For some people, the concept of price might seem simple goods are priced at a certain value, and as consumers, we either buy them or we don’t. However, when we dig deeper, we realize that behind every price, there's a much more complex dynamic at play. What we imagine about prices is often influenced by numerous factors that we may not be aware of. One of the great thinkers who explored this in depth is Adam Smith in his monumental book "An Inquiry into the Nature and Causes of the Wealth of Nations".
His writing doesn’t just focus on how nations can be wealthy or poor, but also lays out the foundational principles that govern economies, including the theory of natural price and market price. In Book I, Chapter 7, Smith introduces these concepts in a manner that is both systematic and easy to follow. Although written in 1776, many of the theories he proposed are still highly relevant to today’s modern economy. So, what can we learn from Smith’s ideas on price, and how can we apply them to our everyday lives? Let’s explore.
What are Natural Price and Market Price?
To the average person, the price of an item is simply the number on the price tag, but as Adam Smith explains, prices don’t just appear out of nowhere. There’s a long process that involves various economic elements, which shape what we call the natural price and market price.
Natural Price
According to Smith, the natural price is the price of goods that "should" prevail in the market, one that is enough to cover all the costs involved in producing the goods. This includes three main components: land rent, labor wages, and profits for capital owners. In other words, the natural price is the price that reflects the actual cost of producing that good, along with the income that is justifiable for the economic players involved.
However, this price doesn’t always materialize because there are many external factors that influence price movements. That’s where the concept of market price comes in.
Market Price
Market price is the price that we actually pay for a good in the market—it can be higher, lower, or the same as the natural price. In practice, market price is heavily influenced by two primary factors: demand and supply. Smith emphasized that market prices can rise or fall depending on how much of a good is available compared to how much people want to buy it. If there’s more of the good than people want, the price will likely fall. Conversely, if demand is high and supply is limited, the price will rise.
However, what’s interesting is that market price is not always stable. Sometimes, market prices move quite far from the natural price, and this is what Smith focuses on in his theory of price.
External Factors Affecting Price
Demand and Supply
Let’s picture a very popular restaurant in town. Every time you try to go eat, the place is packed, and you have to wait for a seat. Why? Because the demand for the restaurant is high while the number of available tables is limited, which influences the price. In this case, the restaurant is charging a higher market price because demand consistently exceeds supply. On the other hand, if the restaurant decides to open more branches, increasing the supply of seats while demand stays the same, the price would likely return to something closer to the natural price.
Smith explains that this is exactly what happens in markets overall. When supply exceeds demand, prices drop. Conversely, when demand exceeds supply, prices rise.
Monopoly Influence
Sometimes, markets are not competitive, and this can cause prices to be much higher than the natural price. One key factor that can cause this is monopoly. When there’s only one company controlling the market for instance, in the tech industry this company has the power to set prices without the fear of competition. This is what happens with market monopolies, where prices are often set much higher than the natural price due to the lack of competition.
Smith also reminds us that monopolies are often detrimental to consumers because the prices they pay are much higher than they should be. This leads to market inefficiency, where resources are not optimally utilized and consumers are forced to pay more for goods that could be cheaper.
Seasonal and Natural Factors
A quick anecdote every time harvest season comes, vegetable prices usually drop because of the abundant supply. However, if there’s a natural disaster or bad weather that disrupts the harvest, prices for those same vegetables can shoot up. In this situation, we see how natural and seasonal factors influence price dynamics. In a broader context, this is why agricultural commodities can be highly volatile.
Smith describes this in terms of agriculture when crops are plentiful, market prices tend to fall. But if crop yields are low due to bad weather or a natural disaster, prices rise. So, even a slight change in weather can have a significant impact on market prices.
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The Role of Time in Natural Price and Market Price
One interesting concept discussed by Adam Smith is time—how price fluctuations can vary in the short-term and long-term. Smith explains that although market prices can fluctuate drastically in the short-term, in the long run, market prices will tend to revert to natural price. Why? Because markets are always gravitating towards equilibrium, where supply and demand meet. When prices go too high, more players will enter the market, increasing supply, and eventually driving prices back to their normal levels.
However, in the short term, especially in sectors like agriculture or seasonal goods, prices can be volatile. For example, staple food prices such as rice, corn, or wheat often experience sharp increases in certain seasons. This is because supply is uncertain or seasonal. Meanwhile, prices for manufactured goods or mass-produced items tend to be more stable year-round.
Why Do Market Prices Tend to Revert to Natural Price?
One of the most intriguing aspects of Smith’s theory is the concept of gravity in pricing. While market prices can soar well above the natural price for a period, over time, they tend to return to the equilibrium point the natural price. This is because when market prices rise, more traders are incentivized to enter the market, thus increasing supply, and ultimately lowering the price back to its natural level.
However, it's important to note that sometimes market prices can remain high above the natural price for extended periods due to factors such as government regulations, monopolies, or natural disasters. But, in general, the market will always seek equilibrium.
Applications of These Concepts in E-Commerce
For those involved in the e-commerce world, understanding the difference between natural price and market price is crucial. For example, when there is a sudden surge in demand for a particular product—such as masks or hand sanitizers during a pandemic—merchants will see an opportunity to raise prices to match the increased demand. While this might boost their profits in the short term, savvy merchants understand that prices will eventually return to normal once supply catches up.
In the online world, if you sell a product at an inflated price, even with high demand, you might lose customers who are searching for a better price. On the other hand, if your price is too low, you may not be able to cover the costs of production and distribution.
Understanding Price Dynamics in Everyday Life
Using the principles Adam Smith laid out, we can gain valuable insights into how markets function. From the natural price, which reflects the actual costs of production, to the market price, which is influenced by demand and supply dynamics, we see that price is not a static number. In the world of economics, prices are constantly moving, adapting, and reacting to changing market conditions.
Are you ready to become a smarter trader? By understanding these basic principles, you can not only optimize your product pricing but also gain a better understanding of how prices are affected by factors that may not always be visible on the surface. Whether you're dealing with physical goods or digital products, these concepts are essential to navigating the modern economic landscape.
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