No one personifies the early capitalist system, or contributed to the intellectual foundations of capitalism, more than Adam Smith. Smith was a Scottish philosopher whose greatest achievement, Inquiry into the Nature and Causes of the Wealth of Nations (published in 1776), was a revolutionary treatise on personal liberty and freedom. Smith articulated what he saw - the transition to a market economy in England. Markets, in which consumers are free to demand products to serve their needs and firms must compete for the right to supply products (and earn profits) are the great equalizer. Wealth was no longer bestowed upon the landed gentry and royalty but could be earned by catering to the needs of the common consumer.
Smith’s greatest contribution to the formation of capitalism is his articulation of what he termed “the invisible hand.” The invisible hand describes how the pursuit of self-interest leads to the best outcome for society as a whole. By exercising the freedom to pursue what you think is best for you and your family, you are (quite unintentionally) benefitting society. This is true for consumers as well as firms. When oil is scarce, the rising gas prices cause people to avoid driving and conserve oil. At the same time, suppliers are motivated to find other sources of oil because the higher prices mean it is more profitable to do so. Each entity is guided by this “invisible hand” to engage in actions that benefit all of society. Yet the motivation for these actions is selfish.
Is selfish behavior beneficial?
Yes, according to Smith and millions of others who follow the capitalist notion of freedom and innovation. But (and this is crucial) only if there exists sufficient competition and there are no market failures. Because a competitive market is its own regulator, Smith’s fundamental philosophy (“laissez-faire”) advocates minimal government intervention. The chaotic interaction of millions of self-interested consumers and thousands of self-interested firms produces outcomes that benefit all of society.
- private property. Critical to the success of a capitalist system is the adherence to private property rights. Although many Americans take property rights for granted, the lack of well-defined property rights in developing countries inhibits economic growth and prosperity. See an interview with Hernando de Soto http://www.reason.com/news/show/32213.html and an article that describes his theories http://www.cato.org/special/friedman/desoto/index.html
- self-interest. It is observed and assumed that people want the best possible outcomes for themselves and their family. Smith’s invisible hand doctrine describes how the pursuit of self-interest leads not only to individual success but contributes to the well-being of society and the wealth of the nation.
- freedom of choice. Capitalism is characterized by the freedom to pursue one’s self-interest and respond to the demands of the market.
- market prices. Market prices signal the value of goods and services and direct the actions of individuals and firms in the economy.
- competition. Smith emphasized that for the invisible hand to translate selfish motives into socially optimal outcomes, firms must be constrained by competition. It is only when producers face the competitive forces of other sellers that it is in their self-interest to provide those products and services that are most desired by consumers.
But Smith’s Inquiry into the wealth of nations also describes a dynamic force that propels society to increasingly higher living standards. Smith was the first to identify how the pursuit of profits leads to innovation, including technological advances and specialization of labor. The drive for profit motivates firms to produce at the lowest possible cost: the result is investment in technology (which allows for greater production and increased standard of living) and the division of labor (each person does one task and, together, production is achieved).
Smith predicted that competition for profits would advance efficiency and society would progress; the wealth of the nation would flourish and the well-being of its citizens would improve.
For an analysis of Adam Smith’s ideas and how they relate to economic growth see