How Prices Are Determined

Austrian Political Economy

Austrian Political Economy

I write about economics and political philosophy.

 

A market price is the exchange ratio between an economic good (or service) and the medium of exchange, viz. money. While the conventional exposition of how supply and demand curves intersect to yield a stable equilibrium market price in order to clear the market is valid, it is necessary to examine the diagram of the intersecting curves from a truly subjectivist perspective.

According to Mises, the “ultimate source of the determination of prices is the value judgments of the consumers.” Each market participant, in buying or selling, or in refraining from either activity, contributes to the formation of money prices on the market. 

Market prices are not measurements of value. Value is inherently subjective and therefore not liable to any form of measurement. Rather, prices are expressive of the valuations of myriad individuals comprising in their totality the market. 

The Demand Side


Each potential consumer will dispose of his stock of money so that his most desired wants are satisfied first. There are three uses to which money can be put; it can be used in consumption or production expenditures or it can be added to an individual’s cash balance. A unit of a good will therefore rank higher or lower than a unit of money on an individual’s value scale. 

In every market exchange, the two parties have reverse valuations in relation to the good and the amount of money. The buyer prefers the good to the amount of money, while the seller prefers the amount of money to the good. If this was not the case, no exchange could occur. It is erroneous to say that exchanges are predicated on equality of value. Inequality of valuation is a prerequisite for any and every exchange to take place. 

A buyer’s value scale may be structured as follows:
At a price of 6 grains of gold, he is willing to buy no units of the good. At a price of 5 grains of gold, he is willing to buy one unit of the good. At a price of 3 grains of gold, he is willing to buy 2 units of the good. And at a price of 2 grains of gold, he is willing to buy 3 units of the good.

The buyer’s value scale obeys the law of utility. As he obtains additional units of the good, its value on the margin declines, and he will only purchase additional units at increasingly lower prices. The law of diminishing marginal utility is constantly operating in the consumer’s purchasing decisions. 

From the buyer’s value scale can be derived his demand schedule. Demand is defined as the relationship between various hypothetical market prices and the total number of units consumers wish to buy at each price. The demand schedule can be represented graphically, and this is how the hypothetical downward-sloping demand curve can be constructed. It is downward-sloping to the right due to the law of diminishing marginal utility. 

A demand curve can be drawn for an individual or for the entire market. The market demand curve is simply the summation of the individual demand curves. 

A standard demand curve:

The Supply Side


While the subjective nature of the demand side is accepted by most, the neo-classical disposition is to attribute the factors of price determination to utility and money costs. This is wrong. The only determinant of the market price is the subjective valuations of buyers and sellers. The supply side of price determination is constituted by the subjective valuations of sellers.

Each seller who has a stock of some good ranks the units of that stock in the same way a buyer ranks units of money. There are three ways he can use his stock: he can use the good directly; he can sell the good now; or he can hold onto the good for later sale. He will ascribe subjective importance to each of these three uses and rank them accordingly. Moreover, he will also rank the amounts of money to be received in exchange on his value scale. 

A seller’s value scale may be structured as follows:
At a price of 1 grain of gold, he would sell no units of the good; the marginal utility of the good is greater than the marginal utility of 1 grain of gold. The same is true at a price of 2 grains of gold. At a price of 3 grains of gold, however, he is willing to sell 2 units of the good. At a price of 4 grains of gold, he is willing to sell 3 units of the good, etc. 

The reason for this is due to the law of diminishing marginal utility, which applies to the selling decisions of producers in the same manner as it applies to the buying decisions of consumers. As the producer acquires more and more units of money from customers, the marginal utility of the money falls, whereas the marginal utility of the good rises as he dispenses with it. This why graphically the supply curve is depicted as being upward-sloping and to the left.

The total market supply curve is composed of the individual supply curves of sellers in the market. 

A standard supply curve:

A Note On Vertical Supply Curves


The Austrian approach is to conceive of the market supply curve in relation to the day-to-day pricing of consumer goods as being more or less vertical. This means that at each hypothetical price the seller is willing to sell his entire stock. 

It is probable that in an advanced economy, characterised by intensive specialisation, producers will derive little utility from using the good directly, so their decisions about how to use the good will ultimately rest on the prospect of immediate sale and later sale. If there is little value for a producer in not selling his whole stock, then his supply curve will essentially be vertical. 

A standard vertical supply curve:

The Tendency Toward Equilibrium


The market price will tend to be set at the equilibrium point corresponding to the intersection of the supply and demand curves; if it is not at this point, it will tend rapidly toward it. If for whatever reason the price is not at this point, profit-maximizing entrepreneurs will soon ensure it is. 

If the price was greater than the market-clearing price, a surplus would arise; the quantity supplied would exceed the quantity demanded (at that price). In order to earn greater profits, entrepreneurs would lower the price to avoid some of their stock going unsold.

Conversely, if the price happened to be less than the market-clearing price, there would be a shortage; the quantity demanded would exceed the quantity supplied (at that price). In order to maximize profits, entrepreneurs would raise prices. 

The Irrelevance of Costs in Price Determination 


You will notice that nowhere in this analysis of price determination have I made reference to past money costs. The prevailing Marshallian view that demand and costs are effective in determining market prices is erroneous. Money costs do not determine prices. Costs may influence supply as they are relevant to the producer’s decision about whether to undertake production in the first place, but that is the full scope of their involvement. 

Only the subjective valuations of the producer with respect to the good are effective in determining how the good in question shall be used, and only the interaction of the subjective valuations of buyers and sellers will determine the market price. 

Furthermore, since the short-term market supply curve is invariably vertical, we can conclude that the paramount factor in the determination of market prices for consumer goods is the subjective valuations of consumers. 

Bibliography 


Rothbard. 1962. Man, Economy, and State.
Mises. 1949. Human Action