prior probability

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).

Which came first? Money or the division of labor? Chapter 4 of The Wealth of Nations is devoted to “The Origin and Use of Money,” and in the first part of this chapter (paragraphs 1 to 11, available here), Adam Smith not only surveys the origins of metal currencies — or how “money has become in all civilized nations the universal instrument of commerce” (WN, I.iv.11) — he also does two other things that are worth taking note of:

1. First off, he uses the term “commercial society” for the first time: “When the division of labour has been once thoroughly established …. [everyone] lives by exchanging, or becomes in some measure a merchant, and the society itself grows to be what is properly a commercial society.” (WN, I.iv.1) Why is this such a big deal? (After all, this term only appears twice in his entire magnum opus.) Simply put, it’s a big deal because Smith was one of the first to recognize that we are living in a new type of world, one in which the pursuit of wealth and riches has replaced the ancient pursuit of martial honor or the medieval pursuit of Christian virtues.

2. Secondly, in a lengthy aside at the end of paragraph 10 of Chapter 4, Smith calls out “the avarice and injustice of princes and sovereign states” for “abusing the confidence of their subjects.” (WN, I.iv.10) How exactly do our rulers abuse us, according to Smith? By debasing the value of their currencies! (Sound familiar?) Smith writes:

“For in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal, which had been originally contained in their coins. The Roman As, in the latter ages of the Republic, was reduced to the twenty-fourth part of its original value, and, instead of weighing a pound, came to weigh only half an ounce. The English pound and penny contain at present about a third only; the Scots pound and penny about a thirty-sixth; and the French pound and penny about a sixty-sixth part of their original value. By means of those operations the princes and sovereign states which performed them were enabled, in appearance, to pay their debts and to fulfil their engagements with a smaller quantity of silver than would otherwise have been requisite. It was indeed in appearance only; for their creditors were really defrauded of a part of what was due to them. All other debtors in the state were allowed the same privilege, and might pay with the same nominal sum of the new and debased coin whatever they had borrowed in the old. Such operations, therefore, have always proved favourable to the debtor, and ruinous to the creditor, and have sometimes produced a greater and more universal revolution in the fortunes of private persons, than could have been occasioned by a very great public calamity.” (ibid.)

Alas, what Smith doesn’t explain, however, is the causal relationship between the division of labor and the use of metals as a universal currency: is it the division of labor that leads to the use of money, or is it the use of metal currencies that leads to the division of labor? Nota bene: I will turn to the last part of Chapter 4 of Smith’s Wealth of Nations (paragraphs 12-18) in my next post.

The Christmas season might be over and done with in most of the Anglo-American world, but it is just getting started in my beloved Island of Puerto Rico: Three Kings’ Day and “Octavitas” are still around the corner!

Chapter 3 of The Wealth of Nations (available here) is a veritable microcosm of Adam Smith’s genius, another timeless reason why his great work is still worth reading today, 250 years later. Here, Smith not only introduces one of his most original and important insights — the division of labor is limited by the extent of the market — the Scottish philosopher also combines his extensive historical erudition with his eloquent literary voice to illustrate the inner logic of this universal economic theorem with a wide variety of real-world examples from numerous times and places: the Highlands of Scotland (WN, I.iii.2), the coast of the Mediterranean sea (I.iii.5), Upper and Lower Egypt and the Nile (I.iii.6), Bengal and the eastern provinces of China (I.iii.7), as well as inland Africa and ancient Scythia (I.iii.8).

Nota bene: We are only three chapters into Smith’s magnum opus, but before proceeding any further, a rhetorical question is now in order: has anyone in the Western canon, with the possible exception of Aristotle, ever even come close to matching either the breadth or depth of Adam Smith’s pen or the continued relevance of his ideas? I will resume my Adam Smith series by turning to chapter 4 of The Wealth of Nations in the next day or two.

In his posthumously published treatise History of Economic Analysis (Oxford U Press, 1954; available here), Joseph Schumpeter made the following gratuitous and now oft-quoted claim: “… the fact is that The Wealth of Nations does not contain a single analytic idea, principle, or method that was entirely new in 1776.” (1954, p. 184, emphasis in the original) Alas, this legendary Austrian academic was wrong, for Chapter 2 of Smith’s Wealth of Nations (available here) contains three such original conjectures alone!

1. Man’s propensity to truck, barter, and trade. First off, Smith identifies the origins of the division of labour: “This division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion. It is the necessary, though very slow and gradual, consequence of a certain propensity in human nature … the propensity to truck, barter, and exchange one thing for another.” (WN, I.ii.1)
2. The butcher, the brewer, and the baker. Next, in what has to be one of the most memorable and most quoted sentences ever written in the English language, Smith explains how humans differ from non-human animals: “Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. . . . But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. . . . It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” (WN, I.ii.2)
3. The street porter and the philosopher. Last but not least, Smith propounds the basic natural equality of all men at birth: “The difference between the most dissimilar characters, between a philosopher and a common street porter, for example, seems to arise not so much from nature, as from habit, custom, and education. When they came into the world, and for the first six or eight years of their existence, they were perhaps, very much alike, and neither their parents nor playfellows could perceive any remarkable difference. About that age, or soon after, they come to be employed in very different occupations. The difference of talents comes then to be taken notice of, and widens by degrees, till at last the vanity of the philosopher is willing to acknowledge scarce any resemblance.” (WN, I.ii.4)

Happy New Year! 2026 is the 250th anniversary of one of the most influential books to be published in the English language: Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations. To commemorate this historic occasion, starting this weekend I will begin a new series of blog posts on Smith’s magnum opus.