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How are prices set? What role does competition play in an economy? Do markets actually regulate themselves if they’re free?
In The Wealth of Nations, Adam Smith argues that free markets are the most efficient way of directing the production and exchange of goods to grow a nation’s wealth (and thereby enable the specialization of labor). He explains the mutually-beneficial interplay of markets and prices.
Read more to understand Smith’s argument that market self-regulation really works.
How Market Self-Regulation Works
To understand how market self-regulation works, we’ll first take a look at two sides of a mutually reinforcing system: how market conditions influence the price of goods, and how prices regulate market behavior. Then we’ll take a look at the forces behind the scenes that determine the natural prices of goods in a balanced and competitive market.
How Markets Regulate Price
The ratio between supply and demand regulates the price of any good. The supply is the amount of a good that sellers are bringing to market. The demand is the amount of a good that customers want to buy.
Smith explains that, if demand is higher than supply, the customers will have to compete with each other. They will compete by offering more money for the same good than the next customer, thus driving up the price. However, if supply outweighs demand, then the sellers will have to compete with each other by lowering prices.
| The Role of Market Competition For the supply and demand system to work, sellers must compete with other sellers, and buyers must compete with other buyers. Therefore, there are two market structures that must be avoided to keep this system in balance: monopolies and monopsonies. A monopoly occurs when markets are dominated by a single seller who doesn’t have to compete. This allows the seller to raise prices to the highest that customers are willing and able to pay. A monopsony occurs when markets are dominated by a single buyer. This sometimes happens in labor markets where one company employs most of the workforce in a small town. There are differing theories on whether governments should take an active role in breaking up monopolies or monopsonies to maintain competitive markets. Nations have a vested interest in the benefits of market competition and are therefore justified in interfering to prevent consolidation. Others fear that this may be a form of manipulation that prevents markets from functioning independently. They contend that consolidation sometimes happens as a result of a preference for a particular company. |
How Prices Regulate Markets
The fluctuation of price regulates markets to naturally create balance between suppliers and customers. Smith states that, as long as there is free competition, and buyers and sellers pursue their own self-interests, the supply of goods will naturally balance itself out to meet the demand for those goods.
To understand this process, we need to consider how it plays out over time. If demand for a good outweighs supply of that good, customers will bid against each other—driving up the price of the good. Guided by their economic self-interest, the sellers will have a strong incentive to bring more of that good to market to take advantage of these high prices.
However, if, in doing so the sellers then bring more of the good to market than customers want to buy, the sellers will then have to sell the good for less money to compete with other sellers’ prices. Guided by self-interest, sellers will naturally bring less of that good to market until supply meets demand. This allows market systems to efficiently balance the production of goods to their demand.
(Shortform note: Economists have found that the process of prices regulating markets works most efficiently when the participants have access to accurate information about pricing. If customers don’t have accurate information about the prices offered by competing sellers, they won’t be able to compare prices as easily and force sellers into competition with each other. Furthermore, sellers who have more information about their competitors’ prices will have an advantage over those who have less information. In reality, it’s impossible for everyone to have perfect information all the time, but markets work more efficiently when participants have accurate and up-to-date information informing their decisions.)
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1 – Adam Smith is dead
2 – Adam Smith was less the “Father of Capitalism” and more the “Codifier of Free Market Economics”, which is very clearly not the model of markets this version of Capitalism is running on
2b – Proof of that is by the time he wrote what he had we’d already seen the Dutch Tulip Mania and the first Ponzi Scheme and precursor to Crypto/FTX via the Hollow Blade Sword Company/South Sea Bubbles collapses