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 www 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. Soch som Ordinary Source: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations. Book One Chapter VIL http//www.adamamith.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 eam zero economie profit in the long run?

Answer 1

1. According to Smith, prime cost is the cost which the seller has to incur to bring the product to the market. It includes the rent on the land, the wages of labor and the profits of the stock employed by the producer. Prime cost is basically equal to the real cost of bringing a commodity to the market which is also known as the market price.

2. If the price of any commodity rises above its natural price and the producers start earning extraordinary profits, other producers will also get tempted to produce the same profits and get extraordinary profits. Since entry is not restricted in a perfectly competitive market, the entry of more and more firms will increase the supply of the product and reduce the market price to the level of natural price. This will ensure that firms earn normal profits in the long run in a perfectly competitive market.

3. Let us suppose that the market price of a commodity is lower than the natural price of the commodity. Since natural price reflects the cost of bringing a commodity to the market, it is the lowest price which a producer expects to stay in the market. Due to lower market price, producers will start experiencing losses and some producers would immidiately withdraw from the market. This will reduce the quantity supplied. Since the effective demand in the market is at the same level, the fall in quantity supplied would lead to the incraese in the market price. The market price will keep increasing till it reaches its natural price in the long run. The natural price will ensure normal profits in the log run.