Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations (1776) is often hailed as the cornerstone of classical economics. It provides profound insights into the workings of economic systems that are still relevant today especially when it comes to understanding why prices fluctuate. Chapter 5 of this work addresses two concepts that might sound simple at first, but they’re fundamental in determining the actual value of goods: nominal price and real price.
Now, before you start thinking, “Ugh, economics,” take a deep breath! This isn’t your typical dry, boring economics lecture. Instead, we’re going to break it down in a fun and relatable way, so you can grasp the core concepts without feeling like you’re drowning in jargon. So let’s dive into what Adam Smith was really trying to say while throwing in a few fun stories and examples along the way!
Nominal Price vs. Real Price: What’s the Difference?
You might be wondering, “What are nominal and real prices, and why do I need to care?” Well, great question! Let’s make it as clear as possible, starting with the basics.
Nominal Price (Price in Money)
The nominal price is the one you see on the price tag or when you check out at the store. It’s the actual amount of money you pay for a good or service at that moment. It’s easy to spot and even easier to calculate just look at the price tag.
For example, imagine you’re shopping for a cool new pair of sneakers. If the sneakers are priced at $150, then that’s the nominal price. No questions asked. But here’s where it gets interesting: nominal price can be misleading, especially when you’re comparing prices over time.
Let’s say you bought the same pair of sneakers for $100 five years ago. So why are they now $150? Is the quality better? Did the sneaker company suddenly sprinkle magic dust on them? Well, no. What likely happened is that inflation or changes in the money supply pushed up the nominal price, making it seem like your sneakers cost more, even though they might be essentially the same product.
Inflation is kind of like the sneaky thief of the economic world. It doesn’t steal your stuff outright, but it slowly reduces the purchasing power of your money. So, if the nominal price keeps going up, it might not necessarily mean that the product is getting better—it could just be inflation doing its thing.
Real Price (Price in Labour)
Now, the real price is a bit different. Instead of measuring the price of goods in money, the real price is measured in labour or, more specifically, the amount of work required to produce or acquire that good. So, it’s the amount of effort or time it takes to produce something, which ultimately gives a better idea of its actual value in terms of what you have to “work” to obtain it.
For example, if you’re a baker and you bake a loaf of bread that takes you 3 hours to make, then the real price of that bread is 3 hours of your labour, regardless of what the price tag says. Even if the bread is being sold for $5, the real price is that 3 hours of work you’ve put in.
Why is this important? Well, because it’s the real price that reflects the true cost of production and, by extension, the real value of the commodity. The nominal price might rise due to inflation or changes in currency, but the real price remains a more consistent and reliable measure of a good’s true value.
Why Does the Difference Matter?
At this point, you might be thinking, “Why is it so important to distinguish between nominal and real prices? Aren’t they basically the same thing?” Well, the short answer is: No, they’re not! And here's why:
Imagine a scenario where you’ve been saving up for months to buy a new phone. You walk into a store, and the price tag reads $1,000. You’ve got the money saved, and you’re ready to make the purchase. But then, you start thinking: Was this phone really worth $1,000 when I could have bought something very similar for half the price just a couple of years ago?
This is where real price kicks in. The nominal price you’re seeing might be higher, but the real price could be telling a completely different story. It might show that, based on the amount of work (or labor) it takes to produce that phone, the true value hasn’t really changed much over time—what’s really changed is the amount of money in circulation due to inflation.
So, understanding the difference between nominal and real price allows you to assess the true cost and value of goods, rather than being tricked by price tags that may be inflated by external factors like inflation, supply chain disruptions, or changes in the money supply.
Related Posts
Inflation and Its Impact on Nominal Price
Let’s take a quick detour into inflation, because it’s a big player in how nominal prices fluctuate. Inflation is like that one friend who always shows up uninvited and doesn’t know when to leave. It’s constantly increasing the nominal price of things so, a sandwich you used to buy for $3 might now cost $5 after a few years. But does that mean the sandwich has gotten better? Maybe not. The sandwich itself might be the same, but the price has gone up simply because there’s more money in circulation, and people have more money to spend.
This is why nominal prices are often misleading, because they reflect changes in the money supply, not necessarily changes in the quality or quantity of the goods you’re buying.
The True Measure of Value
The real price, however, helps us measure productivity and efficiency. It asks, “How much work went into producing this item?” and “Can the average person afford to buy it with their income?”
For example, if you’re looking at the price of a loaf of bread, the real price helps you understand how much time or effort it takes to produce that bread. If bread is becoming more expensive over time, but the amount of labor required to produce it hasn’t changed, it’s a sign that inflation is at play. However, if the bread gets cheaper over time because of new technology or more efficient production methods, then the real price is actually going down.
This is crucial for long-term comparisons in economies. By looking at real price, we can see if people are actually becoming better off that is, if the average worker is able to afford more goods for the same amount of labor or if they’re just experiencing rising nominal prices without any real improvement in their standard of living.
Real Price as a Measure of Welfare
For economists and policymakers, understanding the difference between nominal and real prices is critical. When governments print more money to “stimulate” the economy, nominal prices can rise without actually improving the real welfare of the population. Real prices, however, give us a clearer picture of how well people are doing economically. If real wages (wages adjusted for inflation) are rising, that means people are actually better off, even if nominal wages are stagnant.
Adam Smith himself pointed out that to truly understand the wealth of a nation, we need to look beyond just the money in circulation and instead focus on the real cost of goods, which reflects the actual labor needed to produce them. Only then can we get a true sense of how much people are actually benefiting from the economy.
A Fun Example to Illustrate: Nominal Price vs. Real Price
Let’s wrap this up with a fun little thought experiment. Imagine that you’re in 1776, and you’ve just walked into a general store in London. You look at a loaf of bread and it costs, say, 1 shilling. Now, fast forward to 2025 you walk into a bakery, and that same loaf of bread costs $3. You’re thinking, “Wow, inflation sure made this bread expensive!”
But wait what if we told you that the real price of bread hasn’t really changed much? What if, in 1776, it took you 1 hour of work to afford a loaf of bread, and today it takes about 1 hour of work to buy a loaf of bread in the modern economy as well?
Even though the nominal price has increased, the real price—in terms of how much labor is required hasn’t changed much at all! And that’s the real takeaway here: the real price helps you understand how the economy is evolving in terms of productivity and labor value, not just money.
Why Understanding Nominal vs. Real Price Matters
In conclusion, understanding the difference between nominal and real prices is essential to truly grasp the nature of economic progress. While nominal price is what we pay for goods, it doesn’t always reflect the real value of those goods especially when inflation or changes in the money supply are in play. Real price, on the other hand, gives a more accurate measure of the value of goods based on the work required to produce them, allowing us to understand whether or not we’re truly getting our money’s worth.
So next time you’re out shopping and see a price tag that seems higher than you remember, think about this: Is the price rising because of inflation, or because the product itself has actually improved? And most importantly, is the real price still fair based on the labor required to make it?
It’s a powerful tool for understanding economic growth and true prosperity, and it’s all thanks to the insights of Adam Smith, whose ideas still echo through the halls of economics today.
Download the Ebook Now
To access the FREE Ebook of The Wealth of Nations, simply click link below and enjoy reading one of the most influential books in the history of economics.
Disclaimer: The ebook you will receive from the link provided is free of charge and is not being sold or used for any commercial purposes. We simply wish to share this invaluable knowledge with you.
If you're eager to dive deeper into the concepts and explore more insights, you can easily download the full eBook. Simply follow the link below and start your journey toward gaining a better understanding!
