Formation and Function of Prices
FEBRUARY 01, 1965 by HANS SENNHOLZ
For almost two thousand years economic investigation was handicapped by the common notion that economic exchange is fair only as long as each party gets exactly as much as he gives the other. This notion of equality in exchange even permeated the writings of the classical economists.
Back in the 1870′s the Englishman Jevons, the Swiss Walras, and the Austrian Menger irrefutably exploded this philosophical foundation. The Austrian School, especially, built a new foundation on the cognition that economic exchange results from a difference in individual valuations, not from an equality of costs. According to Menger, "the principle that leads men to exchange is the same principle that guides them in their economic activity as a whole; it is the endeavor to insure the greatest possible satisfaction of their wants." Exchange comes to an end as soon as one party to the exchange should judge both goods of equal value.
In the terminology of the economists, the value of a good is determined by its marginal utility. This means that the value of a good is determined by the importance of the least important want that can be satisfied by the available supply of goods. A simple example first used by Böhm-Bawerk, the eminent Austrian economist, may illustrate this principle.
A pioneer farmer in the jungle of Brazil has just harvested five sacks of grain. They are his only means of subsistence until the next harvest. One sack is absolutely essential as the food supply which is to keep him alive. A second sack is to assure his full strength and complete health until the next harvest. The third sack is to be used for the raising of poultry which provides nutriment in the form of meat. The fourth sack is devoted to the distilling of brandy. And finally, after his modest personal wants are thus provided for, he can think of no better use for his fifth sack than to feed it to a number of parrots whose antics give him some entertainment.
It is obvious that the various uses to which the grain is put do not rank equally in importance to him. His life and health depend on the first two sacks, while the fifth and last sack "at the margin" has the least importance or "utility." If he were to lose this last sack, our frontier farmer would suffer a loss of well-being no greater than the pleasure of parrot entertainment. Or, if he should have an opportunity to trade with another frontiersman who happens to pass his solitary log cabin, he will be willing to exchange one sack for any other good that in his judgment exceeds the pleasure of parrot entertainment.
But now let us assume that our frontier farmer has a total supply of only three sacks. His valuation of any one sack will be the utility provided by the third and last sack, which affords him the meat. Loss of any one of three sacks would be much more serious, its value and price therefore much higher. Our farmer could be induced to exchange this sack only if the usefulness of the good he is offered would exceed the utility derived from the consumption of meat.
And finally, let us assume that he possesses only a single sack of grain. It is obvious that any exchange is out of the question as his life depends on it. He would rather fight than risk loss of this sack.
The Law of Supply and Demand
This discussion of the principles of valuation is not merely academic. In a highly developed exchange economy these principles explain the familiar observation that the value and price of goods vary inversely to their quantity. The larger the supply of goods the lower will be the value of the individual good, and vice versa. This elementary principle is the basis of the price doctrine known as the law of supply and demand. Stated in a more detailed manner, the following factors determine market prices: the value of the desired good according to the subjective judgment of the buyer and his subjective value of the medium of exchange; the subjective value of the good for the seller and his subjective value of the medium of exchange.
In a given market there can be only one price. Whenever businessmen discover discrepancies in prices of goods at different locations, they will endeavor to buy in the lower-price markets and sell in the higher-price markets. But these operations tend to equalize all prices. Or, if they discover discrepancies between producers’ goods prices and the anticipated prices of consumers’ goods, they may embark upon production in order to take advantage of the price differences.
Value and price constitute the very foundation of the economics of the market society, for it is through value and price that the people give purpose and aim to the production process. No matter what their ultimate motivation may be, whether material or ideal, noble or base, the people judge goods and services according to their suitability for the attainment of their desired objectives. They ascribe value to consumers’ goods and determine their prices. And according to Böhm-Bawerk’s irrefutable "imputation theory," they even determine indirectly the prices of all factors of production and the income of every member of the market economy.
The prices of the consumers’ goods condition and determine the prices of the factors of production: land, labor, and capital. Businessmen appraise the production factors in accordance with the anticipated prices of the products. On the market, the price and remuneration of each factor then emerges from the bids of the competing highest bidders. The businessmen, in order to acquire the necessary production factors, outbid each other by bidding higher prices than their competitors. Their bids are limited by their anticipation of the prices of the products.
The pricing process thus reveals itself as a social process in which all members of society participate. Through buying or abstaining from buying, through cooperation and competition, the millions of consumers ultimately determine the price structure of the market and the allocation of the income of each individual.
Prices Are Production Signals
Market prices direct economic production. They determine the selection of the factors of production, particularly the land and resources that are employed—or left unused. Market prices are the essential signals that provide meaning and direction to the market economy. The entrepreneurs and capitalists are merely the consumers’ agents, and must cater to their wishes and preferences. Through their judgments of value and expressions of price, the consumers decide what is to be produced and in what quantity and quality; where it is to be produced and by whom; what method of production is to be employed; what material is to be used; and they make numerous other decisions. Indeed, the baton of price makes every member of the market economy a conductor of the production process.
Prices also direct investments. True, it may appear that the businessman determines the investment of savings and the direction of production. But he does not exercise this control arbitrarily, as his own desires dictate. On the contrary, he is guided by the prices of products. Where lively demand assures or promises profitable prices, he expands his production. Where prices decline, he restricts production. Expansion and contraction of production tend to alternate until an equilibrium has been established between supply and demand. In final analysis, then, it is the consumer—not the businessman—who determines the direction of production through his buying or abstention from buying.
If, for instance, every individual member of the market society were to consume all his income, then the demand for consumers’ goods would determine prices in such a way that businessmen would be induced to produce consumers’ goods only. The stock of capital goods will stay the same, provided people do not consume more than their income. If they consume more, the stock of capital goods is necessarily diminished.
If, on the other hand, people save part of their incomes and reduce consumption expenditures, the prices of consumption goods decline. Businessmen thus are forced to adjust their production to the changes demanded. Let us assume that people, on the average, save 25 per cent of their incomes. Then, businessmen, through the agency of prices, would assign only 75 per cent of production to immediate consumption and the rest to increasing capital.
Our knowledge of prices also discloses the most crucial shortcoming of socialism and the immense superiority of the market order. Without the yardstick of prices, economic calculation is impossible. Without prices, how is the economic planner to calculate the results of production? He cannot compare the vast number of different materials, kinds of labor, capital goods, land, and methods of production with the yields of production. Without the price yardstick, he cannot ascertain whether certain procedures actually increase the productivity and output of his system. It is true, he may calculate in kind. But such a calculation permits no value comparison between the costs of production and its yield. Other socialist substitutes for the price denominator, such as the calculation of labor time, are equally spurious.
Government Interference with Prices
Economic theory reveals irrefutably that government intervention causes effects that tend to be undesirable, even from the point of view of those who design that intervention. To interfere with prices, wages, and the rates of interest through government orders and prohibitions is to deprive the people of their central position as sovereigns of the market process. It compels entrepreneurs to obey government orders rather than the value judgments and price signals of consumers. In short, government intervention curtails the economic freedom of the people and enhances the power of politicians and government officials.
The price theory also explains the various other economic problems of socialism and the interventionist state. It explains, for instance, the unemployment suffered in the industrial areas, the agricultural surpluses accumulated in government bins and warehouses; it even explains the gold and dollar shortages suffered by many central banks all over the world.
The market price equates the demand for and the supply of goods and services. It is the very function of price to establish this equilibrium. At the free market price, anyone willing to sell can sell, and anyone willing to buy can buy. Surpluses or shortages are inconceivable where market prices continuously adjust supply and production to the demand exerted by the consumers.
But whenever government by law or decree endeavors to raise a price, a surplus inevitably results. The motivation for such a policy may indeed be laudable: to raise the farmers’ income and improve their living conditions. But the artificially high price causes the supply to increase and the demand to decline. A surplus is thus created, which finds some producers unable to sell their goods at the official price. This very effect explains the $8 billion agricultural surplus now held by the U.S. Government.
It also explains the chronic unemployment of some 5 million people in the
The price theory also explains most money problems in the world. For several years after World War II, many underdeveloped countries suffered a chronic gold and dollar shortage. And in recent years, the
No matter what the official explanations may be, our knowledge of prices provides us with an understanding of these international money problems. Price theory reveals the operation of "
And finally, our knowledge of the nature of prices and of the consequences of government interference with prices also explains the "shortages" of goods and services suffered in many countries. Whether the interference is in the form of emergency or wartime controls, international commodity agreements, price stops, wage stops, rent stops, or "usury laws" that artificially limit the yield of capital—and whether they are imposed on the people of America,