Such is Smith’s theory of prices. The element of truth which it contains, namely, that the prices of goods tend to coincide with their cost of production (the remark is not originally Smith’s at all), must not blind us to its many faults. It is open to at least two very serious objections.
An attempt is made to explain the price of goods by referring to the price of the services (wages, interest, and rent) which make up the cost of production. When the cost of those services comes up for consideration it is assumed that their cost is dependent upon the price of the goods. Wages, for example, are determined by the selling price of the commodities which labour has produced. Escape from the vicious circle is only possible by availing ourselves of the modern theory of economic equilibrium. That theory shows us how prices generally, whether of goods or of services, are interdependent; all being determined simultaneously—like the unknown in an algebraical formula—just when the exchange is taking place. But this theory of economic equilibrium was, of course, unknown to Smith.
Cost of production being the regulator of price, it is very important that an analysis of cost of production and a study of the causes which determine the rates of wages, profit, and rent should be made. One might have expected that this study would have cleared away any obscurity that still clung to the theory of prices. But this analysis is one of the least satisfactory portions of Smith’s work. We have already had occasion to note the unsatisfactory character of his theory of rent. That of profits—which Smith fails to distinguish from interest—is equally useless;[183] and his theory of wages is hopelessly inconsistent. He hesitates between the subsistence theory of wages and the other theory which makes them depend upon the relations between demand and supply, without ever making a final choice.
We cannot agree with Say in considering Smith’s theory of distribution one of his best claims to fame. His treatment of this problem, which afterwards became the kernel of Ricardian economics, is altogether inferior to his handling of production. We also know that this is the least original part of his work. It was simply added as a kind of afterthought, the original intention being to deal only with production. This becomes evident if we compare the Wealth of Nations with the Glasgow course of 1763, the whole of which is devoted to production. The addition of a theory of distribution to the original skeleton was probably due to the Physiocrats, with whom in the meantime he had become acquainted; and the hesitations and uncertainties which mar this part of the work merely go to prove that Smith had not thought it out as clearly as the other sections.
The subject cannot be pursued here. We can only point to the inference which Smith draws from his theory of value, and how it is made to support the contention that demand adapts itself spontaneously to the conditions of supply. This is how Smith explains the continual oscillation of prices: “When the quantity brought to market exceeds the effectual demand, it cannot be all sold to those who are willing to pay the whole value of the rent, wages and profit, which must be paid in order to bring it thither. Some part must be sold to those who are willing to pay less, and the low price which they give for it must reduce the price of the whole. The market price will sink more or less below the natural price according as the greatness of the excess increases more or less the competition of the sellers, or according as it happens to be more or less important to them to get immediately rid of the commodity.” The reverse will happen when demand exceeds supply. “When the quantity brought to market is just sufficient to supply the effectual demand and no more, the market price naturally comes to be either exactly, or as nearly as can be judged of, the same with the natural price. The whole quantity upon hand can be disposed of for this price, and cannot be disposed of for more. The competition of the different dealers obliges them all to accept of this price, but does not oblige them to accept of less.” Thus “the quantity of every commodity brought to market naturally suits itself to the effectual demand.”[184]
And this very remarkable result is simply the outcome of personal interest. “If at any time it exceeds the effectual demand, some of the component parts of its price must be paid below their natural rate. If it is rent, the interest of the landlords will immediately prompt them to withdraw a part of their land; and if it is wages or profit, the interest of the labourers in the one case, and of their employers in the other, will prompt them to withdraw a part of their labour or stock from this employment. The quantity brought to market will soon be no more than sufficient to supply the effectual demand. All the different parts of its price will rise to their natural rate, and the whole price to the natural price.”
And so, in the majority of cases at least, this natural and spontaneous mechanism secures a constant balancing of the quantities of goods produced and the quantities effectively demanded. The circumstances under which such a result does not follow are really quite exceptional—although Smith does not deny that sometimes they do exist. Whenever such conditions obtain—that is, when the market price remains for a considerable length of time above the natural price—we find that it is always due to the capitalists’ action in concealing the high rate of profits which they draw, or in retaining possession of some patent or natural monopoly, such as wine of a special quality. It occasionally happens also as the result of an artificial monopoly.[185] But these are mere exceptions, their rare occurrence confirming the fundamental rule concerning the spontaneous adaptation of the quantity offered to the quantity demanded, thanks to this oscillation of the market price about the natural.
This theory of adaptation, we know, is one of the most important in the whole of political economy. Since Smith wrote it has been reproduced by almost every economist, and without any very substantial alteration. It remains even to this day the basis of our theory of production.
It is interesting to note the manner in which Smith makes use of his theory to illustrate his thesis. We shall refer to two cases which are intrinsically important as well as affording admirable illustrations of that spontaneity upon which Smith laid such stress.
The first concerns population. Population, like commodities, may be superabundant or it may be insufficient. What regulates its numbers? “The number of people,” Smith replies, “depends upon the demand of society, and this is how it works. Among the proletariat, generally speaking, children are plentiful enough. It is only when wages are very low that poverty and misery cause the death of many of them; but when wages are fairly high several of them manage to reach maturity.” “It deserves to be remarked, too,” he continues, “that it necessarily does this as nearly as possible in the proportion which the demand for labour requires. If this demand is continually increasing, the reward of labour must necessarily encourage in such a manner the marriage and multiplication of labourers as may enable them to supply that continually increasing demand by a continually increasing population. If the reward should at any time be less than what was requisite for this purpose, the deficiency of hands would soon raise it; and if it should at any time be more, their excessive multiplication would soon lower it to this necessary rate. The market would be so much under-stocked with labour in the one case, and so much over-stocked in the other, as would soon force back its price to that proper rate which the circumstances of the society required. It is in this manner that the demand for men, like that for any other commodity, necessarily regulates the production of men; quickens it when it goes on too slowly, and stops it when it advances too fast.”[186]
The second case relates to the demand for money and its supply. We have already seen how the problem of its origin is solved. Alongside of that problem is now placed another, namely, how is the quantity in circulation regulated to meet the requirements of exchange? Smith’s first task was to expose the popular fallacy concerning this topic.[187] According to one school of thinkers, money was wealth par excellence, and it was all the more important that he should get rid of this view seeing that it constituted the very foundation of the