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Old Friday, September 12, 2008
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Default Economics Notes

What is Economics?

We might take our definition from the father of modern economics, Adam Smith. (The symbol means a reference to background material on an economist, historical period or event). He entitled his famous book An Inquiry Into the Nature and Causes of the Wealth of Nations. That is not a bad description of the subject matter of economics, but many modern economists have tried to find a more logical or scientific definition.

Smith was, in many ways, the founder of modern economics. He wrote at a time when the industrial revolution was just beginning to transform European society. He observed that, in his own society, economic development could bring about a widespread prosperity, and yet other countries, and even some districts of an advanced country such as Britain, could lag behind in poverty. It was never difficult to account for poverty -- poverty had been the condition of most people since time immemorial -- but what could account for this prosperity? This was the question Smith put to himself, and in his time it was the central question of economics.

This hyperbook will follow Smith's example. We will be inquiring into the nature and causes of the wealth of nations, and that inquiry will be our definition and our answer to the question, "what is economics?"

Yet economics is a field full of controversy, and even the definition of the field has been a subject of controversy. We will take a look at the controversy before the end of this chapter. For now, however, let us follow the line of thought in the definition. What does it mean to study the nature and causes of the wealth of nations?

"Universal Opulence"

In his great book, An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith took this question as his first subject: what is it that causes production of goods and services to increase with time, so that nations become wealthy rather than poor? According to Smith, "It is the great multiplication of the productions of all the different arts, ... which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people." (Wealth of Nations, Modern Library edition, p. 11) Smith's objective was to learn more about the "multiplication of productions." For him this was the point of economics.

When the production of goods and services for the market grows bigger, this is what we call "economic growth." If production grows fast enough, then we will have more production per person; and this is called a "rise in the standard of living." When Adam Smith talked about "the wealth of nations," modern economists would talk about a high and rising standard of living.

We will spend a few pages on this. What can lead to growing production?

Causes of Growing Production

Here are some of the things which may help a nation to become more productive and thus "wealthier." The list may not cover the whole story (we don't know everything) and the different items on the list may overlap and certainly are interdependent. But the list will serve to organize our "inquiry. "

  • increase in quantities of resources available
  • discovery of new technologies
  • increases in the division of labor and specialization
  • improvements in the allocation of existing resources
  • increases in the rate of use of existing resources

The last two causes will be the subjects of most of the chapters in this hyperbook; accordingly, we will leave them for later. The first three were also the ones which Adam Smith stressed, But not in the order of importance that Smith gave them. Smith put the division of labor first. In this chapter, we will follow the more modern approach, and put resources first.


Generally, the market economy can grow larger if any of the resources available to it becomes more plentiful. In other words, we can produce more outputs if we use more inputs. Traditionally, economists speak of three major kinds of resources, or, in other (and more traditional) words, three factors of production. The three "factors of production" are

  • land
  • labor
  • and capital

1. Land

By convention, economists include in the category "land" both

the "original and indestructible powers of the soil" and
natural resources, such as coal, oil, and metallic ores.

There are, of course, some important differences. Coal and oil, once they are dug out or the ground and burned, are gone for ever. In other words, they are "wasting resources." On the other hand, the fertility of the soil does not have to be a wasting resource, if the farmer uses farming methods which maintain fertility. But this difference is not absolute. Copper ores, for example, may be used and then recycled.

2. Labor

We may not think of labor as a resource, and of course it differs from the other two categories, since labor is directed human action and thus requires that the human being have some motivation. (Money is one possible motivation, of course, and a common one). Land does not require motivation.

But, from several points of view, labor is the most important resource. From the point of view of cost, it is quite important. In the American economy, labor costs amount to something between two-thirds and three-quarters of costs (net of raw materials). Labor is also important to most of us because it is the resource from which we expect to get our living.

3. Capital

Capital consists of all goods produced by human labor (with other resources) and used in the production of still more goods and services; in other words, produced means of production. Some examples are

houses and other buildings
grapevines, fruit trees and hogs on the hoof
and human capital


Thus, investment can be a source of growth. In the long run, probably, discoveries are even more important.

Discovery of new sources of raw materials certainly can lead to a higher standard of living. We can also discover new methods of doing things. The discovery of new methods -- new techniques and technologies -- is called "technical progress." Many students of economic history believe that technical progress is the only source of continuing economic growth in the long run, and that all countries and societies which have experienced rising standards of living over long periods of time (as the European and North American societies have done) have done so because of continuing, and progressive, technological change.

Adam Smith on the Division of Labor

The view of economic growth we have just been discussing is a relatively modern one. Adam Smith had a different view -- not necessarily contrary to the modern view, just different. It will be worthwhile to digress a bit and review what the founder of our science had to say about the growth of production.

Like modern economists, Smith believed that the standard of living (the Wealth of a Nation) could rise only if the productivity of labor would rise. For Smith, the most important force leading to a rising standard of living was division of labor.

What most people associate with Adam Smith is the idea of the "invisible hand;" the idea, that is, that free markets restrain prices to some "natural" level and assure the supply of goods and services at the "natural" price. Indeed Smith's discussion of the "invisible hand" comes quite early in The Wealth of Nations, but it is not the first topic Smith takes up. In Smith's logic, it could not be. The very first topic Smith takes up is the division of labor.

Smith argues that increasing the division of labor increases productivity. In one of the most famous passages in the book, Smith illustrates this tendency by a description of work in a pin factory:

But in the way in which this business is now carried on, not only the whole work is a particular trade, but is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a particular business, to whiten the pins is another; it is even a trade by itself to put them in the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in some others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where only ten men were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound about four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this particular business, they certainly could not each of them have made twenty, perhaps not one pin a day; that is, certainly, not the two hundred fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations. (pp. 4-5)
This passage shows what Smith meant by the division of labor, and by the claim that increasing division of labor increases the productivity of labor. What I want to add is that the division of labor and specialization are aspects of what we might call cooperative production. In the pin factory, each worker is taking a different part of the work, and in doing his part he is working along with -- co-oper-ating with -- the other workers in the pin factory. Each relies on the others for the part he or she does not do. They take different roles in production, and the roles are complementary. Classical economists of the nineteenth century extended this idea, until Richard Ely, a founder of the American Economic Association, argued that cooperation in production is the primary source of high standards of living. Unfortunately, this vision was lost in the twentieth century. Perhaps it will be recovered in the twenty-first.
Smith's first great insight here is that cooperative production increases productivity. "The division of labor ... occasions, in every art, a proportionable increase in the productive powers of labor. ... It is the great multiplication of the productions of all the different arts, in consequence of the division of labor, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people." (pp. 5, 11) In short, "In civilized society [one] stands at all times in need of the co-operation and assistance of great multitudes, ..." (p. 14)

The division of labor into different trades is also an aspect (and perhaps the more important aspect) of the division of labor, according to Smith. "In the lone houses and very small villages which are scattered about in so desert a country as the Highlands of Scotland, every farmer must be butcher, baker and brewer for his own family. ... A country carpenter deals in every sort of work that is made of wood ...[he] is not only a carpenter, but a joiner, a cabinet maker, and even a carver in wood, as well as a wheelwright, a ploughwright, a cart and waggon maker." (p. 17) This is in contrast to a more developed region. "Observe the accommodation of the most common artificer or day-laborer in a civilized and thriving country, and you will perceive that the number of people of whose industry a part, though but a small part, has been employed in procuring him his accommodation, exceeds all computation." (p. 11. By accommodation, here, Smith means not only his residence, but everything he consumes, and the example that Smith gives is his coat). Conversely, the laborer's work usually will contribute, directly or indirectly, to meeting the needs of many others in society.

This division of labor is so characteristic of modern society that we may fail to notice it, as a fish fails to notice the water in which he swims. It was newer, and thus perhaps more noticeable, in Smith's time. Economists have had little to say about it in the twentieth century -- at least, in most of the twentieth century. Just recently, in the 1990's, a number of economists specializing in the study of economic growth have again come to see the division of labor as a key cause of growth in the wealth of nations.

Kinds of Economics

Economics, like other studies, can be broken down into more specialized subfields. The broadest categories are just two: microeconomics and macroeconomics.
In explaining these two terms, it might help to go back in history a bit. The word "economics" is based on Greek roots, but that is a bit of a humbug, since the Greeks didn't have a field of study anything like economics. The two Greek roots of the word "economics" are oikos -- meaning more or less the household or family estate -- and nomos, which can mean rules, natural laws or laws made by the government, but which in this case primarily means "wise saws" or "rules of thumb." Thus the book Oikonomia, by the Greek author Xenophon, is probably best translated as "rules of thumb for estate management."

Here's how the word "economics" evolved to its modern use. By the 1600's, the interdependence of people and nations through markets had grown so great that it was necessary for governments to have carefully thought out policies to deal with the markets. The most common such policy was "mercantilism" -- and the essence of mercantilism is to try to sell as much as you can to your neighbors, while limiting what they sell to you, so that they have to pay you in gold. But this policy was criticized by a number of thoughtful scholars, of whom Adam Smith is the most famous. They were engaged in a new specialization: the study of "rules of thumb for the management of the common political household," which is expressed in the Greek-derived phrase "Political Economy." And that is what the new field was called.

(The Greek root of the word political is, of course, polis -- the word for the political community, or state).

Adam Smith and his immediate successors, the "Classical Political Economists" (as Karl Marx called them) were concerned mostly with the workings of a market economy as a whole. In modern terms, we would say that they were concerned with "macroeconomics." The new Greek root here is, of course, "macro," meaning "big." Macroeconomics is concerned with economic phenomena which are "big" in the sense that the whole is "big" in relation to its parts.

However, beginning in the 1870's, scholarship in economics took a turn toward a much more analytic approach, and economists began to be concerned with the workings of the parts which make up a market economy: with the workings of markets for particular goods and services, the functioning of particular companies, and the determinants of demand on the part of individual consumers. This is now called "micro-economics." The Greek root "micro," meaning small, tells us that the microeconomist is concerned with economic phenomena which are small in the sense that the parts are small in relation to the whole.

This analytic economics began to see itself (with some reason) as a science, and the term "political" in the phrase "political economy" seemed an embarrassment. So it was dropped, and the ending " -ics," as in physics, was tacked onto the end of "econom," to make it sound more scientific.

The analytic approach was very successful for a time. The macroeconomic approach of the Classical Political Economists never disappeared entirely, but it was (so to say) put on the back burner around 1900. But by 1930 -- as the Great Depression got well under way -- the analytic approach didn't look so good. Many economists felt it was time to go back at least partway to the macroeconomic concerns of the Classical Political Economists. The most famous of these economists is John Maynard Keynes.

By the late 1950's -- when Paul Samuelson's seminal economics textbook appeared -- it was clear that there was much that was useful and true in both approaches, and that the economics profession had to be committed to both macroeconomics and microeconomics. Thus, it was necessary to have words for the two great divisions of economics.

Of course, most economists specialize in one or the other. In practice, the microeconomist studies the working of markets for particular goods and services, and the interdependencies among these, and the supplies and demands of individual enterprises and consumers. (I should say that the individual enterprises and consumers are abstract, not concrete and specific, individuals, as a rule. The individual markets may be either abstract or concrete). The macroeconomist studies phenomena which seem to affect or arise from the operation of the market system as a whole: unemployment, inflation, the workings of the monetary system, and the determinants of economic growth

Note: Explore the following link for reading further about Adam smith:

Allah Nagheban,
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