Economics 101: Who Sets Prices?

April 19, 2018

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”.

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, which 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.

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. 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.

However, silver has attracted many uses since. The fall in price relative to gold has seen the jewellery market expand, the photographic market come and go, and the widespread use of voltaic cells arrive. Its antiseptic qualities at ionic level have spawned many more uses. But the price, because it is no longer widely used as money, is still about eighty ounces to one of gold.

A suggestion that silver’s demise as money was the result of governments imposing change on consumers, is not true. It was the markets, collectively comprised of consumers exchanging goods and services for money, which forced the change from an untenable bimetallism to a single metallic standard. If unbacked paper money dies, silver might recapture a monetary role, but that for now is speculation. Meanwhile, it has served as the clearest example of why and how prices depend on how a commodity is used by consumers.

This is also true of intermediate goods, the goods that are used in the production of consumer goods. If a consumer product becomes uneconomic to manufacture, and a machine used in its production can be adapted for another use, it will attain a new value, based on its productive capacity in that changed role. Otherwise, it’s only value is as scrap.

The ways consumers are influenced and controlled

Prices are determined by the value placed on a product or service by consumers, so it is natural to expect a retailer to persuade consumers to buy his goods. At the simplest level, this means making sure the consumer understands all the benefits conferred by a purchase. This is basic communication. Additionally, a manufacturer will emphasise his reputation for quality, reliability, design, and even exclusiveness. This is branding.

A mechanical Swiss watch of the highest quality will cost many thousands in any currency you care to name. A quartz watch, which keeps perfect time, can be had for a small fraction of the cost. The functional utility is the same, yet such is human nature that Swiss manufacturers still manage to sell their expensive watches. The fact that they do is testament to their skill at managing their consumers’ expectations.

Advertising and branding are fair game, because the consumer retains command over choice, including the option not to buy. Other means of getting products sold are not so fair, being based on restricting the supply of competing goods and services. The most obvious artifice, which few question and think is entirely reasonable, is patent protection. A patent allows a manufacturer to profit from a commercial discovery for a period of time while excluding competition. Manufacturers have persuaded law-makers this is necessary, otherwise, they say, there would be little or no investment in research and development. But patents are nothing more than a form of protectionism, allowing a producer to maintain prices through a temporary monopoly.

The freest markets are those that do not enjoy patent protection. For example, there are no patents covering the fashion industry. This and next season’s fashions are determined by the industry’s movers and shakers, anticipating and influencing consumer demand. It is easy to imagine the harm to sales volumes if there were patents. At the other extreme, pharmaceuticals are heavily protected, increasing healthcare costs far above what they would otherwise be.

Government involvement in setting prices is generally passive when granting patents, but by granting contracts and approvals, for example to a company as sole supplier for a new drug, the intervention is invasive. Instead of the consumer setting the price through an expression of preferences, the company in conjunction with the government sets the price. In other words, the price becomes related to the production cost, upending normal free market pricing.

The same is broadly true of any enterprise owned, co-owned, or regulated by governments. Railways and utilities in Britain and Europe are good examples. Prices are set with reference to operating costs. When the government has given a private sector entity the contract, it restricts margins to what might be deemed a necessary return on investment, after consulting the service provider. So, prices are being set by costs.

Nearly all major companies lobby governments to obtain market preference, and therefore a degree of certainty over pricing. They simply do not like unfettered competition. When, for example, the European Union introduces new safety regulations for the motor industry, do not think that somehow the bureaucrats in Brussels produce these regulations on their own. It is the large motor manufacturers who lobby and are consulted with and given the opportunity to set the specifications of future vehicles. These corporations now know what the consumers of tomorrow will be forced to buy, because they set the specifications, which governments then enforce.

Government is the ultimate monopoly

The system of granting patents, referred to above, is a form of monopolistic behaviour that goes unquestioned by the general public. Instead, accusations of monopolistic behaviour are most often aimed at big business, corporations with a significant market presence. However, a company that tries to raise prices without the support of a cast-iron cartel or government regulations will always fail. In some cases, that failure may take some time, such as is the case with utilities, where the deployment of an alternative is a lengthy and costly process. But, as the growth of cable TV has shown, the expense of building a new distribution network can be overcome, if there is genuine consumer demand for it.

Admittedly, this is not a complete refutation of monopolistic behaviour by utility companies. But even they accept there are competitive pressures, evidenced by seeking protection from competition by soliciting local and state government support in setting prices.

Monopolies cannot exist for long without government support, so it is the state that is always the monopolist. Furthermore, where the government itself supplies a service, it will usually do so on a monopolistic basis. If free market competition is permitted, healthcare and education being prime examples, it is at a far higher cost to the consumer, who takes a private sector service in preference to a government one that is  free at the point of use, but paid for through taxes.

Even though the state sometimes tolerates private sector competition to its own services, it has little sympathy with the concept of consumer choice and is the ultimate monopolist. When the state socialises services, the consumer loses his right to choose, and to set prices by his needs and wants as he would in free markets. Without this choice imposed on it, the state invariably acts as if Karl Marx or Adam Smith was right, that costs determine prices. But there is no restraint over those costs without the discipline of consumer choice, and the cost of delivering a government-provided service is always far higher than the free market alternative for this reason.

Conclusion

In a free market, prices are clearly decided by the consumer, by virtue of his freedom to choose, his limited resources, and his option not to purchase. In doing so, the consumer prioritises those goods and services that satisfy him most within his personal resources. In contrast, a provider of goods or services has to find buyers at prices which are the decision of the consumer, or face going out of business.

The popular concept of monopolistic behaviour, that large corporations somehow wield pricing power on their own to the disadvantage of consumers, is incorrect. Yes, they will use advertising and brand-building to woo customers, but that is not monopolistic behaviour, because the consumer is always free to choose, or not to buy at all. Instead, businesses seeking a monopoly advantage recruit the state to regulate, restricting competition and choice, as a means of maintaining prices.

The state uses its position as law-maker to restrict competition through licensing, regulation and the grant of patents. While it affords price protection that is monopolistic, Menger’s marginal utility theory informs us that it can only mean that potential demand being is not being efficiently realised. This being the case, economic progress itself must be compromised, and is the root cause behind the superior performance of free markets compared with command economies.

Furthermore, when the state provides services free or heavily subsidised at the point of use, they are paid for out of taxation. By these means, governments force consumers as a whole to accept services determined on a cost basis, not necessarily paid for by the user, but subsidised by others through taxation.

A cost-basis for prices is a government creature and is the fundamental difference between socialism and free markets, where the consumer is sovereign.

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Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY

 Twitter: @MacleodFinance

MOBILE: +44 7790 419403

9. Bond Street, ST HELIER, JERSEY, JE2 3NP, CHANNEL ISLANDS

Alasdair became a stockbroker in 1970 and a Member of the London Stock Exchange in 1974. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy. After 27 years in the City, Alasdair moved to Guernsey. He worked as a consultant at many offshore institutions and was an Executive Director at an offshore bank in Guernsey and Jersey.

One cubic foot of gold weighs more than half a ton (1,306 pounds).