The price of production of commodities is determined by the cost of production (c + v) plus the average profit. For any type of product, capital will only be advanced if its market price is sufficient to produce that average profit. As wages, interest and rent all appear as costs of production, they all appear, therefore, as determinants of the price of production. If, in some particular sphere of production, wages are at a level which raises the cost of production to a level where the average profit cannot be made, firms will allocate capital to other spheres, attempt to lower wages or introduce labour-saving technologies, to reduce labour costs. The same with rents. High rental levels will encourage capital to either invest in higher profit production, or else to invest in more intensive farming methods that require less land.
“... the market prices in each sphere are continually reduced to the cost-price as a result of the competition between the capitals of the different spheres. Competition amongst the capitalists in each individual sphere seeks to reduce the market price of commodities to their market value. Competition between capitalists of different spheres reduces market values to common cost-prices.” (p 517)
In other words, in each sphere, different firms will produce with different cost structures. The individual value of output of each firm will be different. Averaging out these different individual values gives a market value for that type of production. Some firms, will, therefore, produce at above, below or at this market value. But, competition between them means that they all must sell at the market value, so that those who produce output with an individual value above the market value will make less than the average profit for this particular sphere. The opposite applies to those that produce output with a lower individual value than the market value.
This competition will encourage each individual firm in that sphere to produce as efficiently as the most efficient firm. The more efficient firms will accumulate capital more quickly, and vice versa. When crises occur, the least efficient firms will go bust, and their capital and market share will be seized by the more efficient firms. But, whilst this process, thereby, creates a single market value, and average rate of profit for this particular sphere, the same process occurs in all other spheres. The average profit in one sphere is not the same as the average profit in other spheres, because the organic composition of capital, and rate of turnover of capital differs in one sphere compared to another. Whereas competition within each sphere causes capital to seek out the most efficient method of production, it leads capitals in low profit spheres to accumulate more slowly, and to migrate to higher profit spheres. The consequence is to then create an average rate of profit for all spheres.
It then appears that this average profit is just as much a cost of production as wages, rent or interest, because it is a market price that must be paid for entrepreneurship. In the terms of Adam Smith, it is a necessary price for entrepreneurial labour. Smith, in the vulgar elements of his theory, reverses his analysis that the value of commodities is determined by the quantity of labour required for production, and instead makes it equal to the sum of the costs of production, each of which is, in turn, determined by the natural price of that factor. If the market price of any factor varies from its natural price, competition will lead to less of that factor being employed, and more of some other factor, so that equilibrium is restored.
“Ricardo opposes Smith’s establishment of value out of the parts of value which are determined by itself. But he is not consistent. Otherwise it would have been impossible for him to argue with Smith whether profit, wages and rent or, as he says, merely profit and wages, enter into price, that is, enter as constituent parts.” (p 517)
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