"The Wealth of Nations" about Market Fluctuations

It has been almost two years since I published a hub titled “What Is Missing In Microeconomics Textbooks”. I have been thinking about the issue of market fluctuations incessantly. Now I regard market fluctuations as an important part of demand-supply mechanism and cannot see Basics sections in Microeconomics textbooks without this element. It seems so obvious to me that I cannot comprehend the reasons why it is not the case in the books I am acquainted with. One cannot even find the terms “fluctuations”, “fluctuate” in textbooks’ indexes.

At some point I decided to reread “The Wealth of Nations “ to figure out what Adam Smith has to say about that.

Does the author of “The Wealth of Nations” use the term “fluctuate” in his basic theory of markets?

In Chapter V11 “Of the Natural and Market Price of Commodities” Adam Smith writes: “When the price of any commodity is neither more nor less than what is sufficient to pay the rent of the land, the wages of the labour, and the profits of the stock employed in raising, preparing, and bringing it to market, according to their natural rates, the commodity is then sold for what may be called its natural price. … The actual price at which any commodity is commonly sold is called its market price. It may either be above, or below, or exactly the same with its natural price”(p.62). “The natural price, therefore, is, as it were, the central price, to which the prices of all commodities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them down even somewhat below it” (p.65), “…the quantity produced by a given amount of industry sometimes fluctuates”(p.66).

So Adam Smith does use the terms “fluctuate” and “fluctuations”, but it makes sense only if there is something around which the market price fluctuates. In “The Wealth of Nations” it is natural price.

The difference between the notions of equilibrium and natural price aside (although it is an interesting subject in itself), there is a good reason why the fluctuations aspect of the demand –supply theory should be honored.

Fluctuations have something to do with market efficiency. When market is in equilibrium, the resources are distributed efficiently. If the price is different from equilibrium one, there is deadweight loss, meaning some loss of effficiency.

When the price fluctuates, it deviates from equilibrium price, therefore there is inevitable efficiency loss, despite the fact that fluctuations may eventually abate. At the final equilibrium stage market is efficient, yet before that it is not. The larger the amplitude of fluctuations, the bigger the losses, caused by fluctuations.

There are always fundamental factors at work, of course, shaping the direction of price change. Fundamentals rarely change abruptly, except for crisis situations.

Suppose the fundamentals cause the price to change like this:

But such smooth dynamics rarely happens in real markets. More often than not it goes like this:

So fluctuations superimpose themselves on the trend. They do not change the trend substantially. Probably, these are different from fundamentals factors.

I think fluctuations of the market price are primarily the result of changing expectations of the market price on the part of market agents.

The links below refer to my other hubs showing how the above connection plays in the markets.

Literature cited:

1. Smith, Adam. The wealth of nations. The modern library, New York, 2000.