Wealth of Nations: Book 1: Chapter 9: Of the Profits of Stock

Let's talk about stock!

I'll be honest. I've taken too long to make this post because reading (and re-reading) this chapter was difficult because of the word stock. In contemporary usage it can mean the same thing, like "Do you have Pepsi in stock?" But most of the time we think of stock in terms of stocks and bonds, wall street, buy low sell high etc. So whenever Smith talks about inventory and selling goods as stock I had to loop back round and make another pass at the sentence. Similar issues occurred when I learned in college that what economists call profit, and what business folk call profits are not the same thing. (Basically in the economist world view, if you are making a reasonable rate of return on your business, say 3%, you have zero economic profits, while the MBA would say profits were at 3%.)

So Smith starts off by saying knowing how much the average yearly profit one merchant makes is really hard to figure out, because it large part the profits are tied to so many things like how your inventory is, how many other merchants showed up at the market, how your customers are doing, wages of your workers, etc etc. So knowing how much profit you made is kinda hard to figure out on average. So historically it would be nearly impossible. So instead he comes up with a clever way to figure this out...interest rates.

So let's say it is January first and you have $100,000. What are you gonna do with this? You could hold on to it, and at the end of the year you'd have $100,000. You could buy a whole bunch of stuff, and hire someone to sell that stuff for a profit, or you could lend it out at a rate of interest. These basically help us frame how to think of profits, and in turn judge how an economic region is doing in regards to profits and economic health.

If as a rational person, you could lend the money out at 5%, you'd have $105,000 come Dec 31st. But if you thought you could stock up on products to resell at some price, and by December 31st have $105,001 you would probably do that. So the interest rate serves as a baseline for gauging the economic health of the region in question.

He goes on to say that the lower the interest rate, the more advanced the economy. This is because as more merchants crowd into the market to get a piece of the pie, they end up bidding up wages of employees against each other. This cuts into their profits since instead of the surplus revenue going to their hands, it goes into their workers hands. He compared Scotland to England. Scotland had a 5% interest rate, while England was near 0%. But Scotland was behind England in economic development, wages were lower etc. As progress is made the rates will lower.

He also notes later in the chapter that the ability to enforce contracts equitably is important for the economic society to prosper.

A defect in the law may sometimes raise the rate of interest considerably above what the condition of the country, as to wealth or poverty, would require. When the law does not enforce the performance of contracts, it puts all borrowers nearly upon the same footing with bankrupts or people of doubtful credit in better regulated countries. The uncertainty of recovering his money makes the lender exact the same usurious interest which is usually required from bankrupts. Among the barbarous nations who overran the western provinces of the Roman empire, the performance of contracts was left for many ages to the faith of the contracting parties. The courts of justice of their kings seldom intermeddled in it. The high rate of interest which took place in those ancient times may perhaps be partly accounted for from this cause.

Basically stated without the ability to enforce contracts, people pay for the risk in the money lent. This can also prove as a way for wealth inequity as he notes China does with the Rich enjoying a "pretence of justice" against a poor who have little recourse.

So to restate, profits off of stock(inventory), is influenced largely by the market it is in. In a market where there are few competitors and labor isn't scarce, they can bid down labor prices and have a nice rate of return. But as competition enters and you get closer to a perfectly competitive marketplace your profits will approach zero(in an economic sense).

Up next: "Of Wages and Profit in the different Employments of Labour and Stock"