Natural Prices and Market Prices
According to Smith, the market economy functions in a fairly satisfactory way: for each commodity, the flow of production coming out of the firms more or less corresponds to the flow of the demand coming from the buyers even if exchanges take place freely and the decisions on quantities to be produced, sold and acquired and on exchanges and prices are decentralised. It is the market that links up the productive units operating in the different sectors of the economy, in two distinct ways: through market exchanges each productive unit obtains from the others what it needs to continue its activity in exchange for its own product; through competition, a co-ordination of the myriad of decentralized decision centres is realized.
Smith considered two kinds of competition. The first is internal to the market for each commodity: each buyer seeks among the sellers the one that sells the desired commodity at the lowest possible price; the seller who asks too high a price risks being left with unsold merchandise. Similarly, each seller seeks among the buyers the one that is ready to pay the highest price; the buyers offering too low a price risk being left empty handed. Under ideal conditions, when competition among the sellers and among the buyers does not meet with obstacles, the price of each commodity is one and the same for all the buyers and all the sellers: the so-called ‘law of one price’. The second kind of competition concerns the capitalists in search of the employment that offers the highest returns on their capital. When capitalists are free to move their capital from one sector to another in search of the most fruitful employment, it is not possible for a sector to offer capitalists a return higher than that obtainable in other sectors, since otherwise new capital would flow into it, with the consequence that production would increase, the market price would diminish, and with it also profits and the rate of return. In the same way, it is not possible for a sector to offer capitalists a return lower than that obtainable in other sectors, since otherwise there would be an outflow of capital from that sector, causing a fall in production, with an ensuing rise in the market price and hence in profits and in the sector’s rate of return. Therefore, under free competition the return on capital - the rate of profits - tends to be equal in all sectors. In this way the ‘competition of capitals’ links up in a single capitalistic market the different sectors of the economy.
These two kinds of competition underlie the market adjustment mechanism based on the relationship between market and natural prices: when production of a commodity is in excess of the ‘effectual’ demand (i.e. the quantity that buyers are prepared to absorb at the natural price), then competition between sellers will drive the market price below the natural price: the producers will be unable to obtain the ‘natural’ profits, and an outflow of capitals from that sector will take place; production will decrease, and the excess supply will thus be absorbed.
It was in connection with this adjustment mechanism that Smith (1776, pp. 75, 77) used the famous ‘gravitation’ analogy:
The natural price, therefore, is, as it were, the central price, to which the prices of all commodities are continually gravitating ... But though the market price of every particular commodity is in this manner continually gravitating, if one may say so, towards the natural price, yet sometimes particular accidents, sometimes natural causes, and sometimes particular regulations of police, may, in many commodities, keep up the market price, for a long time together, a good deal above the natural price.
Many authors interpreted the metaphor of gravitation as if it implied a theory of market price based on supply and demand. This idea is in fact totally alien to Smith’s thinking: both because the market price, as we have seen, is not a theoretical variable for him but an empirical correlate and because the reference to gravitation itself, which seems to imply a precise theoretical structure, that of Newton’s theory (in which the behaviour of the body that gravitates around another one is described by precise mathematical laws) is in fact quite vague, as testified among other things by the fact that in each of the two sentences in which the term ‘gravitation’ appears, it is accompanied by expressions (‘as it were’, ‘if one may say so’) that point to its use as an imprecise metaphor. In Smith’s times, the terms ‘demand’ and ‘supply’ did not indicate stable and well-identified functional relations connecting price and quantity of a commodity but a set of fortuitous or contingent elements that cannot be reduced solely to technological (economies and diseconomies of scale) or psychological factors (consumers’ preferences).
Smith only suggested that the market price will be above the natural price when for any reason supply proves lower than the ‘effectual’ demand and below it when the opposite holds true; moreover, deviation of the market from the natural price will provoke reactions on the part of buyers and producers that favour resolution of the disequilibrium situation. The concrete action of these general rules depends on circumstances, and it is not therefore possible to formulate precise reaction functions for the market prices to the disequilibria between demand and supply and of these two latter variables to the prices.
Thus, for Smith gravitation is no more than a metaphor used to evoke the role of competition as a force making for the stabilisation of the market. This is also the role of the ‘invisible hand’ metaphor, which, moreover, Smith uses only once in The Wealth of Nations and in a specific context (the capitalists’ preference for investing in the most profitable sectors of the national industry rather than in foreign countries, although motivated by personal interest, has a positive effect for society since it tends to increase the national income, as ‘led by an invisible hand’).
-  Cf. Smith 1776, p. 456. The term ‘invisible hand’ is used only twice elsewhere by Smith,in different works and contexts (the History of Astronomy, III.2: Smith 1795, p. 49; andThe Theory of Moral Sentiments, IV.1.10: Smith 1759, p. 184) and, moreover, at least onthe first of these occasions, in ironical tones. The theme of the ‘invisible hand’ began to bepropounded only after the development of the axiomatic general economic equilibriumtheory and the two ‘fundamental theorems’ of welfare economics according to whichperfect competition ensures an optimal equilibrium and any optimal equilibrium may beinterpreted as the outcome of a perfectly competitive market. Attributing to Smith theidea of the market as an invisible hand that leads to optimal equilibria is instrumentalto interpreting modern theory as crowning the Smithian cultural design. In reality,however, the two views are quite different. Cf. Roncaglia 2005b.