Question

Case Study No. 2 Adam Smith and the Natural Price Adam Smith explained how economic profits and losses in a competitive market cause the entry and exit of firms. Smith described what he called the natural price, or the long-run equilibrium price, in this passage from his 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations: When the price of any commodity is ... sufficient to pay the rent of land, the wages of labour, and the profits of the stock employed in .. bringing it to market, the commodity is then sold for... its natural price.... The commodity is then sold precisely for what it is worth, or for what it really costs the person who brings it to market for though in common language what is called the prime cost of any commodity does not comprehend the profit of the person who is to sell it... The natural price... is... the central price, to which the prices of all commodities are continually gravitating... When by an increase in ... demand, the market price of some commodity... [rises above the natural price... producers of the commodity] are generally careful to conceal this change. If it were commonly known, their great profit would tempt so many rivals... the market price would soon be reduced to the natural price.... Secrets of this kind, however... can seldom be long kept; and the extraordinary profit can last little longer than they are kept ... The market price... can seldom continue long below its natural price...the persons affected would immediately feel the loss, and some producers] would immediately withdraw...the quantity brought to the market would soon be no more than sufficient to supply the effectual demand. Its market price, therefore, would soon rise to the natural price. Source: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations. Book One, Chapter VIL http://www.adamsmith.org 1. What did Smith mean by the prime cost of a commodity? 2. How did Smith explain how the entry of firms in a perfectly competitive market ensures that firms carn zero economic profit in the long run? 3. How did Smith explain how the exit of some firms occurs in a perfectly competitive market to ensure that firms remaining in the market earn zero economic profit in the long run?

Answer 1

1. Smith illustrates how the price of a commodity sold in the market tends towards its natural price, which also considers the profit of the person bringing the product to the market. However, prime costs does not take into account the profit of the person who resells the commodity through trade. This automatically puts the person in a worse-off situation who could have otherwise earned profit through alternative channels.
2. The actual price at which a commodity is sold in the market is called market price, which may be lower, equal or greater than natural price. However, the tendency is always to converge towards natural price. If market price increases more than natural price due to greater demand, profits of the producers increase. Even though producers do not reveal such information to put off new entrants from entering the market, information flows easilt in a perfectly competitive market. Ultimately, excess profit induces new firms to enter the market which drives market price down to natural price and economic profit becomes zero.
3. Market price also cannot stay below the natural price for a long period of time. As natural price reflects the true worth of the goods, a price less than it would mean significant loss for the producers. Eventually, unavailable to sustain, some firms would be forced to leave the market in the ling run, which would again decrease the economic losses and drive profit up to zero.