Economics 101: Who Sets Prices?


by Alasdair Macleod, GoldMoney:

Since the advent of nineteenth century socialism, politicians and economists in the centre ground have argued for a balanced approach, where vital services are provided by the state, and capitalism is left to provide the rest. Vital services in a modern economy are taken to include pensions, unemployment and disability benefits, healthcare and education. Most states also provide communications, such as rail and road infrastructure, electrical grids and perhaps telecommunications. They often own and operate on behalf of the people utilities, such as the railways, ports, electricity and water.

The rest they regulate. There is hardly a product or service in the private sector unregulated by government. So far as the public is concerned, they see the benefit of a state acting in its behalf, protecting it from the uncertainties in life, and from unscrupulous profit-seeking businessmen. People do not stop to consider that the state and its necessary bureaucracy is less efficient at protecting individuals than the individuals protecting themselves. Nor do they understand the enormous burden on them of having the state act in an economic role.

The central question, why the state is less efficient than free markets, is answered by understanding prices. Should they be set by the state, or by the consumer? The consumer exercises choice. The state intervenes to restrict choice. This article seeks to demonstrate why government services always come at a higher cost than the same services provided by free markets.

The position of Austrian economists
Last week, the Mises Institute published an article by Robert Murphy, explaining why Ludwig von Mises described the consumer as sovereign, and why Murray Rothbard contradicted Mises, and urged his followers to “reject the notion of consumer sovereignty as an inaccurate political metaphor”.[i]

Rothbard’s criticism appears to be semantic, based on a purist argument that the phrase confuses a political statement for an economic one. What von Mises actually meant is that in a capitalist economy all production of goods and services is aimed at satisfying consumer demand, and it is the consumer who ultimately decides what is bought and at what price. And we are not just talking of the retail sector. Retailers through their demand for supplies from wholesalers, importers and manufacturers pass the signals from consumers back up the chain, imparting valuations to the productive process and to the pricing of raw materials.

Rothbard agreed with this entirely. Rothbard’s criticism of consumer sovereignty appears to be a very minor poke at his mentor, but it also betrays a different approach to explaining price theory in his Man, Economy, and State from von Mises’s Human Action. We should bear in mind Rothbard addressed a predominantly neo-Keynesian audience, when the first edition of his book was published in 1962. In the first part of his book, Rothbard deploys charts and examples to show relationships between price and quantity of goods and enters into a discussion of supply and demand schedules. No charts can be found in von Mises’s earlier Human Action, though taken as a whole, the message is the same.

It is easy to confuse Rothbard’s approach to prices with the mathematical one taught by the economic establishment. But the mathematical economists take us in the direction of a static market devoid of evolution and shorn of the dynamics of time. This is where Rothbard differs from today’s mainstream.

The mainstream assumption is equational maths, illustrated by charts, is the way to go. If so, a computer replicating the calculus behind supply and demand curves could accurately model prices, something that is yet to be achieved, even allowing for developments in artificial intelligence. Those who think consumer demand can be replicated by algorithms fail to distinguish between a static economic model and the dynamic world which is ever-changing. This point is fully acknowledged by Rothbard in his approach. Furthermore, he understands, as von Mises did, that the British classical school with its theory, that prices are determined by costs of production, did not accord with reality.

A different approach is found in European subjective value theory, originally developed by the scholastics in the Middle Ages, and taken up by the likes of Cantillon, Turgot and Say. It was Carl Menger, the founder of the Austrian school, who linked the two approaches by explaining that it was marginal supply, satisfying the least important use for a consumer, that sets the price of a good. Therefore, a greater level of supply, by satisfying less important uses leads to a fall in price, while a reduction in supply only satisfies more important uses, leading to a higher price.[ii]

If it is use-value that sets prices, then clearly it is the needs and wants of consumers that decide them. Hence von Mises’s metaphor, that the customer is sovereign.

We are dealing with non-financial assets here. The buying and selling of financial assets should be regarded as a separate subject, where the roles of participants in an exchange are not so neatly delineated. But there is a crossover which must be mentioned: since Rothbard wrote his Man, Economy, and State the prices of commodities have become increasingly distorted by derivatives, which are no longer simply used to iron out seasonality in agricultural production. They represent an extra source of paper supply that is never consumed, but because little or no distinction is made between physical commodities and financial derivatives, an increase in the supply of the latter suppresses relatively prices of the real thing.

Even putting derivatives to one side, it is clear that the question of who takes the lead in determining prices has become a broader subject than it was when the concept of marginal utility was established by Menger in 1871.[iii] The subject, is of course, almost limitless. This article will be confined to some brief comments designed to put consumer subjectivity into a modern context.

The importance of price subjectivity
It is assumed for the purpose of this article that all price changes in consumer transactions come from the product, and not from changes in the purchasing power of money. In other words, in individual exchanges the exchange value of money is regarded as fully objective, and the value of goods and services as fully subjective. For money to function as money, this must be true, notwithstanding the changes in purchasing power for money that always occur all the time, as evidenced in the foreign exchanges and the continual fluctuations in the price of gold.

This means that all subjectivity in value must be confined to the goods and services involved in individual purchases. Within the objective/subjective framework, the seller desires money more than the goods or services being sold, whether he is purely a trader for profit, or a retailer. And if the buyer agrees to buy, at that moment he desires the product more than the money exchanged at the price.

There continues to this day to be confusion over what criteria sets a price. Is it the cost of exploited labour, as Marx proclaimed and is still accepted by modern socialists to this day, or is it the cost of production, as Adam Smith and the classical British school averred? Keynes ducked the issue. As stated above, Menger demonstrated it was neither. Monopolies aside (which I’ll come to in a moment) prices are set by what a buyer will pay, and that will depend on the value to him he puts on a product. The reason this is so is the buyer can always refuse to pay a price he believes is too expensive, while a producer must sell his product or face going out of business. And as a reality check, note that manufacturers usually think in terms of price points: a motor manufacturer will aim for a price that in its judgement the market will pay for a motor car of particular specifications, in the context of competitive offerings. Costs will then be adjusted to ensure the proposition is profitable instead of being price determined on a cost-plus-margin basis.

The consumer normally has a choice of similar products from several different sources. Furthermore, his earnings and savings, except for the very wealthy, are necessarily limited, and he must choose on what to spend his limited funds. He will therefore only buy the goods and services that satisfy his requirements most, relegating subsequent purchases to items of decreasing importance. All consumers, except the few very rich, have to choose, to prioritise. And the very rich will simply save what they don’t spend.

It is for these reasons that manufacturers and service providers tailor their costs to what consumers are prepared to pay. And the level of prices for a particular good depends on the relationship between supply and demand, which in turn is determined by the usefulness, or utility of the item to those wishing to acquire it.

Change of use can dramatically change prices
If the purpose for which a good is demanded changes, the price will change as well, in accordance with Menger’s marginal price theory. An alternative use-value can have an enormous impact on prices, as the history of silver pricing demonstrates.

Silver had a value as money, which when governments dropped it in favour of gold led to a price adjustment that reflected new demand levels for its use for other purposes. Sir Isaac Newton, when he was Master of the Royal Mint had determined silver’s monetary value at fifteen and a half ounces to one ounce of gold, a level which broadly held until the 1870s. Commodity markets now set the ratio at about eighty to one. Newton’s ratio was his best-guess at silver’s value at the time, when its role was as money on a bimetallic standard with gold. When the world of sound money moved exclusively to gold, commencing in the late nineteenth century, silver’s use as money become confined to coins as a money-substitute. Its price, measured in gold, fell.

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