Adam Smith was a Scottish economist, philosopher and author, and a very successful one at that.

His masterpiece, the Wealth of Nations released in 1776 and was at that time considered very controversial, but it has laid out the groundwork for pretty much all economics since. Smith is often referred to as the Father of Economics or the Father of Capitalism for good reasons.

Adam Smith was a pragmatist who knew that people will always act in their self-interest and therefore every economic policy introduced must always take that into account.

Secondary and tertiary effects must always be considered as a society can do no better than to set up the correct incentives so that humans will act in the best way possible.

Here are the main takeaways from the book:

Productivity is the key

The people of a nation will be better supplied with all the products and services that they have occasion for. If one or two of the following happens.

• Increase in the number of people who have a job compared to those who don’t.
• An increase in the productivity of those jobs.

This could be said to increase their wealth. It depends much more on the latter than the former.

Thousands of years ago, our ancestors were all employed. Every day, everyone had the job of catching food for themselves. Yet today, even the poorest people of Western civilization are wealthier than the kings and queens from those times.

Consider this story: a man was handed the task of inspecting the construction of a waterway in a certain communist land. When he arrived at the site, he saw a thousand people digging with spades while great digging machines stood idle nearby. He asked the manager of the project. Why don’t you use the machines over there instead?

Well, Sir,  that’s because these people would be unemployed in no time. The inspector thought about this for a minute and then returned home.

The next day, he went back to the site and went straight to the manager. He handed him a spoon. Why don’t you use a thousand of these instead? To the wealth of a nation, productivity is king.

Increasing Productivity

It is improved by these factors.

• Dexterity and skill in doing something.
• Avoiding loss of time, changing from one task to another
• Proper use of the machine.
• Division of labour and thereby productivity increases as transportation improves.

The two first factors come from the division of labour.

Instead of having everyone in a society, doing everything themselves, we should each do what we are best at and then trade products and services with each other. The greater the extent of this trade or the greater the market, the greater the possible division of labour and thereby greater the productivity.

Think about all these specialized products and services that we exchange with each other in a great city. You would probably not find a store like this one in a small country village, but in the great city of New York, you can. The division of labour increases as transportation is improved.

Adam Smith gives an example from his experience in the eighteenth century. Six to eight men can buy water carriage to transport, the same amount of goods in the same time with a single ship as a hundred men with 50 Broadway wagons and 400 horses.

This is why rivers and seacoast towns often develop faster. They allow a greater division of labour as they extend the market of trade. Ships were much better than horses, but I think that Adam Smith would be jealous if he looked at us today, because now we have Amazon.

Money: What is it and why do we use it?

When the division of labour is established, every man supplies himself with, but a small amount of the goods that he needs. Instead, he participates in exchange, but in the beginning, it must have been very inefficient to try to trade with one another. When supply and demand didn’t always match.

Example:

Ram: Hey! Frankie: look at this nice spear that I just created. Could I get some of that tasty meat that you have? If I give you my spear?

Hari:  No deal Ram. I already have like 10 Spears, but I could use a pound of salt.

Ram:  Hey, Randy, look at this nice spear that I just created. Could I get like a pound or two of your salt? If I give you my spear?

Randy: No deal Ram, you know that I’m too old to go hunt these days, but I could use a new shirt.

Ram:  Hey George, look at this nice spear that I just created. Could I get a shirt if I give you my spear?

Kishore: Yeah, of course, Ram, I’ll be happy to trade a spear for a shirt. Nice. Oh, but I think that one spear is probably worth more than one shirt. How many shirts have you got? I only have one shirt to spare at the moment, unfortunately.

Ram: Well then no deal, Kishore.

This was quite inconvenient, to say the least. Enter money. Money facilitates the exchange of commodities that we produce to get back to the first takeaway. One can say that they increase the productivity of exchange. Quite early, metals were used as money and they have at least two qualities that make them suitable for this purpose.

They basically do not perish and they can be divided into many parts and then fused again. Some things have value in use like Spears, meat, salts, and shirts.

Other things have value in exchange like bills, coins and medals. That which has a high value in one is quite worthless from the other standpoint. You can’t use a dollar bill for anything.

I mean, you can’t eat it or anything. Similarly, a spear might be quite useful, but it doesn’t work well for exchange as we just saw. As long as people trust that money can be exchanged for something else that they need later, they are happy to trade their produce for that money. It all boils down to that trust.

Warren Buffet has said that it is quite misleading that on the backside of every dollar bill, it says in God we trust because what it should say is in the Federal Reserve, we trust.

The three components of price

The real price of everything is its price in labour. Something that takes more time, energy or resources to bring up often as a higher real price. However, there’s also a nominal price and that is the price as measured in money.

It is because it’s difficult to measure and compare labour. We’ve come to estimate real prices in terms of money instead. The price of everything that is produced results itself into either one or more of the following three components:

• A wage to pay the labour that did the work.
• A profit to pay for the capital that was laid out for the work to happen.
• A rent to pay the holder of the land, where the work and or exchange must take place.

We all know that wages can differ a lot between different occupations. Just look at the average salary of a McDonald’s cashier and compare that to the salary of a neurosurgeon. Similarly, profits differ from industry to industry, but not as much and also they should average out over time.

Something that we’ll get to later, these are the average profits measured as return on equity for different industries during the period, 1999 to 2019.

And the factor that can differ the most is of course rent. In New York, for example, you’ll have to pay about $5.2 million per acre of land. While in the country village in Sweden, you’ll pay only about $20,000.

How much you have to pay to buy land correlates well with how much rent you can get for it. Because of this, the portions that make up the price of a certain product or service differs a lot, depending on its type and where it is.

A massage, for example, costs $60 an hour in the previously mentioned village while it costs $105 an hour in Manhattan in New York. The difference in price between the two locations can pretty much fully be contributed to the difference in rents. And some of it is the difference in wages that are necessary to sustain someone in New York.

The price of a certain product or service is determined by supply and demand. Actually; it is determined by something called the Effectual Demand, which is those that demand the product at a price so that it allows for the wages of workers, the profits and replacement of capital of businessmen, and often some rent for the landowner.

Yes. I mean, I want a Tesla. It’s just that I’m not ready to pay $70,000 for it yet. Thus I am the part of the demand, but not the effectual demand that can bring the product to the market.

Let’s have a look at these three components separately.

• Wage: A worker will always demand a wage so that he can at least purchase the necessities of life for himself and his family. This is the bare minimum which even the simplest type of job must pay because otherwise, such workers will cease to exist over time. In countries where no minimum wage exists, the simplest jobs will tend to be at this level and not higher. This is because workers are at a natural disadvantage when trying to bargain how much of that price, which was mentioned earlier, we should go towards their salary. They typically exist in abundance compared to capital and land. Moreover, they typically do not have much money spared, so they can’t afford to wait for a better opportunity, but salaries can differ a lot, which we shall see later.
• Profit: A businessman is someone who employs his capital to earn a profit within a specific trade or industry. The more capital that is employed in a certain industry, the higher the competition there becomes and the lower the profits tend to be. So it must be in society as a whole too. If there are no intelligent ways to employ capital anymore, returns will be below. Over time, even though some companies can hold on for very long returns on capital will even out across industries. This is because where returns are high, there will be incentives to move capital and where returns are low, there will be incentives to re-move capital. This restores the equilibrium of the source. If you want to know more about which types of industries can withstand competition the longest, head over to my summary of competitive strategy land.
• Rent: An owner of the land will either try to sell his land for a profit or lend it out for rent. Either way, someone down the line will eventually try to lend it out for rent or use the land themselves. And then it is a day who gained the rent. Rents vary a lot, depending on the occasion.  Some types of land, basically earn no rent at all. While those that people find attractive land in cities or beautiful beach properties earn a lot of it. Something that should be noted is that rent is quite like a monopoly price. Off normal wages have been paid and the businessman has been able to replace this capital with a decent profit. The owner of the land will pretty much take what’s left. The land is immovable and irreplaceable and it’s therefore peculiar compared to the two other types of revenues that can be earned.

Why do some jobs pay more than others do?

So profits of industries should average out over time and more rent is given to the person who holds property in a city or at a beach. Okay. But why the heck does my neighbour have the highest salary than me even though I’m much smarter than him? The wages of labour are decided by supply and demand. Like everything else. The following five factors tend to affect this, to increase the wages of a specific job:

• The expenses and difficulties of learning it.
• The inconsistency of payment.
• Trust and responsibility.
• The improbability of success and the hardship.
• Dirtiness and disagreeableness of the job.

In the 18th century, a blacksmith had to be an apprentice for many years before he was allowed to open his trade. During this time he owned very little or nothing at all. The higher wage that he got to once finished is compensation for those years and the apprenticeship helps in limiting the supply of such workers.

A Mason could only work during good weather conditions and so his hourly wage had to be compensated for those idle hours. Greater responsibility means that fewer people are suited for that type of work and therefore wages are higher. Back in the days’ lawyers and doctors had such roles and they still have by the way. The improbability of success is another factor that matters.

The expected wage of a job with a very high failure rate is often even lower than normal jobs, but the person who succeeds typically gets the salary of those who fail to. The kind of people searching for gold or treasure belonged to that category.

And in the 18th century, the dirtiest and disagreeable job one could get was probably that of the public executioner and the pay was thereafter high. Today a difficult and expensive job to get would be that to the previously mentioned neurosurgeon, an inconsistent one might be that of a real estate broker and a job that requires a lot of responsibility is that of a pilot. The probability of success is high among elite athletes and musicians and the dirtiest and most disagreeable job is probably that of a hedge fund manager.

Accumulation and employment of capital

What’s the similarity between Michael and a country like the US, China, or Sweden? It is that they get wealthy in the same way. Allow me to introduce the Swedish investor The Stairway To Money. She’s buying a stairway to money, all copyrighted and original content. Of course. Each different step represents a category that an individual can spend money on to become wealthy. A person wants to spend money on the highest steps and not the lower ones.

• Services For Consumption: At the bottom, we have services meant for consumption. These are the worst things that you can spend your money on. On asked you’ll consume them instantly vacations, dinners and video on demand, all belong to this category.
• Products Depreciating: The next worst thing to direct your money towards is products meant for consumption. Products depreciate from the time of purchase, but at least they’re not as bad as services because he will still be able to sell them at a later stage, even though it may only be at a fraction of their original value costs. Clothes and phones belong to this category.
• Products Non–Depreciating: Then we have products that do not appreciate, and that often keep their value through inflation. Important entries in this category are collectables and houses to live in.
• Investments: At the top, we have investments. This is a very broad category indeed, and anything which is expected to generate more cash in the future than the outlay of money is today a plus. A reasonable return belongs here, therefore starting in business, educating yourself, investing in the stock market or renting out properties, all belong here.

It’s the same with countries. If a country buys services from another country, money flows right out from it without being replaced with something else that is valuable. If a country buys products from another country, at least some of the value is still preserved. As products can be sold again at a later stage, it is similar to the third step in our stairway to money.

A country gets rich by increasing its productivity and by starting businesses thereby educating its people so that their skill increases or by buying productive assets from other countries. Neither people nor nations should be afraid of having expenses, just because of this. Both people and nations, if they want to acquire wealth should focus on what they are naturally good at and then outsource the rest.

Globalization-The shortcut to increase wealth

Here we have Michael Lewis, a 32 years old engineer. He’s working at a job where he’s paid a base monthly salary, but he’s also compensated for overtime. For overtime hours he nets approximately $30 per hour. Given this, here comes a few questions for you. Should Michael Cook his food? Should Michael clean his own house? And sorry, now I’m getting a bit silly just to prove a point here.

Should Michael build his phone instead of buying one from apple? From a wealth standpoint, the answer is “NO” to all of these questions. It makes sense for Michael to do what he’s best at burning money from that, and then hire other people to do what they are best at for everything else that he demands. Perhaps Michael can cook his food, but it takes him about an hour to prep a single meal, which means that he does so for $30, because he could have spent that time working as an engineer.

Therefore, it doesn’t make sense for him to do it as he can just buy a meal outside for $15. Similarly, he can clean his own house, but it takes him two hours to do so. That’s $60 for Michael while it can hire someone to do it for $40. And as an engineer, he is capable of building his phone, but it might take him something like 200 hours, plus $200 in materials. That’s a $6,200 phone.

Why not just go buy the latest iPhone for $1000? If it doesn’t make sense to do something at six times the price, it doesn’t make sense to do so at two times the price and probably not at 1.5 times the price either. It is the same with nations. For nations to increase their wealth they should be focusing on the things that they are good at and then hire other nations to do what they are best at. For example, the US is a leader in many different businesses, but among others in the fast food and entertainment industry, China is incredible at producing most products at very low prices. In Sweden, we are quite good at producing furniture.

Sorry. I mean, it’s making everyone else produce furniture for themselves. Now to Sweden, try to produce the same products that China can produce much cheaper. No. Should China compete for head to head with Hollywood? Probably not. Should the US have everyone produce furniture for themselves? No. All these countries can be more productive and that increases their wealth by simply doing what they are best at and then trade goods with each other. Also to make another comparison between individuals and countries in their quest for wealth, both of them will earn more by having rich neighbours or acquaintances. People know that if they want to be rich, they should move where other people are rich.

And probably even more importantly, they should acquire rich friends. It’s the same with nations. A country should want their neighbours and trading partners to be wealthy because eventually, that wealth will spill over to them too. Just look at this map, but we’ve been getting this backwards for centuries now in the 18th century, Great Britain and France, probably the two wealthiest countries in Europe at that time did everything they could to make business miserable for each other. Instead of cooperating, they even went to war with each other. Today, let’s hope that the two most important economies of our time, the US and China don’t make that same mistake.

Why free trade is superior and why governments shouldn’t interfere?

In a capitalistic society, money will naturally flow where the returns are higher and disappear from where their returns are lower. In a society where the government does not interfere two rules will guide capital

• Capital is naturally employed where it can produce the greatest returns: This is a good thing because businesses like these are more sustainable than anything else. They will employ people where there is demand and real competitive advantage.
• Capital is employed in the home market as this comes with less risk: This is also good because it creates working opportunities in the own country.

For these two reasons, it is unproductive when governments interfere with the market. Just as an imaginary example, say that we in Sweden would do something as silly as setting up a ban on movies created in Hollywood.

What would happen when such a ban is introduced? Excluding potential retaliation. It will deal higher profits for the film industry in Sweden. Then what would naturally be the case? Therefore more capital will be incentivized to flow to this industry, but this business still isn’t competitive on a global scale everywhere else.

Then in Sweden, people will still watch movies. Moreover, the capital in Sweden, which goes towards the creation of the film is capital that could have been directed towards something where Sweden is competitive on a global scale. Like the previously mentioned furniture. Generally, politicians must have a small dose of God complex if they think that they are smarter than the aggregated thinking of the market when it comes to capital allocation decisions in businesses. There are two examples when it might be necessary to introduce duties, bans, and tariffs, though.

For goods that are important for the defence or survival of the country. When a tax is imposed, even on such domestically produced goods, you don’t want to shift the favour to the foreign goods at the very least. Apart from that governments should probably stay away from using duties, bands, and tariffs on foreign goods.

They should not incentivize certain industries or disincentive others because the market is likely to do this very well on its own. Thanks to the before-mentioned too, there are a few areas where a government is necessary for the wealth of a nation though. That is what we shall cover in the next takeaway.

Purpose of a government

According to Adam Smith, there are some tasks in a society that the market and private people have little or no interest in solving. The four that Smith discusses on the

• Defence of a country: The defence of a country is necessary for its wealth. Interestingly enough, countries are more and more likely to be invaded the richer it is, or so it was in the old days at least. Consider the rates of Genghis Khan and his Mongolian savages of the much wealthier cities of China. Well, how the Vikings invaded many, much more established societies in Europe. These savages had the advantage at this time, as they were much more skilled fighters. But that all changed with the invention of firearms. Firearms, expensive to make and no matter how skilled an army of Spears and bows were, it couldn’t beat one equipped with firearms. And so the odds changed in the favour of the wealthy nations who could afford these Supreme weapons. Anyways and nation must be able to defend itself to sustain its wealth and as this benefits, everyone in a society. It does make sense that a government has the responsibility for this task.
• The justice system:  Justice is similarly an expense that benefits everyone in a society. In the old days, justice was often exercised by those in power, but one can easily understand how such a system can be very corrupt. Justice and power must be separated, otherwise who should bring justice to those in command. Similarly, a justice system that is based on profits tends to be very corrupt too. So it doesn’t lend itself well to the free markets. It used to be like this to everyone that wanted justice had to bring a gift to the judges. As you can probably imagine the person who brought the greatest gift tended to get a little bit more justice than everyone else. So to speak. Therefore, the task of bringing justice to its people should be paid for by a government. But those that use the justice system often should probably pay extra for that.
• Some type of infrastructure: Infrastructure such as the most important road sander docks used for the commerce of a country is something that benefits everyone too. But it doesn’t invite the same conflict of interest as the justice system does. And should that often be held privately? Infrastructure should be financed with revenue from commerce, which can be carried using it because, in this way, money will much more seldom be wasted on infrastructure projects. Some infrastructure projects can be important without being profitable, but in that case, they should often come with a local tax, not a national one.
• Basic Education: Without some type of basic education being free and probably also mandatory, some of the countries inhabitants, those that are born into poverty will most likely, never learn how to read, write or count. Such inhabitants are unlikely to increase the productivity of a nation. Therefore, we want to avoid that this happened. Benefits such as learning to read, write, and count benefit, everyone. And it should be one of the purposes of the government or making sure that this is done.

How should the government be financed? 

So with defence, justice, infrastructure and education, a publicly financed government seems to be the fairest and logical solution, but there are many different options of financing, something, and some are better than others. He offers four principles for creating a good tax.

• Equality: Each person should contribute in proportion to his or her abilities and in proportion to the revenue which he earns under the protection of the state. It is difficult to make sure that the wages, profits and rents the three sources of income are all taxed equally, but they should, at the very least be taxed equally and  individually
• Certainty: Time, quantity, and manner of payment must always be clear. This is probably the most important principle. A little bit of uncertainty is worse than a great deal of inequality. Uncertainty leads to the potential corruption of the tax-gatherer.
• Convenience: Taxes should be done when the contributor is most likely to be able to, to pay the consumer pays whenever he consumes the service or product and the wage earner should pay taxes as soon as he gets the wage. Not at some other time when he might already have spent it all.
• Efficiency: A tax may never be more burdensome to the people than it is beneficial to the government. For instance, as few people as possible should be required for gathering the tax, a tax should never discourage the industry and the degree of visits and examinations of the people shouldn’t make them feel pressed.

With these four principles in mind. I’d like to ask you a question. Do you think that it is a good idea for a country to have a wealth tax? In other words, a tax, which is in proportion to the total assets of private people?

NOTE: This article is inspired by the Swedish Investor’s interpretation of the book. We thank him for all the awesome work he has done.