First Midterm: Smith
(You may omit all of any question or questions and get 20% credit for the omitted material)

I. Pick two of the following four quotes and explain them. (10 pts)

A. "The work done by freemen comes cheaper in the end than that performed by slaves." p. 99

The employer must pay for the subsistence of the freeman in his wages, just as the slaveowner for the slave, since in Smith's theory wages tend to the level that just maintains the working population. But the freeman's subsistence costs less because he is managing the money frugally on his own behalf, while the slaveowner's employees are doing a less efficient job of spending his money on maintaining his slaves.

B. "What is annually saved is as regularly consumed as what is annually spent,.." pp. 337-8.

What is saved becomes part of the capital stock and as such is spent hiring workers, buying inputs, etc.; the workers, sellers of inputs, their workers, etc. then spend it on their consumption.

C. "The invention of firearms, an invention which at first sight appears to be so pernicious, is certainly favourable, both to the permanency and to the extension of civilisation." p. 708

Capital intensive weapons, such as firearms, give rich, civilized nations an advantage over poor, uncivilized ones. Without them, the poor nations, with a low level of division of labor, have the advantage, because it is cheap for them to raise a large army--they can take the whole male population out of agriculture between planting and harvest and use it to invade their civilized neighbors. And farmers (or nomads) are in better shape for fighting than civilized craftsmen etc.

D. "The revenue which, in any civilised monarchy, the crown derives from the crown lands, though it appears to cost nothing to individuals, in reality costs more to the society than perhaps any other equal revenue which the crown enjoys." p.824

The cost of the revenue from the crown lands includes the lost output due to their being much worse managed than they would be if they were private property.

II. Pick one of the following two quotes and explain it. (5 points)

A. "China is a much richer country than any part of Europe, ... the real recompense of labour is higher in Europe than in China." pp. 208-209 Explain.

China has accumulated more capital, is more densely populated, produces more output per acre, and is thus in Smith's sense richer. But it has reached a steady state, so wages are down to subsistence--unlike Europe, which is in an advancing state.

B."The increase of demand, besides, though in the beginning it may sometimes raise the price of goods, never fails to lower it in the long run." p. 748

Smith believes in long run declining costs, because the larger the scale of production, the more firms, hence the more competition, the greater the opportunity for division of labor, for inventing new machines, etc.

III. Explain the following two quotes; they are related. (15 points)
"Labour, therefore, ... the only standard by which we can compare the values of different commodities at all times and at all places."
p. 54

Smith defines the value of a commodity as the number of hours of labor it takes to earn enough to buy it. By comparing value in that sense in different times and places, we learn how easy or hard it was for someone to get goods at different times and places.

"The nature of things has stamped upon corn a real value, which cannot be altered by merely altering its money price." p. 515

According to Smith's theory of long run wages, they tend to be equal to subsistence; since food is the largest item in the worker's budget, that means, roughly speaking, that equilibrium wage is the price of a certain quantity of corn. Hence the value (hours of work necessary to buy) of a given quantity of corn is roughly constant over time.

IV. "In the progress of the manufacture, not only the number of profits increase, but every subsequent profit is greater than the foregoing; because the capital from which it is derived must always be greater," p. 68
Is the statement true? Explain. (10 points)

The statement is false. To see why, we must first follow through Smith's argument:

Suppose the profit rate is 10%. The farmer growing flax spends $100 on wages, inputs, etc., sells his output at the end of the year for $110, making a 10% profit. The spinning factory must spend $110 to buy his output, plus the wage of their workers, so they require more than $110 of capital, so (Smith believes) must receive more than his $10 profit, and so on down the line.

It is wrong because it assumes that each capital is employed for a year, thus must collect a year's profit--but the spinner's turnover might be much less than that, and similarly for the weaver etc.

V. "Secondly, by this attention they secured themselves from the possibility of issuing more paper money than what the circulation of the country could easily absorb and employ." p. 306
Explain. Use the back of the page. (10 points)

The idea was to make sure that the amount of paper money issued by a private bank corresponded to no more than the amount of gold and silver that the people who use that bank's money would otherwise have held as cash, thus no more than the amount of money those people wish to hold. As long as that is true, the people hold the paper money, so it does not come back to the bank to be redeemed. If the bank prints money and lends it to people who are going to invest it, rather than hold it as cash balances, then the money gets spent, gets into the hands of people who don't want to hold that bank's money, and comes back to the bank for gold and silver.

General Comment

It is important to pay attention to what Smith is saying, rather than filling in from your knowledge of economics what you think he should be saying. This error was particularly noticeable on question V, where a significant number of students seemed to think he was talking about a national central bank concerned with preventing inflation, maintaining economic stability, and other issues largely irrelevant to the Scottish private banking system of the 18th century. Other students seemed to think he was talking about how the banks could make sure they maintained a reserve ratio of 100%, which would make no sense from their standpoint and has nothing to do with the problem he was discussing.

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