prior probability

Chapter 10 of The Wealth of Nations is the second-longest chapter in Book 1 of Smith’s magnum opus: it consists of two parts, contains 115 paragraphs (52 paragraphs in part one, followed by another 63 paragraphs in part two), and spans some 77 pages in the Glasgow edition. Among other things, this chapter addresses the following fundamental question: is it better to be an employee or a business owner, a worker or a “capitalist” (owner of capital)?

What is even more remarkable about this pivotal chapter is Smith’s surprising theoretical answer: the expected returns from labor and capital are in the long run equal! In fact, the Scottish philosopher-economist opens this chapter with the following general principle: “The whole of the advantages and disadvantages of the different employments of labour and stock must, in the same neighbourhood, be either perfectly equal or continually tending to equality.” (WN, I.x.a.1)

In other words, it does not matter whether you are a worker or a capitalist because the expected returns (in theory, at least) from labor and capital will either be “perfectly equal” or will be “tending to equality”! But that said, it is important to note that Smith qualifies his surprising conclusion with two important caveats. One is geographical. (Notice the qualification “in the same neighbourhood” in the quotation above.) The other caveat is legal/regulatory: the existence of free entry and exit into any trade, profession, or business, or in the immortal words of Adam Smith:

This [Smith’s surprising conclusion about equal expected returns from labor and capital] at least would be the case in a society where things were left to follow their natural course, where there was perfect liberty, and where every man was perfectly free both to choose what occupation he thought proper, and to change it as often as he thought proper. (WN, I.x.a.1; my emphasis)

Alas, as Smith himself notes, this second condition rarely, if ever, holds, for “the policy of Europe … nowhere leaves things at perfect liberty.” (WN, I.x.a.2) The father of economics therefore devotes most of Chapter 10 to the “Inequalities occasioned by the Policy of Europe” (WN, I.x.c), i.e. to the distortions in the expected returns from labor and capital resulting from laws and regulations and other restrictions on liberty. (To be continued …)

Chapter 9 of Adam Smith’s Wealth of Nations (available here) is another intellectual and historical tour de force. Among other things, Smith not only compares and contrasts the levels of wealth of many different nations and regions of the world — England and Scotland, Bengal and China, and North America and Holland, just to name a few — Smith also formulates another general principle or general law regarding the relationship between profits and interest rates: “… as the usual market rate of interest varies in any country, we may be assured that the ordinary profits of stock must vary with it, must sink as it sinks, and rise as it rises. The progress of interest, therefore, may lead us to form some notion of the progress of profit.” (WN, I.ix4)

More importantly, Smith anticipates and refutes Karl Marx’s dire thesis in Das Kapital. According to Marx, the profits of the owners of capital come at the expense of the wages of the workers: as the wealthy acquire greater amounts of capital and produce more efficiently (i.e. hire fewer workers), the owners are able to exploit the working classes because of the existence of a large and ever-growing pool of unemployed men (Marx’s famous “reserve army of labor”). For Adam Smith, however, the opposite is true: it’s the workers who, in effect, “exploit” the owners of capital! In Paragraphs 6 and 7 of Chapter 9, for example, Smith writes:

“Since the time of Henry VIII. the wealth and revenue of the country have been continually advancing …. The wages of labour have been continually increasing during the same period, and in the greater part of the different branches of trade and manufactures the profits of stock have been diminishing.” (WN, I.ix.6)

“It generally requires a greater stock to carry on any sort of trade in a great town than in a country village. The great stocks employed in every branch of trade, and the number of rich competitors, generally reduce the rate of profit in the former below what it is in the latter But the wages of labour are generally higher in a great town than in a country village. In a thriving town the people who have great stocks to employ frequently cannot get the number of workmen they want, and therefore bid against one another in order to get as many as they can, which raises the wages of labour, and lowers the profits of stock….” (WN, I.ix.7)

Furthermore, according to Smith, the profits of the owners of capital will tend to decrease toward zero as the stock of capital increases! Why? Because an increase in profits in a given market attracts new entrants and new investments in capital by existing firms, and the resulting competition and investments in capital have the effect of increasing wages and decreasing profits. It suffices to say that history has vindicated Adam Smith and condemned Karl Marx.

Let’s pick up my survey of Adam Smith’s Wealth of Nations where we left off: with Chapter 8 on “The Wages of Labour” (available here). As it happens, this particular chapter is one of the lengthiest and most tedious chapters in Book I of the The Wealth of Nations — it consists of no less than 57 paragraphs and spans over 30 pages of the Glasgow edition of Smith’s magnum opus — but it is also one of the most intriguing and relevant chapters for our times, for buried deep inside (Para. 36) is the following immortal passage:

“Is this improvement in the circumstances of the lower ranks of the people to be regarded as an advantage or as an inconveniency to the society? The answer seems at first sight abundantly plain. Servants, labourers, and workmen of different kinds, make up the far greater part of every great political society. But what improves the circumstances of the greater part can never be regarded as an inconveniency to the whole. No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable. It is but equity, besides, that they who feed, clothe, and lodge the whole body of the people, should have such a share of the produce of their own labour as to be themselves tolerably well fed, clothed, and lodged.” (WN, I.viii.36; my emphasis)

We thus get to see a side of Adam Smith that is often overlooked or ignored: the Scottish philosopher as champion of the worker! He tells us that the working classes deserve their fair share of the overall wealth of society. But unlike Karl Marx, Thomas Piketty or John Rawls, Smith’s concern for ordinary working men (and women!) is grounded in economic reality:

“It deserves to be remarked, perhaps, that it is in the progressive state [i.e. expanding GDP],while the society is advancing to the further acquisition, rather than when it has acquired its full complement of riches, that the condition of the labouring poor, of the great body of the people, seems to be the happiest and the most comfortable. It is hard in the stationary, and miserable in the declining state. The progressive state is in reality the cheerful and the hearty state to all the different orders of the society. The stationary is dull; the declining, melancholy.” (WN, I.viii.43)

In other words, economic growth is more important than economic equality, or more simply put, for the working classes to prosper the economy as whole must be growing! (To be continued …)

Last weekend, I got to meet a pro-market sociologist, Fabio Rojas (Indiana), as well as the “open borders” advocate Bryan Caplan (George Mason) at the Santa Cruz Economic and Political Forum in Santa Cruz de la Sierra, Bolivia. Among the many highlights of this excellent event, which was organized by the Center for Public Policy Studies for Liberty (POPULI), Bryan previewed his forthcoming book Unbeatable: The Brutally Honest Case for Free Markets, and he persuaded me that workers should be free to migrate to whichever country they want, while Fabio explained how free markets not only empower the poor; they also empower racial and ethnic minority groups! Speaking of free markets, I will resume my survey of Adam Smith’s Wealth of Nations in my next post.

Luis Vega is a Bolivian singer and songwriter who originates from Santa Cruz de la Sierra, the tropical town where I visited and read Book I of The Wealth of Nations last week. Below is a small sample of his music:

I have been reading Book I of Adam Smith’s Wealth of Nations in the old town of Santa Cruz de la Sierra in the lowlands of Bolivia this past week, and I will have much more to say about my magical visit — and about Smith’s magnum opus — upon my return …

Chapter 7 of The Wealth of Nations (available here) is a veritable economics tour de force. Among other things, Adam Smith draws a distinction between actual price (or “market price”) and natural price (or what Smith also calls “real price”): “The actual price [market price] at which any commodity is commonly sold is called its market price. It may either be above, or below, or exactly the same with its natural price [real price].” (WN, I.vii.7)

Specifically, in paragraphs 8 to 11 of Chapter 7, Smith explains how the market price of a good or service is determined by the forces of demand and supply: “The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labour, and profit, which must be paid in order to bring it thither.” (WN, I.vii.8)

Like Sir Isaac Newton’s three laws of planetary motion, Adam Smith’s economic analysis (and economics more generally) can be summed up in three “laws” as follows:

• Law #1: market price > natural price when supply < demand (see Para. 9)
• Law #2: market price < natural price when supply > demand (see Para. 10)
• Law #3: market price = natural price when supply = demand (see Para. 11)

The Scottish philosopher-economist then delivers his intellectual coup de grace: market prices are self-correcting! Or in the immortal words of Adam Smith:

“The natural price, therefore, is, as it were, the central price, to which the prices of all commodities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them down even somewhat below it. But whatever may be the obstacles which hinder them from settling in this center of repose and continuance, they are constantly tending towards it.” (WN, I.vii.15)

As an aside, my reference to Sir Isaac Newton is intentional, for Smith himself uses the word “gravitating” to describe this self-correcting feature of markets.

Last but not least, Smith explains how restrictions on liberty — i.e. government interference in the economy — distorts prices and impedes the self-correcting nature of markets:

“But though the market price of every particular commodity is in this manner continually gravitating, if one may say so, towards the natural price, yet sometimes particular accidents, sometimes natural causes [e.g. droughts or soil conditions], and sometimes particular regulations of police, may, in many commodities, keep up the market price, for a long time together, a good deal above the natural price.” (WN, I.vii.20)

By way of example, Smith condemns legally-created monopolies and restrictions on trade (cf. occupational licensure) in paragraphs 24-28 of Chapter 7. Such “regulations of police” (i.e. government regulation) interferes with or perturbs the gravitational forces of the market. (See generally paragraphs 17 to 29 of Chapter 7.) Or, again in the immortal words of Smith: “Such enhancements of the market price may last as long as the regulations of police which give occasion to them.” (WN, I.vii.28)

In Chapter 6 of The Wealth of Nations (available here), Adam Smith writes: “Wages, profit, and rent, are the three original sources of all revenue as well as of all exchangeable value. All other revenue is ultimately derived from some one or other of these.” (WN, I.vi.17) In other words, the real price of a good or service is a function of three variables: wages, profit, and rent. Smith breaks down each one of these key variables as follows:

1. Wages (Paras. 1-4). First off, the Scottish philosopher-economist begins this chapter with wages. In brief, we can think of wages as the revenue generated by one’s labor:

“… the whole produce of labour belongs to the labourer; and the quantity of labour commonly employed in acquiring or producing any commodity, is the only circumstance which can regulate the quantity of labour which it ought commonly to purchase, command, or exchange for.” (WN, I.vi.4)

But wages are just one component of the real price of goods and services. The other two components are rent and profit.

2. Rent (Para. 8). Rent, by contrast, is the revenue generated by one’s real property or land:

“As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce. The wood of the forest, the grass of the field, and all the natural fruits of the earth, which, when land was in common, cost the labourer only the trouble of gathering them, come, even to him, to have an additional price fixed upon them. He must then pay for the licence to gather them; and must give up to the landlord a portion of what his labour either collects or produces. This portion, or, what comes to the same thing, the price of this portion, constitutes the rent of land, and in the price of the greater part of commodities makes a third component part.” (WN, I.vi.8)

3. Profit (Paras. 5-7). Profit is the most fascinating of Smith’s three variables, for in the process of explaining profit, Smith describes an entirely new economic system, i.e. capitalism:

“As soon as stock has accumulated in the hands of particular persons, some of them will naturally employ it in setting to work industrious people, whom they will supply with materials and subsistence, in order to make a profit by the sale of their work, or by what their labour adds to the value of the materials. In exchanging the complete manufacture either for money, for labour, or for other goods, over and above what may be sufficient to pay the price of the materials, and the wages of the workmen, something must be given for the profits of the undertaker of the work who hazards his stock in this adventure. The value which the workmen add to the materials, therefore, resolves itself in this case into two parts, of which the one pays their wages, the other the profits of their employer upon the whole stock of materials and wages which he advanced. He could have no interest to employ them, unless he expected from the sale of their work something more than what was sufficient to replace his stock to him; and he could have no interest to employ a great stock rather than a small one, unless his profits were to bear some proportion to the extent of his stock.” (WN, I.vi.5)

4. Examples (Paras. 11-13). Smith also illustrates his theory of price with numerous examples. Below is Smith’s explanation of the price of one of the most essential commodities of Smith’s time — i.e. the price of “corn” or cereal grains like barley, oats, rye, and wheat:

“In the price of corn, for example, one part pays the rent of the landlord, another pays the wages or maintenance of the labourers and labouring cattle employed in producing it, and the third pays the profit of the farmer. These three parts seem either immediately or ultimately to make up the whole price of corn. A fourth part, it may perhaps be thought, is necessary for replacing the stock of the farmer, or for compensating the wear and tear of his labouring cattle, and other instruments of husbandry. But it must be considered that the price of any instrument of husbandry, such as a labouring horse, is itself made up of the same three parts; the rent of the land upon which he is reared, the labour of tending and rearing him, and the profits of the farmer who advances both the rent of this land, and the wages of this labour. Though the price of the corn, therefore, may pay the price as well as the maintenance of the horse, the whole price still resolves itself either immediately or ultimately into the same three parts of rent, labour, and profit.” (WN, I.vi.11)

Chapter 5 of The Wealth of Nations (available here) draws a distinction between “real” and “nominal” prices. To begin, the “nominal” price of any given good or service is its money price, which can change over time, since the value of currencies is determined by supply and demand:

“Gold and silver … vary in their value, are sometimes cheaper and sometimes dearer, sometimes of easier and sometimes of more difficult purchase. The quantity of labour which any particular quantity of them can purchase or command, or the quantity of other goods which it will exchange for, depends always upon the fertility or barrenness of the mines which happen to be known about the time when such exchanges are made. The discovery of the abundant mines of America reduced, in the sixteenth century, the value of gold and silver in Europe to about a third of what it had been before. As it cost less labour to bring those metals from the mine to the market, so when they were brought thither they could purchase or command less labour; and this revolution in their value, though perhaps the greatest, is by no means the only one of which history gives some account. But as a measure of quantity, such as the natural foot, fathom, or handful, which is continually varying in its own quantity, can never be an accurate measure of the quantity of other things; so a commodity which is itself continually varying in its own value, can never be an accurate measure of the value of other commodities….” (WN, I.v.7)

By contrast, the “real” price of a good or service is the amount of labor (i.e. the amount of time, skill, effort) that went into producing it, or in the immortal words of Adam Smith: “Labour alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. It is their real price; money is their nominal price only.” (WN, I.v.7)

But this distinction between real and nominal prices begs the question: what determines the price or value of labor? For Smith, this price is determined by the “higgling and bargaining” of the market:

“But though labour be the real measure of the exchangeable value of all commodities, it is not that by which their value is commonly estimated. It is often difficult to ascertain the proportion between two different quantities of labour. The time spent in two different sorts of work will not always alone determine this proportion. The different degrees of hardship endured, and of ingenuity exercised, must likewise be taken into account. There may be more labour in an hour’s hard work than in two hours easy business; or in an hour’s application to a trade which it cost ten years labour to learn, than in a month’s industry at an ordinary and obvious employment. But it is not easy to find any accurate measure either of hardship or ingenuity. In exchanging indeed the different productions of different sorts of labour for one another, some allowance is commonly made for both. It is adjusted, however, not by any accurate measure, but by the higgling and bargaining of the market, according to that sort of rough equality which, though not exact, is sufficient for carrying on the business of common life.” (WN, I.v.4)

Before proceeding any further, however, let’s be clear about what Smith is — and is not — saying. He is not saying that labor is the true or ultimate source of economic value, for Smith is not a metaphysicist. What he is saying instead is this: labor is a more accurate and reliable measure of the value of goods and services. (Shout out to my colleagues and friends Maria Pia Paganelli and Jimena Hurtado for this clarification.)

Picking up where we left off, Adam Smith concludes Chapter 4 of The Wealth of Nations (available here) thus:

1. Para. 13a. First, Smith draws a fundamental distinction between use-value and exchange-value: “The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called ‘value in use ;’ the other, ‘value in exchange.’” (WN, I.iv.13)
2. Para. 13b. He then not only employs this distinction to solve the so-called “paradox of value“; he also illustrates his solution with one of the most famous and memorable examples in all of economics: “The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.” [1] (ibid)
3. Paras. 14-17. Next, he provides a roadmap for the next three chapters of The Wealth of Nations:

• To begin, Smith says that he will address the following question: “what is the real measure of this exchangeable value; or, wherein consists the real price of all commodities”? (I.iv.15) (see Ch. 5, “Of the Real and Nominal Price of Commodities”)
• Next, he tells us that he will identify “the different parts of which this real price is composed or made up.” (I.iv.16) (see Ch. 6, “Of the Component Parts of the Price of Commodities”)
• And lastly, he promises to explain the difference between “market prices” and “natural prices.” (I.iv.17) (see Ch. 7, “Of the Natural and Market Price of Commodities”)

4. Para. 18. Last but not least, Smith concludes Chapter 4 with the following words of warning or an apology of sorts:

I shall endeavour to explain, as fully and distinctly as I can, those three subjects in the three following chapters, for which I must very earnestly entreat both the patience and attention of the reader: his patience in order to examine a detail which may perhaps in some places appear unnecessarily tedious; and his attention in order to understand what may, perhaps, after the fullest explication which I am capable of giving of it, appear still in some degree obscure. I am always willing to run some hazard of being tedious in order to be sure that I am perspicuous; and after taking the utmost pains that I can to be perspicuous, some obscurity may still appear to remain upon a subject in its own nature extremely abstracted. (WN, I.iv.17)

In other words, Smith’s deep dive into the foundational concepts of “value” and “price” in the next three chapters of The Wealth of Nations are going to be so “tedious” that Smith is apologizing to us, his loyal readers, in advance!

[1] For an illuminating critique and further discussion of Smith’s solution, see Kwok Ping Tsang, “Three ways of looking at the water-diamond paradox” (April 14, 2021).