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 u 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 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 earn 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). The prime cost is the addition of all cost the an enterprineur bear to produce the good . It includes labor compensation,rent, interest on capital , profit.because he wrote this article when,most likely ,there was no concept of interest,and compensation instead there was just wage ,rent and profit.

2).if market price is more than natural price or prime cost then firms are making super normal profit,which attracts new firms to join the market(enter and exit has no barriers), thus market supply increases and price drop down . Firms keeps entering till when there is no super normal profit and price go back to natural price or prime cost and firms profit go back to zero economics profit or normal profit.

3). When market price is below than natural price then firms makes losses ,then the firms who are affected most from lower price, they exit the market and from their exit market market supply decrease and price go up and this process continues untill price go up to natural price and firms start earning zero economic profit and now no firms want to exit market . Market is stable equilibrium.