Critique of Austrian Price Formation

The Austrian School of economics holds that subjective preferences determine prices and supply and demand while some reject the idea that cost of production plays a central role in price formation.[i]  I will eventually touch on subjectivity and its many flaws but in this article, I would like to mainly discuss how prices form under market capitalism.  Prices are important to all theories of free market capitalism because without flexible prices, markets would lack a major self-adjusting mechanism.  Without a self-adjusting mechanism, markets will not clear and therefore, the free market will fail.  Below, I will attempt to show that in the real world, prices don’t adjust and that supply and demand only plays a minor role in price formation.  Instead, the vast majority of businesses ignore economic theory and instead rely on an accounting technique called mark-up pricing.   In this case, prices are administered and these prices are usually determined even before commodities touch the shelves.  When there is less demand for particular products, inventories decrease while prices remain the same.  When demand increases, inventories are increased in order to fulfill supplies but again, prices tend to remain the same.

I’ve summarized quite a bit so with that, let me unpack these concepts a little bit.  Markets are said to be self-adjusting, that is to say they fix themselves or are self-regulating.  Austrian economists believe that flexible prices are one of the many self-adjusting mechanisms.  We could say that prices are a market clearing device.  Market clearing is when the supply of a particular commodity is equal to the demand of that commodity.  For instance, suppose I supply a particular brand of soap.  If customers are buying them faster than I can get them on the shelf, I’ll raise my prices.  However, if nobody is buying my soap, I’ll lower the price until customers start buying them.  The happy balance of people buying my soap and my soap sitting on the shelf will find the appropriate price.  In this case, we could say that a particular price cleared the shelf.  At larger scales, the movement of prices is supposedly keeping the market functioning smoothly and the self-adjusting mechanism keeps everything in order including an economy with full employment.  While there is a sort of elegance to this story, it is only that, a story.

Israel Kirzner, a student of Lugwig von Mises states that “The theory of supply and demand is recognized almost universally as the first step toward understanding how market prices are determined and the way in which these prices help shape production and consumption decisions-the decisions that make up not only the skeleton, but also the flesh and blood of the economic system. Austrian economics thoroughly agrees with this.”  Kirzner goes on to say “There exists a “right” price, at which all those who wish to buy can find sellers willing to sell and all those who wish to sell can find buyers willing to buy. This “right” price is therefore often called the “market-clearing price.”  Supply-and-demand theory revolves around the proposition that a free, competitive market does in fact successfully generate a powerful tendency toward the market-clearing price. This proposition is often seen as the most important implication of (and premise for) Adam Smith’s famed invisible hand.”[ii]

So what’s wrong with this theory?  In 1936, a number of economists established The Oxford Economists’ Research Group with the aim of studying real world businessmen to see how they made decisions over the trade cycle and gather statistical information in Great Britain since 1924.  The Groups’ study shortly turned to how businessmen reacted to the interest rate and how prices were formed.  In their interviews, there were a number of problems to arise because The Group used the language of marginal economics while the businessmen lacked any such language.  Furthermore, what businessmen did and what was established economic theory were wildly different.  Business didn’t care about economic theory and used their own techniques for pricing.  One of the important results of these studies “was that businessman saw prices as non-market-clearing and not even designed to clear the market, while the members saw prices a[s] market clearing.”[iii]

“All of the members of the Group, except David MacGregor and Henderson, were confirmed marginalists and accepted the imperfect competition/monopolistic approaches to prices.  On the other hand, the information they received from the businessmen clearly indicated that the latter thought of prices in terms of some relationship to average total costs and totally ignored the marginalist approach to pricing.  In fact, businessmen paid no attention to margninal revenue or costs in the sense defined by economic theory….  The Oxford economists were shocked, to say the least.  But what caught their attention even more was the relative stability of prices over the trade cycle.”[iv]

One member influenced by Austrian economics, George Shackle noted his surprise of “the non-influence of the interest rate on the businessmen’s decision to invest because it revealed that uncertainty was the over-riding factor when they made their investment decisions.”  Another member of the group said they had “found no manufacturer or distributer yet who had ever been influenced in his decisions by the rate of interest.”[v]

So how does business set prices?  In a modern capitalist economy, rather than Crusoe’s Island or ancient bazaars, companies are interested in growing sales, entering new markets around the world, producing new products, and investing in future production.[vi]  Therefore, prices are considered “strategic decisions designed to meet these goals.”[vii]  In this case, we can say that the vast majority of prices are set by a price administrator.  What one should understand is that this is not some theoretical guess as to how prices work.  This is an accounting tool that almost every company in the world relies on.  One can even find a number of mark-up calculators online which determine how businesses should determine prices.  In order to determine the price, each company employs a method of its choice but it usually takes into account direct cost of the unit, the overhead costs such as Human Resource and advertising, rents, and a mark-up price.[viii]  The mark-up or surplus is the price over and above the price of the total cost of the commodity.  The mark-up is used for future investments, expansion of production, and allows companies to take up market share.

A further conclusion of the Oxford Group was that businesses set prices not just before the commodity hit the shelf but “well in advance of production.”[ix]  At this point, it becomes clear that prices are not “intended to clear the market” and that this “implies that the market itself is non-clearable.”  If prices cannot clear the market, a number of problems can arise such an increase in economic waste, income distribution becoming distorted, marginal productivity is invalidated, long term unemployment, and the effective use of resources will not be realized.

Instead of changing prices according to supply and demand, companies make inventory adjustments.  If there is a lack demand for a particular product, companies don’t lower prices.  Instead, companies decrease their inventory.  If their products are flying off the shelf, again, they don’t change prices but increase inventories.  In other words, when demand increases or decreases, production follows.  If one would like a simple example, go to a mall where they sell sports hats.  Each sports team is going to have different demand with the best teams having the highest demand.  If this is the cases, we should expect to see each team with different price tags.  Instead, all hats of the same model are priced the same regardless of the logo.  For teams that perform well, the companies increase inventories while the poorly performing teams have their inventories decreased — but all the hats remain at the same price.  Austrians believe that rapid price changes are needed for full employment but this is impossible with quantity adjustments rather than price changes.  While many would like to point toward clearance and liquidation sales, these are rare and in many cases, companies already account for these sales before production even takes place.

Since the time of The Oxford Economists’ Research Group, a number of studies have confirmed and reconfirmed their results.  However, it is not enough to have empirical evidence for mark-up pricing.  We need to understand the incentives involved.  To understand the problem with market clearing, it is important to define a couple of terms.  Fix prices are those commodities that are not up for bargaining while flex prices are those which easily move.  When one goes to the store, one does not haggle over prices nor are retailers “organized like auction markets or oriental bazaars where the retailer engages in individual price negotiation for each transaction.”[x]  In the real world, prices are already set and consumers can either take it or leave it.  In any modern capitalist economy, the vast majority of prices are fix prices (some estimates put fix prices as high as 70 percent).  While Austrians claim that the reason markets don’t clear is because of government intervention they ignore the empirical fact that a. most prices are fix prices, b. prices tend not to change during a trade cycle, c. there are a number of incentives to keep prices stable, and d. that many contracts are based on forward markets.

At this point, I would like to delve into the issues of incentives and why businesses don’t bother with supply and demand and set prices around cost of production.  First, setting prices allows companies to have stable prices over the course of time which allows them to make future plans for production.  As John Kenneth Galbraith states, “price stability also serves the purpose of industrial planning.  Prices being fixed, they are predictable over a substantial period of time.  And since one firm’s prices are another’s costs so costs are also predictable…. In 1964 the automobile firms had profits on sales ranging from five to over ten per cent.  There was security against collapse of prices and earnings at either level.  Planning was possible at either level of return.  All firms could function.  But none could have operated successfully had the prices of a standard model fluctuated, depending on whim and reaction to the current novelties….”[xi]  In other words, when capitalists make decisions today, they don’t expect their products or new projects to come to fruition tomorrow but a year or even two years from now.  Companies also have complex schedules for payments which may involve a number of other companies.  Therefore, companies must be able to plan and price stability allows them to carry out complex accounting actions.  Once production is set in motion, it can be extremely detrimental to change course especially if other companies are switching their prices on a regular basis.  One of the main features of mark-up pricing is that “they are stable in that they remain unchanged for extended periods of time and for many sequential transactions.”[xii]  This not only implies to large companies but small and medium sized firms as well.  For instance, Rufus Tucker had collected statistics going back to the 1830’s and had found that “administered prices were an historical and permanent feature of the American economy and hence not tied to the existence of big business…. Tucker established that prices which changed frequently and those which changed infrequently had both existed in the American economy since the 1830’s.  The explanation for the frequency of price change could not therefore be attributed solely to the size of the business enterprise setting the prices, since “big business” had not yet emerged in the 1830’s.”[xiii]  In brief, administered prices allow companies to function smoothly while fluctuating prices can lead to disaster.  Administered prices also give some degree of certainty for future income and therefore, firms are willing to invest in the future.  Without stable prices, firms would be gazing into an unknowable future and would hesitate to continue, create, or expand production.

Another reason for administered prices is to prevent price wars.  Price wars between companies can be catastrophic.  Even good companies can fall from simple accounting mistakes.  The fear of price wars has been a constant fear among capitalists in the United States.  In the early 1900’s, James Logan of U.S. Envelope Company referred to competition as “industrial war” and stated that “unrestricted competition, carried to its logical conclusions, means death to some of the combatants and injury for all.  Even the victor does not soon recover from the wounds received in the conflict.”[xiv]  In 1912, an American Tobacco Company executive stated that competition had almost led to the bankruptcy of the nation.  He stated that “Unrestricted competition had proven a deceptive mirage, and its victims were struggling on every hand to find some means of escape from the perils of their environment.  In this trying situation, it was perfectly natural that the idea of rational co-operation in lieu of cut-throat competition should suggest itself.”[xv]  There is a reason to believe this is true.  For instance, price competition squeezes profits in each company while “firms will be better off selling products at a loss than not selling them at all.”[xvi]  In his studies on highly competitive firms that come closest to a free market compared to larger oligopolistic firms, Nicholas Kaldor found that more competition was anything but ideal.  Larger companies were the best performing while highly competitive markets were highly volatile and were the worst performing.

Even when one looks at companies that change prices, we find a number of disincentives to changing prices.  “In studies of price determination, business enterprises have stated that variations of their prices within practical limits, given the prices of their competitors, produced virtually no change in their sales and that variations in the market price, especially downward produced little if any changes in market sales in the short term.  Moreover, when the price change is significant enough to result in a significant change in sales, the impact on profits has been negative enough to persuade enterprises not to try the experiment again.”[xvii]

On a side note, I don’t know why many consider more competition to be ideal especially when you consider that human beings are the gears that keep this whole operation running.  That means continuing to increase work speed, more uncertainty and fear of being replaced, and generally increasing the rat race of today.  It seems odd that we would even want to subject ourselves to social Darwinism especially when you consider the fact that after a certain threshold, more wealth has no effect on personal happiness or well-being.  Even worse is the fact that as capital spread overseas, we are seeing worldwide homogenization of people where entire cultures are being swallowed by Western consumer culture and values.

Another reason prices don’t adjust revolves around forward markets.  “A forward market is any market where the buyer and seller enter into a contractual agreement today for payment and delivery at specific dates in the future.”  In a capitalist economy, many contracts such as loans, rents, and leased properties are made by forward contracts.  Even many employment contracts are based on contracts that aren’t freely adjustable.  However, when one talks to many Austrians, they seem to believe that most contracts are based on a spot market, that is, a market “where buyers and sellers contract for immediate payment and delivery at the moment of the contractual agreement.”[xviii]

It is also important to realize that adjusting prices can be extremely difficult for entrepreneurs especially when we are referring to wages.  While entrepreneurs can increase prices with less problems, “[i]t is not at all easy to offset cost increases by raising prices by reducing wages or other costs.  Nevertheless, planning is greatly facilitated if prices and costs are stable.  Inflationary price and cost increases, moving unpredictably through the system, make long-term contracts impossible and everywhere introduce an unwelcome element of randomness and error.”[xix]

To conclude, if prices are not flexible in a capitalist economy, high unemployment could be the rule rather than the exception while resources will not be fully realized.  In other words, the free market does not and will not work as predicted.  I’ve demonstrated with empirical evidence that most prices are fixed and that there are major incentives to keep prices stable.  In fact, the stability of prices means the stability of capitalism.

Luwig von Mises states in Human Action that a free market is a clearing system when he says “The characteristic feature of the market price is that it equalizes supply and demand….” and that “[a]ny deviation of a market price from the height at which supply and demand are equal is – in the unhampered market – self-liquidating.”[xx]  However, this is clearly not the case.  One does not need government to keep prices from moving and there are numerous incentives to keep prices fixed.  Mises goes on to state “If the government is unwilling to acquiesce in this undesired and undesirable outcome and goes further and further, if it fixes the price of all goods and services of all orders and obliges all people to continue producing and working at these prices and wage rates, it eliminates the market altogether….”  Mises then describes this situation as a planned economy and states “The consumers no longer direct production by their buying and abstention from buying; the government alone directs it.”[xxi]  This is all very true but since private companies administer prices, then the same logic should apply.  If price is administered, then the concept of a free market is null and void and consumers ultimately no longer direct production – that task is left up to an authority.  The only “advantage” of a free market is that the ruling class changes hands – from the political class to the capitalist class.

Notes


[i] It should be noted that some Austrian do believe that cost of production plays a key role in prices such as Reisman, von Wieser, and Böhm-Bawerk.

[ii] Kirzner, I. (2000, January 01). The law of supply and demand. Retrieved from http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand

[iii] Lee, F. S. (1998). Post keynesian price theory. (1st ed., p. 88). New York City: Cambridge University Press.

[iv] Ibid., pp. 89.

[v] Ibid., pp. 88.

[vi] It should be noted that there is a primary sector such as basic supplies such as primary foods and basic materials which are highly influenced by supply and demand.  However, I’m speaking of industrial or secondary sector processes such as finished goods for consumption.

[vii] Lee, F. (2003). Pricing and prices. In J. King (Ed.), The Elgar Companion to Post Keynesian Economics (1st ed., p. 285). Northhampton: Edward Elgar Publishing

[viii] There are a number of methods for administering prices such as normal-cost pricing, target-return pricing, and companies which follow the lead of larger companies.

[ix] Lee, F. S. (1998). Post keynesian price theory. (1st ed., p. 95). New York City: Cambridge University Press.

[x] Lee, F. (2003). Pricing and prices. In J. King (Ed.), The Elgar Companion to Post Keynesian Economics (1st ed., p. 287). Northhampton: Edward Elgar Publishing

[xi] Galbraith, J. K. (1967). The new industrial state. (pp. 193-194). Princeton: Princeton University Press.

[xii] Lee, F. (2003). Pricing and prices. In J. King (Ed.), The Elgar Companion to Post Keynesian Economics (1st ed., p. 287). Northhampton: Edward Elgar Publishing

[xiii] Lee, F. S. (1998). Post keynesian price theory. (1st ed., p. 71). New York City: Cambridge University Press.

[xiv] Kolko, G. (1963). The triumph of conservatism: A reinterpretation of american history, 1900 – 1916. (1st ed., p. 13). New York City: The Free Press.

[xv] Ibid., pp. 14.

[xvi] Shapiro, N. (2003). Competition. In J. King (Ed.), The Elgar Companion to Post Keynesian Economics (1sr ed., p. 65). Northhampton: Edward Elgar Publishing Limited.

[xvii] Lee, F. (2003). Pricing and prices. In J. King (Ed.), The Elgar Companion to Post Keynesian Economics (1st ed., p. 288). Northhampton: Edward Elgar Publishing

[xviii] Davidson, P. (2002). Financial markets, money, and the real world. (1st ed., p. 70). Northhampton: Edward Elgar Publishing Limited.

[xix] Galbraith, J. K. (1967). The new industrial state. (pp. 253). Princeton: Princeton University Press.

[xx] Mises, L. V. (1949). Human action: A treatise on economics. (1st ed., p. 756 – 757). New Haven: Yale University Press.

[xxi] Ibid., pp. 759.

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One Response to Critique of Austrian Price Formation

  1. thanks for publishing this article. we’d like to re-post it at the north star (http://thenorthstar.info). can we please have your permission?

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