Adam Smiths Theory of Profit - Literature review Example

Adam Smith’s Theory of Profit of the of the No. Contents Introduction 3 Literature Review 4 Falling Rate of Profit 8 Capital-Output Ratio and Effect on Profits 12 Rate of Profit Secular Movement 13 Conclusion 15 References 17 Introduction Adam Smith was one of the pioneers of political economy and a Scottish philosopher. The first book that Adam Smith had written was “Wealth of Nations” and since then, he is popularly known as the “father of modern economics” (Hollander, 2011). Most of the contemporary economies in the modern world follow mixed economic principles. Valuable decisions in such markets are jointly undertaken by public and private authorities. Adam Smith had first introduced the concept of free market system in the field of economics. His book named “Wealth of Nations” had initiated the idea that self-interested rational agents within the market can create economic prosperity with the essence of competition. This essay will elaborate on the Adam Smith’s theory of profit. After analyzing the theory qualitatively, the essay would also incorporate empirical case studies, which would help in interpreting relevance of the theory in present scenario. Adam Smith had proposed the theory of profit after considering the fact that rational individuals will invariably realize their welfare and in this manner, they can enhance welfare of the society as a whole. He claimed that self-interested individuals would generate higher rivalry within an economic system and accordingly enhance net social welfare thresholds of markets. Even so, it was believed by him that only with increased degree of competition, individuals within an economy would be able to make their consumption choices from a variety of goods and services. In addition to this, he claimed that collusive behavior of companies within an economy lowers social wellbeing of the public and extracts larger proportion of surplus from buyers in the market. Such dominant commercial powers in the business world negatively influence legal and political norms of an economy (Abeles, 2001). Adam Smith advocated that when an economy progresses over time, its existing capital stock grows. However, even though gross capital resources of an emerging nation expand, its aggregate profit rate gradually declines (Hollander, 2011). He added that due to increased market competition, higher demand for labor resource and large investment requirements, the aggregate profit of an economically advanced nation gradually declines. Adam Smith’s profit analysis is based on grounds of competition existing among the capitalists. The following context of the essay would elaborate on this theory of profit in a detailed manner. Literature Review Researchers refer to Adam Smith as the first economist to have introduced the concept concerning rate of profit in a capitalist system. He considered rate of profit as a regulator of economic growth. The capitalist market system was characterized by high degree of competition among the business firms. Adam Smith’s profit theory made a detailed analysis about profits that could be earned by commercial firms. Nonetheless, the theory had highly stressed upon the concept of falling tendency of profit. The entire theory and associated explanations are mentioned in “Wealth of Nations”. The theory stated that when gross stock of capital increases in a market, wage rates of the laborers rises, thereby diminishing profit level of the capitalist firms. The theory also claimed that if several rich merchants share the same amount of capital and resource stock, then the level of rivalry among firms enhances and surplus earned by each firm falls. Adam Smith’s theory of profit was based on the concept of surplus. According to the views of Adam Smith, competition lowered profit level of firms because of two primary reasons. Firstly, each producer in a market only produces those commodities, which can be manufactured at lower costs. Figure 1: A Single Seller Minimizing Costs AC AC0 Average Cost Curve (AC) AC1 Quantity Q1 Q2 (Source: Author’s Creation) As shown in the above figure, when a single seller manufactures output (Q2), he achieves scale economies and experiences lower average costs of manufacturing (AC1). If the degree of market competition enhances and new entrants enter within an industry, then cost per unit (AC0) borne by each firm rises. Secondly, if an industry is highly competent comprising large number of sellers, then aggregate demand for labor resource often offsets its supply in the labor market (Kurz, 2011). Figure 2: Upward Thrust in Wage Rates Wage Rate D1 D2 S W2 W1 D1 D2 Demand and Supply of Labor (Source: Author’s Creation) The above graph shows that, given the backward bended supply curve (S) of laborers in the market due to increased stock of capital, demand curve of labors shifts from D1to D2 and aggregate wage rate rises from W1 to W2. Thus, this implies that rise in demand for labor, given the supply, enhances wage rates in the human capital market. As a result, Adam Smith’s theory of diminishing profit held true when higher rivalry among capitalists lowered their profits by increasing wage rates and average costs (Mirowski, 1982). The theory was against interests of the capitalist classes and supported that of non-capitalists in the economy. This is because increased competition among business firms lowered the aggregate price level of goods and services. In this manner, laborers in the market could benefit from higher wages and households experienced lower prices for consumable goods. However, it was found that David Ricardo had criticized Adam Smith’s theory of diminishing profit. Ricardo claimed that higher competition among capitalists can equalize the rate of profits earned by firms within a given industry. Even so, it was irrational to claim that increased rivalry would not necessarily diminish profit levels of firms on the whole. In addition to that, Ricardo stated that the capitalists primarily offer wages at the subsistence levels. When the degree of competition among business firms increases, market wage rates reach above the subsistence level. Higher wages generate greater amount of productive population and finally helps in increasing demand of labor. Hence, David Ricardo’s theory of profit did not correspond with the traditional view of diminishing rate of profit theory introduced by Adam Smith. Ricardo claimed that increased population pressure increases demand for food in an economy. Higher demand for food implies greater pressure on agricultural productivity. Eventually, higher demand for agricultural produce in a market increases prices of the food products, thereby lowering the real value of money in the economy. Under such circumstances, in order to maintain real purchasing power of the laborers, capitalists are forced to enhance money wages, which in turn lowers their market profits. Adam Smith believed that profit of capitalists decline due to heightened competition in the market. On the other hand, Ricardo argued that profit margin shared by each firm within a highly competitive industry falls over time because of rising price pressure of agricultural products. Contrarily, another group of researchers claimed that rising real wage rates in the market enhances prices of most goods and services available, which makes them available to affluent consumers only (Hollander, 2011). This view of Hollander precisely corresponds with Adam Smith’s theory. Adam Smith suggested that higher competition in the market lowers profit levels of the capitalists due to higher wage rates. Nonetheless, the costs of increased wage rates in the market are passed on to rich consumers in form of higher product prices or to landlords in form of lower rents. Eltis had provided a theory of profit, similar to that of Adam Smith (Hollander, 2011). Confirming Adam Smith’s theory, he stated that increased capital stock in an economy diminishes the rate of profit. Along with this, Eltis also added that intensified competition in one specific industrial sector drags down the surplus level of other sectors as well (Goss, 1980). Adam Smith’s profit theory indicated that higher capitalization in the agricultural sector does not necessarily enhance its productivity (Adam, 2011). This is because better productivity can be experienced with the essence of greater division of labor. In the agricultural sectors, appropriate division of labor is absent. Then again, the theory proposed by other economists such as, Eltis, suggests that higher competition in the market generates lower profitability in the agricultural sector and in turn drains out capital towards manufacturing and commercial sectors. Therefore, from the context of the literature review, it can be said that Adam Smith’s theory of profit was initially opposed by David Ricardo. Over time, several economists have agreed with the arguments on profit stated in the theory of Adam Smith. Falling Rate of Profit Adam Smith mentioned that an individual in an economy has certain invariant features. One such feature is that rational individuals always aim to improve their conditions of livelihood. He added that self-interested individuals in the market desire to procure surplus or profit for facilitating greater welfare. So, a capital owner undertakes decisions to employ resources in the agricultural, manufacturing or retailing sector according to personal profit motives. The urge to earn greater profits encourages capitalists to incorporate division of labor in business. This is because higher degree of labor specialization contributes towards augmenting the level of labor productivity. In turn, increased working efficiency of the laborers helps in lowering per unit costs of production. The selling prices of products in the market eventually falls with the essence of lower unit costs. Furthermore, lower prices in the market helps to enhance aggregate demand for most goods and services. Higher market demand creates need for increased degree of labor specialization, given the stock of capital. As a result, with rise in the degree of labor specialization, existing capital-output ratio improves in market, as per the theory, provided gross stock of capital is constant. Capital-output ratio measures the amount of output generated for each unit of capital. Hence, Adam Smith stated that fixed capital is primarily responsible for labor capital substitution. When a country progresses economically, growth of the economy should be productive in nature. Productive growth appears to be accompanied by rising stock of capital resources. During the process of development, if greater degree of competition among capitalists is coupled with rise in capital stock, then the capital-output ratios remain fixed. Under such circumstances, demand does not substitute capital and market wages do not rise substantially. On the contrary, if commercialization and competition rises without the same in capital stock, then the producer is seen to substitute labor against capital and encourages higher labor specialization; this lowers costs and improves productivity (Adam, 2011). However, this enhances wage rates and lowers profit of the firms in long run. Therefore, Adam Smith advocated that entrepreneurs of developing nations must enhance capital stock and avoid labor against capital substitution for evading threats of diminishing profit. The theory claimed that capital stock (gross wealth resource) of a firm can be enhanced in two dimensions: Circulating capital Fixed capital Fixed Capital The aggregate output that can be manufactured by a firm increases with the essence of greater labor resource and higher division of labor. Through increased specialization, the aggregate amount of work done by a single worker increases owing to rising efficiency (Adam, 2011). Firms accomplish manufacturing process in lesser span of time by applying division of labor. This is because; specific tasks accomplished by laborers are simple and less complex. It should also be noted that higher division of labor is practiced by capitalists acquiring fixed stock of capital. Circulating Capital Adam Smith mentioned in “Wealth of Nations” that capitalists can never generate revenue only with fixed capital. Fixed capital and increased division of labor can ensure higher output productivity. In reality, it is circulating capital, which has the potential to enhance revenue earned by a firm. Circulating capital of a firm increases when fixed capital experiences a rising tendency. Classical economists like, David Ricardo and Adam Smith, had analyzed circulating capital as raw materials used by a firm and wages being paid to the laborers. The machineries and equipments that are used in the manufacturing process of firms were considered to be fixed capital resources. Adam Smith stated in his theory of profit that capitalists can never generate revenue solely with fixed capital resources. Circulating capital should be used over fixed capital resources for securing revenue generation. In his book, “Wealth of Nations”, Adam Smith argued that the most valuable trading machines and equipments cannot help to produce any output without inclusion of raw materials and labor resource (Adam, 2011). Smith stated that when an economy develops and degree of commercialization enhances, capitalists will invariably experience increased demand for labor resource. Mere division of existing labor resource on the given stock of fixed capital can only help in improving produce in very short period of time. In addition, any new technical change introduced in order to enhance quality of existing stock of fixed capital cannot effectively substitute the augmenting demand for circulating capital resources in the market, in form of labor. Furthermore, Adam Smith claimed that fixed capital introduced in a capitalist market indirectly creates higher demand for labor resource. In this way, fixed capital helps a firm earn greater amount of revenue by way of increasing the aggregate amount of employability. Hence, according to Smith, employment and profit shares a positive relationship. Yet, the theory simultaneously confirmed that increase in all variations of employment would not be able to enhance employers’ profit. Smith suggested that profit earned by a firm can be improved only with the usage of productive labor. In the theory of profit, Smith claimed that unproductive labor reduces the potential level of capital accumulation, which lowers the investable level of output. As a consequence, productive human capital can solely help to foster economic growth level of a nation. It should be noted that Smith’s profit could be generated with the help of labor, but not fixed capital. This analysis corresponds with the context of literature review, which states that Adam Smith’s definition of profit is based on surplus value approach. When the capital stock in an economy rises (fixed capital as per Adam Smith’s profit theory), demand for productive labor resource enhances in the market. This is because, according to the theory, neither division of labor nor technical advancement can help in generating surplus value for a capitalist firm. Surplus or profit can only be created with productive human capital. Nonetheless, as stated in the literature review, increased demand for efficient human capital induces an upward thrust on wage rates in the market. Then again, the theory claimed that in long run, the laborers would be able to experience better living standards with the essence of increased wage rates. This enhances aggregate strength of population and improves supply of labor resource in the market. In long run, increased labor supply lowers the previously inflated wage rates, lowering to the subsistence level. Therefore, Adam Smith claimed that increase in productive labor resource can substantially help in stimulating economic growth level of a nation. At the same time, economic growth can also be achieved by way of attaining greater labor productivity, which can be practiced by a capitalist through production mechanization. Capital-Output Ratio and Effect on Profits If the stock of capital increases, then in order to keep the capital output ratio constant, firms must improve their level of output. Adam Smith mentioned that rising capital output ratio declines the profit level for a firm. Under such circumstances, the economy would reach to a stationary state, where mass profit margins earned by the firms would become stagnant. Capital accumulation turns pointless at the stage of mass profit stagnation. This is because; higher capital formation would not bring about any changes in profit thresholds of the capitalists. Under such situations, investment levels in the economy become constant and output as well as employment thresholds in the market do not undergo any further changes. Hence, the theory of profit proposed that if capitalists fail to accrue productive labor resource and replace labor requirements with capital stock, then over time their profit from investments falls or becomes stagnant owing to increasing capital output ratio. In this manner, capitalists lose out on future opportunities to earn more profit through increased direct capital investments (Hirsch, 2008). From the above context, it can be said that higher capital output ratio lowers the profit and competition level in an economy. It can be analyzed that if capitalists increase capital stock for experiencing slow rise in profit margins, then in long run, they would experience falling rate of profits. According to Adam Smith’s theory, when the degree of competition increases in the market, then capitalists can be treated as profit making instruments for the economy. As a result, over accumulation of capital stock would lead to stagnation of firm’s profit margins. In order to resolve the same, Adam Smith advocated that intensification of market competition should be expanded in the labor market. Higher wage rates of the laborers appear to lower profit margins of the capitalists. In reality, continuous capital stock accumulations promote division of labor and in turn increase wage rates of the specialized labor resources within the market. In long run, when the quantity of fixed capital and raw materials increases, demand for labor resources heightens as well. At this juncture, real wage rates in the market remains constant only if increasing stock of fixed capital is aligned with the rise labor demand. The real wage rate rises in the market when growth of capital outweighs that of demand for productive human capital. Consequently, Adam Smith stated in the theory of profit that average real wage rates in the market is directly proportional to the degree of its capital accumulation. In economically advanced nations, the extent of capital accumulation is high; this enhances real wage costs of its entrepreneurs. Therefore, greater competition in an economically advanced nation ultimately results in stagnation of profit, where the real wage costs are high and rate of profit generation is low. Even so, Adam Smith proposed that falling rate of profit in a developing economy can be rectified with the help of new territory discovery and innovative trades. He had also added that such countertendencies are simply ephemeral interruptions of the falling rate of profits. Rate of Profit Secular Movement Without using any national income data, Adam Smith claimed that rate of profit is in reality subjected to various types of fluctuations. Perhaps because of this reason, it becomes challenging to estimate the rate of profit over time. Adam Smith also explained that rate of interest in the market can be regarded as an approximate measure for rate of profit. This is because rate of profit and that of interest in the market are positively related. Increasing interest rate of an economy would eventually heighten the rate of profit. Interest rate, in Adam Smith’s definition of profit, was considered as the cost of risk associated with loan offerings. The theory indicated positive relationship between rate of profit and interest rate in ways that imply that value of profit rate is twice that of interest rate. Hence, relevance of Smith’s theory of diminishing rate of profit can be empirically evaluated with the help of data on interest rate (Cuñat & Fons-Rosen, 2009). Figure 1: Interest Rate Evolution (Source: Tsoulfidis & Paitaridis, 2012) The above figure portrays the rate of interest on bonds experienced by England, Netherlands, Italy and France. It should be noted that interest rate considered in the above figure is the real rate of interest, which considers inflationary and deflationary outcomes in the market. Real Rate of Interest = Nominal Rate of Interest – Inflation (+ Deflation) (Hirsch, 2008). The declining lines of interest rate in the above figure signify falling rate of profit across all markets. The rate of interest in the European medieval period was high, but had gradually fallen at the end of Dark Ages. Such circumstances eventually paved way for Renaissance or Enlightenment, during the era of Adam Smith (Mirowski, 1982). Therefore, Adam Smith’s theory of profit provided great insights into macroeconomic literature and also contributed towards assessing the empirical changes in real interest rate and rate of profit across economies over time (Rosenberg, 2011). Conclusion After conducting the research, it can be rightly stated that many economists initially misinterpreted Adam Smith’s theory concerning falling rate of profit. These scholars believed that rate of profit declined in a capitalist market due to excessive market competition. However, in reality, Adam Smith mentioned that rational urge to make profit of self-interested capitalists in an economically advanced nation drives them to employ capital intensive techniques of manufacturing. This can be attributed to the fact that capital intensive production techniques encourage greater division of labor and lower average costs of production faced by the firms. Even so, while continuing such processes, capitalists increase the surplus amount set aside for depreciation. Higher surplus generation reduces relative share of profits of the firms. At the same time, rising capital-output ratios of these capitalist firms brings down the rate of profits in market, despite presence of countertendencies. All such factors enhance the level of competition among firms and lower the opportunities for profitable investments in the economy. On experiencing constant mass profits in long run, net investment opportunities within the economy become almost zero. This is a stationary state of the economy, where the market experiences negligible growth rate, in terms of output or employment. The market rate of profit and real wage appears to slump under such circumstances. Also, lower real wage does not necessarily enhance demand for labor in such stagnant economies. Hence, Adam Smith had stated in his theory of profit that the growth process of any economic system is terminated at steady or stationary state. Usually it was considered that competition, higher demand for labor resource as well as investment requirements were responsible for the declining rate of profit. Nevertheless, after conducting a thorough analysis, it can be claimed that intensification of competition in reality results from declining profit rate. This is because capitalization of production process basically lowers the rate of profit and enhances level of market rivalry. Higher competition implies reduced product prices and increased wage rates (Adam, 2011). References Abeles, T. P. (2001). Impact of Globalization. On the Horizon, 9(2), 2 – 4. Adam, S. (2011). The Wealth of Nations. PSU. Retrieved from http://www2.hn.psu.edu/faculty/jmanis/adam-smith/wealth-nations.pdf. Cuñat, A. & Fons-Rosen, C. (2009). Relative Factor Endowments and International Portfolio Choice. London School of Economics, 1-37. Goss, B. A. (1980). Adam Smith of Abstinence. Monash University. Retrieved from http://onlinelibrary.wiley.com/doi/10.1111/j.1467-8454.1980.tb00239.x/abstract. Hirsch, A, R. (2008). Macroeconomics. Connecticut: Cengage Learning. Hollander, S. (2011). Samuelsons Canonical Classical Model of Political Economy. Journal of economic literature, 18(2), 559-574. Kurz, H. D. (2011). Smithian Themes of Piero Sraffa’s Theory. Journal of Post Keynesian Economics, 3(2), 271-280. Mirowski, P. (1982). Adam Smith, Emperism, and the rate of profit in the eighteenth-century England. Duke University Press. Retrieved from http://hope.dukejournals.org/content/14/2/178.full.pdf. Rosenberg, N. (2011). Adam Smith on Profit—Paradox Lost and Regained. The Journal of Political Economy, 82(6), 1177-1190. Tsoulfidis, L. & Paitaridis, D. (2012) Revisiting Adam Smiths theory of the falling rate of profit. International Journal of Social Economics, 39(5), 304 – 313. Read More