Wednesday, July 1, 2009

Wealth of Nations: Book 1: Chapter 7: Of the natural and market Price of Commodities

Our prices are so low! We will beat anyone!

In the last chapter we took a journey through a supply chain to figure out what the cost of something is, but that isn't necessarily the price the goods will fetch. Smith divides the price into two kinds. There is a natural price which he defines as:

When the price of any commodity is neither more nor less than what is sufficient to pay the rent of the land, the wages of the labour, and the profits of the stock employed in raising, preparing, and bringing it to market, according to their natural rates, the commodity is then sold for what may be called its natural price.


Now that natural price does include a reasonable amount of profit. It is important to think of profits here as just compensation for your time or stock of goods. So a good example of this is your savings account at the bank. It is you setting aside money with a promise to not use it for other stuff for a small rate of return. This is usually a few percentage points. So the interest is profit. But it is just a modest rate of return. If you could put your money into anything else that had a higher rate, but take on no additional risk, you would do so.

And then there is market price, which is much more dependent on the number of buyers and other sellers in a given market. This can be above, at or below the natural price. Let's give an example of each of these situations to show how they may come about.

Market price equals natural price
. Let's say we take our organic tomatoes from the field to the farmer's market. There are other organic farmers sell organic tomatoes as well. The quality of all the tomatoes are comparable, and the costs to produce the tomatoes are all more or less the same. We are all bloggers who employ our readers at small wages to till our rented land for these tomatoes. There are plenty of buyers each looking for the best deal, they will go from farmer to farmer searching for the lowest price, we will keep lowering our price to get our stuff sold, and it will naturally work itself out that the market price equals the natural price. None of the sellers have an incentive to take a loss per tomato, and buyers don't have a reason to pay more than the natural price. This is called a perfectly competitive market.

Market price is lower than the natural rate. Let's say for a moment that we get to the Farmer's Market and everybody is selling tomatoes. And because of an unseasonably hot day there aren't many buyers. I have a dilemma as a seller. I can't sell at the natural price because there is no way I can sell all my stock and cover the cost of each tomato, and I can't afford to just take home what doesn't sell and try again next week because my stock will go bad and be of no value. So I will lower my price below the natural price and take a loss just to move the inventory. But when it comes time to replenish my stock for the next Farmer's Market, I won't farm as many tomatoes. This could mean less hours for you dear reader, or rent less land to till. This contraction will help the next market day to have supply and demand meeting once again.

Market price is above the natural rate. This happens when the sellers, and products available are less than the demand for the product at the natural rate. Simply put if I normally bring 100 tomatoes to the market, and they fetch a dollar each, if I only bring 80, and no other sellers make up that deficit of 20 tomatoes, then we can fetch a few cents more per tomato by having the buyers bid up the price for each tomato. So per unit instead of a dollar, maybe I get a buck and a quarter. This can happen for various reasons. Maybe the total demanded went up. Maybe an accident wiped out a competitors stock. Maybe I made a deal with the person running the Farmer's Market and became the exclusive tomato provide. That last scenario would be a monopoly, and basically let's me set the price as I see fit to extract the most per unit I can get away with. If the market price is above the natural price, this will encourage other people to look at the market and start producing items in that market until the market price equals the natural price again, provided there aren't barriers to entry like no available farmland or monopolies or something of the kind.

If you think of price a struggle between buyers and sellers I think the following quote from Smith sums it up quite nicely:

The price of monopoly is upon every occasion the highest which can be got. The natural price, or the price of free competition, on the contrary, is the lowest which can be taken, not upon every occasion, indeed, but for any considerable time together. The one is upon every occasion the highest which can be squeezed out of the buyers, or which, it is supposed, they will consent to give: the other is the lowest which the sellers can commonly afford to take, and at the same time continue their business.


Smith finishes up the chapter with an outline for what the next few chapters will be about. There will be labor wages, profits, stock and rent prices coming up.

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