PDF Summary:The Wealth of Nations, by Adam Smith

In The Wealth of Nations, Adam Smith laid much of the groundwork for the field of economics. Published in 1776, this seminal book makes the case for free markets and individual self-interest as the best ways to grow a nation's economy.

Smith was an 18th-century Scottish philosopher who taught moral philosophy and is widely considered one of the founding fathers of capitalism. In this guide to The Wealth of Nations, we’ll explore his ideas on how markets regulate themselves through supply and demand, the importance of international trade, and the proper role of government in fostering a prosperous society. You'll also learn why wages vary so much by region and how governments can accidentally encourage smuggling. Throughout this guide, our commentary will compare Smith's ideas to modern economics and incorporate the perspectives of present-day economists and theorists, while grounding Smith’s arguments in their proper historical context.

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Cost #3: Capital

Smith identifies the cost of capital—all of the equipment, materials, and money (outside of wages and rent) required to run a business—as the third factor that influences the natural price of a good. He explains that capital is typically lent to businesses for a profit. Those who own a surplus of capital lend it out to interested businesses out of self-interest, and they’ll naturally expect a return on their investment. Therefore, the natural price of the good will include not only the cost of the capital itself but also the profit of the investor.

Capital is lent to businesses in a competitive market. When the supply of capital exceeds the demand, capital lenders will have to lower their profit margins to compete with each other. When the demand for capital exceeds the supply, businesses will compete with each other for investment and therefore capital lenders will be able to raise their profits.

(Shortform note: Economists support Smith's assessment of competition in capital markets. The more lenders have to compete with each other, the lower the costs of borrowing capital for business. However, it's important to consider that these markets can have a very different impact on businesses of different sizes. When capital markets aren't competitive, the corresponding rise in costs squeezes small and medium-sized businesses out of the market, as only large companies can afford to borrow capital at the higher rates.)

Smith identifies three key factors that influence the markets for capital: risk to the investor, profit on capital, and changes in supply chains.

1) Risk to the Investor

The cost capital adds to the natural price will change from industry to industry depending on the risk to the investor. Smith states that if a business venture has a significant chance of failure—for example, a ship getting lost at sea—then the investors will need a rate of profit on their capital sufficient to recoup potential losses. This will drive up the natural price of capital for goods whose production requires a risk of financial loss.

(Shortform note: Contemporary investment experts generally agree with Smith's assessment of the relationship between risks and rewards. However, they caution investors against assuming that high-risk investments automatically offer high rewards. Instead, they recommend assessing the chance for risk and reward for each investment using historical precedent. Financial analysts measure the historical returns and losses on an investment and then measure the standard deviation to estimate its future potential for risk and reward.)

2) Profit on Capital

The cost of capital is also going to be influenced by the profit gained by the investor who lends out their capital. Smith states that capital lenders are also guided by their self-interest and invest to gain the most return. However, capital lenders are also competing with each other in a capital market—as such, their ability to profit will be determined by the ratio of supply (capital to lend) and demand (businesses borrowing capital).

Much like labor, the profits of capital are impacted by a nation's overall economic growth. However, Smith explains that they have the exact inverse relationship: Strong economic growth results in lower profits on capital while slow economic growth results in higher profits. During high economic growth, the nation has an excess of circulating capital to invest. This will cause investors to lower their rates of profit in an effort to bid against each other. When economic growth is slow, there is less circulating capital to invest in businesses. This will mean that businesses will have to compete with each other for investors, driving up the profits they’re willing to hand over in exchange for capital.

(Shortform note: The need for businesses to compete with each other for investment can cross-pressure business leaders, as the demands of their shareholders may be in tension with those of their customers. For example, a company that reinvests profits in developing and marketing new products may have a competitive edge when competing with other businesses for customers. However, a company that pays those profits as a dividend to its shareholders will have a competitive edge in attracting capital. This has led some to worry that pressure from investors may lower the competitiveness of businesses in customer markets, which may be more important for a company's long-term success.)

3) Changes in Supply Chains

Recall that capital includes all of the materials and equipment required to run a business. These materials and equipment are also goods that must be purchased at market value and follow their own ratio of supply and demand. Therefore, any change in the price of supplies or equipment will find its way into the natural price of goods. For example, a company making light bulbs would be impacted by changes to the price of glass, metal filaments, or argon gas.

(Shortform note: To insulate themselves from fluctuations in supply chains, many corporations have adopted a strategy of vertical integration. This occurs when a company buys up its suppliers so that it can generate supplies itself instead of buying them at market rate. For example, a company that makes leather belts might buy its own leather tanning factory, or even its own cattle farm, to vertically integrate its supply chain. However, business experts are mixed on the overall effectiveness of vertical integration. Some highlight the costs saved, while others emphasize the enormous cost of purchasing suppliers and contend that the costs outweigh the benefits.)

Part 5: How Capital Grows a Nation's Wealth

Lending capital for profit plays an essential role in growing the wealth of nations. Smith identifies two main reasons: First, the self-interest of the lender encourages them to invest in productive labor. Second, the self-interest of the lender also guides them to invest in less-developed portions of the economy and help them develop.

Reason #1: Capital Naturally Seeks Productive Labor

Smith first contends that capital naturally seeks productive labor: labor that can generate surplus goods. Surplus goods add to a nation's overall wealth because they enter a nation's overall supply of circulating capital. For example, a brickmaker creates bricks all day for a construction project. They make more bricks than the project needs, and the excess bricks are sold to another construction project. The brickmaker increases the national supply of circulating capital, thereby growing the economy.

Smith suggests that when capital lenders are free to pursue their self-interest, they’ll naturally direct their wealth towards productive labor—which strengthens the nation’s economy and produces national wealth. This is because work that generates surplus goods can create greater profit than work that does not.

Productive Labor and Outsourcing

Smith notes that capital markets seek out profitability—businesses with higher margins between costs and revenue. One of the most controversial ways this plays out is in a market preference for outsourcing—the practice of hiring outside contractors at a cheaper rate than it would cost to hire employees.

While most businesses outsource some of their functions to outside contractors, outsourcing becomes controversial when manufacturing jobs in industrialized countries are outsourced to developing countries where labor is cheaper. Some argue that this is simply an example of market efficiency—that it's better for total prosperity if businesses are more profitable and goods are cheaper. Others have maintained that governments have a vested interest in protecting manufacturing jobs to distribute income and protect domestic supply chains.

#2: Capital Markets Seek Out Undeveloped Industries

Smith also asserts that capital markets grow new sectors of the economy, boosting the national economy as a whole.

Recall that the lenders of capital are competing against each other for a chance to lend their capital at profit. Therefore, the more capital that has already been invested in a given industry, the lower the profits for the investors. This is because the supply of capital outweighs the demand.

Therefore, the self-interest of the capital lender directs them to seek out industries with less capital investment. This process balances out the distribution of capital, driving investment toward new industries, new regions, and new markets—growing the economy.

(Shortform note: Smith is largely talking about developing a domestic economy by moving capital from one industry to another. However, in the age of globalization, this same dynamic has led capital investors to seek out "emerging markets''—capital markets in poorer, developing, or post-Soviet countries where there is supposedly room for rapid economic growth. However, this practice has been controversial. Some tout this development as an opportunity to build prosperity in less developed countries. But critics contend that—in practice—this has benefited wealthy investors at the expense of poorer countries, arguing that unregulated predatory lending has left poorer countries with unpayable debts.)

Part 6: The Effects of Trying to Regulate Markets

Recall that the development of a nation's wealth depends on competitive markets in which participants are free to act in their own self-interest. Throughout The Wealth of Nations, Smith identifies government policies—often intended to grow a nation's wealth—that actually interfere with this process and slow down economic growth. In this section, we’ll explore two market-distorting policies that Smith critiques: restricting international trade and subsidizing industries.

Harmful Government Policy #1: Restrictions on International Trade

Many governments try to grow their nation's wealth by preventing the import of foreign goods that would out-compete domestic manufacturers. Either the country bans importing foreign goods completely (an embargo), or it imposes high taxes on the foreign goods to prevent them from being competitive in domestic markets (tariffs).

For example, let's say it's cheaper to produce cheese in Canada than in the US. This will allow Canadian cheese producers to offer lower prices than American cheese producers. If the US allows Canadian dairy farmers to export their cheese to the US, American customers will start buying Canadian cheese instead of American cheese to save money. This will make it harder for American cheese producers to sell their goods. So to protect the businesses of American dairy farmers, the US either bans Canadian cheese completely (an embargo) or imposes special taxes on Canadian cheese to raise its market price (a tariff).

Smith disagrees with restricting international trade for three reasons: It incentivizes smuggling, redirects domestic capital towards inefficient industries, and prevents countries from entering into mutually beneficial trade relationships.

Unrestricted Trade Requires Strong International Relations

Most economists agree with Smith's position that unrestricted international trade benefits the countries involved by growing their economies. However, trade policies are also dependent on mutual international relationships between trading partners for two key reasons.

1. Both parties must agree to unrestricted trade. If one country agrees to lower their tariffs but the other country does not, this could benefit the industries in the country with high tariffs while harming the industries in the country without them. Therefore, countries often lower trade barriers through mutual agreements. Furthermore, when one trading partner decides to raise their trade barriers, the other country often reciprocates, instigating a "trade war."

2. Economic concerns also intersect with national security concerns. Though Smith states that trade is mutually beneficial, he also concedes that you wouldn't want to trade with a country with which you’re currently at war. By benefiting their economy, you’ll also be strengthening their military. Many contemporary debates about free trade between economic rivals—specifically between the US and China—revolve around whether to categorize the other country as a trade partner or as a potential threat to national security.

1) Restricting International Trade Incentivizes Smuggling

Smith contends that embargoes and tariffs are ineffective at achieving their goals because they create stronger incentives for smugglers trying to get around the rules. Recall that in any market, the price is determined by the ratio of supply to demand. An embargo has the effect of drastically restricting the supply while leaving the demand unchanged.

This will drive up the price, as customers who want the illegal goods will now have to outbid each other to purchase from the diminished supply. The high prices will encourage merchants to pursue their self-interest by smuggling the tariffed or embargoed goods into the country and selling them at exorbitant prices.

(Shortform note: Smuggling poses a problem to economists as transactions are unrecorded. This can distort the data used to determine important economic metrics. Some economists estimate that America's black market accounts for roughly 11-12% of the total GDP. Many black market transactions in the US involve evading taxes, but many also involve evading labor laws by paying workers off the books.)

2) Restricting International Trade Misdirects Domestic Capital

Smith cautions that restricting international trade will slow economic growth by redirecting capital away from efficient industries and toward inefficient ones. If it’s cheaper to produce certain goods in another country, then buying those goods from that country will cost less than manufacturing them at home. Domestic consumers and businesses can thus save money by buying these cheaper foreign imports and using their savings to invest in profitable industries at home. Those domestic producers can then put their capital into something that would be more profitable to make in their countries, thereby contributing more to national economic growth than they would have in a less profitable industry.

However, by restricting international trade, governments artificially prop up unprofitable industries while making consumers pay a higher price for the goods these industries produce. This results in lower economic growth than if the market had simply directed capital toward the most profitable domestic industries.

(Shortform note: The pros and cons of international trade continue to be widely debated. Many economists support Smith’s position that trade is a net gain for both countries. However, trade deficits have become controversial because even a policy that is a net gain for the nation may still be a loss for workers formerly employed in the sectors that had been protected by trade barriers. Even if a nation would make more total wealth by reinvesting its capital and workforce in a more profitable industry, not all workers may have the skills to smoothly transition to work in those industries. Therefore, some economists recommend that countries need to pair free-trade agreements with programs to train workers and help them relocate to new industries.)

3) Restricting International Trade Prevents Growth for Both Countries

Lastly, Smith explains that restricting trade prevents opportunities for both the importing and exporting countries to grow their economies. Recall that the size of the market enables greater specialization of labor. Workers can devote more of their time to focusing on a single task if they have access to the customer base and the supplies to support high levels of production. Thus, by trading with each other, countries are able to access larger markets, supporting greater specialization of labor in each country. Smith also contends that countries don't "lose" money by buying more goods from another country than they sell to that same country. Money traded for imports is still exchanged for goods, which also add to the nation's overall wealth.

Are Trade Deficits a Problem?

Economists and policymakers continue to debate the pros and cons of running a trade deficit. Those in favor of trade deficits argue that they are actually a sign of a strong economy: Countries can only import a lot of goods if they have the wealth to purchase them, and therefore wealthier countries can afford to import more than they export. Furthermore, economist Stephanie Kelton (The Deficit Myth) asserts that America's trade deficit is merely the result of a strong currency: Other countries seek out US dollars in exchange for their goods because the US dollar has a high exchange value. This puts the US in a strong position, as the US is the sole supplier of this currency.

However, critics worry about the long-term effects of trade deficits. Some maintain that countries that export more goods and import more currency may use their excess wealth to buy up assets in other countries, monopolizing industries and gaining economic leverage in international relations. Others have pointed out specific circumstances in which trade deficits have harmed countries with smaller economies. For example, an over-dependence on outside capital can leave a country vulnerable to sudden capital outflows should foreign investors rapidly sell off investments.

Harmful Government Policy #2: Subsidies

Another restrictive policy Smith identifies is a subsidy. Subsidies are policies in which governments directly give money to a particular industry or business. The goal is to support this industry and encourage growth in this particular sector by lowering the cost of production. This allows companies to sell their goods at a lower price, artificially making the industry more profitable. Smith explains that subsidies misdirect investment capital in two ways.

First, subsidies move capital directly by collecting it through taxes and giving it to the subsidized industry. This redirects capital by taking it out of the hands of private investors who would otherwise naturally seek out the most productive labor and grow the economy but are instead compelled to invest in the subsidized industry.

Second, by artificially making an industry more profitable, subsidies encourage capital investors to prioritize this industry over others. This redirects capital away from industries that would be profitable without the subsidy and therefore away from industries that would grow the nation's wealth more efficiently.

(Shortform note: Governments often use subsidies to give domestic producers a competitive advantage in international trade. For example, if country A subsidizes wheat production, while country B does not, country A's wheat exporters could sell their products at a lower price internationally, undercutting the wheat industry of country B. Therefore, free trade agreements tend to include restrictions on subsidies for exports. In particular, the World Trade Organization prohibits subsidies that increase export performance or disadvantage industries in other member states.)

Part 7: The Proper Role of Public Spending

In general, Smith opposes taxation and public spending. This is because taxation takes capital out of the hands of the private investors who would naturally invest it in the most profitable industries.

Therefore, Smith recommends that governments should collect taxes and spend public money only if it's on something that’s important for society as a whole and can’t be handled better by the free market. Smith contends that only four expenditures meet these criteria: defense, justice, education, and infrastructure.

(Shortform note: Smith does not include welfare for the poor among the important functions of government spending. However, it’s important to consider the structure of welfare systems in Smith's time. Welfare for the poor existed throughout 18th-century Britain, but as a responsibility of the church, not the state. Christian churches had cared for the poor in Europe since medieval times, but with an inconsistent, patchwork system. Queen Elizabeth I standardized church welfare systems throughout the UK with the "Poor Laws'' of 1601. Smith discusses the poor laws at length in an analysis of parish residency requirements and their impact on labor markets, but he argues neither for nor against the practice of collecting and distributing welfare.)

State Expenditure #1: Defense

Every country must defend itself from foreign invasions with a standing military. Smith provides three arguments for the benefits of public investment in standing armies.

1. Standing militaries in industrialized societies are highly expensive because modern warfare requires implements like cannons, ships, and artillery. Therefore, it's difficult to imagine another funding source that could actually cover the expense and keep the nation well-defended against national security threats.
2. Without a standing army, governments will have to move laborers out of their existing professions to fight for the duration of the war. This will disrupt the economy.
3. Many types of work in modern economies don't prepare workers for the profession of soldiering. Therefore, it's better in wartime to have a core of soldiers that are already trained to fight.

(Shortform note: In his arguments for the importance of a national military, Smith is specifically responding to debates over whether countries should maintain a standing army during times of peace as well as war. Some countries opted to disband their military forces during peacetime and reconstitute them should war break out. Standing armies were controversial in the 18th century because of their enormous cost and the tendency of soldiers to abuse their power and authority over the population. Smith contends that the practice of reconstituting the army in wartime is sufficient for less economically developed societies, but that an industrial society needs a full-time professional military to defend itself.)

State Expenditure #2: Justice

Governments have an obligation to provide justice and enforce the laws. Smith cites two benefits of having a judiciary funded by the government.

1. The wealthier a society becomes, the higher the incentives to commit property crimes like theft and fraud become because the potential gains of such crimes are so much higher. Therefore, wealthier societies need strong courts and legal systems.
2. Laws ought to be impartial. If judges were paid by the parties involved in the trial, they may be tempted to judge in favor of those that could afford to pay them the most.

The Relationship Between National Wealth and Property Crime

Smith contends that criminals will have stronger incentives to commit property crimes in societies with more wealth to steal. Research on this point appears to be mixed. Studies have found that wealthier countries actually have lower rates of property crime than poorer ones. Many researchers attribute this to stronger law enforcement institutions and more opportunities for legal employment in wealthier nations.

However, a growing body of research suggests a correlation between crime and wealth inequality. Societies that concentrate their wealth in fewer hands tend to have more crime. This complements Smith's assessment that self-interest directs property crime. The larger the gap between the rich and poor, the stronger the incentive to bridge that gap with theft.

State Expenditure #3: Education

Smith explains that public education provides an important service to society as a whole, as it not only benefits the students but also promotes social harmony and order. Education develops a person's reason. Therefore, an educated person should be able to make decisions more rationally than an uneducated person. Smith asserts that an educated public is less likely to be overtaken by irrational crazes and enthusiasms that might destabilize public order, such as religious or political fanaticism. Therefore, public education improves social order.

(Shortform note: In his defense of public education, Smith echoes many of the Enlightenment arguments for public education. These views maintained that many social evils were the result of prejudice, superstition, and dogma, and that societies could rid themselves of these problems by cultivating "reason" in the general population.)

State Expenditure #4: Transportation Infrastructure

Recall that the larger a market is, the more able workers are to specialize their labor and generate greater productivity. Smith contends that everyone in a society benefits from transportation infrastructure that facilitates commerce because this expands the size of the market. Transportation infrastructure includes bridges, roads, and harbors—all of which allow for the easier transportation of goods within a market economy.

(Shortform note: Many economists agree with Smith's assessment that transportation infrastructure empowers economic growth by allowing goods and people to move more freely. However, there are some important caveats. Because infrastructure has high up-front costs but yields its primary benefits over a long period of time, it's often financed by borrowing money, which—as we'll see—has its downsides. Furthermore, large and complex projects may be vulnerable to inefficiency and corruption. So while infrastructure spending in general has the power to grow a nation's prosperity, individual construction projects still need to be assessed for their potential tradeoffs.)

Part 8: How Governments Raise Revenue

Before governments can spend money on defense, justice, education, or transportation infrastructure, the money needs to come from somewhere. Smith identifies two principal sources of revenue: taxation and borrowing.

Revenue Source #1: Taxation

Smith views taxes largely as a necessary evil. He remarks that all taxation takes value out of the hands of private investors, whose self-interest encourages them to invest it in the industries that contribute most effectively to national growth. However, he recognizes that it may be impossible to fund important public works without taxes. Therefore, much of his discussion of tax policy is directed toward finding the least disruptive system of taxation.

To explore Smith's ideas on taxation, we'll first look at his general principles for how taxes ought to be collected and assessed. Then we'll examine specific forms of taxation and discuss Smith's analysis of how well they measure up to his guidelines.

Guidelines For Taxation

Smith outlines four guidelines for ethical taxation. These aren’t exact tax policies but rather ideals to guide legislators in deciding policy.

1. Taxation is proportionate to income. Smith states that everyone in society ought to pay an equal percentage of their total income.
2. Taxes ought to be predictable. No one should be surprised by how much they’re taxed or when.
3. Taxes ought to be collected at convenient times. Tax policy should consider the most convenient times of year for people to pay.
4. Levying and collecting taxes ought to be cost-efficient. Governments need to consider the cost of tallying and collecting taxes when designing tax policies.

Smith’s Guidelines Remain Influential

Smith scholars maintain that these four guidelines continue to provide a foundation for debates about ethical taxation today.

His first guideline of proportionality undergirds the principles of "payability" and "benefit" which are still considered in modern tax debates. The principle of "payability" insists that taxes should be levied on those who can afford to pay them. The principle of "benefit" maintains that those who benefit most from public infrastructure ought to pay more in proportion to their benefit. For example, someone with a lot of private property will benefit more from the property protections.

Smith's ideas about the transparency and predictability of taxes continue to guide debates about specific tax codes that are unclear or applied retroactively. His third principle about tax collection at convenient times has largely been adopted by industrial nations that consistently collect taxes at the same time every year.

Lastly, Smith's guideline about limiting the cost of tax collection agencies continues to inspire debate. Some maintain that simplifying tax codes would cut down on the costs of tax collection. Others counter that calls for simplification miss the point that many of the extra features in the tax code are designed for other important goals of taxation policy: preventing evasion, keeping taxes equitable, balancing economic tradeoffs, and so on.

The Difficulty of Fairly Levying Taxes

Smith analyzes three common tax policies: taxing land, taxing profits, and taxing wages. In his analysis of tax policies, Smith acknowledges that even though taxes are necessary, each method of taxation has its shortcomings.

1. Taxes on land: Taxing the rent of land provides a challenge for proportionality and cost efficiency. If you simply tax landlords by the area of land, the tax will fall unevenly because not all land is equally productive. Those making less income off their land will then carry a disproportionately high tax burden compared to those making a lot. However, if you tax landlords by the income they make from their rent, this requires more tax agents to collect that information, making it more expensive.

(Shortform note: In 18th-century Britain, much of the government's revenue was derived from land taxes. This was largely because it was easier to know how much land someone owned than how much money they made. However, rather than charging landlords on the rent they collected, the British government opted to charge each landowner based on a valuation of how much they thought the land was worth. This would at least theoretically account for differences in rents without having to actually calculate how much rent someone collected. While this still required a tax collector to assess the value of someone's land, this valuation would likely fluctuate less than the actual rents collected.)

2. Taxes on profit: Taxing the profits of businesses and merchants may seem like a good way to tax people evenly based on their income. However, Smith argues that these businesses will raise the prices of their goods to recoup their losses. Therefore, a tax on profits is actually a sales tax on consumers. This makes it harder to tax proportionally, as profits won't really be taxed.

Smith also states that taxing profit requires a lot of surveillance and tax agents because you need to know how much profit everyone makes. This makes it harder to be cost-efficient. Furthermore, he asserts that merchants and money-lenders have an easier time hiding their assets than landlords and can therefore evade paying their full share.

3. Taxing wages: Much like the tax on profits, Smith contends that a tax on workers’ wages is also a sales tax on consumers. Taxing wages will drive up labor costs for employers. These employers will then try to recoup their costs by raising the price of their goods, thus passing the tax on to their customers. This again makes it difficult to tax everyone's incomes proportionately through a tax on wages.

Passing Tax Burden Onto Consumers

Much of Smith's analysis of tax policy highlights the ability of businesses to pass tax burdens onto their consumers. However, modern economists suggest that this ability is mediated by the elasticity or inelasticity of demand.

Elastic demand changes in response to changes in price. For example, if someone selling Halloween costumes raises their prices too high, customers looking to dress up will make their own costumes instead of buying them. Therefore, it's harder for the companies to pass the costs onto consumers.

Inelastic demand occurs when people's willingness to purchase something doesn't respond to changes in price. For example, someone needs a certain medication in order to stay alive. They will pay nearly any cost to get it. Therefore, a tax on medications could be endlessly passed onto consumers.

Revenue Source #2: Borrowing

Finally, governments can raise revenue for public spending by borrowing it, either from private lenders, other governments, or their own citizens. Smith maintains that government borrowing is a drain on a nation's economic growth. Because governments will have to pay off this money eventually, borrowed revenue is still paid for by taxation, but in the future. However, it will be paid off at a higher rate because the government must also pay off the lender's profits through interest.

Therefore, borrowing money pays for the same public works but redirects more private capital in doing so. Because self-interest directs the efficient investment of private capital, government debt becomes a burden on a nation's economic growth by consuming more of this capital than regular taxation.

(Shortform note: Smith was writing at a time when Britain had taken on enormous debts to finance its military in the Seven Years’ War. While Britain prevailed against their French and Spanish rivals, their national debt had increased to £122 million, about £19 trillion today ($22.8 trillion). Their yearly payments totaled over £4.4 million. To ease the enormous burden of its debt, Britain began increasing taxes on its colonies in the Americas. However, this inflamed tension with the colonies, contributing to the build-up to the American Revolution. Smith concludes The Wealth of Nations by recommending that Britain let go of its American colonies. He contends that they would be of greater benefit to Britain as an equal trade partner that paid for its own defense.)