Course Hero. "The Wealth of Nations Study Guide." Course Hero. 28 Sep. 2017. Web. 27 May 2018. <https://www.coursehero.com/lit/The-Wealth-of-Nations/>.
Course Hero. (2017, September 28). The Wealth of Nations Study Guide. In Course Hero. Retrieved May 27, 2018, from https://www.coursehero.com/lit/The-Wealth-of-Nations/
(Course Hero, 2017)
Course Hero. "The Wealth of Nations Study Guide." September 28, 2017. Accessed May 27, 2018. https://www.coursehero.com/lit/The-Wealth-of-Nations/.
Course Hero, "The Wealth of Nations Study Guide," September 28, 2017, accessed May 27, 2018, https://www.coursehero.com/lit/The-Wealth-of-Nations/.
Smith now moves on to profit, the second of his three major components of price. He first offers a caveat: profit is even harder to quantify than wages, because it fluctuates even more rapidly. With this in mind, he proposes to use the rate of interest as a proxy for profit, since high interest rates make people more likely to lend their money and less likely to invest it in industry. Based on historical data of England's interest rates, Smith infers that as the country's economy has developed, the profits of its various manufacturing industries have gradually decreased while wages in the same industries have increased. This trend, he suggests, extends to other countries: in rich and stable economies, like Holland, the rate of interest is low, but in emerging markets like the American colonies, it is high.
The latter half of the chapter deals with factors that temporarily raise or lower the rates of interest and profit. Profits and interest are high, Smith says, just after a new territory is acquired or a new trade route is discovered since there is a greater demand for capital as the new trading opportunity is developed. Likewise, "a defect in the law"—for example, poor enforcement of contracts—can keep interest rates artificially high. When people are afraid of losing their money for good, they will lend it out only at extremely inflated rates. Even a prohibition on charging interest can raise the market rate of interest because lenders will charge a premium for "the difficulty and danger of evading the law."
In the last few paragraphs, Smith returns to the relationship between rates of profit and interest—or, more precisely, to the lack of a stable relationship between the two, since there is no fixed proportion that can be applied to all markets. The chapter closes with a rather pointed societal observation. Employers, Smith says, "complain much of the bad effects of high wages ... [but] say nothing concerning the bad effects of high profits." This, he suggests, is disingenuous, since high profits have a disproportionate impact on the overall price of goods.
"The rise of profit," Smith asserts at the end of this chapter, "operates like compound interest." At first glance, the argument he uses to support this declaration seems reasonable enough, but it may be worth revisiting in a simplified form. To paraphrase Smith:
If merchant A begins with $100 worth of goods and sells them at a 5 percent profit to merchant B, then merchant B has, from his own perspective, bought $105 worth of goods. If B then sells these goods to merchant C at 5 percent profit, the price paid by C will be $110.25. Then, if C sells the goods to consumer D at the same rate of profit, the final sale price will be $115.76. If, instead, a single merchant sells $100 worth of goods at 15 percent profit, the sale price will be only $115.00.
So far, the scenario seems to add up: each merchant seeks a profit based on the price he paid for the goods, not on their original value. Smith, however, is oversimplifying a bit, as economist Edwin Cannan points out in his own 1904 edition of The Wealth of Nations. Although the "compound interest" analogy is true enough, as Cannan concedes, such compounding does not dramatically alter the final sale price to the consumer. In the above example, the "compound interest" effect translates to about 76¢; even if the interest rises to 10 percent per transaction, the compounding effect only adds $3.31 to the final sale price. The rate of profit must be quite high—and, by Smith's standard, 10 percent profit is already pretty high—before the compound-interest effect becomes significant. In many cases, including those proposed by Smith in this chapter, a modest increase in wages will have a much more pronounced effect on the overall price.