Guidebook to the Wealth of Nations. CH 3: Book I.4-7

 

 

Chap 3: Book 1, Chapter 4-7

 

BOOK I, chapter 4: of the origin and use of Money

As we just saw, one of the limitations of the division of labor is the extent of the market. Another limitation is the presence or absence of money. But while the extent of the market as described in chapter 3 is in part exogenous, meaning it depends on the natural conditions of a country, that is, on the presence or absence of navigable rivers and seas, the presence or absence of money is endogenous, meaning it depends on the stage of evolution of the division of labor. Division of labor and money go hand in hand.

A commercial society is a society in which much that we consume comes from exchange, where division of labor is fully established, and every man is basically a merchant. A commercial society exists where transactions are monetarized since without money trade and thus division of labor are very much limited.

When division of labor starts to take place, we start to produce more than we consume, and we would like to exchange it for something we do not produce but want to consume. This is not easy if we rely only on barter, because we run into all the difficulties of the double coincidence of wants. If a baker wants to get a beer, he needs to find a brewer who wants bread in exchange for his beer. If the brewer has already enough bread, the baker will not get his beer. With barter there are few incentives to divide labor.

So, Smith says, any prudent person will keep at hand something that he imagines someone else may not refuse in exchange for goods or services.

The choice of words here may not be an accident. I imagine myself as you, and I think: what would I not refuse if I was in your position? The role of imagination is critical here. It is critical, even if not explicitly mentioned, that when I want to appeal to your self-love to get my dinner I have to imagine what you want and persuade you that I have what you want. Here Smith is explicit in appealing to the use of imagination to understand what others may want. The use of the imagination is key in Smith’s other book, the Theory of Moral Sentiments. It is only through our imagination that we can try to relate to each other and, that we can understand each other, and help each other grow morally. Here the same imagination helps us develop a solution to the problem of barter: money — what Smith calls the instrument of commerce.

Historically, what people imagine others would not refuse in exchange for the produce of their industry varies. Different commodities take the role of the instrument of commerce: cattle, salt, shells, dried cod, tobacco, sugar, hides, even nails. But metals take dominance as money in most countries, because they are less perishable and more easily divisible than other things previously used as money, such as an ox for example.

In different countries, we see different metals becoming the most common form of money. This is due mostly to chance and availability.

A simple bar of metal has its limitation. It needs to be weighted and assayed (verifying the quality and purity of the metal) every time it is exchanged. So, to decrease these transaction costs and the chances of fraud, metals tend to be stamped in mints. Originally the stamp is only on one side of the bar, to verify the finesse of the metal, and it is exchanged by weight. So the trouble of weighting remains. Eventually, thus, the metal is made into coins, with stamps on both sides. The denominations of this coined money usually reflects the weight and/or quality of the metal. So the English pound sterling originally actually contained a pound of silver, just like the penny contained a pennyweight of silver, that is, the 20th part of an ounce of silver.

Note that Smith is defining money only with regard to its function of medium of exchange, and he disregards its function as a unit of account. This may not be historically accurate. The example he gives of someone who wanted to buy salt and having to exchange a cow for it, so having to get a huge amount of salt, is ludicrous today. An ox was indeed a form of money, but mostly as a measure of value not as a medium of exchange. You measure value in oxen but do not actually exchange the ox, you exchange something else of comparable value, or more likely, you keep track of what you owe with a credit system the unit of which is oxen. Yet the story Smith tells makes some sense given the priority that Smith gives to exchange.

His account of the evolution of money is, like the one of the division of labor, spontaneous, linear, and unintentional, in the sense of not having a specific designer. We go from barter to money because barter becomes inconvenient as commerce develops. As the number of transactions increase we go from using metals as money to coin and we stamp them because it is more convenient to do so. Nobody, in the sense of no specific individual, planned these changes; they emerge spontaneously from the interactions of people. The role of the state is simply to fulfill a need when that need emerges. The state does not create money in Smith’s account. This is a very different story from the more constructivist story which associates the introduction of money with an invention of a particular individual or with an imposition by the state, or even with the need for the state to act as a guarantor of money. This view of money is often called the state theory of money, with Georg Knapp (1842-1926) as its most famous exponent, but it dates back to antiquity. Smith, on the other hand, ignores this hypothesis and sticks to the idea that great human institutions are unintentional results of human interactions. Just like the division of labor is not the result of any human wisdom able to predict its consequences, similarly money is not the result of any human wisdom but the unintentional consequence of human actions.

In this account the government fulfills a positive role by stamping the coins with their weight and purity of metals. But before you know it, Smith twists it, claiming that basically everywhere in the known world the avarice and injustice of princes and sovereigns lead them to diminish the real quantity of metal in coins, while the stamp does not change. So, for example, the English pound in Smith’s days had about a third of the metal it originally had.

The reason why princes and sovereigns decrease the quantity of metals in coins, while leaving the coin names the same, is that princes abuse the confidence of their subjects and defraud their creditors, paying their debts with a lower real amount of metal. They fulfill their nominal obligations by ruining their creditors. This avarice and injustice is, for Smith, a greater cause revolutions in private fortunes than public calamities.

So, money, as useful as it is, is immediately presented as problematic. It causes fraud when it is not stamped and coined. It causes fraud even when it is stamped and coined. It causes fraud when it is left in private hands as well as when it is put in government hands. In saying this Smith is starting his criticism of the incorrect idea that money is wealth, one of its major intellectual fights in the Wealth of Nations. Money is an indispensable universal instrument of commerce, but it is also a dangerous tool for fraud. It is definitely not wealth.

This chapter is also the start of some problematic economic analysis for Smith. What today we see as a naïve account of the evolution of money is one of the problems that we recognize, while Smith may not have seen it as problematic. But there are also a series of problems that are problems for both us and Smith. He is candid about his unclear understanding of the subject matter of the following three chapters and he apologizes to us because he will be tedious and obscure! The problem Smith will run into in the next chapters is the one of trying to understand value and prices without marginal analysis. The so called marginal revolution took place about a century later when Leon Walras (1834-1910), William Stanley Jevons (1835-1882), and Carl Menger (1840-1921) put forward the theory of subjective and marginal value. Smith, not having the benefit of that insight, struggles in understanding and explaining what he sees as the rules of exchange: that is, the rules that determine the “relative or exchangeable value of goods”. Although Paul Samuelson (1915-2009) would eventually vindicate Smith and show that his analysis of relative prices is robust even without marginal analysis, it remains a complicated analysis.

Smith’s struggle is evident with the example he chooses to use: the water-diamond paradox, a paradox that disturbed scholars for centuries and centuries. Water is necessary for life, yet you can get it for free or buy it very cheaply. Diamonds are basically useless, yet they are very expensive. Lacking a unified theory of value, Smith needs to rely on an ad hoc explanation: we have two kinds of values, a value that captures the usefulness of something, the value in use, and a second value that captures the power of purchasing other goods, the value in exchange. The two kinds of values are different and unrelated. Water has low value in exchange and high value in use and diamonds have low value in use and high value in exchange.

Life would become much easier when the idea of marginal utility is introduced: the value of one more unit depends on how many of those units we already have. On average the value of water is very high, true, but our willingness to pay does not depend on the average utility of water, but on its marginal utility. If we have a lot of water, having one more unit of water is not going to increase our utility by much, so we do not value it much, that is we are not willing to pay much for it. On the other hand, having very little water (or having very few diamonds) implies that we will value very highly having one more unit of water (or diamond) and we will be willing to pay a high price for it.

Without marginal theory, though, things get tedious and obscure, especially when one needs to explain “the real measure of this exchangeable value; or, wherein consists the real price of all commodities” and “what are the different parts of which this real price is composed” and why the market price may different from the natural price of commodities. Note that Smith is here telling us that even if there are two meanings of value, he will not deal at all with value in use and concentrate exclusively on value in exchange.

The next three chapters will deal with this, and although they are incorrect in the light of subsequent understanding, they are nonetheless more interesting that Smith gives himself credit.

 

BOOK 1, chapter 5: real and nominal price of commodities or of their price in labor and their price in money

If we want to measure this exchangeable value, or value in exchange, how do we do it?

First of all, as for any measurement, what we need is a stable unit of measurement. If we measure height in feet (or meters), we do not want a foot (or a meter) to become longer or shorter over time or between different places, otherwise we are no longer able to have a meaningful measurement of height since we have no shared understanding of the unit of measurement. So the first thing we need to do is to find a stable or fixed unit of measurement. When dealing with value, this is easier said than done.

Generally, money is considered the measurement of value. That is, for example, how Aristotle defines money, as the unit of account used to compare values. The problem is that when this idea of money as a unit of account is directly linked with money as a medium of exchange, the unit of account may become unstable. If the medium of exchange is a precious metal like gold or silver, and if the value of the gold or silver changes, then the unit of measurement of value may risk changing as well.

All is well when our monetary transactions are not that frequent and when the number of gold and silver mines known to us is limited. But when most of our “necessities and conveniences” come from market transactions, as in a commercial society, and when we discover several new rich mines, like the ones in the Americas, then measuring things with gold and silver money becomes a problem as their value becomes significantly variable.

The attempt to find a stable measurement of value is a problem that afflicted scholars for centuries. Most of the attempts to stabilize the unit to measure value involved try to fix the value of money, of gold and silver coins. But the mint becomes in this way a constant source of instability rather than stability. Even Isaac Newton was put in charge of the mint of England, with unconvincing results. Others proposed alternatives to gold and silver money. One thing that does not change in quantity is land. Therefore its value does not change either. Today we know this is not correct on both fronts, but in the 18th century it may not have been so clear. So if land is fixed, then land can be money, meaning the instrument with which we measure value. But land cannot be the medium of exchange, as it cannot circulate. So instead we use paper that represents pieces of land. This ingenious solution to the problem of an unstable measurement of value was implemented, for example, in the form of Land Banks. One of the most famous was designed by John Law (1671-1729), another Scot, whose bank failed spectacularly making things even worst.

So here is Smith, also trying to understand what could be a stable measurement of the exchangeable value of things. His answer is just as unconventional as John Law’s, perhaps even more so in fact. But Smith’s answer at least was not implementable and so it had no disastrous real world consequences. It just caused a lot of confusion in the subsequent economists who tried to understand his theory of value.

In chapter 5 of Book 1, Smith tells us that the real measure of exchangeable value is labor. This was not something he says while distracted, because he repeats it over and over throughout the chapter: Labor is the real measure of value in exchange.

His warning that his argument is going to be obscure is most appropriate here.

How can labor be the real measure of value? Equal quantities of labor have equal value to the laborer. A laborer must always lay down the same proportion of his ease, his liberty and his happiness, therefore labor alone never varies in its value and alone it is the ultimate and real standard of value (paragraph 7). If we are naturally the same, as he told us in chapter 2, and if we do not know the theory of marginal utility and disutility, then what I give up in an hour of work is the same as what you give up in an hour of work, being that hour our first of the day or our tenth one: we both give up our ease, our liberty and our happiness to the same proportion.

Notice that Smith is not saying that my output of an hour’s work should be valued the same as yours. Nor that time spent working should be the measure of value. The output of an hour of my work may contain 10 years of training, and therefore more labor, than a month worth of work in another activity. There are variations in hardship and ingenuity which will also make a difference and we do not know how to measure them. What Smith is saying is that, given the assumption that we are by nature all equal, what we give up to work an hour is the same for everybody: ease, liberty, and happiness.

It follows that the real price of something is the toil and trouble of getting it. Thus, the real value to a seller is the quantity of labor we can buy with what we receive. And the value to a buyer is the toil and trouble which it can save. Later on, Smith will muddle with these definitions, but so far this is what he proposes.

The consequence of this definition is that being rich or poor means being able to command the labor of others, that is how much of the necessities, conveniences, and amusements one can afford to buy and enjoy. With an increased division of labor, we depend more and more on the labor of others. So the difference between rich and poor relies more and more on how much labor one can command, or how much one can afford to buy: wealth is purchasing power.

And if it seems that labor varies in value because it can buy different amounts of goods at different times, we have to remember that it is the value of those goods that changes, not the value of labor. The value of labor remains fixed, it is the value of everything else that changes instead.

Note that so far in this account of Smith’s theory of value, money is not present. Money is not wealth. We use it as an intermediary in exchange, to make exchange easier. Hitting straight at the mercantilists, Smith shows that it is labor that buys wealth, not gold or silver.

We may think, incorrectly, that money matters because we exchange money for commodities, rather than directly exchanging labor for commodities. So we think it is easier to estimate value with money rather than with labor. We exchange bread for money and money for beer, not directly bread for labor needed to brew a beer. So it becomes natural to think of value in terms of money. Additionally, it is easier to grasp the quantity of a concrete thing rather than the abstract quantity of labor. So we think that money is the measurement of value, even if it is labor, and only labor, that is the real and unique measurement of exchangeable value.

The problem of using money as a measure of value is that the value of gold and silver money varies, and varies a lot. Commodities which continually vary in value cannot be good measures of value. The value of gold and silver varies for two independent reasons which, when combined, can make things very difficult.

One source of the instability of the value of gold and silver coins is that the quantity of gold and silver in coins that have the same denomination will change over time. The change is usually in one direction and one direction only: down. The reason being, as Smith told us in the previous chapter, that the princes like to decrease the quantity of precious metals in coins while leaving their denomination constant because they can more easily pay their debts (by cheating their creditors). This is also why it is basically impossible to see an increase of the metal content of coins of the same denomination: who would cheat in such a way as to pay more than what owed?

The other source of instability of the value of gold and silver coins is that gold and silver are commodities like any others. If new mines are discovered, as they have been with the discovery of the Americas, the value of gold and silver will go down, as it did in Europe. If one is paid a fixed amount of gold and silver over time, even if by weight and not with coins, one would receive less over time. The quantity of gold and silver will be the same, but what they can buy will be less.

This is particularly devastating if one estate has a perpetual rent to be paid in money. Some “ancient rents”, once very valuable, are now worthless. If the same rents are to be paid in corn, rather than money, then the value of rent would remain the same because corn preserves its value over time.

Which leads us to corn. Corn is not maize, or “Indian corn”, but is the generic name that Smith uses to include all grains. For Smith, even corn (that is grain) is a better, that is more stable, measurement of value than money! True, the value of corn varies significantly from year to year. From year to year, gold and silver are quite stable instead. But over the centuries, the value of gold and silver varies significantly while the value of corn remains more or less unchanged. So to compare value in different places and in different times, we should use the price of corn, for which there are decent records. Ideally we should use the price of labor, but records of this are basically nonexistent.

Smith soon enough undermines even this concession that money is more stable than corn on a yearly basis. He does not take a shortcut to do it, but he starts from the beginning.

First, Smith describes how different metals became measures of value because they were first used as medium of exchange. Then, he points out that even if we may still count in those metals, we use coins of different metals. Generally gold is used for large payments, silver for medium payments, and copper for small change. But in Rome, copper was the most common metal and their estates were denominated in copper. Even silver coins had value in copper.

Then, Smith continues, the coins of the metal used as standard of value were made into legal tender, that is, they were the form of money which could not be refused to extinguish a debt. Other metals were accepted at will and with a flexible exchange rate. Eventually though, by law, the exchange rate for the different metals became fixed. The fixed exchange rate between gold and silver implies that changes in the value of a coin would cause changes of how much of the other metal was needed to pay debts.

As a result of this the value of metal coins becomes quite volatile. Before the reformation of the gold coins of William III, the price of gold bullion was more than the mint price of gold. That is, the price of uncoined gold (bullion), determined by the market, was more than the price of a gold coin (minted)—the gold coins being old and worn out. But after the reformation the price of gold bullion becomes less than the mint price of gold. The price of silver bullion remained more than its mint price. According to Smith, even John Locke misunderstood what was going on. Locke believed that silver bullion was pricier than silver coins because the exports of bullion increased its demand, thus its price. But since silver coins were banned from being exported, their price was lower. Smith notices that in his day, the same policies apply to gold—gold bullion can be exported and gold coins can’t—but the bullion price of gold is less than its mint price. The problem for Smith is that there is a fixed exchange rate between gold and silver and that fixed exchange rate is wrong. True, the quality of silver coin is quite poor, especially compared with the excellent quality of gold coins, but reforming the silver coins will not solve the problem. It will make it worse. By restoring the quantity of silver in the old coins, while keeping the exchange rate between the two coins the same, we would encourage people to get silver coins and melt them into bullion, since silver is more valuable as bullion than as coin. They would sell the silver bullion for gold coins, and then sell the gold coins for silver coins and bring them to the mint to be melted again. What is needed, for Smith is to increase the fixed ratio of silver and gold so that the value of silver is higher.

If one looks at the behavior of gold coins, one can learn what to do with the silver coins. The gold coins are more valuable than the gold bullion even if there is no seigniorage. Seigniorage is a fee, or a tax, to be paid to the mint to coin a metal. When you bring bullion to the mint to be coined, it takes time. And that long wait is like a fee. So you prefer to keep the coins rather than to have bullion and then wait for it to be coined. So if the value of silver coins is brought to proportion to the one of gold coins, there should be no need to reform the coins. Or, if we add some seigniorage, the coins will be worth more than the bullion, as the coins will increase in value by the same amount of the seigniorage, just like the value of plate (precious metal melted into something other than coin) increases in proportion to the amount of fashion. This would decrease the melting of coins and reduce the exportation of metal. And if the coins would go abroad, they would also come back soon enough. Abroad they sell for their weight. At home they sell for more than their weight.

This is a very long story Smith tells us to indicate that the value of gold and silver is unstable and unsuited to be used as a measure of value. Not only does their value vary like the value of any other commodities, in the sense that the wear and tear of the metal and their non-monetary uses create a constant demand for them, but also the supply may at times be more, and at times less, than is needed so the price of the metals will vary accordingly. But there are times in which the price of a metal will be systematically higher or lower than what it should be. That is usually when there is a problem with the coinages. Reading between the lines, Smith is giving us one more reasons for being skeptical of considering money as a measure of value or as anything more than what it is: a medium of exchange.

 

BOOK I, chapter 6: of the component parts of the price of Commodities

If the value of labor embedded in each good does not change, but the value of the good itself changes, there must be other things that determine its value. That is the subject of the next two chapters.

The first example Smith uses to address the problem is an example in which the problem does not arise. In societies where there is no accumulation of stock (what he later will call capital, or useful resources) and no ownership of land, production depends on labor alone. So the labor embedded in a good (the labor used to make a good) is more or less the same as the labor one good can command (the labor that one good can buy with its sale). The rule of exchange seems simple enough: things exchange in proportion to the amount of labor contained in them, that is in proportion to the relative cost of production of those things, assuming of course, as Smith does, that producing a unit has the same cost as producing subsequent units. For example, if it takes twice as much labor to kill a beaver than to kill a deer, a beaver will exchange for two deer. Yes, some activities are harder than others, but that is taken care by the proportion with which things exchange. And yes, some activities require more dexterity and ingenuity than others, but as we saw in the previous chapter, that simply means that the superior value of their produce is a compensation for the labor spent acquiring that skill. In advanced societies, when labor is monetized, the more hardship and the more skills are present in a job, the higher is the wage for that job. But in rude societies, where only labor is required to produce things, only the labor embedded in a good can regulate the labor that that good can buy. This is why, in rude societies, Smith tells us, the whole produce of labor belongs to the worker.

Things become more complex as society becomes more complex. When stock (productive resources other than labor, as mentioned earlier and as Smith will explain later on) can be accumulated, the owner of stock will use it, and not let it sit idly. With the accumulated stock, an undertaker (which is what Smith calls an entrepreneur) will set industrious people to work. He will advance them the materials and what they need to live on until they are able to produce something and successfully sell it. The undertaker therefore takes a risk when he advances his stock (when he advances the materials and what they need to live) to these people. Thus he needs to be compensated for the risk involved with the use of his resources while setting industrious people to work. The compensation for the advance of the stock is profit. If there were no profit, there would be no point in advancing one’s resources and taking risks. Profit is therefore a necessary condition for the use of the accumulated stock and for stock accumulation to begin with.

Smith notices that the profits of stock should not be confused with the wages of labor for inspection and direction. The labor needed to inspect and direct different activities may be the same, but the profit those activities generate may be very different if the risk of the two activities is different.

Under these circumstances then, when stock is accumulated and advanced to workers, the value that the laborer adds to the materials needs to pay both the wages of the laborer and the profits of the undertaker. In a ruder state of society, where stock was not accumulated, whatever a sale generates belongs to the worker. Here instead, not all the labor that can be commanded by the sale of a good belongs to the worker, because a share of it belongs to the owner of stock too for having anticipated the materials and the subsistence of the laborer.

There is one more layer of complication to consider. In advance societies, not only stock is accumulated, but there is private ownership of land. The production of most goods is now done by using this privately owned land. Landlords ask for a fee to use their land, which is called rent. Smith seems to indicate that the reason for these rents is simply because the landlords can ask for them: they “love to reap when they never sowed and demand rent even for its natural produce”. So the labor which a good commands must now cover not only the wage to the worker, but also the profit to the stock owner and the rent of the landlord.

This also means that we have the three components of price: wages, profits, and rents. All of which are still measured by labor, by the way, since labor measures the value of everything, as Smith reminds us here as well.

There are a few exceptions to this in an advanced society. Fishing in the ocean does not have any rent, but fishing salmon in rivers does. And scotch pebbles, small stones collected from river banks and sold for carving, just have labor. But the price of most other things does depend on all three components. Granted, the more advanced the society, the less rent plays a role, and the more profit plays a role, but still all three components are present.

How is this possible? How is it possible that in rude society a laborer can keep all the produce of his labor, while in an advanced society he has to share it with both stock owners and landlords? Smith does not remind us explicitly about it, but the explanation is implied in his argument so far. With the division of labor, stock can be accumulated, and production and productivity increased. A worker gets only part of the labor his own labor commands but can get more of it because of the pie got larger. Before he would get a small pie all by himself. Now he has to share the pie, but the pie is much bigger, so his part may actually be bigger. Smith does bring up this explanation, explicitly, as he concludes the chapter: In a civilized society, the labor embedded in a product, that is the labor needed to produce something, is less than the labor that product can command, that is the labor that can be bought with that product, because of the contributions of profit and rent. If a country could put to work the equivalent labor that it can buy, that country would experience a continuous economic boom. But a lot of the value of what labor can command is used to support idle people. And this is more and more true in a civilized society. This is the same argument Smith used in the introduction of the Wealth of Nations. Rich countries are rich since they can support the life of many people who do not work. Poor and rude countries cannot spare able hands, all have to work, or they may die.

There are a couple of caveats to keep in mind.

First, there are distributional implications. Even in the aggregate, we would use the idea of wage as the revenue generated by labor, of profit as the revenue generated by stock, and rent as the one generated by land. This implies that the whole revenue of a country will be distributed among wage, profit, and rent earners.

Second, the profit of stock can come both if the owner uses his own stock and if the owner lends his stock to someone else to use. In this latter case, profit is a derivative revenue, and it is called interest. The interest, or use of money, is the compensation that the borrower gives to the lender for the risk the lender takes in giving the opportunity to the borrower to make this profit. So the profit for lent stock must belong in part to the borrower, who runs the risk and uses it, as well as to the lender, who also runs the risk of lending it.

Third, if we think that some activities require a fourth component of price, the one determined by the cost of replacing worn out materials or animals used in production, we have to remember that even the price of those is composed to wage, profit, and rent. So that at the end all always boils done to wage, profit, and rent.

Finally, Smith tells us that common language, with its imprecise use of terms, adds to difficulties of the topic. So, if a gentleman farms his own land, he gets both profits and rent, but calls all of it profit. A common farmer does the job of both as a laborer and as his own overseer, earning wages from both activities, but its revenue is often called profit. An independent manufacturer earns both wage as a journeyman and profit as the master of a journeyman (himself), but calls all of it profits. If a gardener earns rent, profit and wage, he calls all of it wage.

 

BOOK I, chapter 7: natural and market price of commodities.

Now that we know what constitutes value, we need to figure out what determines how much we end up paying for the goods we buy. What we pay is the market price, which may or may not be the same as the natural price.

For Smith the natural price is the price that pays for the natural costs of all its components: that is, the price that covers the natural rate of wages, the natural rate of profits, and the natural rate of rents.

What is natural about these rates, you may ask? Smith defines natural rates as the ordinary rates, the average rates; the typical rates are the natural ones.

The natural rates of wage and of profit depend on the general conditions of society and the nature of the employment. And the natural rate of rent also depends on the general circumstances of society as well as on the fertility of the land. Smith will go into the details of these claims in the following four chapters.

One interesting thing to notice here is that the analysis of this chapter starts with a defense of the earnings of the middleman. The middleman is the person who buys goods at their natural prices and brings them to the market to be resold, and for doing this he deserves a profit. Not only does he need to earn enough to live, but he also needs to earn the ordinary rate of profit. If not, he loses out and should use his stock in a different way. He does earn profits from his activities because he advances his wage to himself, so without profits he would have no way to recover his costs. So the natural price of a good will include the profit of the middleman too.

The actual selling price, which is the market price, may differ from the natural price. The market price depends on the quantity supplied in the market and the demand of those who want to pay the natural price, that is, on the effectual demand. Note that the willingness to pay for a good (the effectual demand) is different from the absolute demand (the people who want the good). Only the effectual demand is effective in attracting goods to the market. The absolute demand does not bring goods to the market because the buyers are not willing or able to pay the natural price, the price that covers all the costs of production.

Why is the market price not always equal to the natural price? Because the suppliers may not know for sure how large or small the effective demand is. So if the quantity supplied is less than the one demanded, the market price will go up, above the natural price, because of the competition among buyers. Rather than go without the good in question, buyers will be willing to pay more. How much more? It depends on their wealth and on how important the item is to them.

If, on the other hand, the quantity supplied is more than the quantity demanded, the market price will go down, below the natural price, because of the competition among sellers. How much lower? It depends on how important it is for the sellers to get rid of the goods for sale. Perishable goods, like oranges, will see a deeper decrease in market price than durable goods, such as iron.

If the quantity demanded and supplied are the same, then the market price will be the same as the natural price. Note that this argument is extremely familiar to our modern ears even if the distinction between natural and market price is not how we commonly think about it. This distinction between natural and market prices make Smith’s argument quite peculiar for us today. In Smith’s apparatus, the natural price is fixed and we have adjustment via the supply side. It also seems to imply that the effective demand and the natural rates are somehow known. It is indeed the effective demand to determine the quantity of goods brought to market. Prices help clear the market but do not necessarily convey information about relative scarcities, as we think about them today.

Since it is in the interest of earners of wage, profit, and rent not to bring a quantity of goods that is more than the effective demand, and it is in the interest of everybody else not to have a quantity supplied that is less than the effectual demand, the natural price is the central price, around which the market prices gravitate, thanks to adjustment of the quantity supplied.

Indeed, if the quantity of a good brought to market is more than the effective demand, its market price will be less than the natural price. So either rent, profit, or wage, or any combination of them, will earn less than their natural rate. So now there are incentives to offer less so that the quantity supplied will be equal to its effectual demand with the rent, wage, and profits at their natural rates, which means with the market price nearing its natural price.

The same thing is true in reverse. If the quantity supplied is less than the effectual demand, the market price will be more than its natural price, which means that the rate of profit, rent, and wage will be more than ordinary, attracting more people into this activity and therefore producing more. The increased supply will bring the quantity supplied in line with its effectual demand and the rent, profit, and wage close to their natural rate. Here Smith’s language is a bit ambiguous for today’s standards especially in terms of changes in quantity supplied or demanded versus changes in supply or demand.

So the market price will always naturally gravitate toward its natural price.

Twice in this chapter Smith refers to gravity: market prices gravitate toward their natural prices. The use of the world gravity may be an implicit reference to Newton’s discovery of physical gravity. In the physical universe there is a force that holds planets together. In the economic universe there is also a force that holds natural and market prices together: market competition. As we saw in chapter 1, Smith is quite familiar with the latest development of astronomy and is also an admirer of Newton’s system. Newton has a simple and elegant explanation for the movements of the skies: gravity. Smith possibly has an equally simple and elegant explanation for the movements of the economy: competition. The implicit reference to Newtown may not be accidental, but historically it also led to the recognition of Smith as the ‘Newton’ of the social sciences.

That said, Smith notices that the supply of certain goods is much more volatile than that of other goods. For example, the production of corn, as we saw before, is quite volatile from year to year, since it depends in part on the weather. The production of linen on the other hand is quite stable. This implies that the market price of corn has greater variations than the market price of linen because it depends on changes in both demand and supply, while the market price of linen depends mostly just on changes in demand.

These changes in market prices will affect wages, and profits, but only marginally affect rent, because they depend on whether there is too much or too little of a good or of the labor required to produce it. Smith gives the example of changes in market price of black cloth due to a change in demand. If there is a public mourning, the price of black cloth will increase. But the wages of weavers will stay more or less the same. Only the profits of the merchants will increase. What is missing is black cloth not weavers. Yet, the wage of tailors will go up because in this case more work needs to be done. At the same time the price of color cloth will go down with the same but opposite effect.

Finally, Smith concludes this chapter noticing that while the market price will always naturally gravitate toward its natural price, there may be obstacles such as accidents, natural causes, and regulations, that prevent the market price from being as close to its natural price as possible.

If there is an increase in effectual demand, the market price will increase. The suppliers will try to hide it to avoid competitors entering their market and eating their profits by lowering the price. Distance helps. But extraordinary profits seldom last long.

Secrets will last longer in manufacturing than in trade since it is easier to hide new discoveries in ways of productions than in changes in demand, Smith claims. Sometimes with manufactures, the extraordinary gains may be due to very high price of labor, which requires high wages. It may also be by accident, or by a singularity in production such as something very unique about a specific soil, such as the one of some vineyards in France. In these cases, it is the rent that will capture the higher price, while wages and profits remain normal.

Having a monopoly is similar to having a secret. Monopolies keep the market undersupplied so that the market price remains more than the natural price. Note, Smith tells us, that the monopoly price is the highest possible that it is squeezed from buyers. While the competitive price is the lowest possible while staying in business.

Corporations (as in guilds) tend to put restrictions in the labor market. They are like monopolies, like enlarged monopolies, and they last as long as their regulation last.

So the market price can stay above the natural price for a long time; but it cannot stay below it for long. The group that feels the loss the most will eventually changes its employment, if there is the liberty to do so.

Apprenticeships exclude people from employment, in the sense that they exclude people from one’s employment, but they also exclude one from other employments. When the price of labor is kept above its natural rate, things are ok. But when it is kept below its natural rate, there will be problems. Keeping wages below their natural rates can’t last for more than a generation. If the price of labor is kept too low, the next generation will not be there.

 

 

Further readings:

Buchanan, James. [1969] 1999. Cost and Choice: An Inquiry in Economic Theory. Indianapolis: Liberty Fund.

Hollander, Samuel. 1973. The Economics of Adam Smith. Toronto: Toronto University Press.

Meek, Ronald. 1956. Studies in the Labor Theory of Value. New York and London: Monthly Review Press.

Samuelson, Paul. 1977. “A Modern Theorist's Vindication of Adam Smith” American Economic Review. 67.1: 42-49.