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 nly 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 Oue, Chapter VII. 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 eam 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 eam zero economic profit in the long run?

Answer 1

1. Prime cost- The overall cost associated with the final commodity that is brought to the market. A commodity can be land, house, etc.

Example: When we want to build a house, there are many things taken into consideration like land, construction, interiors cost, etc. When all decisions are made towards for a house and the person wants to sell it, the house has to mention an overall cost that covers all the other cost which the person has undertaken. It does not have any profit made when it sells under the overall cost.

2. This can be explained briefly with the help of the above example. The person who wants to sell the house with its prime cost wants to increase the price if he sees there is a rise in demand in the market. If this happens, the person could earn a profit and could stay a little bit longer in the market in the long run.

3. The person, if he sells the house below the prime cost, it will incur a loss to him. Losses cause can be high or less. It explains that the cost bore by the person to make the house, if he sell below the prime cost, it will becomes a big loss for him. It would affect the person and will have no choice but to withdraw from the market.