, and scarcity.
Lastly, the concept of value. Smith states that value is either expressed by the utility of a particular object (i.e. “value of use”) or by its purchasing power (i.e. “value in exchange”). Smith describes the paradox by saying, “The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use.” He then provides the example of how nothing is more useful than water, yet water will scarcely purchase anything in exchange. On the other hand, a diamond has scarce any value, yet a great quantity of other goods can be purchased in exchange for it.
Hope you learned a little and found this blog post helpful. We talked about the 5 Key Takeaways from The Wealth of Nations, by Adam Smith. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
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