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How Should Prices Be Determined?

Henry Hazlitt

"How should prices be deter­mined?" To this question we could make a short and simple answer: Prices should be determined by the market.

The answer is correct enough, but some elaboration is necessary to answer the practical problem concerning the wisdom of govern­ment price control.

Let us begin on the elementary level and say that prices are de­termined by supply and demand. If the relative demand for a prod­uct increases, consumers will be willing to pay more for it. Their competitive bids will both oblige them individually to pay more for it and enable producers to get more for it. This will raise the profit margins of the producers of that product. This, in turn, will tend to attract more firms into the manufacture of that product, and induce existing firms to invest more capital into making it. The increased production will tend to reduce the price of the product again, and to reduce the profit margin in making it. The in­creased investment in new manu­facturing equipment may lower the cost of production. Or — par­ticularly if we are concerned with some extractive industry such as petroleum, gold, silver, or copper — the increased demand and out­put may raise the cost of produc­tion. In any case, the price will have a definite effect on demand, output, and cost of production just as these in turn will affect price. All four — demand, supply, cost, and price — are interrelated. A change in one will bring changes in the others.

Direct and Indirect Price Interrelationships

Just as the demand, supply, cost, and price of any single com­modity are all interrelated, so are the prices of all commodities re­lated to each other. These rela­tionships are both direct and in­direct. Copper mines may yield silver as a by-product. This is connexity of production. If the price of copper goes too high, con­sumers may substitute aluminum for many uses. This is a connexity of substitution. Dacron and cotton are both used in drip-dry shirts; this is a connexity of consumption.

In addition to these relatively direct connections among prices, there is an inescapable intercon­nexity of all prices. One general factor of production, labor, can be diverted, in the short run or in the long run, directly or indirectly, from one line into any other line. If one commodity goes up in price, and consumers are unwilling or unable to substitute another, they will be forced to consume a little less of something else. All prod­ucts are in competition for the consumer’s dollar; and a change in any one price will affect an in­definite number of other prices. No single price, therefore, can be considered an isolated object in itself. It is interrelated with all other prices. It is precisely through these interrelationships that society is able to solve the immensely difficult and always changing problem of how to allo­cate production among thousands of different commodities and serv­ices so that each may be supplied as nearly as possible in relation to the comparative urgency of the need or desire for it.

Because the desire and need for, and the supply and cost of, every individual commodity or service are constantly changing, prices and price relationships are con­stantly changing. They are chang­ing yearly, monthly, weekly, daily, hourly. People who think that prices normally rest at some fixed point, or can be easily held to some "right" level, could profitably spend an hour watching the ticker tape of the stock market, or read­ing the daily report in the news­papers of what happened yester­day in the foreign exchange mar­ket, and in the markets for coffee, cocoa, sugar, wheat, corn, rice, and eggs; cotton, hides, wool, and rub­ber; copper, silver, lead, and zinc. They will find that none of these prices ever stands still. This is why the constant attempts of governments to lower, raise, or freeze a particular price, or to freeze the interrelationship of wages and prices just where it was on a given date ("holding the line") are bound to be disruptive wherever they are not futile.

Price Supports for Export Items

Let us begin by considering governmental efforts to keep prices up, or to raise them. Governments most frequently try to do this for commodities that constitute a prin­cipal item of export from their countries. Thus Japan once did it for silk and the British Empire for natural rubber; Brazil has done it and still periodically does it for coffee; and the United States has done it and still does it for cotton and wheat. The theory is that raising the price of these ex­port commodities can only do good and no harm domestically because it will raise the incomes of do­mestic producers and do it almost wholly at the expense of the for­eign consumers.

All of these schemes follow a typical course. It is soon dis­covered that the price of the com­modity cannot be raised unless the supply is first reduced. This may lead in the beginning to the imposition of acreage restrictions. But the higher price gives an in­centive to producers to increase their average yield per acre by planting the supported product only on their most productive acres, and by more intensive em­ployment of fertilizers, irrigation, and labor. When the government discovers that this is happening, it turns to imposing absolute quantitative controls on each pro­ducer. This is usually based on each producer’s previous produc­tion over a series of years. The result of this quota system is to keep out all new competition; to lock all existing producers into their previous relative position, and therefore to keep production costs high by removing the chief mechanisms and incentives for reducing such costs. The necessary readjustments are therefore pre­vented from taking place.

Meanwhile, however, market forces are still functioning in for­eign countries. Foreigners object to paying the higher price. They cut down their purchases of the valorized commodity from the val­orizing country, and search for other sources of supply. The higher price gives an incentive to other countries to start producing the valorized commodity. Thus, the British rubber scheme led Dutch producers to increase rubber pro­duction in Dutch dependencies. This not only lowered rubber prices, but caused the British to lose permanently their previous monopolistic position. In addition, the British scheme aroused resent­ment in the United States, the chief consumer, and stimulated the eventually successful develop­ment of synthetic rubber. In the same way, without going into de­tail, Brazil’s coffee schemes and America’s cotton schemes gave both a political and a price in­centive to other countries to ini­tiate or increase production of coffee and cotton, and both Brazil and the United States lost their previous monopolistic positions.

Meanwhile, at home, all these schemes require the setting up of an elaborate system of controls and an elaborate bureaucracy to formulate and enforce them. This has to be elaborate, because each individual producer must be con­trolled. An illustration of what happens may be found in the United States Department of Ag­riculture. In 1929, before most of the crop control schemes came into being, there were 24,000 persons employed in the Department of Agriculture. Today there are 109,­000. These enormous bureaucra­cies, of course, always have a vested interest in finding reasons why the controls they were hired to enforce should be continued and expanded. And of course these con­trols restrict the individual’s lib­erty and set precedents for still further restrictions.

None of these consequences seem to discourage government efforts to boost prices of certain products above what would otherwise be their competitive market levels. We still have international coffee agreements and international wheat agreements. A particular irony is that the United States was among the sponsors in orga­nizing the international coffee agreement, though its people are the chief consumers of coffee and therefore the most immediate vic­tims of the agreement. Another irony is that the United States imposes import quotas on sugar, which necessarily discriminate in favor of some sugar exporting na­tions and therefore against others. These quotas force all American consumers to pay higher prices for sugar in order that a tiny minority of American sugar cane producers can get higher prices.

I need not point out that these attempts to "stabilize" or raise prices of primary agricultural products politicalize every price and production decision and cre­ate friction among nations.

Holding Prices Down

Now let us turn to governmental efforts to lower prices or at least to keep them from rising. These efforts occur repeatedly in most nations, not only in wartime, but in any time of inflation. The typi­cal process is something like this.

The government, for whatever reason, follows policies that in­crease the quantity of money and credit. This inevitably starts push­ing up prices. But this is not pop­ular with consumers. Therefore, the government promises that it will "hold the line" against fur­ther price increases.

Let us say it begins with bread and milk and other necessities. The first thing that happens, as­suming that it can enforce its decrees, is that the profit margin in producing necessities falls, or is eliminated, for marginal pro­ducers, while the profit margin in producing luxuries is unchanged or goes higher. This reduces and discourages the production of the controlled necessities and rela­tively encourages the increased production of luxuries. But this is exactly the opposite result from what the price controllers had in mind. If the government then tries to prevent this discouragement to the production of the controlled commodities by keeping down the cost of the raw materials, labor and other factors of production that go into them, it must start controlling prices and wages in ever-widening circles until it is finally trying to control the price of everything.

But if it tries to do this thor­oughly and consistently, it will find itself trying to control liter­ally millions of prices and trillions of price cross-relationships. It will be fixing rigid allocations and quotas for each producer and for each consumer. Of course these controls will have to extend in de­tail to both importers and ex­porters.

Necessary Price Flexibility

If a government continues to create more currency on the one hand while rigidly holding down prices with the other, it will do im­mense harm. And let us note also that even if the government is not inflating the currency, but tries to hold either absolute or relative prices just where they were, or has instituted an "incomes policy" or "wage policy" drafted in ac­cordance with some mechanical formula, it will do increasingly serious harm. For in a free mar­ket, even when the so-called price "level" is not changing, all prices are constantly changing in rela­tion to each other. They are re­sponding to changes in costs of production, of supply, and of de­mand for each commodity or service.

And these price changes, both absolute and relative, are in the overwhelming main both necessary and desirable. For they are draw­ing capital, labor, and other re­sources out of the production of goods and services that are less wanted and into the production of goods and services that are more wanted. They are adjusting the balance of production to the un­ceasing changes in demand. They are producing thousands of goods and services in the relative amounts in which they are socially wanted. These relative amounts are changing every day. Therefore the market adjustments and price and wage incentives that lead to these adjustments must be chang­ing every day.

Price Control Distorts Production

Price control always reduces, unbalances, distorts, and discoordi­nates production. Price control be­comes progressively harmful with the passage of time. Even a fixed price or price relationship that may be "right" or "reasonable" on the day it is set can become increasingly unreasonable or un­workable.

What governments never realize is that, so far as any individual commodity is concerned, the cure for high prices is high prices. High prices lead to economy in consumption and stimulate and increase production. Both of these results increase supply and tend to bring prices down again.

Very well, someone may say; so government price control in many cases is harmful. But so far you have been talking as if the market were governed by perfect compe­tition. But what of monopolistic markets? What of markets in which prices are controlled or fixed by huge corporations? Must not the government intervene here, if only to enforce competition or to bring about the price that real competition would bring if it ex­isted?

Unwarranted Fears of Monopoly

The fears of most economists concerning the evils of "monopoly" have been unwarranted and cer­tainly excessive. In the first place, it is very difficult to frame a satis­factory definition of economic monopoly. If there is only a single drug store, barber shop, or grocery in a small isolated town (and this is a typical situation), this store may be said to be enjoying a monopoly in that town. Again, everybody may be said to enjoy a monopoly of his own particular qualities or talents. Yehudi Menu­hin has a monopoly of Menuhin’s violin playing; Picasso of produc­ing Picasso paintings; Elizabeth Taylor of her particular beauty and sex appeal; and so for lesser qualities and talents in every line.

On the other hand, nearly all economic monopolies are limited by the possibility of substitution. If copper piping is priced too high, consumers can substitute steel or plastic; if beef is too high, consumers can substitute lamb; if the original girl of your dreams rejects you, you can always marry somebody else. Thus, nearly every person, producer, or seller may en­joy a quasi monopoly within cer­tain inner limits, but very few sell­ers are able to exploit that mo­nopoly beyond certain outer limits. There has been a tremendous lit­erature within recent years de­ploring the absence of perfect competition; there could have been equal emphasis on the absence of perfect monopoly. In real life com­petition is never perfect, but neither is monopoly.

Unable to find many examples of perfect monopoly, some econo­mists have frightened themselves in recent years by conjuring up the specter of "oligopoly," the competition of the few. But they have come to their alarming con­clusions only by inserting in their own hypotheses all sorts of im­aginary secret agreements or tacit understandings between large pro­ducing units, and deducing what the results could be.

Now the mere number of com­petitors in a particular industry may have very little to do with the existence of effective competi­tion. If General Electric and Westinghouse effectively compete, if General Motors and Ford and Chrysler effectively compete, if the Chase Manhattan and the First National City Bank effectively compete, and so on (and no person who has had direct experience with these great companies can doubt that they dominantly do), then the result for consumers, not only in price, but in quality of product or service, is not only as good as that which would be brought about by atomistic com­petition but much better, because consumers have the advantage of large-scale economies, and of large-scale research and develop­ment that small companies could not afford.

A Strange Numbers Game

The oligopoly theorists have had a baneful influence on the Ameri­can antitrust division and on court decisions. The prosecutors and the courts have recently been playing a strange numbers game. In 1965, for example, a Federal district court held that a merger that had taken place between two New York City banks four years previously had been illegal, and must now be dissolved. The combined bank was not the largest in the city, but only the third largest; the merger had in fact enabled the bank to compete more effectively with its two larger competitors; its com­bined assets were still only one-eighth of those represented by all the banks of the city; and the merger itself had reduced the number of separate banks in New York from 71 to 70. (I should add that in the four years since the merger the number of branch bank offices in New York City had increased from 645 to 698.) The court agreed with the bank’s lawyers that "the general public and small business have benefited" from bank mergers in the city. Nevertheless, the court continued, "practices harmless in themselves, or even those conferring benefits upon the community, cannot be tolerated when they tend to create a monopoly; those which restrict competition are unlawful no mat­ter how beneficent they may be."

It is a strange thing, inciden­tally, that though politicians and the courts think it necessary to forbid an existing merger in order to increase the number of banks in a city from 70 to 71, they have no such insistence on big numbers in competition when it comes to political parties. The dominant American theory is that just two political parties are enough to give the American voter a real choice; that when there are more than this it merely causes confu­sion, and the people are not really served. There is this much truth in this political theory as applied in the economic realm. If they are really competing, only two firms in an industry are enough to create effective competition.

Monopolistic Pricing

The real problem is not whether or not there is "monopoly" in a market, but whether there is mo­nopolistic pricing. A monopoly price can arise when the respon­siveness of demand is such that the monopolist can obtain a high­er net income by selling a smaller quantity of his product at a higher price than by selling a larger quantity at a lower price. It is as­sumed that in this way the mo­nopolist can realize a higher price than would have prevailed under "pure competition."

The theory that there can be such a thing as a monopoly price, higher than a competitive price would have been, is certainly valid. The real question is, how useful is this theory either to the supposed monopolist in deciding his price policies or to the legislator, prose­cutor, or court in framing anti­monopoly policies? The monopo­list, to be able to exploit his posi­tion, must know what the "de­mand curve" is for his product. He does not know; he can only guess; he must try to find out by trial and error. And it is not merely the unemotional price re­sponse of the consumers that the monopolist must keep in mind; it is what the effect of his pricing policies will probably be in gaining the goodwill or arousing the re­sentment of the consumer. More importantly, the monopolist must consider the effect of his pricing policies in either encouraging or discouraging the entrance of com­petitors into the field. He may ac­tually decide that his wisest policy in the long run would be to fix a price no higher than he thinks pure competition would set, and perhaps even a little lower.

In any case, in the absence of competition, no one knows what the "competitive" price would be if it existed. Therefore, no one knows exactly how much higher an ex­isting "monopoly" price is than a "competitive" price would be, and no one can be sure whether it is higher at all!

Yet antitrust policy, in the United States, at least, assumes that the courts can know how much an alleged monopoly or "con­spiracy" price is above the com­petitive price that might-have-­been. For when there is an alleged conspiracy to fix prices, purchasers are encouraged to sue to recover three times the amount they were allegedly forced to "overpay."

Avoid Price-Fixing

Our analysis leads us to the con­clusion that governments should refrain, wherever possible, from trying to fix either maximum or minimum prices for anything. Where they have nationalized any service — the post office or the rail­roads, the telephone or electric power — they will of course have to establish pricing policies. And where they have granted monopo­listic franchises — for subways, railroads, telephone or power com­panies — they will of course have to consider what price restrictions they will impose.

As to antimonopoly policy, what­ever the present condition may be in other countries, I can testify that in the United States this policy shows hardly a trace of con­sistency. It is uncertain, discrimi­natory, retroactive, capricious, and shot through with contradictions. No company today, even a mod­erate sized company, can know when it will be held to have vio­lated the antitrust laws, or why. It all depends on the economic bias of a particular court or judge.

There is immense hypocrisy about the subject. Politicians make eloquent speeches against "mo­nopoly." Then they will impose tariffs and import quotas intended to protect monopoly and keep out competition; they will grant mo­nopolistic franchises to bus com­panies or telephone companies; they will approve monopolistic patents and copyrights; they will try to control agricultural produc­tion to permit monopolistic farm prices. Above all, they will not only permit but impose labor monopo­lies on employers, and legally compel employers to "bargain" with these monopolies; and they will even allow these monopolies to impose their conditions by physi­cal intimidation and coercion.

I suspect that the intellectual situation and the political climate in this respect is not much differ­ent in other countries. To work our way out of this existing legal chaos is, of course, a task for jurists as well as for economists. I have one modest suggestion: We can get a great deal of help from the old common law, which forbids fraud, misrepresentation, and all physical intimidation and coercion. "The end of the law," as John Locke reminded us in the seven­teenth century, "is not to abolish or restrain, but to preserve and enlarge freedom." And so we can say today that in the economic realm, the aim of the law should not be to constrict, but to maxi­mize price freedom and market freedom.



Rule of Law

Arbitrary power, enforcing its edicts to the injury of the persons and property of its subjects, is not law, whether manifested as the decree of a personal monarch or of an impersonal multitude. And the limitations imposed by our constitutional law upon the action of the government, both State and national, are essential to the preservation of public and private rights, notwithstanding the representative character of our political institutions. The enforce­ment of these limitations by judicial process is the device of self-governing communities to protect the rights of individuals and minorities, as well against the power of numbers, as against the violence of public agents transcending the limits of lawful author­ity, even when acting in the name and wielding the force of government.

JUSTICE MATHEW in Hurtado V. California, 1¹º U.S. p. 535

This article is from a paper presented be­fore a special meeting of the Mont Pelerin Society in Tokyo, September, 1966.

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