Smith Offered More than a Cost of Production Theory of Prices

Jeffrey Jean writing in Red State.org - a Republican community weblog - on 11 October 2005 (RedState.org - Maclean, VA, USA) writes a thoughtful piece on the gasoline price controversy associated with Katrina and the recent rise in world gasoline prices (“Gasoline prices- Who's to Blame?”).

I find most of the article an accurate statement of the economics of the gasoline markets. I find problematical, however, the account given by Jeffrey Jean of Adam Smith’s views applied to this situation.

First, a quote from the beginning of the article:

“We all know the causes of high gasoline prices are systemic price gouging by the oil companies; dependence on foreign sources of crude oil; Congress' lack of political courage for not passing sensible energy legislation to force more conservation measures on the public and to overcome the complete failure of the market process to bring about alternative sources of energy. Or do we? Let's start with gouging.

The reasoning here is that in their pursuit of profit, the oil companies possess the market power to willy-nilly push the price of oil to increase profits which in turn causes the price of gasoline to rise. This is the view of Classical Economists starting with the famous Adam Smith (1723-90) and on down to today.

This theory would say that price is the sum of all the individual costs up the entire production chain. Thus, oil is one of the determinants of gasoline prices. The early classical economists were aware there were problems with this theory, as it only explains certain prices and not others. Nevertheless, this theory seems so intuitive one can only hope advances in theory will eventually occur to make it a general price theory. It's not to happen. For example, if the determent of gasoline is oil, what determines the price of oil, certainly not the cost of pumping it? What determines the price of labor if it isn't the value produced by the final product?”

A close reading of “Wealth of Nations” does not support the view that Adam Smith held rigorously to a ‘cost of production’ theory of price. Smith’s theory of prices, and of supply and demand in markets, is covered in Book I, chapter VII: ‘Of the natural and market prices of commodities’. I will cover this very briefly (it is covered in more detail in my “Adam Smith”, forthcoming, for Palgrave’s “Great Thinkers in Economics” series).

True, Smith puts forward a primitive cost of production theory, which he called the “Natural Price”, in the opening sections of his chapter. If he had left it there he could justly be accused of the errors alluded to by Jeffrey Jean. However, he went on to explain why the Natural Price did not obtain at all times and, to account for this phenomenon, he advanced the idea of the “Market Price”, which dominated real markets. This is a straight supply and demand explanation, of which Jeffrey Jean’s own explanation in the article is a good example.

Profits (like prices) cannot be predicted a priori; they are the outcome of markets, not their precondition. Entrepreneurs must take a view on price and an influence in that decision would be a product’s costs, including the profit they expect. To say that they don’t do this suggests a complete non-acquaintance with business decision-making. Actual prices are determined afterwards, when the products reach their markets. From this point on the costs of production have no influence on market prices; entrepreneurs become price takers not price makers.

Changes in supply and/or demand cause changes in the behaviours of the people in the markets. Smith’s detailed explanations of these changes may reinforce the ‘look back quickly’ school of the history of economics, to confirm its inherited prejudices from interpretations of his ideas. More leisurely contemplation of what he said indicates an overlap in the contributions to price theory a hundred or more years later.

He used his ‘factor price’ model (using modern terminology) to show how the owners of the factors (land, labour and capital stock) would react to changes in their markets. None of this contradicts Jeffrey Jean’s analysis (or the distinguished contributions of Carl Menger, Ludwig Von Mises, Murray Rothbard, or Frederick Von Hayek - see the web blogs listed alongside).

We should also note that Smith’s markets were street fairs selling food, farming tools, trinkets, ‘baubles', household goods and such like, made by largely individual handicraft tradesmen and women, and not large scale capitalist factories employing thousands and retailing in vaster markets across the land. By the time that Menger, Mises, Hayek, and most certainly Rothbard, applied their brilliant minds to market pricing, the world had moved through the ‘industrial revolution’ to the mass consumer society (though I have a note inmy files of Menger explaining price changes using a horse sale as his example).

Smith’s association with the ‘labour theory of value’ should not be taken too literally (he was definitely not a ‘proto-Marxist’) and his awkward presentation of Natural and Market prices should not be judged by the sophisticated analyses that became possible over 100 years later from a group of very bright economists, each with access to each others work.

I am working on this section of my new book at present and hope it helps to clear up a too easy dismissal of Smith’s contributions.