Does this Passage show that Mises understood Mark-up Pricing?

The blogger Guillermo Sanchez points to this passage in Mises’s book The Theory of Money and Credit where Mises happens to mention “fixed prices”:

“when the abstention of the purchaser indicates to the seller that he has overreached his demand, the seller may reduce his price again (and, of course, in so doing, may possibly go too far, or not far enough). But under certain conditions a different procedure may be substituted for this roundabout process. The buyer may agree to the price demanded and attempt to recoup himself elsewhere by screwing up the prices of the goods that he himself has for sale. Thus a rise in the price of food may cause the laborers to demand higher wages. If the entrepreneurs agree to the laborers' demands, then they in turn will raise the prices of their products, and then the food producers may perhaps regard this rise in the price of manufactured goods as a reason for a new rise in the price of food. Thus increases in prices are linked together in an endless chain, and nobody can indicate where the beginning is and where the end, or which is cause and which effect.

In modern selling policies ‘fixed prices’ play a large part. It is customary for cartels and trusts and in fact all monopolists, including the state, to fix the prices of their products independently, without consulting the buyers; they appear to prescribe prices to the buyer. The same is often true in retail trade. Now this phenomenon is not accidental. It is an inevitable phenomenon of the unorganized market. In the unorganized market, the seller does not come into contact with all of the buyers, but only with single individuals or groups. Bargaining with these few persons would be useless, for it is not their valuations alone but those of all the would-be purchasers of the good in question that are decisive for price determination. Consequently the seller fixes a price that in his opinion corresponds approximately to what the price ought to be (in which it is understandable that he is more likely to aim too high than too low), and waits to see what the buyers will do. In all of those cases in which he alone appears to fix prices, he lacks exact knowledge of the buyers’ valuations. He can make more or less correct assumptions about them, and there are merchants who by close observation of the market and of the psychology of buyers have become quite remarkably expert at this; but there can be no certainty. In fact, estimates often have to be made of the effects of uncertain and future processes. The sole way by which sellers can arrive at reliable knowledge about the valuations of consumers is the way of trial and error. Therefore they raise prices until the abstention of the buyers shows them that they have gone too far. But even though the price may seem too high, given the current value of money the buyer may still pay it if he can hope in the same way to raise the price which he ‘fixes’ and believes that this will lead more quickly to his goal than abstention from purchasing, which might not have its full effect for a long time and might also involve a variety of inconveniences to him. In such circumstances the seller is deprived of his sole reliable check upon the reasonableness of the prices he demands. He sees that these prices are paid, thinks that the profits of his business are increasing proportionately, and only gradually discovers that the fall in the purchasing power of money deprives him of part of the advantage he has gained. Those who have carefully traced the history of prices must agree that this phenomenon repeats itself a countless number of times. It cannot be denied that much of this passing on of price increases has indeed reduced the value of money, but has by no means altered the exchange ratios between other economic goods in the intended degree.” (Mises 2009 [1953]: 163–164).

Before I turn to what Sanchez makes of this passage, we should be clear on what it does not prove.

This passage does not provide any evidence that Mises understood the concept of administered pricing/mark-up pricing in modern market economies: that is, the widespread existence of prices set by businesses through their cost accounting conventions in an ex ante manner before transactions take place, on the basis of total average unit costs plus a profit mark-up, at a given, estimated, projected or target quantity of output or level of sales (from which of course the actual quantity of output produced or sold in a given time period might differ).

Empirical evidence shows us that mark-up prices are generally inflexible with respect to demand, but tend to change – though it is by no means a necessary or universal process – when total average unit costs change or when the business wants to change its profit mark-up.

But a careful reading of the passage shows that Mises is not thinking of mark-up prices in the modern sense in his reference to “fixed prices.”

Mises is quite clearly thinking of two phenomena, as follows:

(1) “fixed prices” in the sense of deviations from flexible marginalist price setting as practised by cartels and monopolies, who can price their product higher than a competitive market would allow, precisely because there is a lack of sufficient competition in their respective markets, and

(2) instances where businesses (such as retail traders) set or “fix” initial prices as a guess because they encounter buyers only incrementally, not as a group.

But even in case (2) Mises is implying that such prices will often change in accordance with supply and demand as sellers encounter buyers:

“Consequently the seller fixes a price that in his opinion corresponds approximately to what the price ought to be (in which it is understandable that he is more likely to aim too high than too low), and waits to see what the buyers will do.”

And even in his instance (1), this is still not evidence Mises has administered pricing in mind, because mark-up pricing is not just confined to cartels, oligopolies or monopolies: it is a persistent trait of competitive markets too (Lee 1998: 72–73).

The secondary process Mises is describing in last part of the passage is one where sellers raise prices or demand a higher price than buyers would normally be willing to accept, but some buyers nevertheless still buy and raise their own prices, causing a price inflation.

In another post, Guillermo Sanchez asserts that this passage from the quotation above proves that “Mises and other economists already knew by 1912 that ‘fixed prices’ ‘play a large part’ in selling policies”:

“In modern selling policies ‘fixed prices’ play a large part. It is customary for cartels and trusts and in fact all monopolists, including the state, to fix the prices of their products independently, without consulting the buyers; they appear to prescribe prices to the buyer. The same is often true in retail trade.”

Indeed, Mises does say that in “modern selling policies ‘fixed prices’ play a large part.” Does Mises mean that they form the majority of prices or a very economically significant portion of prices? If so, that just raises an incredible and devastating inconsistency in Mises’s economic theory: if Mises thinks that fixed prices are “a large part” of modern economies, then how can there be any effective tendency towards market clearing in product markets? One major part of Mises’s view of how market economies achieve self-equilibration would collapse. So Guillermo Sanchez has succeeded in identifying a damning contradiction in Misesian economics.

Moreover, according to Guillermo Sanchez, this passage supports his following views:

“1) Firms do not and can not violate or suspend the Law of supply and demand.

2) Firms do not violate consumer sovereignty by ‘fixing prices’.

Sanchez, Guillermo. “Mises on ‘Fixed Prices,’” October 12, 2013
http://econo-miaytuya.blogspot.com.ar/2013/10/mises-on-fixed-prices.html

He then points to a passage in Shapiro’s Foundations of the Market Price System.

Since Shapiro has an idiosyncratic system of abbreviating common economic terms, I include those terms below in square brackets:

“The concept of ‘administered prices’ (AP hereafter) implies that the large firm has an unrivaled power to raise its [price] at will – presumably in virtual defiance of the law of demand and supply! That is to say, the mere posting of its selling price by the firm suffices to realize this price in the market place. In the past 30 years or so, the concept of AP has cropped up whenever the general price level in the economy spurted upward—in association with charges that the big corporations were to blame for ‘too high’ prices and ‘inflation.’

This is not the place to get into the true causes of price inflation. Suffice it to note that, other things being equal, the primary inducement to raising the firm’s [prices] is to increase its [total revenue] (not decrease it). This implies that the firm believes it has an inelastic [demand] schedule …: only an inelastic [demand] will enable the firm to increase its [total revenue] by a price hike. That is, if the firm had an elastic [demand] instead, the price hike would only cause its [total revenue] to drop and it would therefore have to rescind its price hike.

All Firms Are Price-Takers!

Two conclusions follow. One is that the bugbear about AP can only have relevance to firms possessing inelastic rather than elastic [demand] schedules. The issue then becomes this: Does the big firm—or any firm—have the natural right to raise its [price] in order to increase its [total revenue]? We have argued the affirmative. More important is the second conclusion: After all is said and done, in the real world all firms turn out to be price-takers no less effectively than in the [perfect competition] model. For instance, no real-world firm really has the ‘power’ to suspend the law of demand and supply—that is, to avoid ending up with a surplus for overpricing its product, or to avoid less-than-maximum profits by underpricing its product and realizing a shortage.

Sooner or later, after trial-and-error searching for the market-clearing price, every real-world firm finds itself eventually having to ‘take’ the market price that actually clears its supply. Thus real-world firms are ‘price-takers’ no less than firms in pure competition, the only difference being this: [perfect competition] firms ‘take’ their [price] from the market right from the start (they have perfect knowledge!), whereas real firms ‘take’ their [price] only after trial-and-error search in the market. Irony of ironies: real firms are, in an ultimate sense, pricetakers, too!” (Shapiro 1985: 365–366).

Take Shapiro’s first statement:

“The concept of ‘administered prices’ (AP hereafter) implies that the large firm has an unrivaled power to raise its [price] at will – presumably in virtual defiance of the law of demand and supply!

Shapiro does not even understand what “administered prices” even are. Administered prices are not confined to “large firms” or oligopolies: they are prevalent across modern markets in firms of any size (even small business). They occur in highly competitive markets.

Nor does modern mark-up pricing theory say that an administered pricing firm has an “unrivaled power to raise its [price] at will.” What it says is that such firms set prices as an ex ante administrative decision before transactions take place, on the basis of total average unit costs plus a profit mark-up, at a given or estimated quantity of output or level of sales.

They then generally leave their prices unchanged and such mark-up prices are, generally speaking, not response to demand changes.

Firms will directly adjust production to meet changes in demand and use inventories to deal with demand changes.

So from the very beginning Shapiro does not even properly understand the concept of an administered price: he misses the substantive points about mark-up pricing.

For him, administered pricing means that a “large firm has an unrivalled power to raise its [price] at will.” Yet administered price theorists recognise that mark-up pricing firms do face serious constraints on price setting. Nobody claims that mark-up pricing firms can just raise prices to very high levels at will.

Administered prices are actually often set by a mark-up pricing leader (generally the most powerful firm) within each market and constrained by the fear that competitors may not raise prices.

Regarding the issue of inelastic demand curves, it is rather interesting to note the results of the empirical evidence from mark-up pricing firms:

“Where reported … business enterprises stated that variations in 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 non-insignificant change in sales, the impact on profits has been sufficiently negative to persuade enterprises not to try the experiment again.” (Lee 1998: 207).

Next, Shapiro says:

“For instance, no real-world firm really has the ‘power’ to suspend the law of demand and supply—that is, to avoid ending up with a surplus for overpricing its product, or to avoid less-than-maximum profits by underpricing its product and realizing a shortage.”

But this merely begs the question by assuming that most firms (1) do not make effective use of inventories, (2) change capacity utilisation to deal with demand changes, and (3) need to maximise profit in the marginal sense.

If a firm creates a price that creates excess demand, it can generally meet the demand by drawing down inventories and increasing capacity utilisation to meet demand.

If a firm charges too high a price, it might or might not find that sales decline, but even here a firm might simply cut production and employment and accept lower sales volume and given profits at that price, rather than cut its mark-up price.

And finally profit maximisation in the marginalist sense of trying to equate price with marginal cost is rejected as a recipe for bankruptcy by many firms, so it is neither a “law” of real markets nor a policy businesses are in any way required or forced to accept.

Finally, the question begging flaw in Shapiro’s analysis is quite blatant:

“Sooner or later, after trial-and-error searching for the market-clearing price, every real-world firm finds itself eventually having to ‘take’ the market price that actually clears its supply.”

But this just assumes that firms are forced to search for a market clearing price, and that they are driven – even against their will – to clear their supply quantities by price flexibility.

These assumptions are grossly untrue for many firms: real firms that simply shun flexible prices and do follow “price signals” but rather “quantity signals,” and adjust production and employment directly in relation to demand signals.

BIBLIOGRAPHY
Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

Sanchez, Guillermo. 2013. “Mises on ‘Fixed Prices,’” October 12
http://econo-miaytuya.blogspot.com.ar/2013/10/mises-on-fixed-prices.html

Sanchez, Guillermo. 2014. “Social Failurecracy,” 1 February
http://econo-miaytuya.blogspot.com/2014/02/social-failurecracy.html

Shapiro, Milton M. 1985. Foundations of the Market Price System. University Press of America, Inc. Lanham, MD and London.