Every price, Smith demonstrates, resolves itself into three component parts: wages, profit, and rent. Understanding what determines each component is the foundation of any accurate assessment of economic conditions — whether of a market, an organization, or a strategic position.
The Three Components
- WagesDetermined by the contract between masters and workmen. When masters compete for workers, wages rise. When workers compete for positions, wages fall. The subsistence level sets the floor — below which workers cannot be recruited or retained. Prosperity raises wages; stagnation holds them flat; decline reduces them.
- ProfitThe return on stock after wages and rent are paid. Profit rates are highest in new markets and declining industries — high because risk is high or because competition has not yet arrived. As competition increases, profit falls toward the minimum rate that makes investment worthwhile.
- RentThe price paid for the use of land or any resource whose supply is fixed. Rent is determined by what remains after wages and profit are deducted from the produce — it is the residual, not the determinant. The landlord extracts what the market will bear, constrained by the returns available elsewhere.
Strategic Application
When assessing the health of any operation, identify what proportion of its output goes to wages, profit, and rent. An operation where wages are rising, profit is stable, and rent is controlled is in a healthy condition. One where rent is rising and profit is falling is being extracted from outside — the strategic response is either to reduce dependence on the fixed resource or to increase output sufficiently to absorb the rent increase.