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 kepl.. 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 Inspiry into the Nature and Conses of the wealth of Nation Book One Chapter VIL / www.adumamith.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 cam zero economic profit in the long run

Answer 1

1. Smith means by the prime cost of commodity that the total cost which the producer has to bear in helping the goods reach the market .The labor , the material and transport etc. It does not include any profit that the producer is expecting to make .

2. Adam smith explained that whenever there is profit to be made, new firms will enter the market . If there is rise in demand at a goods for any reason,temporarily its prices will rise giving profits to its producers. Other would come to know of the profit and will enter the market to get some part of profit. Supply would increase and prices would start falling again . Once the supply and demand in equilibrium again, there will be no profit. Hence in the long run there would be no profits.

3. This case the product is selling at lower price then its natural price, at least some producers would definitely be at loss. The ones at loss would immediately exit the market to control the losses. This would decrease the supply of the product and raise its the prices. This price will keep rising till there is equilibrium between demand and supply and the produce has achieved its natural price.