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Updated March 29, 2023

What is Adam Smith's Economic Theory?

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DEFINITION:

Adam Smith is considered the father of classical economic theory and the
founder of the invisible hand theory that underpins capitalist economic systems.

Understanding Adam Smith's economic theory

Adam Smith was an 18th-century philosopher whose work focused on economics.
Smith’s most popular work was probably The Wealth of Nations, which later gave rise to
macroeconomics. Much of modern economic theory is rooted in Smith’s ideas; he’s
often known as the father of economics. In one of his most famous concepts, the
invisible hand theory, Smith argues that individuals looking out for themselves (rather
than government) ends up doing a better job deciding what people should produce. He
described the process like an “invisible hand” that guided the marketplace better than
the “physical hand” of a government official serving as the central planner. This theory
later became the foundation for capitalism.
 EXAMPLE

Imagine a farmer with several plots of land. Each year, he must choose what to
plant. Under a command economy, the government might decide that each
person in the surrounding area needs a certain amount of food. They might
calculate the number of lima beans, potatoes, corn, and grains each person
needs. Then, they might instruct the farmer on what to grow to meet those needs.
Adam Smith argued that such instructions from the government weren’t
necessary and might even be detrimental.

Smith promoted the idea that, for example, the farmer should plant whatever he
wants, then let the people vote with their money. If the potatoes sell out and the
lima beans rot without being purchased, the market, rather than a central planner,
would instruct the farmer to plant more potatoes and fewer lima beans. In the end,
a series of individual choices would more efficiently guide the farmer’s
production than a government choosing winners and losers.

Takeaway
Adam Smith’s economic theory is like learning by trial and error…

Rather than dictating what you should or shouldn’t do, life has a way of giving you
feedback and influencing your behavior. For instance, if you touch a hot surface, your
body informs you not to do it again. Although the system doesn’t prevent you from
getting burned once, it does provide some guidance so you can avoid repeating your
mistakes.

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Tell me more…

What is Adam Smith’s economic theory?

How did Adam Smith contribute to economics?

Did Adam Smith create capitalism?

Why was Adam Smith important to the industrial revolution?

What is the main purpose of Adam Smith’s The Wealth of Nations?

What were Adam Smith’s accomplishments?

What is Adam Smith’s economic theory?

Adam Smith’s economic theory is the idea that markets tend to work best when the
government leaves them alone. Smith argued that rational people (aka acting in their
own interest) would naturally find the best way to use the nation’s resources — He
viewed government regulation as potentially detrimental to economic growth.

Smith’s laissez-faire (French for “let it/them do”) approach to economic policy in the
18th-century came at a time when governments discouraged international trade. Many
believed that a nation’s wealth was measured by the amount of gold it had — And while
imports meant bringing goods into a country, it also meant sending gold out. Domestic
businesses (aka merchants) tended to support these policies because it eliminated
foreign competition for their products. These merchant protection policies later became
known as mercantilism.

In The Wealth of Nations, Smith showed that a nation’s wealth wasn’t determined by the
precious metals it held in its vaults. Instead, he argued that wealth existed in the value a
commercial society created through production and trade. Smith’s ideas formed the
basis for how most countries determine their wealth to this day — By determining the
market value of the products created within their borders (aka gross domestic product),
or by their people (aka gross national product).

How did Adam Smith contribute to economics?

Adam Smith didn’t just contribute to economics, he basically invented it. In the early 18th
century, moral philosophy was the closest thing to what we now think of as the field of
economics. Smith grew up in Kirkcaldy, Scotland and studied moral philosophy at the
University of Glasgow in the 1730s. One professor in particular, Francis Hutchinson (a
notable Scottish philosopher of the time), had a profound impact on Smith’s training and
seems to have guided his early work.

Smith continued his education at Oxford University in 1740, where he became close
friends with David Hume — Another philosopher whose work would become well-known
during this age of Scottish Enlightenment. Smith and Hume are rumored to have spent
many hours in the Edinburgh taverns discussing their ideas.

Smith published his first notable body of work, The Theory of Moral Sentiments, in 1759. In
it, Smith discussed the idea that self-interested people naturally end up working toward
an outcome that benefits everyone. He described this idea as an “invisible hand” that
guided individuals toward paths that simultaneously improve their lives and the lives of
the people on the other side of a trade. This concept of natural liberty leading to optimal
outcomes is perhaps the most significant contribution to what we now call economic
theory.

In 1776, Smith published An Inquiry Into the Nature and Causes of the Wealth of Nations.
Smith’s ideas in these works and others helped develop the foundation of political
economics, inspired policies that shifted away from mercantilism, established the
concepts of specialization and the division of labor, and laid the groundwork for
macroeconomic theory. Because of his wide influence, Smith is often known as the
father of economics.

Did Adam Smith create capitalism?

Adam Smith was among the first philosophers of his time to declare that wealth is
created through productive labor, and that self-interest motivates people to put their
resources to the best use. He argued that profits flowed from capital investments, and
that capital gets directed to where the most profit can be made. These ideas — That
wealth follows capital, and that individuals own capital — are core to capitalism as we
know it today. But at the time, Smith’s ideas were revolutionary.

Why was Adam Smith important to the industrial

revolution?
Adam Smith is sometimes cited as an influential figure of the Industrial Revolution, which
is usually described as beginning in 1760 in England. During that period, advances in
technology changed the way that human society lived and worked. This was also the
decade that Smith worked on his life’s work, The Wealth of Nations (1767-1776) — The
timing suggests that Smith was working on his book just as industrialization began, and
may be why Wealth of Nations makes little reference to the tectonic shifts that were
starting to happen around him.

Before the Industrial Revolution, most of the population lived and worked on farms.
Skilled artisans handcrafted most of the products that people used. These craftsmen
were often part of a guild, which controlled the manufacturing and sale of products.
Smith critiqued the monopoly power of the guild system, as well as the protectionist
policies in which the government intervened to direct commerce. He pointed out that
allowing individuals to decide how to use their money, land, equipment, and labor how
they saw fit would generate the most benefit for the nation. His work suggested that
allowing people to pursue their self-interest would result in a self-organizing system that
was better for everyone.

At the same time, the Industrial Revolution turned manufacturing into a centralized
process with the help of machinery and steam power. Factories could make products
faster and cheaper than individuals could. Consequently, a significant portion of the
population transitioned from cottage industries into new urban factories.

As Smith wrote about the theoretical benefits of the division of labor (having people
specialize in specific tasks), and of allowing the free-market to guide the direction of an
economy (as opposed to state intervention), his ideas were already playing out in real
life.

It’s unclear to what degree Smith’s ideas influenced, observed, or predicted the way the
world would change going into the 19th century. But his work did overlap with the
expansion of the capitalist system that he described. The decades that followed are full
of examples of countries adopting the free-market economy and laissez-faire policies
that Smith promoted.

What is the main purpose of Adam Smith’s The Wealth

of Nations?
The main purpose of Adam Smith’s The Wealth of Nations was to further the
understanding of political economy (the role of government in economic policy). He
wanted to encourage governments to adopt a free-market approach to production and
commerce.

At the time he wrote the book, the world was pre-industrial and largely ruled by empires
with colonies. The working class relied on a system of journeymen and apprenticeship,
managed by a network of guilds. In many places, kings and queens still ruled over the
lands and measured the strength of their nations by the amount of gold and silver they
owned.

Smith studied the motivations and natural tendencies of human beings. He observed
that people were primarily driven by self-interest — Committing their resources to those
things that most benefited them. He argued that all trade was mutually beneficial — If
one person in the exchange didn’t come out better off, they’d simply decline the deal.
Therefore, Smith observed, all voluntary trade resulted in increased wealth, and therefore
regulating trade was unnecessary and potentially damaging.

Smith’s work showed how government policies that prevented trade reduced the
amount of wealth that a country could create. (This idea included the mercantilist
policies of England and France, but also the monopoly power exerted by the guilds.)

Smith wrote his book as a way to demonstrate that controlling free trade was
unwarranted and unwanted. He showed that members of a society, each looking out for
their own gain, embraced the natural competition that results from human nature. The
forces of competition place a check on all activity, ensuring that everyone receives their
value — Laborers earned wages, landlords received rents, and capitalists got profits, and
so on. In Smith’s view, the best system ensured that resources would get exchanged
until they resulted in the best possible allocation.

What were Adam Smith’s accomplishments?

Adam Smith is considered the father of economics, but he did more than just write the
book on the subject. His life’s work laid a framework of thinking that is widely believed to
have changed the course of humanity. For example, Smith’s work pointed out the flaws in
restricting international trade and encouraged governments to relax their protectionist
policies.

As the world moved past mercantilism — Helped by improvements in transportation,

communication, and commerce — Smith’s work inspired political leaders to adopt free
enterprise principles. His crowning achievement was the completion of The Wealth of
Nations, which revolutionized the way people thought about trade and laid the
foundation for capitalism. Smith is widely considered one of the most influential people
of the 18th century, and remains so to this day. In 2007, the United Kingdom
commemorated him on its 20-pounds-sterling banknote.
Smith’s best-known ideas formed the basis of economic theory, including the invisible
hand theory (the idea that free-markets coordinate themselves), the division of labor
(the idea that people should specialize in specific tasks), and the measurement of
economic activity (Gross Domestic Product). Smith was a strong advocate for individual
freedom, free-market economics, competition, and capitalism.

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Updated March 30, 2023

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