Thursday, December 13, 2012

E. K. Hunt on Equilibrium Prices in Neoclassical Economics

E. K. Hunt in his book the History of Economic Thought: A Critical Perspective (2002; although a new edition [Hunt and Lautzenheiser 2011] is now available, I quote from the 2nd edition) identified three problems with neoclassical theory:
(1) its conception of the entrepreneur,

(2) its conception of the nature of production, and,

(3) its conception of the process by which markets supposedly attain their competitive equilibrium prices (Hunt 2002: 373).
In particular, problem (3) above is directly relevant to the alleged “economic (mis)calculation” problems that so concern Austrians.

Hunt discusses point (3):
“The third principal obfuscation of neoclassical theory was its conception of the process by which competitive equilibrium prices were determined. In this theory, each consumer, each owner of a factor of production, and each entrepreneur were passive ‘price takers.’ All prices were determined by the competitive market completely independently of the actions taken by any individual or business firm.

Despite the considerable amount of attention that this problem received after the publication of Walras’s Elements, the neoclassical theorists did not substantially improve on Walras’s attempts to solve it. They could assert that these equilibrium prices were arrived at through a process of ‘groping,’ but they were never able to give any convincing empirical or theoretical argument to show that such groping would not take the economy farther away from equilibrium rather than closer to it. They could rely on Walras’s useful fiction of the crier [that is, the Walrasian auctioneer – LK], but such an obvious resort to a useful fiction as a deus ex machina designed simply to hold the theory together reduced the effectiveness of the theory’s ideological defense of free market capitalism.

In the more esoteric literature of professional journals, the neoclassicists demonstrated that the existence of such a set of equilibrium prices was not logically impossible, given their initial assumptions. This demonstration was taken as a reasonable justification for the textbook practice of simply assuming that this set of equilibrium prices existed and was known to ail individuals and business firms.

This was a particularly critical assumption because the three pillars of the neoclassical ideological defense of free market capitalism were the marginal productivity theory of distribution …, the invisible-hand argument, and the belief, held purely on faith, that the free market forces of supply and demand automatically and efficaciously take the economy to a full employment equilibrium … . None of these three ideological props for capitalism could be defended if the market did not automatically create equilibrium prices.” (Hunt 2002: 374).
This analysis conveys how fundamentally bound up the argument for free markets is with the idea that real world markets do have a tendency to create equilibrium prices in each commodity market.

Of course, the metaphor of the Walrasian auctioneer was always a most bizarre and unrealistic part of the neoclassical theory, because prices in a market economy are most decidedly not formed by some auctioneer clearing markets in a centrally organized auction. What can you say about a pro-free market model that analyses decentralised market activities as if they were overseen by some kind of central planner? (which is what the Walrasian auctioneer really is).

While one can point to certain flexprice markets where traders or business people do need to adjust prices rapidly to clear their stock, such as producers and wholesalers who sell perishable goods (e.g., fresh seafood), or alternatively to clearance sales that retailers hold to clear stock, other markets have prices set. The latter are fixprice markets. The empirical reality is that in many fixprice markets businesses engage in price administration or price setting. They are price makers, not price takers. And this is before we even get to the issue of prices as set by oligopolies, cartels and monopolies.

Many firms quite deliberately set prices. They act to ensure their survival and grow their business and market share. By looking more at the long-term state of demand, the price of many products is often not affected by short-term changes in demand. Short-term increases in demand can be met by holding stocks of their product and by having excess capacity. The most important cause of price adjustments are changes in the costs of factor inputs and wages.

Empirical studies show that, outside given limits, businesses find that variations in their set prices produce no significant change in sales volume, and, above all, when prices are cut, this does not necessarily lead to changes in short term market sales (Gu and Lee 2012: 462). And experiments with prices adjusted downwards to a significant extent show that this causes a severe blow to profits, so severe indeed that enterprises quickly abandon such experiments (Gu and Lee 2012: 461).

Prices set by businesses are not equilibrium prices. As Lee says, “administered prices are not market-clearing prices and nor do they vary with each change in sales (or shift in the virtually non-existent market or enterprises ‘demand curve’)” (Lee 1994: 320, n. 18).

The neoclassical and Austrian view (or at least a view held by some Austrians) of universal supply and demand dynamics governing all prices which gravitate to their equilibrium values thus becomes untenable.

Curiously, the existence of fixprice markets and its implication for economics was taken up by the Austrian economist Ludwig Lachmann:
“Those who glibly speak of ‘market clearing prices’ tend to forget that over wide areas of modern markets it is not with this purpose in mind that prices are set. They seem unaware of the important insights into the process of price formation, an Austrian responsibility, of which they deprive themselves by clinging to a level of abstraction so high that on it most of what matters in the real world vanishes from sight.” (Lachmann 1986: 134).
The lesson Lachmann learnt, however, was never learnt by Mises, Rothbard and other Austrians who continue to analyse most prices unrealistically in terms of demand curves and equilibrium prices.


BIBLIOGRAPHY

Gu, G. C. and F. S. Lee. 2012. “Prices and Pricing,” in J. E. King, The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 456–463.

Hunt, E. K. 2002. History of Economic Thought: A Critical Perspective (2nd rev. edn.). M.E. Sharpe, Armonk, N.Y.

Hunt, E. K. and M. Lautzenheiser. 2011. History of Economic Thought: A Critical Perspective (3rd edn.). M.E. Sharpe, Armonk, N.Y.

Lachmann, L. M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford.

Lee, F. S. 1994. “From Post Keynesian to Historical Price Theory, Part 1: Facts, Theory and Empirically Grounded Pricing Model,” Review of Political Economy 6.3: 303–336.

37 comments:

  1. I don't think that administered prices (cost plus mark-up) are not market prices. They may not follow the model of prices determined under perfect competition, but they are still strongly influences by market forces. Costs of production fluctuate because of changes in supply and demand, for example a bad harvest causing the price of an agricultural commodity to rise. And what about the size of the mark-up? What stops a business selling goods for 5 or 10 times the cost of production? The answer is competition from other businesses and the demand curve of consumers. Market forces and competition are the still the dominant long-term factors, even though they don't change prices on a day-to-day basis. Maybe this would be more apparent if you looked at data on a year-to-year basis instead.

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    1. Ivan Denisovich,

      The argument presented above is not that administered prices have no relation to market phenomena to some degree (of course they do), but that they are not equilibrium (market clearing) prices.

      As Lachmann says, "over wide areas of modern markets" prices are not set by the supply and demand dynamics you read about in economics textbooks.

      Perhaps my point is not properly spelled out, but it is this: where does this leave Walrasian general equilibrium theory? At best, looking highly suspect; at worst, as a load of nonsense.

      Many Austrians also subscribe to the notion of a market tendency to equilibrium on the basis of a set of market clearing prices being a tendency of the real world (e.g., Mises, Human Action, Auburn, Ala. 2008, pp. 756-757). This is not true, and the Austrian paradigm is equally absurd.

      And this is before we get to the theoretical problems about the law of demand and the possibility that many markets do not have any potential market clearing prices at all, even if they were flexible.

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    2. Surely the most important Austrian contribution to describing the role of market prices in the real world is Hayek's The Use of Knowledge of Society. The focus of this paper is not general equilibrium, but the gain in efficiency achieved when economic agents respond to changes in prices by conserving scarce resources and utilising abundant ones. Early in that paper Hayek writes "The fundamental problem, I am afraid, has been obscured rather than illuminated by many of the recent refinements of economic theory, particularly by many uses made of mathematics." Isn't that a rejection of GE theory?

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    3. Hayek did indeed come to reject GE theory after 1937. Already in 1937 he starts to redefine equilibrium (from a set of equilibrium prices) to plan coordination. Even by the time of The Pure Theory of Capital (1941), Hayek asserted that it was necessary to “abandon every pretence that [sc. equilibrium] … possesses reality, in the sense that we can state the conditions under which a particular state of equilibrium would come about” (Hayek, The Pure Theory of Capital, London 1976 [1941], p. 28).

      So how can Hayek invoke a Walrasian equilibrium structure of wages and prices as a serious explanation of unemployment in 1975 (as he does in a talk on April 9, 1975 to the American Enterprise Institute) without severe intellectual inconsistency?

      See here:

      http://socialdemocracy21stcentury.blogspot.com/2012/12/vulgar-austrians-economic-calculation.html

      If you don't think that a real world economy converges to a set of equilibrium prices in all markets, then there is no unique "right" set of prices that government distorts.

      Most of the alleged "economic (mis)calculation" problems invoked by Austrians (especially the vulgar internet ones) - where they complain prices are distorted away from the set of their market clearing values - are just imaginary, because the economy does not gravitate to any such set of "right" prices at all.

      And as I said, this is before we get to the theoretical problems about the law of demand and the possibility that many markets do not have any potential market clearing prices at all, even if they were flexible.

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    4. Just to elaborate on the last paragraph: a sufficient argument to refute the idea of the existence of a set of market-clearing prices in a real world economy is the fact that the law of demand is simply not universally true, and does not apply to market demand curves: it can only be true if an economy has only one commodity and only one consumer.

      Steve Keen:

      [sc. the law of demand] … is an essential element of the neoclassical model of how prices are set, which says that in competitive markets, supply will equal demand at the equilibrium price. For this model to work, it’s vital that there is only one price at which that happens, so it’s vital for the model that demand always increases as price falls (and similarly that supply always rises as price rises).” (S. Keen, 2011. Debunking Economics: The Naked Emperor Dethroned? [rev. and expanded edn], Zed Books, London and New York. pp. 48–49).

      The equilibrium price is the price at which the quantity of a product supplied will equal the quantity demanded, and there will be market clearing. There is “market equilibrium” when the price attains the equilibrium price. A “structure of equilibrium prices” is a set of equilibrium prices across all markets that will clear those markets.

      But, as Steve Keen shows (Keen, 2011. Debunking Economics: The Naked Emperor Dethroned?, pp. 38–73), the law of demand is a myth, in the sense that it is not universally valid, because market demand curves can have virtually any shape, a finding of even higher-level neoclassical research literature.

      Yet equilibrium prices have to be determined by means of a universally true law of demand: but once the necessarily and universally true law of demand collapses many product markets cannot have “equilibrium prices” and the whole notion of a set of market-clearing “equilibrium prices” across all markets is logically impossible.

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    5. I don't see any neoclassical market in fixed-price markets. Take the simplest example: the Swiss central bank pegging the franc at 1.20 vis-a-vis the euro. Where is there any "market forces" operating here? I don't see any. Demand is dictated by the desire for investors and traders to hold francs while supply is elastic so that the price remains constant. There is no market equilibrium. This is the same across all fix-price markets.

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  2. Hayek's main argument was that trade unions force wages above the level that would exist in a competitive market, which reduces the demand for labour. You don't need to believe GE theory to accept this point, which is pretty standard in modern economic textbooks.

    I agree that the law of demand is not universally valid, particularly for consumer goods, where consumers make inferences about quality from prices. I would not expect the law of demand to be valid for jewellery and wine. However, an idea can be generally true without being universally true. The law of demand is surely useful in understanding the labour market. Firms will substitute capital for labour as the price of labour rises. Your post about robots in the motor industry is a good example of that.

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    1. But no doubt forgets the point that large companies force the wage level down below that which would exist in a competitive market.

      trade unions exist because we have large companies.

      A business only hires when it has need of the labour and can profit. Labour however has to get hired or it starves to death. That is not an equal trade. Both sides have to be able to say 'no deal'.

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    2. "Hayek's main argument was that trade unions force wages above the level that would exist in a competitive market, which reduces the demand for labour."

      Yes, reduce its below "market clearing" value - just another form of GE theory.

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    3. "Hayek's main argument was that trade unions force wages above the level that would exist in a competitive market, which reduces the demand for labour."

      I don't agree with this point. Assuming a relatively closed economy increases in wages will increase aggregate demand. This will result in higher nominal profits and a higher demand for labour. This is actually a rather obvious point, both theoretically and empirically, and only a microeconomically inclined neoclassical could miss it.

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  3. "The empirical reality is that in many fixprice markets businesses engage in price administration or price setting. They are price makers, not price takers."

    But surely, you must grant that firms are price takers limited to a certain band of prices (lower bound: minimum price allowing for profitable operation; upper bound: price beyond which customer base is too small to provide enough revenue for the firm to pay its costs).

    Ford can set its prices within a certain range, but it can't double its prices and expect to stay in business. In that sense, isn't Ford (and every other business) a price taker?

    The "equilibrium price of cars" is of course an unobservable theoretical construct. Still, it seems to be a useful one, insofar as the price of cars with comparable features seem to cluster closely around a certain level:

    http://www.motortrend.com/features/consumer/1205_comparing_mainstream_midsize_sedan_prices_options_and_features/photos/#1

    To what can we attribute this phenomenon if not the workings of the free market? (If there is some giant carmaker cartel conspiring to keep costs up, it doesn't seem to have been very successful)

    http://mjperry.blogspot.kr/2009/03/real-price-of-new-cars-has-fallen.html

    Even if this outcome is second best (and that would be hard to defend), what's the alternative?

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    1. "Ford can set its prices within a certain range, but it can't double its prices and expect to stay in business."

      That isn't inconsistent with price setting.

      What I am talking about above is how prices are set and often not changed when short-term changes in demand happen.

      They can be set for a year or more at a certain level.

      The point is that they are not formed by textbook supply and demand curves.

      As to the price of certain manufactured goods fluctuating around a certain level, no doubt that's true: it will be at some point around (1) costs of production + (2) a reasonable profit markup.

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    2. "Ford can set its prices within a certain range, but it can't double its prices and expect to stay in business. In that sense, isn't Ford (and every other business) a price taker?"

      Categorically: no. Unless you want to bend the meaning of "price taker" to the point where it has no real meaning and simply means whatever you choose it to mean.

      http://www.investorwords.com/6890/price_taker.html

      "An individual or company which is not influential enough to affect the price of an item."

      So, if Ford has ANY influence over price it is not, by definition, a price taker. Unless you want to change the meaning of the terms (as I find often happens when I debate neoclassicals).

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    3. "Unless you want to change the meaning of the terms (as I find often happens when I debate neoclassicals)."

      It's a tactic that is the stock in trade of many Rothbardians too, not to mention Rothbard himself.

      E.g., one of his main innovations was simply to redefine "monopoly" to mean a right of exclusive production granted by the state.

      So - hey, presto - Rothbard can prove that “monopoly can never arise on a free market” (Rothbard 2009: 670).

      By the same trick, I could prove that the sky is green on a clear day, by redefining "green" to mean "blue," and "blue" to mean "green".

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    4. "It's a beautiful thing, the destruction of words." -- Syme, 1984

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    5. "if Ford has ANY influence over price it is not, by definition, a price taker."

      Do you mean (1) the price it sets for its products or (2) the overall market price of cars?

      If you mean #1, then of course, every firm sets the price it charges for its products. But such prices have no influence on the market price unless customers actually purchase the goods at the new price (I could open a cookie company and "set the price" at $100/box, but what effect does this have on market price of cookies if no one buys them?)

      What possible alternative do you suggest? That firms not have the freedom to charge what they want? I honestly don't understand what you're getting at (cue insults; whatever, I'm trying my best to be polite).

      If you mean #2, then I disagree. Ford does NOT have the power to unilaterally change the average market price that 4 door sedans sell for. If they raise their prices too high, then they will start to lose sales to competitors.

      If this were not true, and it were true instead that Ford could increase its prices and not lose sales, then why don't they do so? By not doing so they are leaving billions on the table.

      Btw, I am not a Rothbardian. I espouse the views of, for lack of a better term, GMU Austrians (Freebanking.org and Coordinationproblem.org).

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    6. Again, we don't really need to get into semantic debates -- which seem a staple of the Marxist and Austrian communities. These terms are fairly well agreed upon. Again from the Investopedia definition:

      "A company is considered to be a price taker if the price it sets and quantity of goods it produces do not have any effect on the market price, and therefore the company is usually forced to go with the market price if they want to sell its goods."

      That's clear as day. And if you've taken a basic course in micro you'll know what it means. Namely, that the market demand-curve is flat and so the firm has absolutely no influence over the market price. They merely accept it and then produce up to the point where MC=MR.

      Now, you're getting all mixed up here. In one post you say:

      "Ford does NOT have the power to unilaterally change the average market price that 4 door sedans sell for."

      But prior to that you said:

      "Ford can set its prices within a certain range..."

      If Ford can set its prices even within a certain range and we are in agreement that Ford is part of "the market" then by definition Ford can effect the average market price.

      Here's an example. Ford can set the price on its 4-door within the range of $20k to $25k. Ford makes up 10% of the market. Ford currently sells is 4-door for $20k while the average price is $22k. Ford raises its price to $23k. Does the average market price remain the same? No. At least not unless you want to change the definition of the word "average".

      I know I often come across as a bit of an asshole when dealing with people on here, but it seems to me that often neoclassical and Austrian economists don't understand very basic economic concepts. Beyond that they don't seem conversant with the implications for their theories is some of these concepts are refuted.

      The implications of dropping the idea of perfect markets is enormous: literally none of Austrian theory works as an accurate description of contemporary capitalist economies. At best it becomes a normative program like Marxism. But the proponents keep using it to describe really existing economic conditions. It's beyond bizarre.

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    7. Philip,

      I may not "understand very basic economic concepts," but I fear that you do not seem to understand very basic business concepts. Let's take a closer look at your hypothetical case, using more realistic estimates.

      Using the motortrend.com link I cited above, a quick and dirty estimate of the average base price of midsize sedans gives a figure of: ($213,805 /10) = $21,380.50. Giving greater weight to the market leaders Camry and Accord, a figure of $21,500 (equal to the Ford Fusion S) is, I believe, a reasonable rough estimate.**

      You postulated that a 15% price hike by Ford (from $20K to $23K) would raise the average selling price of midsize sedans. I contend that it would not, because no one would buy a Ford Fusion S after a 15% price hike.

      Raising the price of the Fusion S by 15% from $21,500 to $24,725 would leave it at a $3,225 price disadvantage vs. the avg price of competing sedans. When car buyers can check prices in seconds using their smartphones, do you believe that anyone would be willing to accept such a raw deal? And if there are no buyers at the new price, then the avg market price of midsize sedans remains unchanged.

      Let's assume that there are a few massive suckers. This is still a trivially important outcome because:

      1) it would barely affect the avg selling price (generously assuming 1% of car buyers are total morons, that still only raises the avg price by $32.50, or 0.15%)

      2) Ford can't raise enough revenue to cover its fixed costs by selling exclusively to a few innumerate consumers. Eventually, Ford will have to cut prices again to increase sales volume and take advantages of economies of scale. So even this miniscule price increase would be fleeting.

      In short, you have attempted to refute my assertion that Ford can't unilaterally raise the market price of sedans by putting forth a scenario that is:

      1) fanciful (the probability that Ford would ever do this is, roughly speaking, zero)

      2) highly unlikely to have more than a trivial effect on the avg selling price

      3) certain to have, at best, a temporary effect on the avg selling price

      I respectfully remain unmoved by your arguments.

      ** (I omitted the Malibu Eco 1SA, since it is a gas electric hybrid and should be compared with similar models such as the Fusion SE Hybrid: http://www.genemesserchevrolet.com/details/New+2013+Chevrolet+Malibu+Eco%201SA+1G11D5SR8DF149348)

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    8. I realize that models of perfect competition are abstract constructs and do not describe the real world in perfect detail. However, this is far different from saying that such models are worthless and don't tell us anything about how markets work. Austrians don't contend that markets are perfect, just that they allocate resources better than any other alternative. If you disagree, then I believe the onus is on you to describe a superior system of resource allocation.

      Re: theoretical alternatives to competitive markets--which articles/books do you recommend that I read to understand your perspective? I have purchased Minky's JMK and Davidson's "Keynes Solution" (and now finally have time to go through them). I suppose Keen's "Debunking Economics" is the way to go?

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    9. Of course, I forgot that you include detailed bibliographies with all of your posts. Still, to save time, which of these articles would you most recommend?

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    10. John S,

      In fact, if you want some work done by an Austrian that raises much the same issues as Post Keynesian economics, why not just read some of Ludwig Lachmann's work?

      I recommend:

      Lachmann, L. M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford, Chapter 6 (about p. 127 onwards on fixprice versus flexprice markets).

      Lachmann, L. M. 1976. “From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society,” Journal of Economic Literature 14.1: 54-62.

      On Post Keynesianism, Steve Keen's Debunking Economics is a great book, but is likely to be heavy going - a difficult read.

      If you want short, lucid introductions:

      Davidson, Paul. 2009. The Keynes Solution: The Path to Global Economic Prosperity (1st edn), Palgrave Macmillan, New York and Basingstoke.

      Skidelsky, R. J. A. 2010. Keynes: The Return of the Master (rev. and updated edn.), Penguin, London.

      I personally think Paul Davidson's Financial Markets, Money, and the Real World (Edward Elgar, Cheltenham, UK, 2002) is a very good book: though heavy going at times, it is very rewarding if you want read it properly.

      If you want higher-level analysis:

      Davidson, Paul. 2009. John Maynard Keynes (rev. edn.). Palgrave Macmillan, Basingstoke.

      Hayes, Mark. 2006. The Economics of Keynes: A New Guide to The General Theory. Edward Elgar, Cheltenham.

      Hein, Eckhard and Engelbert Stockhammer (eds.). 2011. A Modern Guide to Keynesian Macroeconomics and Economic Policies. Edward Elgar, Cheltenham.
      ------

      If you want detailed info on Post Keynesian textbooks, see here:

      http://socialdemocracy21stcentury.blogspot.com/2011/07/post-keynesian-textbooks.html

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    11. John,

      I'm not going to argue with you if you dance around the maypole contradicting yourself. You now said:

      "You postulated that a 15% price hike by Ford (from $20K to $23K) would raise the average selling price of midsize sedans. I contend that it would not, because no one would buy a Ford Fusion S after a 15% price hike."

      But prior to that you said:

      "Ford can set its prices within a certain range..."

      This latter statement implies that Ford had leeway to raise price to some extent without losing market share. These are the assumptions I was taking when I engaged with you (which I now regret):

      "Here's an example. Ford can set the price on its 4-door within the range of $20k to $25k."

      I meant that we assume that Ford could increase price to $25k without losing market share. In reality this is too high an assumption, but I was just illustrating a simple point.

      EVEN IF FORD CAN ONLY INCREASE PRICES BY $0.50 WITHOUT LOSING MARKET SHARE IT CAN STILL HAVE AN EFFECT ON THE AVERAGE MARKET PRICE. That's because, as I said, if Ford are part of the market and they have ANY leeway to move their price then BY DEFINITION they can influence the average market price because THEY'RE PART OF THE MARKET. Duh!

      "I respectfully remain unmoved by your arguments."

      That's because you're being dishonest both with yourself and with everyone else on here. First you tried to evade obvious facts by changing the meaning of well-defined words. Then you tried to evade obvious facts by trying to obfuscate the argument with needless empirical detail that you used to make it appear as if you were "refuting" my arbitrary example with empiricism. This was coupled with a sly evasion of the assumptions that YOU originally postulated.

      This is the rhetoric of the scoundrel and a sophist. And it is for this reason that I am so curt with these people. This argument is over.

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    12. It's a matter of fact that businesses can change their price without affecting their market share.

      I've put prices up in a business four years running by 5% at the beginning of the year to cover 'inflation' and it never affected turnover one little bit.

      And of course as any accountant/lawyer/consultant knows if you want to increase the amount of business you take, double your charging rate.

      The charging rate is seen in services as a proxy for experience and knowledge by those doing the hiring.

      There are so many practical examples that don't fir with the classical theory that it can only be described as the equivalent of believing in fairies at the bottom of the garden.

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    13. "And of course as any accountant/lawyer/consultant knows if you want to increase the amount of business you take, double your charging rate."

      I wonder whether we can see some types of specialist services (lawyers/consultants) as either Veblen goods or analogous to Veblen goods?
      (although obviously the standard exmaples of Velben goods are things like diamonds, designer clothing, high-quality, old wine etc. - things which supposedly confer "prestige," "social status," or "distinction", and so on).

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    14. Got to be something. Let's face it the banks didn't hire their auditors because of their ability to audit banks...

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    15. LK, thank you for the reading list. I'm about 15% through Debunking Econ, and so far it's not too bad. Perhaps it will get tougher, but I will persevere.

      Philip,

      You wrote: "This latter statement implies that Ford had leeway to raise price to some extent without losing market share."

      I never said anything implying this. When I said, "Ford can set its prices within a certain range," I meant precisely that--that Ford can change the numbers on the price tag or invoice. I did not write or imply that such changes would have no effect on Ford's market share, revenue, or profit/loss amount. Perhaps I should have spelled this out; apologies for the confusion.

      Additionally, I identified my views as GMU Austrian. Thus, you should have assumed that I believe in some form of the law of demand (perhaps with Veblen/Giffen exceptions). If that is true, then I could not possibly believe, as you assumed, "that Ford could increase price to $25k without losing market share," since this would clearly violate the law of demand!

      EVEN IF FORD CAN ONLY INCREASE PRICES BY $0.50 WITHOUT LOSING MARKET SHARE IT CAN STILL HAVE AN EFFECT ON THE AVERAGE MARKET PRICE.

      Even this limited claim is not necessarily true in the short run, and it is almost certainly not true in the long run. It is not necessarily true in the short term because it assumes that other carmakers are not 1) concurrently cutting prices; AND/OR 2) increasing their sales of cheaper cars.

      (Presumably, the only outcome we should be concerned with is whether or not Ford can unilaterally RAISE the avg mkt price. If the mkt price remains unchanged or goes down, then consumers are either unaffected or benefit from greater purchasing power. Again, apologies for not explicitly spelling this out before).

      So if in Q1 2013, Ford raises its price by 50 cents and Toyota (with its greater market share) cuts its price by 50 cents, then the avg selling price would go down, in spite of Ford's price hike. The same would be true if in Q1 2013 Kia ($20,250), through better marketing, raises sales sufficiently among consumers at the margin (ie those contemplating a compact car or a used sedan) to more than offset the impact of Ford's price increase.

      In the long run, due to competition, it is almost certainly true that Ford cannot unilaterally raise the avg selling price. If you look at the actual data, you will see that the fastest growing brand in the US has indeed been bargain-priced Kia. And that is in spite of Kia's extremely low shopper consideration ranking (9%), which is almost certain to improve. http://www.bloomberg.com/news/2012-05-01/kia-fastest-growing-u-s-brand-suffers-in-hyundai-shadow.html

      And if you consider the world market, Chinese carmakers are certainly lowering the avg selling price of cars. It will probably be 5-10 year before they make any inroads into the US market, but the margins of all carmakers will come under severe pressure in emerging markets: http://www.nytimes.com/2012/07/06/business/global/valuable-gains-for-china-in-emerging-auto-markets.html?pagewanted=all&_r=0

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    16. Philip,

      Is looking at trends in actual, real-world markets "needless empirical detail"? Perhaps, but I'd rather see what's actually going on rather than speculate on what might possibly happen if Ford raised its prices by X%. Who cares if it's technically true that Ford might be able to temporarily raise the avg selling price of sedans by some arbitrary amount if they threw all profit and loss considerations out the window? The reality is that because they are kept in check by competitors, they do not (and will not). This generalized finding is, in my opinion, more important than hypothetical musings re: fanciful scenarios.

      You still have not answered my questions:

      1) If Ford does indeed have leeway to raise prices without losing market share, why don't they do so? Aren't firms profit maximizers?

      2) If free markets are flawed, then what resource allocation mechanism do you propose? Or at least, how do you plan to rectify the flaws of free markets in goods and services?

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    17. Neil,

      You wrote: "I've put prices up in a business four years running by 5%... and it never affected turnover one little bit."

      May I respectfully ask, why only 5%? Why not 10 or 15%? If raising prices has no effect on turnover, then you are leaving money on the table every single year.

      "as any accountant/lawyer/consultant knows if you want to increase the amount of business you take, double your charging rate."

      Again, why don't you do so?

      Re: accountant/lawyer rates--I believe Austrians would say that part of the reason such prices are inelastic is that occupational licensing requirements artificially limit the supply of potential competitors (I don't know about consultants).

      I readily acknowledge that buyers of such services often conflate rates with knowledge/competence. All I can say here is caveat emptor. Services such as Angie's List are attempting to circumvent such asymmetric information. At the very least, thanks to the internet, consumers are better informed than they ever were before.

      May I ask if you would support govt regulation to cap the amount you are allowed to increase your rates year to year?

      "There are so many practical examples that don't fit with the classical theory that it can only be described as the equivalent of believing in fairies at the bottom of the garden."

      What are some of these examples? I'm not denying that they exist, but I'd rather not simply take your word for it.

      Again, no snark or hostility intended. I am genuinely interested in any examples you could provide.

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    18. If you just read the first 15% of Debunking Economics, you will have read Keen's chapter on why the law of demand is not universal - for reasons far beyond Veblen/Giffen goods.

      Delete
    19. "Again, no snark or hostility intended. I am genuinely interested in any examples you could provide"

      I've already given you the examples. How many more do you need?

      The other one I've analysed recently was in a reasonably competitive market - fish and chips. There the rule of thumb was to push for 5% every six months or so as long as you kept the product quality up. That has actually been affected by the commodity price changes on the raw materials and the VAT changes and now really isn't enough.

      It's quite an interesting market as it is in decline and there is a heavy Gresham dynamic going on there - tax evasion is rife.

      With the law of demand in the classical theories *any* change in price, however small, that doesn't reduce the turnover invalidates the law. And that means the theories that rely on it cannot apply to the real world either.

      The nature of the acceptable range and frequency of price changes in the market place has not been explained very well IMV.

      But you can push prices and you can push them quite often. It varies by industry and it varies over time and there is skill in knowing what you can get away with.

      It's got more to do with boiling the frog than an auction though.

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    20. Neil,

      Since you didn't clarify which industries you mean, I assume you're citing the accounting, legal, and fish & chip industries as ones in which "businesses can change their price without affecting their market share."

      Let’s look at accounting first. Is it really true that businesses can wantonly raise prices (or even ignore competitors’ price cuts) and not suffer losses of market share? Here is Allan Koltin (named "eleven consecutive years... by Accounting Today as one of the Top 100 Most Influential People in the accounting profession"), who says otherwise in CPA Report (July ‘10):

      In many markets, the Big 4 are coming back to the middle market and, with that, we are seeing price wars like we've never seen before. Almost every day I get a phone call from a local or regional firm telling
      me about an existing client they recently lost due to price.


      http://www.cpareport.com/Newsletters/Sept10/CPFM_July10.pdf

      Or how about this quote from Accountancy Age (May ‘12):

      An audit partner at one top ten firm said that clients were telling them not to expect to retender their business unless they were willing to come back with price cuts of up to two-thirds of the original cost.

      http://www.accountancyage.com/aa/analysis/2172604/quality-casualty-brutal-audit-price-war

      It seems that accounting firms do not share your view that you can “increase the amount of business you take [by] doubling your charging rate.”

      How about the legal industry, then? Here’s a quote from the American Bar Association Journal (Nov. ‘09):

      “One firm manager told of hearing stories about “well-established New York firms” telling clients they will not be underbid. Another told of firms offering "drastically" lower hourly rates and other fee-cutting proposals.”

      http://www.abajournal.com/news/article/law_firm_price_wars_break_out_as_some_try_loss_leader_bids_for_work

      And it doesn’t seem that price-cutting was merely a short-term effect of the post-crisis slump. From May ‘12:

      ”What appeared to be short-term, cost-cutting tactics to survive the recession are now a way of life for law firms across the country... That trend has continued today. Nearly 91.6 percent of law firm leaders believe that price competition will increase.

      http://www.bizjournals.com/pittsburgh/print-edition/2012/05/25/post-downturn-price-wars-likely-continue.html?page=all

      So law firms also seem to believe that keeping prices at or below competitor levels is important to staying in business. Both accounting firms and law firms seem to be reacting to, rather than setting, market prices.

      Again, no snark, just facts. If you disagree, please cite counterevidence.

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    21. I also believe your other examples are not convincing evidence against the law of demand.

      You cited two examples: 5% annual rate increases at your business and 5% semi-annual price increases in the fish&chip industry.

      First, re: your business—I would have to know what your rates were 4 years ago, and the prevailing avg market rates for whatever service you provide, to answer whether your experience contradicts the law of demand. If your rates were somewhat below the market rate to begin with, then it could certainly be the case that raising your rates would not affect turnover because there were still enough customers whose willingness to pay exceeded your increased rates.

      Second, 5% annual increases would in fact partially “cover inflation” as you said. Thus, your rate increases, in real terms, would only be somewhere around 3-4% per year in real terms (assuming 1-2% annual inflation).

      Finally, the law of demand holds “ceteris paribus.” A number of factors could have changed year-to-year that allowed you to maintain the same amount of business despite slightly higher rates. Perhaps your services have improved over time, or increased word-of-mouth marketing has bolstered your pipeline of customers.

      At any rate, I find the industry wide examples I provided in the accounting and legal fields more persuasive than your anecdotal evidence.

      And it’s far too stringent a requirement to stipulate that any increase in price that doesn’t immediately result in a change in turnover invalidates the law of demand, at least from an Austrian perspective.

      Austrians believe that price discovery is a process that takes place in time and that actors do not instantaneously receive updated, perfect information. So in the short run, it may well be true that your clients would rather continue to retain your slightly higher (but familiar) services instead of spending time and effort to research competing, untried options.

      But I will say this—I do not believe that you can continue to increase your prices by 3-4% per year (in real terms) indefinitely. Eventually, your clients WILL go somewhere else if your rates deviate too far from the market average.

      You also implicitly believe this. If you don’t, then as I said before, why don’t you increase your rates by 10, 15, or 20% per year? If “businesses can change their price without affecting their market share,” then you are leaving money on the table each year. (Indeed, you stated that doubling your rates would actually increase your business. Why not do so, then?)

      Re: fish and chips—I do not believe that chip shops can increase their prices at an annualized rate of 10.25% indefinitely (5% semi-annually). And the data shows that they have not--if avg prices for a meal were 2.43 pounds in the UK around 2005, then they would be 4.81 today if they increased at that rate. Instead, they are only 3.30 (July ‘12).

      http://www.bainesandernst.co.uk/infographics/fish-and-chips-inflation/

      So again, I don’t think that fish and chips violate the law of demand either. Raise the price too much, and people will eat curries/kebabs/Chinese. Lower the price by half, and the line at the chip shop will spill out into the street.

      Thanks for the examples--I learned a few interesting things about the fish&chip industry!

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    22. Citing newspapers is hardly evidence is it. Everybody who has done a media course knows that newspapers are only interested in selling newspapers and write what they are given in press releases.

      I've done the price change thing personally, and that renders the law of demand *required* by the theories incorrect.

      Don't forget that *all* prices have to respond auction like or the theory cannot relate to the real world.

      So you need to show that *all* prices respond in an auction manner - and one single example that doesn't renders it incorrect.

      And since I am that example, the theory is obsolete.

      Your time would be better spent working out what is really happening out there.

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    23. Neil,

      You have an amazing talent for evasion. So I will get straight to the point.

      You stated: "It's a matter of fact that businesses can change their price without affecting their market share."

      You also said: "as any accountant/lawyer/consultant knows if you want to increase the amount of business you take, double your charging rate."

      If you believe these statements, then why do you limit your annual rate hikes to only 5%, when you have the leeway to increase your rates by up to 100% without any risk of losing revenue?

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    24. "You have an amazing talent for evasion."

      Nowhere near as good as yours for avoiding the reality that the law of demand is not as stated in the classical models.

      I shall leave you to your belief. May it comfort you as the world fails to conform to it.

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  4. I found this brief comment (at 16:38) re: GE theory by Steve Horwitz interesting (as well as the whole talk).

    http://www.youtube.com/watch?v=n64yEg-x5Ko

    What do you think of the Free-banking Austrian/Yeager theory of cash balances and depressions (monetary equilibrium theory)? Do you have any major criticisms?

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    Replies
    1. The free banking libertarians are certainly considerably more intelligent than Rothbardians. I have respect for much of Selgin's work, even if I do not agree with it all.

      But I do not think monetary policy will prevent problems of aggregate demand. If QE1, QE2 and QE3 could not induce a sufficient private investment to restore full employment, why do they think unregulated FR free banks will?

      As to Horwitz's comments after 16:38 in the video, he is quite right. Walrasian GE theory does not properly model money, and is at heart an inappropriate barter analysis of a monetary economy.

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