by Bobby Akart
Some trades – the profession of a porter, for example – are possible only in large towns, where there are enough customers to provide constant work. At the other end of the scale, though, each family in the remote Highlands of Scotland must be its own farmer, butcher, baker, brewer and carpenter. In between, a country smith must deal in every sort of ironwork, and a country carpenter must be a joiner, a cabinetmaker, carver, wheelwright and wagon-maker all at once.
Money and value
One thing that definitely does extend the market is money. In a commercial society, where specialisation is strong, we make few of our own needs, and rely on our exchanges with others to supply our wants. But exchange would be difficult if, for example, hungry brewers always had to search out thirsty bakers. Rather than everyone having to rely on finding some person with exactly the inverse of their own needs, ancient human societies therefore strove to find some medium of exchange – some third commodity that most people would be happy to trade for their own product, and could then trade with others.
In Homer's time it was cattle; in Abyssinia it is salt; shells serve the purpose in India, dried cod in Newfoundland, tobacco in Virginia, and sugar in the West Indies. But over time, metal became the standard currency. It is durable, and (unlike cattle) can be divided without loss into small amounts, then reassembled into larger amounts again, according to the need. Originally, simple bars of copper served as money in ancient Rome; but these were variable, and the quantity had to be weighed each time they were used. So eventually, stamps were devised, showing the standard of weight and fineness of the metal – the first coins.
But, whether exchange is mediated through money or not, what is it that determines the rate at which different products are exchanged? The word value has two meanings – one is value in use, the other is value in exchange. Water is extremely useful, but has almost no exchange value, while a diamond is largely useless but has enormous exchange value.
Explaining the principles that determine exchange value, the components of this price, and the factors that cause it to fluctuate, was no easy matter. Indeed it is not. It takes Smith several chapters of The Wealth of Nations to do it, specifically Book I, Chapters V–XI. Today we might solve the diamonds and water problem with marginal utility theory: since diamonds are so rare, an additional one is a great prize, but since water is so plentiful, an extra cupful is actually of little use to us. Or we might use demand analysis. But such tools did not exist in Smith's time.
The real measure of the exchangeable value of all commodities is the labour put into their production. The reason why we put effort into creating the product we sell is precisely to spare ourselves the effort of creating the things we buy. When we trade, what we are buying is the labour of others. Ultimately, wealth is not money – it is the amount of other people's labour that we can command, or purchase. (Of course, some sorts of labour might be more difficult, or require more ingenuity than others. But these things will be adjusted by the bargaining in the marketplace.)
For many commentators, this looks uncomfortably like a crude labour theory of value, which focuses on production costs and overlooks demand. Some argue that it led Karl Marx into his appalling errors about labour. One could defend Smith as just trying to simplify things by talking about an age before land or capital ownership, where labour was the sole production cost, and temporarily ignoring other factors such as land and capital, and also ignoring demand, all of which he goes into later. At best his words are misleading, at worst they are mistaken: but then he was breaking new ground.
Usually, of course, we estimate exchange value in terms of money, because money is far more tangible and easy to measure than labour. But it is not a perfect measure. The metals we use for coinage, such as gold and silver, fluctuate in value over the long term, depending, say, on the productivity of the mines and the cost of transportation. Labour remains the real price: money prices are just nominal prices. We buy in from others things that it would cost us more toil and trouble to do for ourselves. The real wealth that we obtain from exchanging with others is their labour, not their money.
Labour, capital, and land
In a primitive, hunting society where there is no stock and land is free, labour is the only factor of production. Since there is no point in anyone buying something they could make with less effort themselves, prices should always reflect the labour involved. If it costs twice the labour to kill a beaver than it does to kill a deer, one beaver should exchange for two deer (though the difficulty or dexterity of the required labour will be reflected in market prices).
In the hunting society, the whole product of labour belongs to the labourer. It is different, though, when people acquire capital and employ others to work with it. Then, the product must be shared between them – in the wages of the labourer and the profit of the employer. Profits, though, are different from wages: they reflect not the work of the employer, but the value of the capital that is employed in the production.
In the earlier chapters of The Wealth of Nations, Smith uses the word 'stock' rather than 'capital'. He later explains that 'stock' includes fixed and circulating capital, as well as materials being used in the process of manufacture, finished goods that are still unsold, and goods being held for later consumption. And then he starts talking more about 'capital'. Normally today we would call all these things 'capital', including any 'stock' of semifinished, unsold or unconsumed goods; it seems easier to use this term.
When land is taken into private ownership, a third group shares in the national product, namely the landlords. Food, fuel, and minerals are now no longer available merely for the labour of collecting them. The landlords demand that part of the product must now be remitted to them as rent.
Thus there are three factors of production, remunerated by different principles. The price of wheat comprises partly the rent of the landlord, partly the wages of the labourers, and partly the profit of the farmer who provides the money and the equipment to run the business. In the price of flour, the profits of the miller and the wages of the miller's workers must be added; and in the price of bread, similarly, the profits of the baker and the wages of the baker's staff. However many people are involved in a productive process, the costs always resolve themselves into some or other of these three elements.
Of course, it is possible for two or more of these revenue streams to belong to the same person. A planter may combine the roles of landlord and farmer, and a farmer may combine the roles of farmer and labourer: so some mixture of rent, profit and wages then comes to the same person.
Production costs and market prices
The wages and profits in any production process tend to an average rate that depends on the market. When the price of a commodity exactly matches the cost (rent, profit, wages) of producing it and bringing it to market, we might call it the natural price. If it sells at more than that, the seller makes a profit. If it sells at less, the seller makes a loss. The language is antiquated, but by 'natural price' Smith means no more than the cost of production, including a 'normal' rate of profit under competition.
This is in line with his view that value has more to do with what goes into a product, whereas today we would talk about supply and demand. This makes the term 'natural price' difficult to render in modern language, but it seems sensible to use simply 'cost of production'. The price at which products are actually sold is called the market price. This depends on supply and demand – the quantity of the product that sellers bring to market, and the size of the demand from potential buyers. When supply falls short of demand, there is competition between buyers, and the price is bid up. If a town is blockaded, for example, the prices of essential goods rise enormously. By contrast, when there is a glut and supply exceeds demand, sellers have to drop their price – particularly if the product is perishable, like fruit, and cannot be brought back to market later.
When supply and demand match exactly, however, the natural and market price are equal, and the market exactly cl
ears. If a market is overstocked and prices are below the cost of production, landlords will withdraw their land, employers their stock, and workers their labour, rather than suffer continued losses in this line of production. So the quantity supplied will fall, and market prices will be bid up again to the natural price, at which the market is cleared. If, by contrast, a market is understocked and prices are high, producers will commit more resources to this profitable line of production. So the quantity supplied will rise, and market prices will be bid down again to the natural, market-clearing price.
The market is therefore self-regulating. Prices are always gravitating towards the cost of production under competition, and producers are always aiming to supply the amount of their product that exactly matches customers' demand.
Here is yet another hugely important insight from Smith. The market is a completely inevitable system. In their natural pursuit of profit, sellers steer their resources to where the demand, and therefore price, is highest, thereby Smith calls this effectual demand, pointing out that some people who would like a product cannot actually afford it. Today this is understood, and we would say simply resources are drawn to their most valued application, without the need for any central direction.
Specific price factors
Of course, market prices still fluctuate above or below the cost of production. Because harvests are variable, for example, the same labour may produce more wheat, wine, oil or hops in one year than in another, and the market price will fall or rise accordingly. The production of other goods, such as linen and woollen cloth, suffers less variation of this sort, and prices are more stable. But a public mourning will raise the price of black cloth, for example, along with the wages of journeymen tailors.
When demand increases and the market price of a commodity rises above its cost of production, suppliers naturally try to conceal the fact that they are making extraordinary profits. They do not want to alert their competitors. So prices may remain high for a while. But such secrets cannot be kept for long.
Manufacturing secrets may last longer. A dyer, for example, who finds a way of producing a particular colour at half the usual cost, might enjoy extraordinary profits for many years before competitors also discover it. So here the market price may diverge from the natural price for a long time.
Other special circumstances can have the same effect. The favourable soil and situation of particular French vineyards, for example, may raise their rent well above others in the same neighbourhood. Or again, a supplier who is granted a monopoly can keep prices up, simply by restricting supply. Likewise, laws that limit apprenticeships, or restrict the number of people who can enter a trade, enable particular professions to keep their prices high.
As a result of such accidents, natural causes, and regulations, the market price of a product may remain above the production cost for some time. But it cannot long remain below it. In that case, suppliers would simply withdraw, rather than face continued losses (assuming they are free to do so – unlike ancient Egypt, for example, where boys were forced to follow their father's trade).
Wages depend on economic growth
As we have seen, in an age before land is appropriated by owners, and capital is accumulated by employers, the whole produce of labour belongs to the labourer. But as soon as land is appropriated, landlords demand a share of any production that uses their land, and as soon as capital is accumulated, employers demand the same.
There are a few workers who own all the stock needed for their own production activities, but this is uncommon. Usually, workers are employees of other people, who own productive assets. How the product is shared, then, is a matter of contract between workers and employers: but the employers usually have the upper hand.
Since there are fewer of them, they can combine more easily to rig the labour market and keep down wages. They have greater resources with which to sit out a trade dispute. And while the law forbids combinations of workers, the collusion of employers is everywhere.
Throughout his writings, Smith shows great sympathy for the ordinary working people of the time, and little for the merchants and employers, whom he sees as trying to rig markets in their own favour. This often comes as a shock to people who assume that Smith, as a believer in markets and free trade, must be on the side of the bosses. Smith believes that free and competitive markets are the best way to spread wealth, and in particular, to spread it to the poor – and that the efforts of politicians and business people to diminish competition and freedom should therefore be resisted.
When the demand for labour is rising, however, the workers have the advantage, and competition between employers bids up wages. But the demand for labour can rise only when gross national product rises, since wages can only be paid out of income or capital. When wealthy landlords have spare revenue, for example, they hire more servants; when weavers or shoemakers have surplus stock, they hire more journeymen. Wages cannot rise if the national product is static or falling.
China has long been a rich, fertile, industrious and populous country; but there seems to have been little or no development there since Marco Polo visited it five hundred years ago. The land is still cultivated and not neglected, but China's economy is not growing. That is why the poverty of the poorest labourers in China is greater than in even the poorest nations of Europe.
Bengal is also a fertile country, but poverty is so rife that hundreds of thousands of people die of hunger each year. Clearly, the national product that is needed to maintain the labouring poor is in fact shrinking (for which we can blame the oppression of the East India Company).
Factors affecting wage rates
In growing economies such as that of Great Britain, however, wages are above subsistence, though they do vary. Summer wages, for example, are higher, because workers need to save for the winter, when wages are lower but costs are higher. Wages also vary from place to place. The usual price of labour in London is about eighteen pence a day; in Edinburgh it is ten pence; in rural Scotland it is eight pence. And yet, grain – the food of the common people – is dearer in Scotland than in England, where it grows better. If working people in Scotland can sustain themselves on these low wages and with high grain prices, it suggests that the working people in England must be living in some affluence.
Though wages are rising in Great Britain, prices are generally falling as a result of the rising productivity brought on by specialisation. Potatoes, turnips, carrots and cabbages, for example, cost half of what they did forty years ago. Linen and woollen cloth is cheaper, as is ironmongery and furniture. We should welcome the fact that the working poor are becoming better off: a country where most people live in poverty can hardly be called rich and happy. (It is true that soap, salt, candles, leather and alcohol have become more expensive – though mainly because of the taxes on them. But these are luxuries which do not feature in the budgets of most working people.)
No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable. Decent wages are essential for the well-being of labourers and their families. But to pay decent wages is in the interests of employers, too. When wages are high, workers are better fed and stronger. They also have the prospect of saving and improving their condition, which makes them more inclined to work diligently. And when workers are given sufficient rest, they are likely to be healthier and more productive.
Capital and profits
The profit which employers derive from capital is even more variable and hard to measure than the wages of labour. It depends on market prices, on how competitors are faring, and on the many problems that can occur in the production, transportation and storage of goods. Interest rates, however, provide a rough index of profitability: if people can make a good profit from the use of money, they will be prepared to pay well to borrow it.
As we have seen, an increase in capital allows more business to take place, and so tends to raise wages. But it also tends to reduce profits. The greater supply
of capital increases the competition between its owners, and bids down the rate of return that it can generate, and the interest rates that borrowers will be prepared to pay for its use.
However, there are exceptions in particular circumstances. In the North American and West Indian colonies, for example, wages are high, and so are interest rates. So those are indicators that profits are high too. The reason is that there is plenty of fertile land in these territories, but as yet there aren't enough people or capital to cultivate it. Workers and equipment are in great demand, and therefore they command high prices. This, of course, does not last forever: as new colonies grow, they have to bring more marginal land into production, and profits gradually fall.
Another special case might be where a country has become as rich as its soil and situation can sustain, and could grow no further. Being fully populated, there would be great competition and wages would be low; and being fully capitalised, the competition between employers would be great, and profits would be low as well. But no country has yet reached this degree of wealth.
Today we see no limit to economic growth. Our capital and technology give rise to all kinds of new business sectors and opportunities for employment. In Smith's time, however, the economy was dominated by agriculture, and he mistakenly sees the impossibility of developing land beyond its fertility as a limit to economic growth.
Market wage rates
In any locality, the net benefits of employing labour or capital should tend to equalise across all uses. If they did not, and there were higher wages or profits to be made in some particular industry, workers or employers would flood into that employment – whereupon wages or profits would be bid back down towards the norm. In reality, however, it is obvious that the financial rewards that are actually achieved in different lines of work and industry vary widely. But in saying that the rewards of employment tend to equality, the non-pecuniary costs and benefits of different industries must be considered too, along with the purely financial returns. There are several such factors: