Question

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 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 mentioned in the passage means a cost without abnormal profits. In economics both explicit and implicit(opportunity costs) are considered. Profits will consider price that is charged for normal profits.

According to Adam Smith, In the perfect market, in the long run only normal profit will be achieved. Normal profit price is 'prime cost' in this case, which exactly covers all costs(implicit as well as explicit)

2 and 3 answered together:

Competitive market is a market in which there are many firms and product is similar, all firms are price takers and there is free entry and exit for any firm.

This market in the long run only has normal profit. In the short run it may have a abnormal profit or a loss but it achieves the normal profit in the long run.

Profit is maximised when marginal cost= marginal revenue and firm charge that price.

Let us look at the following figure.

Case 1: Firm is having a abnormal profit as the price charged is P1 and average total cost in the market is ATC2 , then looking at this other firms will enter in the market and supply curve in the market will shift to right, it will decrease the prices and this firm will be forced to charge only P3 as a price which is equal to average total cost. Normal profit is achieved in long run.

Case 2: Firm is having a loss as the price charged is P1 and average total cost in the market is ATC3 , then looking at this other firms will exit along with many other in the market and supply curve in the market will shift to left, it will increase the prices and firms  will be charging P2 as a price which is equal to average total cost.Normal profit.

Hence in the short run a firm may have loss or abnormal profit but in the long run it achieves only normal profit in the competitive markets.

In monopoly, firm is a price maker and charges price above the average total cost and hence aims at abnormal profits.

АТС 3 АТ, Prie Pet AT(2 MAAR duantity