The Economics Book

58 FREE MARKET ECONOMICS

Smith described the ways in which
labor, landowners, and capital (here
invested in the horses and plow) work
together to keep the economic system
moving and growing.

collapsed in Eastern Europe because
central planning failed to deliver the
goods that people wanted. Some
criticisms of Smith’s first point have
been raised, such as the fact that
the market might only provide the
goods that are wanted by the rich;
it ignores the desires of the poor. It
also responds to harmful desires—
the market can feed drug addiction
and promote obesity.

Fair prices
Second, Smith said that the market
system generates prices that are
“fair.” He believed that all goods
have a natural price that reflects
only the efforts that went into
making them. The land used in
making a product should earn its
natural rent. The capital used in its
manufacture should earn its natural
profit. The labor used should earn
its natural wage. Market prices and
rates of return can differ from their
natural levels for periods of time, as
might happen in times of scarcity.

In that case, opportunities for gain

will arise, and prices will increase,

but only until competition brings

new firms into the market and

prices fall back to their natural

level. If one industry begins to

suffer a slump in demand, prices

will drop and wages will fall, but

as a different industry rises, it will

offer higher wages to attract

workers. In the long run, Smith

says, “market” and “natural” rates

will be the same: modern

economists call this equilibrium.

Competition is essential if

prices are to be fair. Smith attacked

the monopolies occurring under the

mercantilist system, which

demanded that governments

should control foreign trade. When

there is only one supplier of a

good, the firm that supplies it can

permanently hold the price above

its natural level. Smith said that

if there are 20 grocers selling a

product, the market is more

competitive than if there are just

two. With effective competition

and low barriers to entry into a

market—which Smith also said

was essential—prices tend to be

lower. Much of this underlies

mainstream economists’ views

Consumption is the

sole end and purpose

of all production.

Adam Smith

about competition, although

dissenters, such as Austrian-

American economist Joseph

Schumpeter (p.149), would later

say that innovation can also lower

prices, even where there appears to

be little competition. As inventors

come forward to provide higher

quality products at lower prices,

they blow away existing firms in

a storm of creative destruction.

Fair incomes

Smith also argued that market

economies provide incomes that

are fair and can be spent on goods

in a sustainable “circular flow,”