Economics Unit-2 Fa-1

Ravichandra Dasari

Adam Smith and David Ricardo's contribution to free market and wage level
determination:

Adam Smith:
Adam Smith is regarded as the Father of Economics, and his insights regarding the
role of the market in setting prices contributed significantly to the comprehension of
modern wage determination. Smith, Adam, in his magnum opus, "The Wealth of
Nations," argued in favor of the benefits brought by a free market regime. To this end,
he noted that the economy runs through people with diverse interests, which in turn is
directed by an 'invisible hand' to the general prosperity of the same. Smith's main
contributions are:

1. Free market: Smith argued for the minimum government's participation in the
economy. His main assumption was that self-interested individuals entered into
voluntary exchanges whereby resources were optimally allocated.
2. Price Determination: According to Smith, there is a demand-supply mechanism for
setting free market prices. If supply equals demand, then it means that the prices will
be equal to the perceived worth of society.
3. Determination of wage rate: According to Smith, wages are regulated by the supply
of labor and the demand for labor. Usually, the worth of work done by employees
determines wages in a competitive labor market.

David Ricardo:
Following Smith was the great economist David Ricardo, who enhanced the
comprehension of the free market and wage theory. He was the one who developed
the theory of comparative advantage, which argued about how specializations and
trades were beneficial to any country participating. Major Benefits include:

1. Comparative advantage: According to Ricardo's theory of comparative advantage, it

is possible for differentiation amongst two countries, even though one might be
inefficient or inferior in producing all goods as compared to the other, to result in a
mutual benefit through trade. 2. Choice of Wage Level: Ricardo's theory states that
wages can vary from industry to industry and country to country depending upon their
comparative advantages. Higher productivity in efficient countries usually results in
higher wages for workers.
Theory and evidence of opportunity cost:

Opportunity Cost Theory: Opportunity costs are what you can get when you opt for
one action or option against others. opportunity-cost-based explanation for Smith's
and Ricardo's theories. In a free market system, individual countries make choices
considering their comparative advantages and also the cost implications of their
decisions.
Evidence supporting the opportunity cost theory:
1. Trade Patterns: There is often a tendency to export goods and services where
countries have an advantage and import those that they lack. In this mode of
operation, one would select the best and least expensive means of production.
2. Allocation of Resources: Resources, including labor, capital, and raw materials,
move to areas that are most effective in a free economy. This efficient allocation helps
to avoid the highest possible opportunity cost by making full use of the available
resources.
3. Specialization: People or companies concentrate on the activities with the least OC
(Opportunity Cost). The result is that general productivity goes up, ultimately
boosting the economy.

Bibliography:

"Klm Institute." Klm Institute, klminstitute.com/course/chapter/ibdp-economics. Accessed 13

Oct. 2023.
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"Lesson Summary: Scarcity, Choice, and Opportunity Costs (Article)." Khan Academy,
www.khanacademy.org/economics-finance-domain/microeconomics/basic-economic-
concepts-gen-micro/economics-introduction/a/lesson-overview-scarcity-choice-and-
opportunity-cost#:~:text=satisfy%20unlimited%20wants-.
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