Markets, Prices and Profits

The essential complement of Smith’s macroeconomic account of growth is a corre­sponding treatment of capital and profit at the microeconomic level. Before Smith (and Turgot) profit was regarded as a special kind of wage, a reward for risk taking, or a form of exploitation resulting (say) from a monopoly position.

Smith distinguished between market prices and natural prices. Market prices are the actual prices at any moment, determined by supply and demand. He did not use curves in diagrams or supply and demand functions subject to market clearing equations, but it is clear from the examples that he worked through that he understood how markets work. The natural price of anything is the price that will just pay the going rate to the various inputs required, including the going return on capital. If the market price of something is below its natural price then at least one input must be getting less than it could earn else­where, so supply will be cut, pushing the price up, while if the market price is above the natural price, the reverse will hold. It is clear that Smith saw competition in the market as a process in which changes in conditions on the supply or demand sides have a succes­sion of repercussions - see, for example, the discussion of a public mourning (Smith 1776 [1976]: 76-7 and elsewhere) or of the effect of the acquisition of new, profitable, branches of trade on existing trades (ibid.: 110), among many others.

In Smith’s system there are three types of income arising in production and corre­sponding to three elements of cost in determining natural prices: wages, profits and rent. This framework dominated the mainstream of economics for about a century.

Wages are determined by supply and demand. Recall that population is endogenous, so that wages above subsistence induce population growth as more children survive to reach working age and swell the supply of labour. In a stationary economy, that is, an economy with a constant demand for labour, wages would be forced down to subsistence by growth of the supply of labour. In a growing economy, by contrast, wages can remain significantly above subsistence as the labour force grows in step with the growth of the economy. “The progressive state is in reality the cheerful and the hearty state to all the different orders of the society. The stationary is dull; the declining, melancholy” (Smith 1776 [1976]: 99). Since growth is normal in a commercial society, it is normal for wages to be above subsistence. Indeed, “a workman, even of the lowest and poorest order, if he is frugal and industrious, may enjoy a greater share of the necessaries and conveniences of life than it is possible for any savage to acquire” (ibid.: 10). This, then, is the case for a commercial society - even the worst paid are better off than in a primitive society, better off by far than the “master... of ten thousand naked savages” (ibid.: 24).

Smith’s treatment of profit and rent has been less highly rated by subsequent writers. In his defence, simply to provide the category of profit, or return on investment, calcu­lated as a percentage or proportional return on the value invested, distinct both from wages (per hour’s work) and rent (per unit of land) was an important step forward. Smith had a great deal that was interesting to say about the determinants of profits or rent in particular cases as, for example, in the long digression on the value of silver (Smith 1776 [1976]: 195-275) which includes a discussion of the different uses of land and how they change, and how rents change, during the process of development.

Although Smith treated growth as normal, he did imply an ultimate limit to growth in each country, its “full complement of riches”. In a country which had reached that level, and “which could, therefore, advance no further”, both wages and profits would be low, wages reduced to subsistence for reasons already explained and profits, in an analogous way, reduced to a level such that no new investment would be forthcoming (Smith 1776 [1976]: 111). Smith seems to have thought of this stage as far away. China, perhaps, had reached the full complement that its laws and institutions permitted (ibid.: 89), but that is far from what might be possible with appropriate reforms. Overall the full complement seems almost a formality, not to be taken seriously.

Smith did recognize that continuing growth would lead to structural changes, prima­rily because land becomes relatively scarce as population and capital grow. Hence the “natural progress of opulence”, exemplified by the American colonies, in which agricul­ture comes first when land is plentiful, but “where there is either no uncultivated land, or none that can be had upon easy terms” (Smith 1776 [1976]: 379) the emphasis shifts to manufactures for distant sale, and so on. Note, incidentally, that Smith, like all his con­temporaries, assumes an open economy engaged in some sort of foreign trade through­out. It would be odd to do otherwise - a commercial economy is a trading economy.