When Adam Smith wrote his famous 1776 treatise, he called it An Inquiry into Nature and
Causes of the Wealth of Nations.
Some have taken this as indicating that
he was concerned
primarily with economic growth
In this way, Smith moved away from the Cantillon-
Physiocratic system which concentrated on "natural equilibrium" of circular flows, and
brought back into economics what had been the Mercantilists' pet concern.
Smith posited a supply-side driven model of growth.
Succinctly we can lay out the story via
the simplest of production functions:
Y = ¦(L, K, T)
where Y is output,
L is labor, K is capital and T is land, so output is related to labor and
capital and land inputs. Consequently output growth (gY) was driven by population growth
(gL), investment (gK) and land growth (gT) and increases in overall productivity (g¦).
gY = f(g¦, gK, gL, gT)
Population growth, Smith proposed in the traditional manner of the time, was
endogenous: it depends on the sustenance available to accommodate the increasing
workforce. Investment was also endogenous: determined by the rate of savings (mostly
by capitalists); land growth was dependent on conquest of new lands (e.g. colonization)
or technological improvements of fertility of old lands. Technological progress could also
increase growth overall: Smith's famous thesis that the division of labor (specialization)
improves growth was a fundamental argument.
Smith also saw
machinery and international trade as engines of growth as they facilitated further
Smith also believed that "division of labor is limited by the extent of the market" - thus
positing an economies of scale argument. As division of labor increases output (increases "the
extent of the market") it then induces the possibility of further division and labor and thus
further growth. Thus, Smith argued, growth was self-reinforcing as it exhibited increasing
returns to scale.
Finally, because savings of capitalists is what creates investment and hence growth, he saw
income distribution as being one of the most important determinants of how fast (or slow) a
nation would grow. However, savings is in part determined by the profits of stock: as the
capital stock of a country increases, Smith posited, profit declines - not because of decreasing
marginal productivity, but rather because the competition of capitalists for workers will bid
wages up. So lowering the living standards of workers was another way to maintain or
improve growth (although the counter-effect would be to reduce labor supply growth).
Despite increasing returns, Smith did not see growth as eternally rising: he posited a ceiling
(and floor) in the form of the "stationary state" where population growth and capital
accumulation were zero.