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 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) Here Adam Smith explained the prime cost is the cost which is actually the cost which happens to bring the commodity in the market. It is the direct material and labour cost which a producer pay to bring the commodity in the market. It is the cost at which commodity are sold at natural price where no profit is associated.

2) Smith explained that when the demand of a commodity will rise and market price rises above the natural price then the greater profit will attract the new rivals or new firms and this profit will not last long and prices will come down to natural price. In the long run there will be no firm who can extra profit and they will get only zero profit.

3).If prices falls below the natural price then some firms will face loss will exit from the market. The price will go up to natural price. Ultimately in the long run there will be normal profit or zero economic profit. Some producers will immediately withdraw the quantity they bring into the market. The quantity will reach at that level where it only able to meet the effective demand. The price will rise to the natural price level where supply is just able to meet the effective demand. In the long run it will only get zero economic profit.