Theory of Growth

 Adam Smith’s Theory of Economic Growth has not received as much attention as his Theory of Value and Distribution. He does provide an internally consistent dynamic Model. Irma Adelman rightly asserts,” The main strands of his Theory—the investigation of capital accumulation, population Growth, and labour productivity still underlie all current treatment of the problem and many of his policy recommendations are as controversial now as when they were first made”.

(1) Production Function:

Since he recognised the existence of three factors of production, namely labour, capital and land, his production function may be expressed as;

Y = f (K, L, N)

where, K = capital stock, L = Labour force, N = Land.

The production function is subject to increasing returns to scale because he did not assume diminishing marginal productivity. In his opinion, with the passage of time, the size of market will expand and in turn result in internal and external economies which will reduce the capital production. The greater degree of division of labour was expected to realise the economies of scale in production.

According to him, division of labour did not depend merely on technological feasibility but on the extent of the market as well; whereas the size of the market depends on the availability of capital stock. Thus accumulation of capital is a precondition to increasing division of labour.

The regulatory measures against trade have a tendency to restrict the size of the market and limit the division of labour. He recognised the importance of technological development for improvement in productivity. To understand Smith’s theory of growth we should also examine the growth of labour force, capital accumulation, and increase in the supply of land and the change in the institutional set up.

(2) Supply of Land and the Change in Institutions:

In his theory, two factors, namely supply of land and the change in institutions are comparatively less important. The rent of land therefore considered as the price paid for the use of land, is naturally a monopoly price. He nowhere explicitly stated the supply of land. Regarding institutions the change in them is determined exogenously.

Institutional variable is quite important. He asserts that free trade and laissez-faire provides a highly congenial environment for economic growth. He was thus a strong believer in ‘natural reason’ guiding human affairs. He regarded state interference not only superfluous but harmful to economic progress.

Guided by self-interest, each individual was capable of promoting his own well-being and welfare of the whole society in the process. It is wise, therefore, according to Smith to be led by the ‘Invisible Land’ that is motivation of the competitive market forces. As a matter of policy, therefore, Adam Smith advocated the removal of all restrictions on trade, choice of occupation and the use of property.

(3) The Growth of Labour Force:

The rate at which the population grows in a country largely determines the growth of the labour force. According to Adam Smith rate of population growth in the long run, depends on the fund available for human sustenance. The size of the population is determined by prevailing wage rate. If actual wages exceed the subsistence wage, population will show a tendency to increase and vice- versa.

The supply of labour is normally expected to be in equilibrium with the demand for labour. If the demand for labour records a continuous rise pushing wage rates upward, it induces working population to multiply faster, as a result of which supply also continually increases and vice-versa. Smith has explained the demand for labour in the framework of wage fund doctrine.

Since the supply of labour has a tendency to respond to the demand for it. Smith’s argument implies that in a growing economy population will be increasing, that in declining economy it will be falling, and that in a stagnant economy characterised by the constancy of National Wealth it will be stable. In his opinion, high wage rates are consistent only with the growth of the economy.

(4) Capital Accumulation:

In Smith’s theory Capital Accumulation has been assigned a strategic role in the growth process. To him, growth is functionally Related to rate of Investment with a fixed capital stock a country is bound to suffer stagnation. According to him, any increase in capital stock in a country generally leads to more than proportionate increase in the output on account of continuously growing division of labour. Adverse institutional developments nullify the gains of capital accumulation from the point of view of growth.

According to Smith, the Rate of Investment as a crucial factor in economic growth, is determined by the Rate of Savings. He did not visualize any possibility of leakages occurring (-) saving and investment although the two activities are not performed by the same set of people. Savings and Investment are determined by private profit.

However, ability to save and investment is limited by income. Due to competition among the capitalists, Overtime when a country develops and its capital stock expands, the profit rate shows a tendency to fall. In the first place, the growing stock of capital, results in larger demand for labour which pushes up the wage rate leaving a smaller surplus to the entrepreneurs, secondly a larger capital, stock required abundant opportunities for investment which may not always exist in an economy.

Therefore, when capital stock expands in a sustained maimer, entrepreneurs will be able to employ it only at a lower marginal profit Ratio, that is why he postulated a downward sloping marginal efficiency of capital curve. He postulated a negatively sloped supply curve of capital implying an indirect relation between Supply of Capital and Rate of Investment. Capital accumulation stops only when Rate of Investment falls to a rate of profit which is sufficient only to compensate for the Risk premium.

(5) Agents of Growth:

According to Smith, farmers, producers and businessmen are the agents of progress and economic growth. It was free trade, enterprise and competition that led farmers, producers, and businessman to expand the market which in turn made economic development possible.

The functions of these three are inter-related. To Smith, development of agriculture leads to increase in construction works and commerce. When agricultural surplus arise as a result of economic development the demand for commercial services and manufactured articles rises.

This leads to commercial progress and the establishment of manufactured industries. On the other hand, these developments lead to increase in agricultural production when farmers use advanced production techniques. Thus, capital accumulation decreases, economic development takes place due to the emergence of the farmer, the producer and the businessman.

(6) The Growth Process:

According to smith, the process of growth is cumulative. When there is prosperity as a result of progress in agriculture, manufacture of Industries and commerce, it leads to capital accumulation, Technical progress, increase in population expansion of markets, division of labour, and Rise in profits continuously. But this process is not endless. It is the scarcity of natural resources that finally stops growth.

According to Smith, in a development process of an economy both income level and capital stock rise. In addition, the rate of capital accumulation also shows a tendency to increase. Obviously this factor enhances the capital stock of an economy in succeeding periods by increased doses of investment.

Another factor of vital importance which contributes to the progress of an Economy is a successive decline in the incremental capital output ratio on account of the influence of capital on the productivity of labour. These factors reinforcing each other accelerate the pace of development until such time that the economy’s capital stock grows large enough to eliminate profits, not of risk. At this stage the stationary state sets in.

The stationary state in Smith’s system is distinctly different from under development economies having reached the stationary state is characterised by unchanged population, constant total income, subsistence wage, elimination of profit in excess of the minimum consistent with risk and absence of Net Investment. Adam Smith did not suggest any measures to remedy this ‘dull’ state of affairs.

In his opinion, an economy in the stationary state finds itself at the highest level of prosperity consistent with its natural resources and environment. An under- developed country in contrast, reaches stagnation before it has reached the highest degree of opulence attainable with its resources. Smith has mentioned China by way of an example of an under -developed country.


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