Economics By Adam Smith

1. Smith and wealth of nations

Adam Smith was a classical economist who discussed the source of wealth for the already developed countries today. Smith stated that wealth of nations was as a result of capital accumulation, trade and division of labour. He stated that economic growth depended on capital accumulation which in turn depended on savings and investment. Therefore wealth would be accumulated through capital accumulation whereby capital accumulation would depend on savings and investment in the economy, however Smith did not consider the role played by technological advancement, this is because he only considered capital accumulation in the absence of technological advancement.

He also recognised the role played by trade in accumulation of wealth, he advocated for free trade where trade between countries was characterised by no restrictions to trade such as tariffs and quotas. Therefore countries would acquire wealth by trade, division of labour was another factor that smith considered whereby division of labour would lead to economic development. Through division of labour productivity and the cost of production would enable a country to accumulate wealth.

From the above discussion therefore on Smith work on wealth of nations it is clear that he did not consider technology as a factor that would lead to economic development, apart from the classical school there also exist other scholars from various schools that explain the wealth of nations, example the mercantile school, the Rostow growth stage theory. However as considered today the classical school was referred to as classical because of their unquestionable authority in economic thinking and also that scholars who wrote on economics have borrowed a leaf from the classical scholars. For this reason therefore capital accumulation, division of labour and trade are still considered today as a source of economic development and a source of wealth.


Economics By Adam Smith

2. The law of diminishing marginal utility and the law of demand

The law of diminishing marginal utility depict that as the consumption of a good increases then the utility derived from consumption of one extra unit of a good will decline as the consumption of that good increase, this theory shows that a consumer will derive utility from the consumption of a good but the utility derived from the consumption of one extra unit of a good keeps on declining.

This theory is related to the law of demand where consumers will demand the level of goods at which they maximise their utility, they have to consider the utility derived and the price level, and the optimal utility level is determined by the marginal utility curve while the price level is determined by the demand and supply.

This theory of diminishing marginal utility and the theory of demand may not be in line with each other, this is where the prices are reduced and the demand increases. However the law of demand at an individual level is violated especially when we have abnormal goods, this include giffen goods, for a giffen good as the price of a good rises then its demand also rises.

3. Absolute advantage and comparative advantage:

Absolute advantage is the advantage that t a country has over another country, this theory assumes that we have two countries and that we have two products and that the only factor of production is labour, now if we assume that the two products that they produce include sugar and cloths. Now if we have country A and country B and that country A will use 20 units of labour to produce one bag of sugar and that country B will use 10 units of labour to produce one bag of sugar, then using the absolute advantage theory we conclude that country B has absolute advantage in producing sugar.


Economics By Adam Smith

When we consider comparative advantage, this theory still assumes that we have only two products, two countries and the only factor of production is labour, then if one country has absolute advantage over the other country inb production of both goods, the comparateive advantage theory states that both countries will still gain by trading. We consider country A and B and product X and Y which are produced in both countries, is country A uses10 units of labour in the production of good X and country B uses 20 units of labour in the production of good X. country A uses 15 units of labour in the production of good Y and country B uses 18 units of labour in the production of the good Y.

From the above discussion it is clear that country a has absolute advantage in the production of both goods, this is because it uses less units of labour in producing both goods than country B. according to the comparative advantage theory country A has comparative advantage in the production of good X and country B has comparative advantage in the production of good Y, if both countries produce the goods they have comparative advantage then both countries will trade.

The comparative advantage theory explains why countries trade even if they can produce goods at lower costs, this can be explained by the comparative advantage theory. Therefore the comparative advantage theory by David Ricardo best explains the current situation in trade and why countries trade.

4. Say’s law

Says law was formulated by Jean Say, this law states that there can be no demand without supply, for this reason therefore Says law state that a recession does not occur due to failure in aggregate demand, according to Keynes recessions can be caused because of a failure in aggregate demand but according to Says law a recession cannot be caused due demand side failure.


Economics By Adam Smith

According to the Says law unemployment could not be caused by a decline in aggregate demand but however according to Keynes unemployment could be caused by a failure in aggregate demand and this is what he referred to as cyclical unemployment, this type of unemployment is caused by business cycles that exist in an economy. From the above discussion therefore it is clear that Keynes is able to criticise the classical economist views regarding the economy especially on issues regarding recession and unemployment.

5. J. S. Mill

John Stuart Mill built on ideas that were presented by David Ricardo and Adam Smith, these were classical economist who based their philosophy on human nature, Mill stated that the business of life should be left to those who are best able and interested in it, through his statement it is clear that Mill advocated for a free market. However he accepted the intervention by the government through taxes and expenditure in the economy.

Mill described a system of logic where he identified five principles which include the method of difference, the method of agreement, the double method of difference and agreement and finally the method of residues. For this reason therefore it is clear that Mill advocated for the classical school.

6. profit-maximizing firm.

Given information on the increase in the production of a firm as it increases its employees it is easy to determine the most optimal point of production, according to the neoclassical theory there are three phases of production as the firm increases its variable inputs, this include increasing returns to scale, constant returns to scale and diminishing returns to scale. A firm will


Economics By Adam Smith

increase its variable inputs and experience an increase in the marginal productivity of labour; however the marginal return reaches a peak and starts to decline, at this peak therefore this is the most optimal point of production.

Given our data therefore we can get our marginal change in production by deriving the change in production as we increase employees:

The table below summarises the changes;


total product


change in production





Economics By Adam Smith













Economics By Adam Smith













Economics By Adam Smith




Total production can be demonstrated by the following chart:

The marginal change can be demonstrated by the diagram below:

From the above diagram therefore the firm should only employ one person, this is because when we employ one person the marginal change is the greatest and our diagram shows that when one person is employed the change in production is at its highest.


Economics By Adam Smith

7. Price elasticity of demand

When the demand of a good produced by a firm is price elastic then this means that an increase in the price of that good will result into a decline in the level of demand, if the demand is price inelastic then this mean that an increase in the price of that goods will not result into a decline in demand.

Therefore when the price elasticity of demand of a firm is inelastic then the firm can increase its revenue by increasing the price of that good, this is because even after raising the price the demand of the good does not decline and therefore revenue will increase.

8. Econometrics and mathematical economics

Econometrics involves economic modelling of economic relationships. it involves testing hypothesis given economic theory and data. Econometrics therefore involves the use of the linear classical estimation model to estimate models that explain independent and dependent variables that can be used to predict and forecasting. This models are tested for validity using appropriate test such as the t test given the null and alternative hypothesis. An example is to test whether the demand of a good is a function of the price and the model to estimate is DD = a

+ b P where DD is a dependent variable and P is an independent variable. Using data given on prices and demand we can be in a position to estimate the model.

Mathematical economics involves the introduction of mathematics into the field of economics; this involves the introduction of such mathematical t4echniques as calculus, differentiation, integration. These methods are useful in economics and for example given the total product function we can derive the marginal product function by differentiating the total product function, example given the total product function as: TP = X2 + 3x + 4


Economics By Adam Smith

Then our marginal product function will be given by δTP/ δ X = 2x + 3

9. Monetarists and new classical economists and the Keynesian school

Monetarist and neoclassical schools are against the Keynesian explanation of the economy, Keynes argue that an economy should be a free market economy and the government should not interfere with the operations of the free market, however the classical economist state the importance of government and state intervention in the economy in order to resolve issues that lead to market failure.

Keynes argue that recession can be caused by a decline in the aggregate demand in an economy, however the other schools are opposed to this idea and they argue that a recession cannot be caused by aggregate demand deficits. Also they differ in their explanation of the causes of unemployment where Keynes argue on the existence of cyclical unemployment.

10. Galbraith theory of countervailing power

The theory of countervailing power was developed by Galbraith, this theory is a theory of political modification of the markets, according to the free market economist goods and services are provided in the market and the price of these goods are determined by market forces depending on the level of supply and demand in the market, however according to Galbraith this is not the case in the modern world, this is because large business have massive power who in


Economics By Adam Smith

turn distort the free market.

However according to him this results to increased pressure by trade unions and other organisations aimed at depriving these large businesses off their power over the market. A good example can be the existence of imperfect market structures such as monopoly, oligopoly and monopolistic competition in the economy that have power over prices in the economy.

11. Economic rent

There are various factors of production that classical economist identified and they include land, labour, capital and enterprise. They also identified the various rewards to these factors of production where land earns rent, labour earns salaries or wages, capital earns profits and enterprises earn profits.

It should however be clear that the economic rent is not the reward that is derived from land use, economic rent is the difference between what is paid for factors of production and the actual; value that should be paid for the factor use. Smith however identified that economic rent can be created through monopoly power and political influence.

Because economic rent is the difference between what should be paid and what is actually paid then the control over prices will result into economic rent, in monopoly market power the firm is in a position to charge high prices above what should actually be charged and for this reason create economic rent.


Economics By Adam Smith

Land as economic resource will accrue increasing rent overtime due to the fact that land overtime will experience changing and new opportunities fr it to acquire more earnings, for example land that is left un used may be converted into a playground, later it may be developed by building residential houses. This way there will be increased income of the factor.

12. Marginal productivity and minimum wage legislation

Firms will use the marginal productivity concept to determine the most optimal point of production, the cost of labour in the economy will determine the production costs of products in the economy. Firms have to consider the marginal cost function and will produce at the point where costs are at their lowest.

When the minimum wage legislature is introduced then the cost of labour increases, when this happens the cost of production increases and the total cost function of firms will increase, when the marginal cost shifts due to an increase in total cost then a firm will tend to lay off workers due to the increase in cost and because they would like to produce where their costs are at lowest and therefore they will lay off workers which will result into increased unemployment in the economy.


Hadjimichalakis M. (1982) Modern Economics, Prentice Hall Publishers, New Jersey

Stratton (1999) Economics: A New Introduction, Pluto Press, New  York


Economics By Adam Smith

Samuelson (1964) Economics, McGraw-Hill publishers, New York

Thomas B and Paschal F (1995) Beyond Rhetoric and Realism in Economics: Towards a reformulation of economic methodology, Rout ledge, London

Philip Hardwick (2004) Introduction to Modern Economics, Pearson Press, New York