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Smith on Relative Prices

Because Smith was somewhat confused about the factors determining relative prices, he developed three separate theories relating to them. (1) a labor cost theory of value, (2) a labor command theory of value, and (3) a cost of production theory of value. He postulated two distinct states of the economy: the early and rude state, or primitive society, which is defined as an economy in which capital has not been accumulated and land is not appropriated; and an advanced economy, in which capital and land are no longer free goods (they have a price greater than zero).

Labor cost theory in a primitive society.

In the early and rude state of society which precedes both the accumulation of stock [i.e., capital] and the appropriation of land, the proportion between the quantities of labour necessary for acquiring different objects seems to be the only circumstance which can afford any rule for exchanging them for one another. If among a nation of hunters, for example, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.16

According to Smith's labor cost theory, the exchange value, or price, of a good in an economy in which land and capital are nonexistent, or in which these goods are free, is determined by the quantity of labor required to produce it. This brings us to the first difficulty with a labor cost theory of value. How are we to measure the quantity of labor required to produce a commodity? Suppose that two laborers are working without capital, that land is free, and that in one hour laborer Jones produces one unit of final product and laborer Brown produces two units. Assume that all other things are equal—or, to use the shorthand expression of theory, ceteris paribus—so that the only cause of the differences in productivity is the difference in the skills of the workers. Does a unit of output require one hour of labor or two? Smith recognized that the quantity of labor required to produce a good cannot simply be measured by clock hours, because in addition to time, the ingenuity or skill involved and the hardship or disagree-ableness of the task must be taken into account.

At this point Smith encountered a difficulty that all labor cost theories of value have encountered and that has not been successfully solved by subsequent writers. If the quantity of labor is a function of more than one variable, then

16Ibid., p. 47.


we must find a means of stating the relative importance of all the variables. Suppose we have the following information about the production of good A and good B:

Time Hardship Ingenuity

Good A 1 hour X 2Y

Good  2 hours 2X Y

How does one compare the quantity of labor required for good A with that required for good B? The units for measuring time are clock hours, but the units for measuring ingenuity and hardship are not given. Though it is not crucial to know these units for the problem at hand, it is essential to be able to measure the differences in the amount of hardship and ingenuity required to produce the two goods. Smith tried to solve this problem of reducing time, hardship, and ingenuity to a common denominator by maintaining that differences in time, hardship, and ingenuity are reflected in the wages paid to labor. If laborer Brown receives wages of $2 per hour and laborer Jones wages of $1 per hour, these wage payments reflect differences in their skill or ingenuity. If they work in different industries, their wages will also reflect (in part) varying degrees of unpleasantness or hardship.



Smith's suggestion merely restates the problem rather than providing a solution. The purpose of his value theory is to explain those forces that determine relative prices, but wages themselves are one of the many prices in an economy that his theory must explain. When he concluded that the wage paid to labor is a measure of the relative amounts of time, hardship, and ingenuity required to produce a commodity, he was begging the question. He was saying that a good has value according to the wages paid to labor, not according to the quantity of labor contained in the good. This is circular reasoning. Smith used one set of prices, namely wages, to explain another set of prices.

Labor command in a primitive society. Now that we have worked through the labor cost theory of relative prices for a primitive economy, the labor command theory will be smooth sailing. According to Smith, under the labor command theory, the value of a good "to those who possess it, and who want to exchange it for some new productions, is precisely equal to the quantity of labour which it can enable them to purchase or command."17 If it requires two hours to capture one beaver or two deer, Smith concludes that two deer will be equal to one beaver in the market, or the price of beaver will be twice the price of deer, IB = 2D.

17Ibid., pp. 30-31.


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Labor theory in an advanced economy. Smith's model for an advanced so­ciety differs from his primitive economy model in two important respects—capi­tal has been accumulated and land appropriated. They are no longer free goods, and the final price of a good also must include returns to the capitalist as profits and to the landlord as rent. Final prices yield an income made up of the factor payments of wages, profits, and rents.

Cost of production theory of relative prices. Smith wrestled with develop­ing a labor theory of value for an economy that included more than labor costs in the final prices of goods, but finally abandoned the idea that any labor theory of value was applicable to an economy as advanced as that of his times. Once capital has been accumulated and land appropriated, and once profits and rents as well as labor must be paid, the only appropriate explanation of prices, he seems to have found, was a cost-of-production theory. In a cost theory the value of a commodity depends on the payments to all the factors of production: land and capital in addition to labor. In Smith's system, the term profits includes both profits as they are understood today and interest. The total cost of producing a beaver is then equal to wages, profits, and rent, ÒÑâ = Wr + Pr + R%; likewise for a deer, TCd = Wd + Pq + Rq. The relative price for beaver and deer would then be given by the ratio of TCb/TCd- Where Smith assumed that average costs do not increase with increases in output, this calculation gives the same relative prices whether total costs or average costs are used. Where Smith assumed that average costs change with output, prices depend upon both demand and supply. However, in his analysis of the determination of long-run natural prices, Smith emphasized supply and cost of production, even when the supply curve was not assumed to be perfectly elastic. Where competition prevails, he maintained, the self-interest of the businessman, laborer, and landlord will result in natural prices that equal cost of production.

DISTRIBUTION THEORY

The personal distribution of income depends on the prices and quantities of factors of production sold by individuals. Labor is the only factor of production owned by most households; so a household's income generally depends upon the wage rate and the number of hours worked. The amount of property income received by those households that do own property depends on the quantity of capital and land held by the household and the prices of these factors. Because wages, profits, and rents are prices in an economy, their relative values—along with the quantities of labor, capital, and land that individuals bring to the market—determine the distribution of income. Although distribution of income was not of prime concern to Smith, he did offer several different and sometimes contradictory theories of wages, profits, and rents. We shall confine ourselves to mentioning some aspects of his analysis that anticipate later writers and illustrate both his insights and his misunderstandings.


Wages

Smith offered a number of theories to explain wages. In Chapter 8, Book I, he suggested a subsistence theory of wages, a productivity theory, a bargaining theory, a residual claimant theory, and a wages fund theory. Apparently he was not disturbed by the contradictions among these positions, and in other parts of his book he explicitly rejected some of his own propositions. However, two aspects of his discussion of wages deserve further comment.

Smith pointed out that labor is at a disadvantage in the wage-bargaining process. Because there are fewer employers than employees, he said, employers can more easily join together to strengthen their position. Furthermore, the law permits these employer combinations but prohibits employees from forming unions. Parliament has many acts against raising wages, according to Smith, but none against lowering them. Finally, employers have ample resources that make it possible for them to live even if they employ no labor during a strike or lockout. On the other hand, "many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment."18 In these passages Smith weakened his case for the beneficent working of market forces and appears to have recognized that his assumption of perfectly competitive markets is subject to qualifications.

Wages Fund Doctrine

In his discussion of wages, Smith presented his version of the wages fund doctrine, which became an important tool of the classical economists. This doctrine supposes that there is a fixed fund of capital destined to pay wages. Because the production process is time-consuming, previously produced goods that laborers can use for food, clothing, housing, and other things between the start of the process and the final sale are required. This inventory of goods or capital is termed the wages fund, and its source is the saving, or failure to consume, of the capitalists. Given the size of the labor force and the wages fund, the wage rate is determined as wage rate = wages fund/labor force. Smith did not develop all the theoretical and policy implications of this doctrine. We will return in the next chapter to the implications of the wages fund doctrine and its importance in the classical system.

Profits

Surprisingly, Smith's discussion of the nature and source of profits is extremely brief. In general, the classical economists made no serious attempts to explain the nature and source of profits until the 1820s, when they responded to socialist criticism of profit. Smith apparently accepted without question the legitimacy of profits as a payment to the capitalist for performing a socially useful function,

lsIbid., p. 66.


namely, to provide labor with the necessities of life and with materials and machinery with which to work during the time-consuming production process. According to Smith, labor permits this deduction of profits from its output because it has no materials to work with and no independent means of support. Here, then, profit is composed of two parts: a pure interest return and a return for risk.

Smith's brief and inadequate treatment of profits opened the door to the exploitation theory of profit advanced by Marx:

The produce of labour constitutes the natural recompence or wages of labour.

In that original state of things, which precedes both the appropriation of land and the accumulation of stock, the whole produce of labour belongs to the labourer. He has neither landlord nor master to share with him.19

Thus, in Smith's primitive economy the laborer received the whole of the product, but in his own time labor had to share the product with the capitalist and the landlord. Smith never explained why profits and rents are deducted from the output of labor, and he thereby exposed his system to attack by any reader who is critical of a private property, capitalist economy. Readers who, like Smith, believe in the basic harmony of the system would probably not even notice this omission.

Rent

Smith suggested at least four theories of rent, all of which contradict one another. The origins of rent are variously held to be (1) demands by the landlord, (2) monopoly, (3) differential advantages, and (4) the bounty of nature. Early in Wealth of Nations, rent is regarded as price-determining,20 whereas later Smith anticipated Ricardo and regarded rent as price-determined.21 Smith was usually very critical of landlords who "love to reap where they never sowed."22 He sensed the basic conflict between the interests of the landlords and those of the capitalists, which Ricardo expounded in full. This is another example of Smith's realization that the basic harmony in the economy is subject to some areas of discord.

The Rate of Profit over Time

Smith believed that the economic growth of a nation depended on the accumu­lation of capital. Although he paid little attention to the nature and source of profits, he was extremely interested in changes in the rate of profit over time. He predicted that the rate of profit would fall over time for three reasons:

19Ibid., p. 64. 20Ibid., p. 50. 21Ibid., pp. 145-146. 22Ibid., p. 49.


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(1) Competition in the labor market. The accumulation of capital will result in
competition among capitalists in the labor market, with the result that wages will
rise. Smith concluded that the increased wages would bring about a fall in profits.

(2) Competition in the commodity market. Smith reasoned that as output
increased, so would competition among producers, with the consequences that
commodity prices would fall and profits decline. This implies the possibility of
overproduction for the entire economy, which conflicts with Smith's position
that overproduction cannot occur. (3) Competition in the investment market.
Smith apparently believed that there were a limited number of investment
opportunities and that increased capital accumulation would therefore lead to
falling profits. When he examined what historical information was available on
the secular trend of interest rates, the data supported his theoretical conclusions.
He did note that some of the colonies (e.g., those in North America) were
characterized by both high wages and high profits.

WELFARE AND THE GENERAL LEVEL OF PRICES

We pointed out earlier that Smith's discussion of value theory failed to formulate distinct theories of welfare, relative prices, and the general price level. We now consider his theories of how to measure changes in welfare over time and what factors determine the general level of prices.

Chapter 5, Book I

Historians of economic theory have wrestled with Chapter 5, Book I, of The Wealth of Nations, entitled "Of the Real and Nominal Price of Commodities, or of Their Price in Labour, and Their Price in Money." We believe that in this chapter Smith tried to answer several questions that, although related, create confusion when they are examined simultaneously. He attempted to discover, first, the factors determining the general level of prices, and second, the best measure of changes in welfare over time. The second question is the more difficult. How are we to define welfare in an unambiguous way so that changes in welfare can be measured? Suppose that an economy produces only one final product, deer. Welfare for the economy could be defined and measured in terms of the quantity of deer consumed. Consumption of larger quantities of deer would represent increased welfare for the society, and consumption of smaller quantities would represent decreased welfare or "illfare." The issue becomes more complex when we introduce a second final good, beaver. We can state unequivocally that more of both beaver and deer will increase welfare, and less of both will decrease it. But what if consumption of beaver increases and consumption of deer decreases? The welfare of the people in the society who place a high value on beaver would increase, and the welfare of those who value deer would decrease. Is it possible to define and measure changes in welfare for an economy of two or more products? Smith tried to answer this question.


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If welfare is defined as either the total consumption orlrtie output of society, the initial problem to be solved for a multiple-product eccmomy is to find a way to add the output or consumption of the products—for «example, beaver and deer. A possible solution to this problem is to convert al commodities to one common measure. If IB = 2D, then an increase in output off two beavers coupled with a decrease in output of two deer represents an increase in welfare. The new level of output can be said to be one beaver better off or two deer better off. However, if the relative prices of beaver and deer change as their outputs change, the problem of measuring welfare becomes much more complicated. In an economy with many products, the relative prices of commodities are expressed in a common measure, usually the monetary unit of the government. In theory, and occasionally in practice, this common measure (in the jargon of economics, the numeraire) could be any one of the commodities oof the economy—for example, cows, corn, or gold. In our economy, we measures output by adding up the money value of each commodity to obtain a sum we call the gross domestic product. If the gross domestic product increases from one year to the next, can we conclude that welfare has increased?

Measuring changes in output in a multiple-product ecconomy by this means presents difficulties, because the unit of measurement, ti« e yardstick money, is itself variable. The general level of prices changes; theretoore, the money value of output may not correctly reflect the true output. S-rnith considered the possibility of using gold or silver as a common measure, or numeraire, but concluded that because the prices of these commodities vary, they are unsatisfac­tory for this purpose. He then turned to labor but found rhat the price of labor also varies over time. In the end, the only invariant measure he could find to assess changes in welfare was the disutility of work, because "equal quantities of labour, at all times and places, may be said to be of equal vallue to the labourer."23

Given Smith's conclusion that labor disutility can be unsed in computing an index of welfare, the problem of measuring changes in vedfare is easily solved. We first measure changes in total output in terms of the monetary unit; then we adjust for changes in the general level of prices accordingtoo changes in the price of either gold, silver, or corn. By this process, we have converted money income and nominal price into real income and real price. To measure changes in welfare, we then compare the amount of labor disutility involved in producing the different outputs. For example, if the money value of output increases 10 percent and the general level of prices as measured by the price of" gold also goes up 10 percent, the real value of output remains the same, ^leelfare increases if the disutility of producing this output decreases. Translated iffito everyday language, if we could produce the same quantity of output with less labor, we would have more leisure and be better off.

Measuring changes in welfare is much more complicated than Smith thought, however, and our discussion cannot touch on all the issue :s involved. Smith did not discuss how to define or measure the disutility of labor. This appears to be

2iIbid., p. 33.


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D

etermining the long-run growth rate of a society, one of the main concerns of Adam Smith, has not al­ways been the primary focus of the discipline we now term economics. Analysis of growth was not a prime con­cern of the neoclassical writers, for ex­ample. As we enter the twenty-first century, however, economic growth and its causes and consequences have again come into focus. Somewhat ironically, modern economists, using high-powered econometric systems to test hypotheses, have succeeded in verify­ing empirically some of the factors that Smith, in his loosely constructed theo­retical framework, found to be key de­terminants of the wealth of a nation. One recent study looked at how the "extent of the market" influences eco­nomic growth. Another has found that secure property rights contribute sig­nificantly to the high rates of economic growth characteristic of Western devel-


oped economies. This work, called "new growth theory," is a major focus of mod­ern macroeconomics. Interestingly, many of its insights were anticipated in Smith's work (though careful scrutiny was needed to identify some of them), but during the intervening ages, they have been lost to economics, as the pro­fession focused on different issues.

A good summary of modern empiri­cal attempts to understand the causes of the wealth of nations is Robert Barro's Determinants of Economic Growth, MIT Press, 1998. See also Alberto F. Ades and Edward L. Glaeser, "Evidence on Growth, Increasing Returns, and the Ex­tent of the Market," The Quarterly journal of Economics, August 1999; and Charles I. Jones, "Was an Industrial Revolution In­evitable? Economic Growth Over the Very Long Run," National Bureau of Eco­nomic Research Working Paper No. W7375-


completely subjective. One of his assumptions that was not questioned by orthodox economists until the twentieth century was that more goods are better than fewer, or that increases in output that occur without increases in labor disutility must always result in increased welfare. The various goods that constitute total output are not an issue in his writing. Growth of output is an improvement in welfare even if the enlarged output includes goods of doubtful benefit to the society. Furthermore, Smith and the orthodox economists who followed did not consider the "quality of life" produced by this enlarged output. Little or no attention was given to the costs in the form of pollution or other harmful externalities that society might pay for ever-larger outputs.

SUMMARY

Smith's contribution to and influence on economic thought was tremendous. More than any other writer of his time, he saw the central ideas and forces that govern a market economy. However, his work is not without problems. Smith


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confused himself and generations of economists by failing to elaborate separate theories of, and distinguish clearly among, relative prices, the general level of prices, and changes in welfare. Historians of economic ideas have debated whether Smith propounded a labor theory of value. If this means a labor theory of relative prices, the answer is yes and no. He applied a labor theory of relative prices to a primitive economy, but for a modern economy he held to a cost of production theory. According to Smith, the general level of prices can best be measured by the price of gold, silver, or corn. To explain changes in welfare over time, he formulated a subjective labor-disutility theory. We must conclude that for a modern economy Smith did not accept a labor theory of value to explain relative prices. Once land and capital become economic goods, natural prices will depend mainly on costs of production—namely, wages, profits, and rents.

Smith was primarily interested in questions of economic policy affecting economic growth and development, specifically in determining policies that would best promote the wealth of the nation. His major recommendation was that the government follow a policy of laissez faire; this, he claimed, would effect a maximum rate of growth of per capita income in the economy. His analysis of the workings of markets (what today would be called the microeconomic aspects of the economy) must be viewed within the framework of his concern for economic development. His belief that laissez faire was the most effective policy available was based not primarily on its efficiency in allocating resources but on its beneficial effects on economic growth. His policy positions, for both laissez faire and government intervention, were always contextual. They were based on theoretical arguments combined with his observations of households, firms, politicians, and institutions. Nor was his methodological predilection that of a pure theorist; he also took into consideration political, historical, and institu­tional factors. This stance extended, moreover, from his analysis to his policy. The mercantilist regulation of domestic and foreign trade had been designed purportedly to increase the wealth of the nation, but Smith concluded that such regulation was misguided and that economic growth was best promoted by the free operation of markets. Smith's policy conclusions flowed not solely from his theoretical structure but in part from his application of the art of economics.

Although Smith was concerned chiefly with questions of economic develop­ment, it was in his investigation of the workings of competitive markets that he contributed most significantly to economic theory. In this endeavor he drew from the later mercantilists and the physiocrats and brought together in one book much of the solid analysis of his predecessors. He was able to describe the functioning of competitive markets with greater precision than previous writers. In the details of his theoretical structure, particularly in his attempts to formulate a value theory, he provided a necessary point of departure for Ricardo and other theorists who followed.

Smith was not a pure theorist. Rather, he was a political economist who was able to supplement a grand vision of the interrelatedness of the sectors of a market economy with descriptive and historical material and to influence economic policy for at least two hundred years. The pure theorist Ricardo was followed by J. S. Mill, and Mill by Alfred Marshall; both tried to return economics to Adam Smith's contextual analysis and policy. With few exceptions,


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the methodological position of orthodox economists since Marshall was one of almost exclusive focus on pure abstract theory, with little attention to historical and institutional material. In that focus, modern mainstream orthodox theory has rejected the Smithian methodology. However, it has been kept alive by heterodox economists who rejected Smith's laissez-faire policy conclusions.

Generally speaking, the history of economic analysis and policy discloses three major developments since Smith: (1) Microeconomic theorists have tried to fill in the details of Smith's grand vision of how markets work. Part of this activity has been technical, aimed at giving greater precision to Smith's vision, and part has attempted to develop areas that Smith failed to treat or to comprehend, including the development of the demand side of price analysis, the formulation of a theory of the economic forces determining the distribution of income, and the analysis of resource allocation in other than perfectly competitive markets. (2) After Smith, macroeconomic analysis received little attention from orthodox theorists until the 1930s, when Keynes returned to one of the mercantilists' concerns and attempted to explain the forces determining the level of income and employment. (3) Smithian economic policy remained virtually intact, despite the grumblings of Marx, Veblen, and others outside the orthodox camp, until the twentieth century, when theoretical developments (welfare economics and some parts of Keynesian theory) and events in the real world (revolutions that replaced some private property economies and severe depressions that shook the remaining ones) led to either rejection or reexamination of Smithian policy.

We turn now to the second great classical economist, David Ricardo. Like Smith, he was primarily interested in questions of macroeconomics; but in the course of developing a theory of distribution, he was instrumental in turning orthodox economics away from macroeconomic questions for more than a century.

Key Terms

advanced economy natural price

capital accumulation numeraire

contextual economic policy primitive society

cost of production theory of value productivity of labor

diamond-water paradox profits

division of labor Protestant ethic

early and rude state specialization and division of labor

extent of the market value in exchange

labor command theory of value value in use

labor cost theory of value value theory

laissez faire wages fund doctrine

market price wealth of nations

Questions for Review, Discussion, and Research

n 1. Contrast and compare Adam Smith's and the mercantilists' views on the nature and causes of the wealth of nations.


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2. What do you think is the relationship, if any, between the rise of capitalism in Western Europe and religious beliefs?

., 3. Explain Adam Smith's analysis of the consequences of self-interest coupled with competitive markets.

- 4. Contrast and compare Adam Smith and the mercantilists on the proper role of government in the society.

^ 5. Explain how the former Soviet Union was mercantilistic rather than Smithian.

^ 6. List Adam Smith's qualifications of his laissez-faire policy (reasons for government intervention in the society) and then give your own views on the proper role of the government in society.

7. The success of Adam Smith is explained by the fact that his theories
rationalized the activities of the rising capitalist class. Write an essay that
either supports or refutes this statement.

8. If there is learning by doing, why is it unclear who ultimately will have the
absolute advantage? What implications does this insight have for the argu­
ment for free trade?

-* 9. Explain Smith's views on why the rate of profit will fall as capitalism grows older.

10. What do you think is the relationship between a person's well-being and his
or her possession and consumption of economic goods? Is it possible for an
individual as well as a society to be better off with fewer goods? Does your
answer to this question depend upon where you are in the present distribu­
tion of income?

11. The absent-minded professor has another job for you. She knows that
somewhere in Smith's writing, there is a famous "dogs don't trade" quota­
tion, but she does not quite remember where. Your assignment is to find the
selection and the complete bibliographic citation for it.

Suggested Readings

Anspach, Ralph. "The Implications of the Theory of Moral Sentiments for Adam

Smith's Economic Thought." History of Political Economy, 4 (Spring 1972). Clark, John M., et al. Adam Smith 1776-1926. Chicago: University of Chicago

Press, 1928. Elmslie, Bruce. "The Endogenous Nature of Technological Progress and Transfer

in Adam Smith's Thought." History of Political Economy, 26 (Winter 1994). Hollander, Samuel. The Economics of Adam Smith. Toronto: University of

Toronto Press, 1973. Hutchison, T. W "The Bicentenary of Adam Smith." Economic Journal, 86

(September 1976).


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Rashid, Salim. The Myth of Adam Smith. Northampton: Elgar, 1998. Redman, Deborah A. The Rise of Political Economy as a Science. Cambridge,

Mass.: The MIT Press, 1997. Robbins, Lionel. The Theory of Economic Policy in English Classical Political

Economy. London: Macmillan, 1952. Rosenberg, Nathan. "Adam Smith on the Division of Labor: Two Views or One?"

Economica, 32 (May 1965).
------------------ . "Some Institutional Aspects of the Wealth of Nations." Journal of

Political Economy, 68 (December 1960). Samuels, Warren J. The Classical Theory of Economic Policy. Cleveland: World,

1966.

Scott, W R. Adam Smith as a Student and Professor. Glasgow: Jackson, 1937. Skinner, A. S., and Thomas Wilson. Essays on Adam Smith. London: Clarendon

Press, 1975. Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations.

Ed. Edwin Cannan. New York: Modern Library, 1937. Spengler, Joseph J. "Adam Smith's Theory of Economic Growth." Southern

Economic Journal, 25-26 (April-July 1959). Stigler, G. J. "The Successes and Failures of Professor Smixh." Journal of Political

Economy, 84 (December 1976).

Readings in Original Sources

All readings by Adam Smith are from his Wealth of Nations.

Value: Introduction and Plan of Work; Book I, Chapters 1-7.

Wages: Book I, Chapters 8 and 10 (Part I).

Profits: Book I, Chapter 9; Book II, Chapter 4.

Rent: Book II, Introduction and Chapters 1-3, 5.


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