Adam Smith and the Working of Competitive Markets - Research Paper Example

Adam Smith and the Working of Competitive Markets Introduction At the end of 1989, communism economic system broke down unexpectedly and unpredictably in several key continents such as Europe and America among others. In a number of nations such as Soviet Union, communism still existed, but there was extraordinary social and economic disorder, suggesting that the supporters of communism were outnumbered by capitalism. In the western nations, capitalism has already triumphed over communism. The logical father of this capitalism system is Adam Smith. He forecasted that in future, competitive markets will be controlled by invisible hands and will convert self-interests into a force of public properties. Smith clarified the way competition enhances the productivity and social wellbeing by promising ideal distribution of resources and labour in the overall economy. Yet, as a pragmatist, Smith had also identified that capitalism will corrupt the competitive markets. He had also realised that in capitalist economy, certain individuals would turn out to be much wealthier and rich in comparison with others. On the assumption that there will be economic growth, the wealthy would become wealthier, however, the poor would also be more affluent. Adam Smith put substantial level of effort for establishing the theory of capitalism and how it would determine competitive markets. Even after his death, the ideas provided by Adam Smith remained significant in the fields of economy (Yardeni & Moss, 1990). Focusing on this aspect, the study examines Adam Smith’s explanation of competitive market. The study also delineates the way in which Adam Smith has viewed the present competitive markets and the manner in which these markets work. In relation to this, the study defines how the rule of exchange works in a competitive market for determining the prices. Relative Economic Policy Capitalism is an economic structure which protects private property and allows free trade in the competitive markets. In capitalism system, individuals are allowed to follow self-interests as long as these interests are controlled by competition and society obtains advantages from lower expenses and increased choices. However, the problem related to capitalism is that self-interest has a natural tendency for collusion and corruption. In other words, capitalists tend to pursue power and to exploit it in order to rigout the market in their favour at the cost of economic disadvantage (Yardeni & Moss, 1990). Adam Smith often cited capitalism as a supporter of free market which signifies deregulation. A deregulated market where government has low intervention can result in optimal allocation of resources because in the long run under competitive pressure, organisations would produce products or services at lowest possible average expenses. Adam Smith’s argument on free market is based on theoretical model about the way market generates specific outcomes. Smith agreed that markets frequently become unable to generate best social outcomes and government interventions were less satisfactory in comparison with those rolling from free markets. Smith advocated free market not because he assumed markets to be perfect but owing to the fact that markets can usually generate better outcomes in case of low government intervention (Sandstrom, 2005). According to Adam Smith, government employed mercantilist policies by permitting monopolies and providing supports in order to safeguard its own organisations against international competition. Mercantile system was followed during 16th to 18th century which was based on commercial and religious conflict and huge revenue. Mercantilist economic system measured national wealth in terms of level of money and precious metal possessed by a nation. Thus, in order to obtain more revenue and wealth, government encouraged more exports and discouraged imports. Government exercised control on economy mostly by empowering originations and imposing regulations such as import quotas and tariff rate among others (Sandstrom, 2005). Adam Smith had provided different opinions on economic process. He argued that national wealth must not be evaluated in terms of money, but in terms of production. On the other hand, the main objective of production according to Smith is not to generate revenue but to meet the requirements of customers. Hence, he had proposed free trade, deregulation and free competition. His opinions about market were applied during 19th century, and in present days, he is regarded as the key founder of modern economic thought (Sandstrom, 2005). The economic policy described by Smith was borrowed from the critics of mercantilist and Physiocrats. Physiocrats also opposed the viewpoint of mercantilists and stated that the worth of economy is not subjected to money, but production. However, according to Physiocrats, the foremost productive segment is agricultural industry. Physiocrats emphasised natural order and justified limited role of government in economy. Smith disagreed with the fact that agriculture is the sole source of production but agreed with low government intervention. Smith assumed that it was possible to determine the law of economy through scientific examination. Smith also assumed that human beings are rational and are largely driven by satisfying self-interests. Thus, in free circumstance, each individual will chase their own self-interest. In pursuit of self-interests, they eventually would stimulate the interests of society. Hence, in such a condition, government must not interfere in the procedure and must follow the policy of laissez faire market (Sandstrom, 2005). Components of Adam Smith’s Economic Viewpoint The economic viewpoint of Adam Smith shares certain basic components. These components are influenced by mercantilist and Physiocrats’ approach. One key difference between Smith’s thought and the thought of mercantilist was his supposition that competitive markets exist and within these markets the aspects of production move spontaneously in order to encourage economic benefits. The second difference was the supposition that a natural procedure of economy can resolve conflicts more efficiently than any provisions devised by people. Smith has used several terminologies in order to explain his thought on competitive markets such as division of labour, the invisible hand, government involvement and free trade. Division of Labour According to Smith, increase in productivity is an outcome of division of labour. Division of labour can only arise when people are permitted to exchange products and services. In this context, it can be stated that every employee has certain amount of tasks he/she is capable of exchanging with others within certain field of production. Furthermore, it has also been stated that trade is the key requirement of division of labour which in turn creates prosperity. Smith also argued that self-interest of people hence is the major force for trade along with creating prosperity. However, the procedure of trade and division of labour is restricted by the degree of market (Sandstrom, 2005). The Invisible Hand Adam Smith has developed the phrase named ‘the invisible hand’ which summarises the faith that market is determined by certain unseen instruments that enhance the wealth in society. Smith had also explained the reasons for which government is unable to create wealth. There are certain activities which cannot be undertaken by the government, because the level of information that market encompasses cannot be integrated to one public institution (Sandstrom, 2005). Government Involvement Adam Smith claimed that government involvement can be harmful for economy and can hinder the market from performing appropriately. Smith justified three aspects as to why government involvement can create an impact on market. Firstly, government can detain the numbers of players in a specific business. Thus, when the limited players of similar businesses confront, they tend to conspire against the public interests for enhancing the prices of products and services. Furthermore, when these actors are permitted to plan oligopoly, it can result in excessive costs, replicating a loss of public welfare. Secondly, government can enhance the competition beyond natural prerogative by providing subsidiaries. Thirdly, government can hinder the free circulation of workforce and resources. By doing so, employees and organisations obtain certain privileges that hinder perfect competition in the market (Sandstrom, 2005). Free Trade Adam Smith claimed that the objective of production is consumption. Thus, the protection of organisations by providing subsidies and imposing tariffs seems irrelevant, because it ultimately harms the interests of consumers as they are required to pay excessive prices for obtaining products or services. Additionally, by trade liberalisation, the cost of production can be reduced and affluence of economy can be increased (Sandstrom, 2005). Adam Smith’s Rule of Exchange in Competitive Market In order to understand the natural law which oversees the consistencies of economic life, Adam Smith had experimented prudently about the way business organisations function, markets are structured and prices of products are exchanged. Adam Smith also found the relationships between supply and demand that determine the prices of products and services. He had also explained the way in which complex economic and social undertakings are synchronised (Smith, 1985). Adam Smith had described the rule of exchange which plays a vital part in competitive market. Smith developed the terms namely ‘absolute demand’ and ‘effectual demand’. When an individual demands a product, it demonstrates absolute demand. However, when that particular individual describes the level to which he is actually eager to pay, it is considered as effectual demand. The market price of each product is determined by a fraction of quantity which is truly brought to the market and the demand of those individuals who are eager to pay the usual price of the product. These individuals are called effectual demanders and their demand may be adequate for supplying the products in the market (Smith, 1985). In order to overcome the natural poverty of humankind, Adam Smith focussed on the fact that there must be growth in resources. Resource accumulation can change the ratio of labour to capital which signifies that an extra unit of labour can generate more wealth than previous state. Hence, it can effectively promote the living standards of the population. Those individuals who are anxious about poverty must be concerned regarding increasing the resources in terms of capital, as it is the only method to enhance the lifestyle of people. Adam Smith had also shown that free market is perhaps the most benevolent establishment of economic system (Smith, 1985). Adam Smith used self-interest as the basis of motivation for consumers’ activities. Smith projected that sympathy is the tool by which motivation can be arbitrated. For Smith, free market is the only system where price generated by market appears ethically reasonable and can fulfil the requirements of commercial society. Adam Smith developed three theories i.e. relative price, labour cost theory and cost of production theory in order to evaluate the factors which determine prices of products and services in a competitive market. Relative Price Adam Smith clarified relative prices which are defined solely by the supply of products and prices of production. He believed that in competitive market, prices are determined by both supply along with demand. Smith’s evaluation regarding the creation of relative prices in the competitive economy is classified into two periods namely short-run and long-run, particularly in two broad sectors viz. agriculture and manufacturing. In the short-run period, Smith had observed that the demand curve is downward sloping and supply curve is determined as upward sloping. Smith’s view of natural price usually occurs in the long-run period. Concerning agricultural industry, Smith stated that the long-run supply curve is upward sloping, representing growing expenses. Though, in manufacturing segment, the long-run supply curve is frequently expected to be perfectly elastic, representing constant expenses. Thus, in manufacturing industry when long-run supply curve becomes elastic, the costs of commodities depend entirely on production. However, when it is downward sloping, natural prices of commodities are subjected to demand and supply (Menudo, 2011). Labour Cost Theory In accordance with the labour cost theory, Smith stated that the exchange value or prices of products is regulated by the level of labour where land and capital are non-existent or free. Smith had recognised that the quantity of labour required to generate commodities cannot simply be measured by work hours, because apart from work hours, the ingenuity or skill involved in the creation of products or services must be considered as a part of rule of exchange (Menudo, 2011). Cost of Production Theory Smith struggled with the development of labour theory in economy which comprises the constituent of labour expenses in the creation of finished products or services. However, he had abandoned the idea the labour theory was applicable to any advanced economy. Thus, he further explained the prices in competitive markets by cost of production theory. In this theory, the cost of commodities is subjected to the payment of every factor of production such as land and capital, apart from labour. In Smith’s economic system, profit comprises both revenue and interest. The total cost of production henceforth is equal to wages, profits and rent. On one hand, Smith assumed that average expenses are subjected to production and the prices of products and services depend on demand and supply. On the other hand, where competition prevails, he focused on the self-interests of people in order to determine the prices, i.e. the self- interests of businesspersons, labour and land owners can help to determine the natural prices which are equal to the cost of production (Menudo, 2011). The Working of Competitive Market The most important involvement of Adam Smith in his economic theory is his explanation on working of capital market. He was capable of identifying the mechanism whereby the price resulting from competition in the long-term becomes equal to the cost of production. In his evaluation of competitive market, he demonstrated market prices to be short-term in nature and natural prices of commodities to be long–term in nature. His key concern was the creation of long-term natural prices, rather than short-term market prices. He had observed competition as essentially necessitating large amount of sellers, a group of capital owners who are well-informed regarding revenue, wage, rent and the economy. Given this situation, the self-interests of sellers can result in the establishment of long-term natural prices at such level which would balance the rate of revenue, wage and rents within several industries of the economy. For instance, if the price of finished goods in a specific industry is more than long-term natural price then either revenue, wages or rent in this particular industry will be higher than its usual level. In such circumstance, amendments will happen through the movement of resources until the normal prices prevail. With free and competitive market and with the absence of government intrusion, the resulting normal price would bring about an optimum allocation of capital in such a level where consumers can obtain the commodities they desire at lowest possible prices and maximum rate of economic growth will be guaranteed (Bradley, 2010). Through the establishment of the theory of competitive markets, Adam Smith lucidly presented his viewpoints against monopoly market and government intervention. He identified the aspiration of business organisations to monopolise the trade by joining powers and also recognised that monopolists can extract a higher price from consumers by confining the level of output or supply. It is worth mentioning that Smith’s encouragement of free market presumed the presence of competitive markets. Several economic groups have impersonated Smith’s opinion about government intervention while disregarding his principle that a free market policy accepts the existence of competitive market. Nevertheless, Smith’s dispute about low level of government intervention has certain political, logical and economic reasons. He stated that in general, any kind of intrusion by government is undesirable as it violates the natural rights and freedoms of people. He studied several mercantilist principles on national and international business and demonstrated that these principles resulted in inappropriate distribution of resources in keeping with competitive market forces. Smith assumed that several mercantilist policies for government regulations, although claimed to encourage social welfare, in reality, promoted self-serving attitudes. The government regulations on national and international trade not only provide benefit for the nation, but it also renders benefit to the merchants. However, it was not purely a notional argument; rather it was derived from Smith’s individual observation about functions of government. He also stated that in several areas, government intervention was essential. For example, in infant industries, he had revealed his expectation that government should protect them by imposing various tariffs. Furthermore, government regulations are also essential when national defence deteriorated by the policies of free trade. It is the responsibility of government to provide national security, develop infrastructure such as roads and to maintain justice in the society. It is worth mentioning that Smith developed his argument for free market by advocating government provisions regarding such commodities that gave great social welfare, but are not solely supplied by private establishments. For example, the social welfare of education is considerably high and the revenue-earning prospect from this industry is also strong, but if the education industry is left free, it might result in the supply of less education than the desirable level. Thus, in this industry, government intervention is supported (Bradley, 2010). Adam Smith contributed numerous important concepts about the way in which capital helps to generate wealth in a competitive market that can in turn lead to economic progress. He pointed out that the affluence of a nation is subjected to capital accumulation as it can regulate division of labour and also the amount of population involved in productive labour. In the centre of every step taken by the government, the capital has been progressively hoarded by private prudence through their universal, constant and incessant effort to develop the lifestyle. This effort is protected by regulations and allowed by liberty to employ in such a way which can be most advantageous for economy. Besides, the self-interests of people together with accretion of capital results in the finest application of resources in several industries (Bradley, 2010). One key aspect of Smith’s view is that capitalists play a vital role in the functioning of competitive market. He stated that the pursuit of people to gain wealth and revenue can direct the economy to ascertain an effective utilisation of resources. In private organisations, the source of capital is primarily the savings of people. Smith believed that the labour cannot accrue capital as the level of wages can only satisfy the immediate desires for consumption. He observed that the members of land owning group have sufficient income to accrue capital, but they spend the income on uncreative labour in order to meet their enormous desire for maintaining luxury lifestyle. On the other hand, the members of industrial class usually strive for making more revenue and accumulating capital for increasing their wealth by way of higher savings and investments. These members are regarded as the benefactors of economy according to Smith. Smith stated that unequal distribution of income acts in favour of capitalist and it also allows economic progress (Bradley, 2010). Smith demonstrated that capitalists are not driven by unselfish purposes, rather by a desire to earn more revenue. Thus, capitalists’ view of market with respect to products in order to enhance revenue can produce such commodities which are desired by mass public. Furthermore, competition in capitalist market can help to minimise the cost of production. Thus, if profit beyond normal rate of return exists in any industry of an economy, other organisations will enter in those industries and force down the cost of production at such level where no additional profit exists. Capitalist puts their effort on numerous aspects of production, providing higher prices for more industrious aspects and thereby directing employees and resources in such segments of the economy where efficiency is optimum. In capitalist system, consumers direct the economy by their spending and any changes in consumers’ desires can determine the rise and fall of prices of products and therefore the profit. Smith established that less planning and less governmental direction can result in the fulfilment of consumers’ desires at lowest possible social expenses. In the lexicon of modern economics, he stated that the optimal provision of resources occurs in competitive markets without government intervention (Bradley, 2010). Conclusion Adam Smith’s viewpoints on competitive market have made great contributions towards the modern day’s capitalist economic system. He had provided a broad view regarding the method in which competitive markets can allocate the capital for the benefit of the economy. His key contribution about economic policies was that government must follow the strategy of free trade and must make less interference against businesses. The impact of his theory in present days’ industrialised economy is immense, particularly in developed nation such as in the United States or the United Kingdom. Although it should be noted that no single idea has influenced the development of modern day economy still the capitalist system proposed by Adam Smith has become the prime philosophy of the contemporary society and economists are endeavouring to encourage his thought in the underdeveloped and developed economies of the world. References Bradley, M. E. (2010). Adam Smith’s system of natural liberty: competition, contestability, and market process. Journal of the History of Economic Thought, 32(2), 237-262. Menudo, J. M. (2011). Market stability in Adam Smith: competitive process and institutions. Universidad Pablo de Olavide, 1-20. Sandstrom, C. (2005). Adam Smith’s view of the market and the government - An analysis of the wealth of nations. Goteborg University, 4-25. Smith, G. H. (1985). Adam Smith’s the wealth of nations, part 2. Retrieved from http://www.libertarianism.org/media/video-collection/cato-home-study-course-vol-5-adam-smiths-wealth-nations-part-2 Yardeni, E. 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