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Smith´s ideas in modern price theory




Price theory Smith begins his analysis of the determination of the relative prices of goods and services with a story of price formation in a primitive society of hunters. The point of the example was obviously not to present a theory that could immediately be applied to contemporary economic conditions, but to construct a pedagogical case that would lead the reader to understand more complicated issues. In this society hunters aim to kill beavers and deer, both of which animals are desired by consumers. If it takes twice as many hours to kill a beaver than to kill a deer, it follows, Smith argues, that the price of a beaver will be twice that of a deer. Since the prices are determined exclusively by the labor time of the hunters, this is a clear and simple illustration of what became known as the labor theory of value. The modern reader, accustomed to think of price formation in terms of the joint effects of supply and demand, may be puzzled by the neglect of the demand side in this example. Is demand irrelevant for the understanding of prices? In fact, demand does play a role in the determination of the market outcome, but given the simple assumptions made about costs, the role of demand is solely that of determining quantities, i.e. the number of beavers and deer 3 that are actually caught and brought to the market. Costs determine prices, demand determines quantities. Smith generalized the example to the case where costs have more components than simply labor time. If costs also include necessary expenditure on weapons and the possible costs related to the use of the land, the total costs of production have three components that reflect the payment to the three factors of production, labor, capital and land. When all three factors earn their normal reward, this defines the “natural price” of the commodity in question. With this extension, Smith’s original labor theory of value became a more general cost of production theory of value. However, in the real world the actual market price may deviate from the natural price, as in his celebrated example of a public mourning. The death of a king increases the demand for black cloth, but since the supply of cloth in the short run is a given quantity, the effect of the rise in demand is to push up the price. In the longer run, the fact that the market price is above the natural price may lead to the entry of additional suppliers who are attracted to the market by the prospect of earning more than the normal reward to their resources. Moreover, once the period of public mourning has come to an end, demand diminishes and the price falls back to its normal level. This is the normal operation of a free market. However, there are other reasons why the market price may stay above its normal level, the most important of which is a public monopoly that has been established because the government has combined the privilege of exclusive rights of production with the prohibition of entry by other firms. While the competitive price – the price under “the system of perfect liberty” – is “the lowest which the sellers can commonly afford to take, and at the same time continue their business”, the monopoly price is “the highest that can be squeezed out of the buyers, or which, it is supposed, they will consent to give.” (WN, pp. 78-79.)i To a large extent, Smith’s reasoning is well in line with modern analysis of competition and monopoly. The distinction between the natural and market price corresponds to the modern 4 distinction between the long-run and short-run equilibrium price under perfect competition, where the cost-based constancy of the long-run equilibrium price is the result of the twin assumptions of constant returns to scale for the industry as a whole and free entryii. Thus, the modern notion of the long-run equilibrium price is essentially equivalent to Smith’s natural price, and deviations of the market price from its long-run equilibrium are explained by the modern economist in terms that are essentially similar to Smith’s discussion of the example of public mourning. But there are also aspects of Smith’s analysis that are unsatisfactory. His characterization of the equilibrium price under monopoly is loose and suffers from the lack of an explicit analysis of profit maximization. There is also a notable lack of a general equilibrium perspective when he seems to consider the natural price as caused by the normal rewards to the factors of production instead of – as in modern theory – regarding both commodity and factor prices as being jointly determined by preferences, technology and market structure. The system of perfect liberty and monopoly are the limiting cases of competition. What about the cases in between, referred to by later economists as imperfect competition? On this point, there is some ambivalence in Smith’s writing. On the one hand, he sometimes expresses himself as if effective competition simply means the absence of monopoly, and the crucial condition for the existence of effective competition is free entry. If an existing monopoly position can be challenged by new entrants it is simply not viable, and competition will reign in the long run. But he also admits that even a fairly large number of producers may not be a guarantee of effective competition. A famous passage in the Wealth of Nations argues that “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” (WN, p. 145.) The fundamental insight that producers have individual incentives to deviate 5 from the competitive conditions for their own benefit underlies modern ideas of competition policy, designed to uphold effective competition in the interests of society as a whole. What is it that makes such conspiracies against the public likely to occur? Smith points to the role played by the number of producers, and his argument, remarkably, is not the simple and mechanistic one that as the number of producers grows large, each of them will take the market price as given. If trade in a town is divided between two grocers instead of being in the hands of just one, this will make both of them sell cheaper. Suppose now that it is divided between twenty. Then “their competition would be just so much the greater, and their chance of combining together, in order to raise the price, so much the less” (WN, p. 361, my emphasis). This line of analysis bears a striking resemblance to the modern game-theoretic analysis of the core which points out that as the number of competitors increases, the difficulty of forming coalitions which cannot be challenged by other coalitions increases until the only equilibrium outcome that remains is that of the competitive equilibrium. Thus, Smith’s theoretical insight was confirmed by the analysis of mathematical economists and game theorists during the 1960s and ‘70siii.

 

 


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