All Commentary
Monday, February 1, 1965

Formation and Function of Prices

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 United States. For po­litical and social reasons and in attempted defiance of the law of supply and demand, the U.S. Gov­ernment has enacted minimum wage legislation that is pricing millions of workers right out of the market. The minimum wage is set at $1.25 per hour—to which must be added approximately 30¢ in fringe costs such as social secu­rity, vacations and paid holidays, health, and other benefits—so that the minimum employment costs of an American worker exceed $1.55 an hour. But in the world of eco­nomic reality, there are millions of unskilled workers, teenagers, and elderly workers whose produc­tivity rates are lower than this minimum. Consequently, no busi­nessman will employ them unless he is able to sustain continuous losses on their employment. In fact, these unfortunate people are un­employable as long as the official minimum wage exceeds their indi­vidual productivity in the market. This kind of labor legislation, even when conceived in good inten­tions, has bred a great variety of problems which give rise and im­petus to more radical government intervention.

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 United States it­self has had serious balance-of-­payments problems, which are re­flected in European countries as a dollar flood.

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 “Gresham‘s Law,” according to which an in­flated depreciated currency causes gold to leave the country. Gresh­am‘s Law merely constitutes the monetary case of the general price theory, which teaches that a short­age inevitably results whenever the government fixes an official price that is below the market price. When the official exchange ratio between gold and paper money understates the value of gold, or overstates the paper, a shortage of gold must inevitably emerge.

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,

Africa, Asia, or Europe—govern­ment controls over prices control and impoverish the people. And yet, omnipotent governments all over the world are bent on substi­tuting threats and coercion for the laws of the market.

  • Hans F. Sennholz (1922-2007) was Ludwig von Mises' first PhD student in the United States. He taught economics at Grove City College, 1956–1992, having been hired as department chair upon arrival. After he retired, he became president of the Foundation for Economic Education, 1992–1997.