Adam Smiths Concept of Profit - Essay Example

Adam Smith – Option Introduction Adam Smith’s concept of profit can be understood through two different trajectories. Whereas profit as residual value is the concept of profit that contemporary citizens are most familiar, his concept of profit as compensation or cost of doing business can be argued to be the underlining characteristic of a good’s natural price. In the Wealth of Nations, Smith argued for a labor theory of value that is regulated by the invisible hand of the market which regulates the moral status of profit through supply and demand mechanisms. It is these supply and demand mechanisms and their relation to the labor theory of value that ultimately determine a good’s market price. This essay considers these strands of Adam Smith’s theory of classical economics by investigating their interrelation. 1. Describe the difference as understood by SMITH between "profit as a residual" and "profit as a compensation or cost of doing business." Profit as compensation or cost of doing business In the Wealth of Nations Smith offers a famous example of a primitive value system. Using the example of a beaver and a deer, he states that it takes twice as long to hunt the beaver as the deer, so that the beaver should be worth twice as much as the deer. In this example the value of a good is directly related to the labor that is required to procure it, therefore the profit is the compensation or cost of doing business. Smith states, “In this state of things, the whole produce of labour belongs to the laborer” (Medema & Samuels, 2003, p. 162). Smith acknowledges that such an example is not only simplistic, but due to the complications of the contemporary economic structure is no longer feasible. Indeed, the contemporary market (18th century United Kingdom) has given way to a process he refers to as division of labor, which complicates this example. Profit as residual In the Wealth of Nations Smith argues that one of the fundamental characteristics of the 18th century British economic structure is the division of labor. According to the division of labor In Chapter 1 (Medema & Samuels, 2003), Smith describes a situation where labor is divided within a pin factory so that the ultimate number of pins produced is greatly increased. In order to achieve this increase in production the capitalist must engage the services of the laborer and the landlord, and invest heavily in machinery. It follow that “In every society the price of every commodity finally resolves itself into some one or other, or all of those three parts” (Medema & Samuels, p.162). Smith is ultimately stating that the price of the commodity, after factoring in the costs of the land, labor, and machinery, is the residual profit. 2. Be sure to explain also how this is related to the concepts of natural price and market price. Natural Price Smith distinguishes between natural prices and market prices, both of which are closely interrelated to his concept of profit as compensation and profit as residual. Smith states that, “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” (Medema & Samuels, p.163). Here he is arguing that value is originally determined by the costs of its production, as such he terms this the natural price. Smith writes, When the price of any commodity is neither more nor less than what is sufficient to pay the rent of the land, the wages of the labour, and the profits of the stock employed in raising, preparing, and bringing it to market, according to their natural rates, the commodity is then sold for what may be called its natural price. (Medema & Samuels, p.163) As one might expect, the concept of natural price is most closely aligned with Smith’s concept of profit as compensation or cost of doing business. Market Price Conversely, the market price of a product is aligned with Smith’s concept of profit as residual. A product’s market price is a complex element that involves both the labor theory of value and Smith’s understanding of supply and demand. Smith states that, “The actual 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” (Medema & Samuels, p.163). Smith argues that when a commodity is produced and reaches the market it is subject to what he terms ‘effectual demand,’ which is the actual current demand for the product (Medema & Samuels 2003). Effectual demand is not a static factor and is contingent on the quantity of the product in market place. For example, if there are a high number of video game systems available the price of the system will be reduced, but as they become scarcer demand will increase and the price of the system will correspondingly rise. Furthermore, Smith argues that the price of goods tends toward an equilibrium that is occasionally disrupted causing fluctuations in market price. Smith states, 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, 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 (Medema & Samuels, p.165). 3. Also, be sure to discuss how these 2 aspects of profit relate to the moral status of profit. Moral Status of Profit Smith refrains from inquiring into, “the principal which gives occasion to the division of labour” (Medema & Samuels, 2003, pg. 159), but implies that such an occurrence is a natural element of social organization. Indeed, when considering Smith’s understanding of the moral status of profit, it’s important to note that Smith believes that the market naturally regulates morality, oftentimes in-spite of the population. This is the concept of the invisible hand. An example of the invisible hand in action occurs when a merchant has chosen to sell his goods for an exorbitant sum of money to greatly increase his residual profit; while consumers may at first be required to purchase these goods, soon other merchants will step in and undersell the merchant, effectively lowering the market price of goods (Heilbroner 1999). This is the invisible hand in action. While later theorists, most notably Karl Marx, argue that residual profit is actually the embodiment of the exploitation of labor, it’s also possible to view it in terms of compensation or the cost of doing business. Screpanti and Zamagni (2005) identify instances where Smith’s understanding of profit as residual and as compensation seem to merge. They state that while the commodity achieves a market price that is greater than its natural price, this residual profit is actually the embodiment of the capitalist’s investment; ultimately, then the capitalist is morally justified in achieving the residual profit. Many individuals note that there seems to be an inconsistency in Smith’s understanding of human morality, as in his Theory of Moral Sentiments he discusses the means by which humanity regulates itself through self-conscious means; however, Screpanti and Zamagni (2005) argue that the two understandings of morality are not mutually exclusive, but that Smith’s ‘invisible hand’ is related more to macroeconomic concerns, whereas his concept of self-conscious moral regulation refers to more individual and personal instances. References Steven G. Medema and Warren J. Samuels, The History of Economic Thought: A reader. (NewYork: Routledge,2003) Robert L. Heilbroner, The Worldly Philosophers. (New York:Touchstone, 1999) Ernesto Screpanti and Stefano Zamagni, An outline of the History of Economic Thought, 2nd Edition. (Oxford, UK: Oxford University Press, 2005) Read More