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Book 1, Chapter 6
Themes
Key
LitCharts assigns a color and icon to each theme in The Wealth of Nations, which you can use to track the themes throughout the work.
Labor, Markets, and Growth
Capital Accumulation and Investment
Institutions and Good Governance
Mercantilism and Free Trade
Money and Banking
Summary
Analysis
Each society’s average rate of wages, profit, and rent depends on its specific circumstances—including its overall wealth, amount of fertile land, degree of economic specialization, and rate of growth. A commodity’s natural price is the cost of rent and labor to produce it, plus the average rate of profit in the investor’s area. (The investor will take their money elsewhere if they do not earn this level of profit, and they live off profit the same way as landlords live off rents and laborers off wages.) Due to differences in supply and demand, the market price of commodities often fluctuates above or below the natural price. Specifically, the market price depends on effectual demand (demand from people who are willing and able to pay for the commodity) and not on absolute demand (how much people actually want or need the commodity).
Each society will tend toward average wage, profit, rent, and price levels so long as the people within it are free to switch from one kind of economic activity to another. Workers who can’t afford to live on their wages will look for better jobs, for instance, and as Smith points out here, an investor who isn’t making enough profit will take their capital elsewhere. In the real world, factors like scarcity, crises, regulations, and repression can drive market prices, wages, rents, and profit rates well above or below the theoretical natural ones. For instance, a flood that destroys farmland will increase food prices. The distinction between absolute and effectual demand is important, because it again shows the difference between Smith’s actual thinking and the way he is understood today. Namely, Smith knows that markets do not naturally meet all of people’s needs; rather, they only meet the needs that people with means are able to pay for.
Themes
When effectual demand for a commodity exceeds the amount of that commodity that suppliers can bring to market, the buyers will compete for the commodity by offering higher prices, and so the commodity’s market price will rise. But when supply exceeds effectual demand, suppliers will become willing to sell their commodities at a loss—for less than the natural price. These effects are particularly strong with perishable or essential commodities, like food. When supply and effectual demand match, the market price comes to match the natural price. Suppliers are selling all of the goods they bring to market, and all buyers willing to pay the natural price are satisfied.
Smith’s analysis of supply and demand will be familiar to any contemporary readers who have studied basic economics. All else held constant, greater supply lowers prices, while greater demand increases them. This doesn’t apply equally to all commodities: some are more price-sensitive (or elastic) than others. In a perfectly free market, supply and demand match up at a natural (or equilibrium) price, so that all of the goods brought to market are sold, and everyone who wanted them is able to purchase them. Real markets almost never achieve this perfect equilibrium, but the closer they get, the better it is for society as a whole.
Themes
If the supply of a commodity exceeds effectual demand for it and its prices drop, then rent, wages, and/or profit must fall below their ordinary rates. Thus, landlords, workers, and/or investors will correspondingly withdraw their land, labor, and/or capital. This will reduce the amount of the commodity produced and supplied in the market, until it falls to the level of the effectual demand and returns to its natural price. Conversely, if effectual demand exceeds supply, the commodity will sell at a premium, so rent, wages, and/or profit will increase. Landlords, workers, or investors will want to redirect their land, labor, or capital towards the production of that commodity, so the amount of it supplied will increase until it meets the effectual demand and sells for its natural price. This is why “the prices of all commodities are continually gravitating” toward the natural price.
The dynamics of supply and demand also guide the economy towards the highest-value activities. Workers rationally seek the highest wages, investors the highest profit rates, and landlords the highest rents. This is why a nation’s economy naturally transitions from some kinds of economic activities to others over the course of its development. Once again, the freer a market is—or the faster and more easily workers, investors, and landlords can change what they do with their labor, capital, and land—the closer market prices will get to natural ones. Of course, this also leads to boom-and-bust cycles when workers quit their jobs, capital managers fire workers and shut down their operations, and landlords evict their tenants.
Themes
Producers constantly try to measure and exactly meet demand, but their success depends on the industry. For instance, farmers often cannot predict how much they will produce each year with a constant amount of labor, while weavers generally can, which is why grain prices fluctuate more than cloth prices from year to year. These price fluctuations don’t affect rents, but they do affect wages and profits, which go up in times of scarcity and down in times of over-supply.
Smith now turns to some of the many real-world conditions that can distort the ideal model of free-market supply and demand that he has developed in this chapter so far. The demands of nature make agriculture unpredictable and productivity gains in it difficult to achieve. But curiously, even though grain prices fluctuate significantly from year to year due to weather, they are still more stable than other prices from decade to decade due to the limits to agricultural productivity.
Themes
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Even though market prices naturally gravitate towards natural prices, sometimes they can stay far above natural prices, for a variety of reasons. Some companies hide their true rate of profit from competitors or benefit from trade secrets. For some specialty goods, like certain French wines from specific regions, the amount that can be produced will never be enough to meet demand. Monopolies also raise market prices well above natural prices “by keeping the market constantly under-stocked.” A commodity’s monopoly price is the highest that buyers will ever pay, and its natural price is the lowest that sellers will ever take.
Monopolies are the ultimate market distortion. Smith’s analysis of free market exchange relies on the assumption that many different suppliers can offer each good or service, and many different buyers are interested in purchasing them. But monopolies create an opposite situation, in which one supplier holds the whole market hostage. (The same principle applies to monopsony, or markets with just one buyer.) Readers interested in the legacy of Smith’s ideas today should pay special attention to how his arguments about free trade are often recast as arguments against regulation, and thereby used to support the exact kind of monopoly positions that he despised.
Themes
In contrast, market prices don’t usually stay below natural prices for a long time. When a commodity’s market price dips below its natural price, sellers stop selling it; when an occupation’s wage dips below its natural wage, new workers stop joining it.
High prices benefit producers, but low prices benefit consumers. Since producers decide what to produce, they do not accept low prices for more than one production cycle (unless they expect them to quickly rise again). Today, market prices do sometimes fall below natural prices, as with goods that benefit from government subsidies (like corn in the U.S.).
Themes
Ultimately, the natural price is made up of wages, profit, and rent, which all vary depending on a society’s wealth and rate of economic growth. The next four chapters will respectively focus on wages, profit, why wages and profits vary, and rent.
The people who direct production must pay their workers’ wages and their production facilities’ rent, in addition to securing at least the average rate of profit in their society. (Otherwise, they will move their capital elsewhere.) Accordingly, when they sell the goods they produce, they must cover these three costs, at a minimum. In monopoly situations, they can get away with charging far higher prices to increase their profit rates.
Themes
