Adam Smith and California

Franco, Josue

Prof. Mueller

English 100, MW 8-10AM

December 8, 2003

Adam Smith and California

I am running out of time. The clock has committed its final “tick.” There is nothing left I can do, but stop, think, and do. No one is going to set forth a goal and expect someone else to earn it. I need to make the decision, right here, right now on whether or not I want to achieve. I, as a single individual, have been afforded a choice, just as all other individuals. I can either go out and accomplish a goal I set forth, or I can not. Simple, there is no “it depends” or “in between.” No one is going to make me strive for excellence. The hand is about to “tock.” What is the driving force behind a choice and how outcomes can it produce? How did California lose because of Adam Smith?

Adam Smith’s Wealth of Nations is a remarkable piece of innovative thinking which consists of five separate books. I made the choice to read the first book, Of the Causes of Improvement in the Productive Powers of Labor, and of the order according to which its Produce is Naturally Distributed Among the Different Ranks of the People. Throughout Book I, Smith presents the major concepts of: labor, money, commodities, wages, profits, and rent. In order to relate, I will take an in depth look into the economics of California through each of the major concepts in Book I and determine the negative and positives implications of Smith on California.

In the first three chapters, labor is the central concept. In chapter one, “Of the Division of Labor,” Smith describes what the division of labor is and three factors that lead to the division. In modern terms, division of labor can be translated into specialization. Specialization is the process in which an individual, corporation or nation focus on a particular unit of production.

Smith offered the example of workers in a pin factory. “One man draws out the wire, another straights it, a third cuts it, a forth points it, a fifth grinds it at the top for receiving the head” (Smith 11). Each man has a certain task to accomplish. By focusing each man on a certain task or “reducing every man’s business to some one simple operation, and by making this operation the sole employment of his life” (Smith 14), three advantages are earned.

Due to the fact that a person is set to perform a single task, over time, the person is able to produce more since the task becomes second nature. Smith called this “improved dexterity.” Next, as time passes and the task becomes second nature, the person is able to produce more within a reduced amount of time. In essence, the “saving of time” occurs. The final advantage is created in performing the task over and over. Observations are made and the worker realizes a reoccurring process within the task. Over time the worker or anyone with a firm understanding of the mechanics of the process construct a machine to perform the repetitive task. Due to the “application of machinery, invented by workmen, or by machine makers and philosophers” a task becomes automated.

Why does specialization occur? “The division of labor arises from a propensity in human nature to exchange” (Smith 22). In other words, humans need to trade with one another since humans have a desire for products they are unable to produce. Desire is self-interest and it comes from within.

However, specialization can be restricted. How can it be restricted? In chapter three, “That the Division of Labor is Limited by the Extent of the Market,” Smith believes that the size of the market or area where products can be exchanged can inhibit specialization. “When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment” (Smith 27). If I live alone in the woods and am isolated from the entire world, then I cannot expect someone else to accomplish what I need to accomplish. I will need to hunt game, chop wood, start the fire and cook the food. Since I am isolated and unable to gain from the production of others, I won’t be able to specialize in a specific task. Instead of becoming great in chopping wood or cooking food, I will be mediocre in all.

“Water-carriage widens the market, and so the first improvements are on the seacoasts or navigable rivers” (Smith 29). Life in the woods isn’t working and I am told that a “pirate’s life is for me.” I trek to the nearest seaport and discover the area is hustling and bustling with activity. Why is the seaport more active than a cabin in the woods? Seafaring is much more efficient that land venturing. Smith reinforces his statement with the empirical examples of ancient Egypt and how its population and trade occurred near the Nile River. The Nile Rive brought great wealth because it allow a means for trade to occur. In sharp contrast, Austria, a landlocked nation, took much longer to grow since it didn’t have a waterway to foster trade.

Smith explains in chapter four, “Of the Origin and Use of Money,” that specialization, which leads to the exchange of products, is the origin of the use of money. Over time, humans have learned to settle on the use of metal, since it’s “durable and divisible.” Holding a coin is less work that lugging around a bag of pins, a loaf of bread and a bucket of milk.

“The word VALUE, it is to be observed, as two different meaning, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys” (Smith 41). Value, Smith depicts, can either be the value in “use” or value in “exchange.” Smith then presents the diamond-water paradox: water is more useful than a diamond, but water does not have the same purchasing power as a diamond because the “value” is different. In order to determine “value” Smith investigates the price of commodities.

In “Of the Real and Nominal Price of Commodities, or of their Price in Labor, and their Price in Money,” Smith examines how the price of a commodity or product is determined. The “real” price of a product is the amount of labor that goes into producing the product. However, the lack of “accurate measure” of labor is due to the idea that each individual has a unique method of valuation. This personal method of valuation leads to the “nominal” price of a product. The producer, determines the price of an object based on the cost of a resource and means of production. The cost of a resource and means of production are just a method of valuation. For example, I own a steel mill which produces sheets of steel. In order to create the sheet, I must use a machine and workers, which are means of production and purchase  iron ore from a mine. The cost of the iron ore is determined by the mine owner. The mine owner decides how much he will sell the iron ore for based on how much he is willing to pay his workers for their labor. So, the price of all commodities will boil down to how much an employer is willing to pay for labor, either directly via worker, or indirectly via resources or means of production.

Now that a “nominal” price is determined, money, in the form of metal, is needed. “The value of the most precious metal regulates the value of the whole coin” (Smith 58). A standard is set and over time the “price of goods is adjusted to the actual contents of the coinage” (Smith 65). Due to commercial reasons, the price of gold and silver change because people adjust the cost of their product based on the value of the coin.

In chapter six, “Of the Component Parts of the Price of Commodities,” Smith indicates there are three components that dictate the price of a product: labor, rent, and profit.  Labor is labor. Rent must be incurred when land is no longer under public domain, but under private ownership. Profit is an incentive. If a worker believes it more profitable to fish rather than farm, then it is because of the potential additional gain. The potential additional gain is an incentive. “Labor measures the value not only of that part of price which resolves itself into labor, but that which resolves itself into rent, and that which resolves itself into profit” (Smith 71). The example of the steel mill returns. Labor is the measure of all costs.

“Of the Natural and Market Price of Commodities” offers several reasons why the market price is above the natural price for long periods of time. The natural price accounts for all the three components that create price: labor, rent, profit. The market price is dependent on the profit level. It can be below the natural price if there is a substantial increase in product or substantial drop in demand. On the other side, it can be above the natural price for the opposite reasons. However, Smith explains that  “monopolists, by keeping the market constantly understocked, by never fully supplying the effectual demand, sell their commodities much above the natural price” (Smith 86).

In chapter eight, “Of the Wages of Labor,” Smith provides extensive analysis into how wages are considered. “High wages are occasioned by the increase, not by the actual greatness of national wealth” (Smith 98). For the most part, wages are just above the minimum or just enough to afford subsistence for a worker and family. It doesn’t matter how opulent a nation is, but rather how much it’s contracting or expanding that determines whether wages are considered “higher” or “lower.” When wages are high, the population increases, and Smith states “To complain of it, is to lament over the necessary effect and cause of the greatest public prosperity” (Smith 114).

“In reality high profits tend much more to raise the price of work than high wages” (Smith 136).  From “Of the Profits of Stock,” Smith declares that if profits are increased, they will have a greater impact on price, rather than producers paying their workers a higher wage. When profits increase, the cost of each unit increases for the next person in line to purchase the unit, and the next person. The process will continue to multiply and increase the cost. Now, if a producer raised wages, it would a add single increase in wages to the cost. That tacked on to cost is less than the extra cost of each unit since profit takes into account each unit without having to spend more via higher wages.

Smith goes into greater depth in chapter ten, “Of Wages and Profit in the Different Employments of Labor and Stock,” to point out factors that cause inequalities to sprout from different types of employment. Wages vary with the following factors: agreeableness of employment, cost of learning the business, constancy of employment, trust, and probability of success. Not only do wages vary, but profits as well. Profits vary with the following factors: employments must be well known and long established, employments are within their natural state, and principal employment of those who occupy it. Employments are considered in their “natural state” when the demand for them is not over or under the normal demand. It’s a tough concept to understand. What is the natural state and how does one determine it? It’s subjective, so it depends on the individual or the majority of market to decide.

In the final chapter of Book I, “Of the Rent of Land,” Smith jumps into the largest portion of the first book, explaining the variations in rent. The chapter is broken down into three parts: always, sometimes, and variations in proportion between respective values. “Rent, considered as the price paid for the use of land, is naturally the highest which the tenet can afford to pay in the actual circumstances of the land” (Smith 198). Smith brings forth the analysis of a mine and “The lowest price of the precious metals must replace stock with ordinary profits, but their highest price is determined by their scarcity” (Smith 234). The preceding statement is true. If we look back to the diamond-water paradox, then we can see that the price of diamonds is great because the amount of diamonds is quite low. And the opposite is true for water. The price of water is all but free, due to the fact there is so much of it.

Adam Smith’s theories are all well and good, but explaining them is not enough. Several questions surface: How did California win or lose because of Adam Smith? What caused the rise and collapse of California’s prestige? Who shall we point the finger at? It’s time for an examination into how Smith’s concepts of self-interest, division of labor, natural and market prices, and wages of labor relate to the Golden State.

Why does division of labor matter? The Bureau of Economic Analysis reports that the gross state product or GSP of California, or the amount of goods and services produced within a state, it has been on a steady increase. With 973,395 million dollars in 1996 to 1,359,265 million dollars in 2001, California accounts for thirteen percent of the United States’ entire output.

An economic “division” exists within the United States. Each state has its own borders and can regulate itself. Yes, the federal government can create “blanket” laws that apply to each state in the union, but a certain amount of freedom is afforded to states. Cross applying the division of labor, we can see the United States is structured in a way to prevent itself from placing all the marbles in a single jar. A state is able to pursue what best suits their interest rather than a central government dictating or regulating states with an iron hand.

Now, if we break down the economy of California, according to 2001 statistics, there are five major areas: manufacturing, finance, real estate, services, and government. The amount each contributes to a gross state product of 1,359 in thousands, is as follows respectively: 163, 317, 220, 326, and 152. For a total of 1178 of 1359 or 86 percent of total output based on the five areas. Out of the five, the single one that has been the on decline is manufacturing, but the other four are increasing. Even though California is said to be experiencing “hard times,” total output is increasing. The five major sectors should be seen as a division. The largest industry is service, with 326 of 1359 or roughly 23 percent of California’s total output based on it.

“In 1999, the Internet was on fire. Venture capitalist appeared to be raining money on any idea remotely involving the web, e-commerce, and e-solutions” (Cassidy), then it all went bust. The “dot com bubble” popped. Due to over speculation, demand for “everything Internet” exceeded the effectual or actual demand. Reverting back to the price of commodities and how monopolies can cause it to be above the natural demand. Commonly, a monopoly is a single company that can artificially set the price of a product too high by limiting the supply of products in the market. The Internet and people’s self-interest helped formed a different type of monopoly, something called a monopsony.

It’s Adam Smith’s idea, just reversed. In a monopsony a single-buyer artificially sets the price of a product too low by limiting the demand. In this case, the “single-buyer” is each person who contributed to the “boom” through speculation. Speculation forced people to over-value the Internet and instead of limiting demand, increased it. Demand continued to rise and rise and rise. People wanted more, and companies made more. However, once the “single-buyer” realized the Internet wasn’t going to be as big as speculated… bust!

The dot-com boom did cause the population of California to increase. Adam Smith stated that when wages are high, the population increased. During the boom, wages were high, not only in Silicon Valley, but throughout the state. Personal income, or the amount an individual earns, rose from 797,150 in 1996 to 1,128,075 in 2001. The potential to earn more acted as an incentive for people to move to California.

From the numbers presented above, it’s not clear that the dot-com crash is the single or even most important cause for California’s economic turmoil. Lack of division is not the problem because California’s GSP is not heavily concentrated in a single industry. It’s true that the population of California increased due to an increase in wages. What is not so clear is the root cause of California’s economic downfall.

“In the end, the state’s energy crisis could prove to be an unwanted wild card for the American financial markets and the global economy at large” (“A state of gloom”). Now, I know, the question could come up: What energy crisis? Just in case some people have been living on another planet for the past four years, I will explain. California experienced a terrible energy crisis in 2000 due to deregulation. What is deregulation?

So they [utility companies] proposed the following: Regulation of distribution lines will stay intact. We will separate the business of generating power from the business of distributing it to the public. We will spin off much if not all of our generating capacity (though in fact much of this was done only on paper, with power plants merely being transferred to the distribution companies’ parent corporations). Then, as pure distribution companies, we will compete with other resellers for customers, who can choose their suppliers and even purchase “green” energy from companies selling wind and solar. Competition will rule. Prices will go down. (Wasserman)

Things did not go according to plan. Adam Smith’s concept of self-interest and competition created a terrible mess. The government decided to allow utility companies to manage themselves. The problem: without government regulation, utility companies’ self-interest are the driving force which cost Californians “somewhere between $20 billion and $28.5 billion” (Wasserman).

In an article titled “California Deregulation II: The Sequel,” Kenneth Betz opens with “California is the state of firsts: first state to deregulate its electricity industry and the first to abandon that free market experiment” (Betz). Within the article, Governor Schwarzenegger states:

California is one of several states that adopted electricity restructuring. However, only California’s restructuring caused severe price hikes and energy shortages. It is time to learn from other successful restructuring enacted by Texas, the New England states, and the Mid-Atlantic States of Pennsylvania, New Jersey, and Maryland. In addition, California should also look to the standard market design created by FERC. (Betz)

For some, the entire concept of re-deregulating the utility industry is a bit frightening, but Gov. Schwarzenegger, who is a proponent of capitalism and free trade, is not afraid. His main concern is forming a better business environment warmer. If the deregulation reoccurs, the governor contends, then business will be able to compete and gain lower prices on their utilities.

Where did things go wrong? Who or what is to blame? I could be childish and state things went wrong when Adam Smith published Wealth of Nations in 1776. His book brought forth the idea of self-interest which is the foundation of capitalism. But I need to be realistic. What makes Smith great is that he affords great explanation of the concepts in Book I. With the application of Smith’s principles to California several conclusions float. California’s eggs were not in the single basket of the Internet, so the entire “dot-com” boom and bust cannot be blamed. Or can it? The California state government’s brush with deregulation inflicted massive hurt to California and caused a political revolt and installation of a new government that wants to restart the deregulation train, but is facing some opposition.

Who is to blame!? Each person’s Internet-based speculation gave the California government an unstable foundation from which decisions were built. The boom led people within the government to believe that the “good times” would keep on rolling, but the bust exhausted all of the state’s surplus, or additional monies, coupled with deregulation sealed California’s grim fate at least for the time being. “Our deficit is out of control, due largely to five years of binge spending by the legislature” (Maddox).

Adam Smith’s last words “I’ll be back.” He put California in a hole but he is bringing it out of it:

MORE JOBS.  It’s a diverse blend of low- and high-tech industries that spans the manufacturing and service sectors, giving the Golden State breadth, depth, and resilience. According to the Bureau of Labor Statistics, the top California employer is the trade, transport, and utilities sector, followed closely by the government, professional and business services, manufacturing, and education. (Wallace)

Division of labor and all the other good stuff powered by self-interest! “TOCK!” I may be out of time, however California is not. A conglomerate of millions of people, the state is home to the same number of choices. Each choice can raise an economy to its greatest pinnacles and lowest depths. There are two possible outcomes of a choice: achievement or failure. With the application of Adam Smith’s theories, it boils down to the following: self-interest or lack of it.

Works Cited

“A state of gloom.” The Economist. 20 January 2001. < http://www.economist.com/displaystory.cfm?story_id=S%26%28X0%24RQ7%20%0A>

Betz, Kenneth. “California Deregulation II: The Sequel.” Energy User News. 24 November 2003. < http://www.energyusernews.com/CDA/ArticleInformation/coverstory/BNPCoverStoryItem/0,2582,113149,00.html>

Cassidy, Mike. “From boom to bust.” Silicon Valley. 21 January 2002. < http://www.siliconvalley.com/mld/siliconvalley/business/columnists/mike_cassidy/2579782.htm>

Maddox, Ken. “Returning the Golden State to a golden shape.” Los Angeles Times. 30 November 2003. < http://www.latimes.com/news/local/pilot/news/opinion/la-dpt-commnet30nov30,1,1383502,print.story>

Smith, Adam. The Wealth of Nations. New York: Bantam 2003.

Wallace, Michael. “Where the Golden State Still Shines.” Business Week. 9 October 2003. < http://www.businessweek.com/investor/content/oct2003/pi2003109_8863_pi031.htm>

Wasserman, Harvey. “California’s Deregulation Disaster.” The Nation. 12 February 2001. < http://www.thenation.com/docprint.mhtml?i=20010212&s=wasserman>