Origin of the Idea

According to Adam Smith, specialization and economic growth are motivated by self-interest. At the same time, pursuit of self-interest by individuals promotes the well being of the rest of the community. "It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to the their own interest"⁽¹⁾ Smith’s logic here is simple and effective. Society benefits by having goods provided. People don’t provide those goods for us because they like us, but because it is a way for them to generate income to satisfy their own wants. If, to earn that income, the butcher, brewer, and baker must compete with others in their industry to sell their products, it encourages the production and sale of quality goods at lower prices.

Adam Smith (1723-1790) is perhaps the most famous of all economists. At the very least he is the best-known classical economist and his contributions have played a significant role in shaping modern economic thought.

Born in Kirkcaldy, Scotland, Smith attended Glasgow College at age 14, and later studied moral and political science and languages at Balliol College, Oxford. After serving as a lecturer on rhetoric and literature in Edinburgh, Glasgow College, in 1751, elected Smith to be professor of logic and, a year later, the chair of moral philosophy.

Smith left Glasgow College 12 years later to serve as a private tutor. In the course of his travels as a tutor, Smith spent time in France, where he befriended Francois Quesnay and Anne Turgot. The two physiocrate economists helped shape Smith’s thinking, as evidenced by his use of the French term, laissez-faire.

Before focusing his attention on political economy (the old term for economics), Smith published The Theory of Moral Sentiments in 1759. This work concentrated primarily on philosophy and ethics, and in particular the moral forces which guide behavior. Smith’s best known work, the work that clearly defines Smith as an economist, was An Inquiry into the Nature and Causes of the Wealth of Nations (often referred to simply as Wealth of Nations), published in 1776. The 900 pages of Wealth of Nations contain not only the articulation of many time-tested concepts in economics, but also a refutation of the economic philosophy known as mercantilism. Mercantilists believed that nations should enact trade barriers with other countries so as to reduce imports and achieve a trade surplus. Their belief was that the wealth of a nation was in the gold and silver (bullion) it possessed, and that trade surpluses were a primary means to accumulating bullion. Smith argued that the wealth of a nation was the real goods it produced, not the money it possessed.

1. Smith, Wealth of Nations, 27.

The wealth of a nation could be increased, according to Smith, by specialization, also known as "division of labor". Smith illustrated the concept by describing the workings of a pin factory.

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour had rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certain could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins might be considered as making four thousand eight hundred pins a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twentyperhaps not one pin in a day.⁽¹⁾

Adam Smith (1723-1790) is perhaps the most famous of all economists. At the very least he is the best-known classical economist and his contributions have played a significant role in shaping modern economic thought.

Born in Kirkcaldy, Scotland, Smith attended Glasgow College at age 14, and later studied moral and political science and languages at Balliol College, Oxford. After serving as a lecturer on rhetoric and literature in Edinburgh, Glasgow College, in 1751, elected Smith to be professor of logic and, a year later, the chair of moral philosophy.

Smith left Glasgow College 12 years later to serve as a private tutor. In the course of his travels as a tutor, Smith spent time in France, where he befriended Francois Quesnay and Anne Turgot. The two physiocrate economists helped shape Smith’s thinking, as evidenced by his use of the French term, laissez-faire.

Before focusing his attention on political economy (the old term for economics), Smith published The Theory of Moral Sentiments in 1759. This work concentrated primarily on philosophy and ethics, and in particular the moral forces which guide behavior. Smith’s best known work, the work that clearly defines Smith as an economist, was An Inquiry into the Nature and Causes

of the Wealth of Nations (often referred to simply as Wealth of Nations), published in 1776. The 900 pages of Wealth of Nations contain not only the articulation of many time-tested concepts in economics, but also a refutation of the economic philosophy known as mercantilism. Mercantilists believed that nations should enact trade barriers with other countries so as to reduce imports and achieve a trade surplus. Their belief was that the wealth of a nation was in the gold and silver (bullion) it possessed, and that trade surpluses were a primary means to accumulating bullion. Smith argued that the wealth of a nation was the real goods it produced, not the money it possessed.

1. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, (New York: G.P. Putnam's Sons, 1877), 19. [Originally published in 1776.]

Although Henry Sidgwick (1838-1900) first articulated the idea of spillover costs and benefits (externalities), Arthur C. Pigou (1877-1959) receives most of the credit for formalizing the concept. Pigou, a British welfare economist (meaning that his economic theories focuses on maximizing the well-being of society), studied at King’s College in Cambridge and later served as the chair of political economy at Cambridge from 1908 to 1943. The previous chair, Alfred Marshall, significantly influenced Pigou’s thinking, as both were concerned about how to use economic theory to promote social well-being.

To illustrate the concept of spillover effects, Pigou used the example of sparks from railway engines. These sparks would ignite surrounding woodlands or farmland, destroying timber or crops. Because the owners of the land were not compensated for the damage, those directly involved in the railway transaction (for example, the railway company and passengers) were not bearing the full cost of their exchange.

Pigou illustrated the idea of spillover benefits through an example of someone planting a forest. The reforestation benefited surrounding property owners through natural seeding of their vacant land, yet no compensation was paid for the benefit. As a result, said Pigou, less tree planting occurred than was optimal from society’s perspective.

Pigou is also known for his contributions to the aggregate demand-aggregate supply model (the "real balances effect"), and to theories of price discrimination. He also argued that a more equal distribution of income would increase social welfare. "Any transference of income from a relatively rich man to a relatively poor man of similar temperament, since it enables more intense wants to be satisfied at the expense of less intense wants, must increase the aggregate sum of satisfaction."⁽¹⁾ Pigou’s reasoning was that the marginal utility of a dollar for a poor man was greater than for a rich man, and so by transferring dollars from the rich to the poor, the net gain in social welfare would be positive.

1. A.C. Pigou, The Economics of Welfare, 4th ed. (London: Macmillan, 1932), 89. [Originally published in 1920.]