Adam Smith's theory of distribution was fully as disastrous as his theory of value. Though he was aware of the functions performed by the capitalist, his only venture in explaining the rate of long-run profit was to opine that the greater the ‘amount of stock’ the lower the rate of profit. He arrived at this highly dubious conclusion from his perfectly valid observation that capitalists tend to move out of low-profit and into high-profit industries, their competition tending to equalize the rates of profit throughout the economy. But more production, lowering selling price and raising costs in a particular industry, is scarcely the same causal claim as more capital throughout the economy lowering profit rates. Indeed, the rate of interest, or long-run rate of profit, is related, not to the quantity of accumulated capital, but to the amount of annual saving, and moreover falling profit rates are not caused by increasing saving. On the contrary, as the Austrians would point out, both are the results of lower rates of time-preference in the society. It is perfectly possible for a highly capitalized economy to experience rising rates of time-preference, which in turn would bring about higher rates of interest.
Smith saw correctly that increasing capital means an increase in the demand for labour and therefore higher wages, so that an advancing society necessarily means a secular increase in wage rates. Unfortunately, Smith's mechanistic view of the profit rate as being inversely proportional to the total amount of capital led him to believe that wages and profits are always moving inversely to the other – an adumbration of an allegedly inherent class struggle which Ricardo would do much to aggravate.
Moreover, if the supply of labour increases to absorb the increase in demand, wage rates will then fall. At this point, Adam Smith provided the Malthusian hook, for, as we shall see further, the Rev. Malthus was a devoted follower of Adam Smith. Smith, indeed, was picking up a theme common in the eighteenth century: that the population of a species tends to press on the means of its subsistence. As Smith put it: ‘Every species of animals naturally multiplies in proportion to the means of its subsistence’. So that Smith saw the secular trend of the economy as capital increasing, wages rising, and the rise in wages calling forth an increase in population:
The liberal reward of labour, by enabling them to provide better for their children, and consequently to bring up their number, naturally tends to widen and extend those limits [the means of subsistence]... If this demand [for labour] is continually increasing, the reward of labour must necessarily encourage in such a manner the marriage and multiplications of labourers as may enable them to supply that continually increasing demand by a continually increasing population.
In this way, wages tend to settle at the minimum subsistence level for the existing population. A fall in wages below subsistence will forcibly reduce the population and hence the supply of labour, raising wages to the subsistence rate; and if wages should rise above subsistence, the ‘excessive multiplication’ of workers ‘would soon lower it to this necessary rate’.
One of the many problems of this ‘Malthusian’ approach is that it assumes that human beings will not be able to act on their own to limit population growth in order to preserve a newly achieved standard of living.
In addition to Smith's erroneous Malthusian view that long-run wage rates are at the means of subsistence, he also introduced into economics the unfortunate fallacy that wages, at least in the shorter run, are determined by the relative ‘bargaining power’ of employers and workers. It was a simple leap from that position to the view that employers have greater bargaining power than workers, thus setting the stage for later pro-union propagandists claiming erroneously that unions can raise overall wage rates throughout the economy.
In his view of rent, Smith characteristically held several unintegrated views running side by side. On the one hand, as we have seen, rent is demanded by landlords who ‘reap where they have never sowed’. Why are they able to collect such a rent? Because, now that land has become private property, the labourer ‘must pay for the licence’ to cultivate the land and ‘must give to the landlord a portion of what his labour either collects or produces’. Smith concludes that ‘the rent of land therefore... is naturally a monopoly price’, since he regards private property in land in the same category as monopolization. Surely, socialist and Henry Georgite calls for land nationalization found here their fundamental inspiration. Smith also sensibly points out that rent will vary according to superior fertility and location of the land. Furthermore, as we have indicated, he attributes rent to the ‘powers of nature’, which supposedly earns an extra return in agriculture as compared to other occupations.
Smith is also inconsistent on whether land rent is included in cost. At various points he includes land rent in cost and therefore as an alleged determinant of long-run price. On the other hand, he also asserts that high or low rents are the effect of high or low product prices and that since the supply of land is fixed, the full incidence of taxes upon rent will fall on land rather than being shifted. All these inconsistencies can be cleared up if we regard all costs as determined by expected future selling prices, and individual costs to be the opportunity foregone to contribute to expected productive revenue elsewhere. More specifically, while costs do not determine price directly, they do limit supply, and in this sense every expenditure, whether on rent or elsewhere, is definitely a part of cost.
But as we have seen, the greatest of the many defects in Smith's theory was his totally discarding Cantillon's and Turgot's brilliant analysis of the entrepreneur. It was as if these great eighteenth century Frenchmen had never written. Smith's analysis rested solely on the capitalist investing ‘stock’ and on his labour of management and inspection; the very idea of the entrepreneur as a risk-bearer and forecaster was thrown away and, again, classical economics was launched into another lengthy blind alley. If, of course, one persists in fixing one's vision on the never-never land of long-run equilibrium, where all profits are low and equal and there are no losses, there is no point in talking about entrepreneurship at all.
The political implications of this omission were also not lost on nineteenth century socialists. For if there is no role for entrepreneurial profits in a market economy, then any existing profits must be ‘exploitative’, far more so than the low, uniform rate existing in long-run equilibrium.
The perceptive Scottish historian of economics, Alexander Gray, wrote of Smith's theory of wages that he presented several theories ‘not wholly consistent with each other, [which] lie together in somewhat uneasy juxtaposition’. Gray then slyly added that it is a ‘tribute to the greatness of Smith that all schools of thought may trace to him their origin and inspiration’. Other words for such inchoate confusion, for what Gray referred to aptly as a ‘vast chaos’, come more readily to mind.