Hayek on Costs and Pricing

This comment that Hayek makes occurs in a discussion of Keynes’ General Theory, which I first quote merely for context:

“Now if there is a well-established fact which dominates economic life, it is the incessant, even hourly, variation in the prices of most of the important raw materials and of the wholesale prices of nearly all foodstuffs. But the reader of Mr. Keynes’ theory is left with the impression that these fluctuations of prices are entirely unmotivated and irrelevant, except towards the end of a boom, when the fact of scarcity is readmitted into the analysis, as an apparent exception, under the designation of ‘bottlenecks’. And not only are the factors which determine the relative prices of the various commodities systematically disregarded; it is even explicitly argued that, apart from the purely monetary factors which are supposed to be the sole determinants of the rate of interest, the prices of the majority of goods would be indeterminate. Although this is expressly stated only for capital assets in the special narrow sense in which Mr. Keynes uses this term, that is, for durable goods and securities, the same reasoning would apply to all factors of production. In so far as ‘assets’ in general are concerned the whole argument of the General Theory rests on the assumption that their yield only is determined by real factors (i.e. that it is determined by the given prices of their products), and that their price can be determined only by capitalising this yield at a given rate of interest determined solely by monetary factors. This argument, if it were correct, would clearly have to be extended to the prices of all factors of production the price of which is not arbitrarily fixed by monopolists, for their prices would have to be equal to the value of their contribution to the product less interest for the interval for which the factors remained invested. That is, the difference between costs and prices would not be a source of the demand for capital but would be unilaterally determined by a rate of interest which was entirely dependent on monetary influences. (Hayek 2009 [1941]: 374–375).

But the crucial passage is here:

“The reason why Mr. Keynes does not draw this conclusion, and the general explanation of his peculiar attitude towards the problem of the determination of relative prices, is presumably that under the influence of the ‘real cost’ doctrine which to the present day plays such a large role in the Cambridge tradition, he assumes that the prices of all goods except the more durable ones are even in the short run determined by costs. But whatever one may think about the usefulness of a cost explanation of relative prices in equilibrium analysis, it should be clear that it is altogether useless in any discussion of problems of the short period.” (Hayek 2009 [1941]: 375, n. 3).

Of course, the idea here seems to be that, in the long run, prices move towards marginal cost, so it is not modern mark-up pricing theory per se.

Nevertheless, Hayek is utterly wrong that many, even most prices, are not determined by costs of production in the short run. On the contrary, we now know, after many decades of empirical study, that most prices are cost-based or mark-up prices and are determined by total average unit costs plus a profit mark-up, not only in the long run but also in the short run. Therefore an economic theory that assumes this is how most prices are set is entirely realistic and correct, and it is marginalist pricing theory that is severely flawed and wrong.

BIBLIOGRAPHY
Hayek, F. A. 2009 [1941]. The Pure Theory of Capital. Ludwig von Mises Institute, Auburn, Ala.

Reality Refutes Mises on Costs and Prices

In a passage that should simply provoke hilarity to any person knowledgeable about real world prices, Mises shows us how far his economic theory is from reality:

“Any price determined on a market is the necessary outgrowth of the interplay of the forces operating, that is, demand and supply. Whatever the market situation which generated this price may be, with regard to it the price is always adequate, genuine, and real. It cannot be higher if no bidder ready to offer a higher price turns up, and it cannot be lower if no seller ready to deliver at a lower price turns up. Only the appearance of such people ready to buy or to sell can alter prices.

Economics analyzes the market process which generates commodity prices, wage rates, and interest rates. It does not develop formulas which would enable anybody to compute a ‘correct’ price different from that established on the market by the interaction of buyers and sellers.

At the bottom of many efforts to determine nonmarket prices is the confused and contradictory notion of real costs. If costs were a real thing, i.e., a quantity independent of personal value judgments and objectively discernible and measurable, it would be possible for a disinterested arbiter to determine their height and thus the correct price. There is no need to dwell any longer on the absurdity of this idea. Costs are a phenomenon of valuation. Costs are the value attached to the most valuable want-satisfaction which remains unsatisfied because the means required for its satisfaction are employed for that want-satisfaction the cost of which we are dealing with. The attainment of an excess of the value of the product over the costs, a profit, is the goal of every production effort. Profit is the pay-off of successful action. It cannot be defined without reference to valuation. It is a phenomenon of valuation and has no direct relation to physical and other phenomena of the external world.

Economic analysis cannot help reducing all items of cost to value judgments. The socialists and interventionists call entrepreneurial profit, interest on capital, and rent of land ‘unearned’ because they consider that only the toil and trouble of the worker is real and worthy of being rewarded. However, reality does not reward toil and trouble. If toil and trouble is expended according to well-conceived plans, its outcome increases the means available for want-satisfaction. Whatever some people may consider as just and fair, the only relevant question is always the same. What alone matters is which system of social organization is better suited to attain those ends for which people are ready to expend toil and trouble. The question is: market economy, or socialism? There is no third solution. The notion of a market economy with nonmarket prices is absurd. The very idea of cost prices is unrealizable. Even if the cost price formula is applied only to entrepreneurial profits, it paralyzes the market. If commodities and services are to be sold below the price the market would have determined for them, supply always lags behind demand. Then the market can neither determine what should or should not be produced, nor to whom the commodities and services should go. Chaos results.” (Mises 2008: 393).

Let us look through the litany of errors in this passage:

(1) Mises says that:

“Any price determined on a market is the necessary outgrowth of the interplay of the forces operating, that is, demand and supply.”

The word “necessary” in this sentence should raise eyebrows. And what type of “market” is Mises speaking of?

Is Mises referring to (1) real world markets or (2) imaginary, hypothetical markets that exist only in his head and where his “necessary outgrowth of the interplay of the forces … [sc. of] demand and supply” hold true? If the latter, then his analysis is irrelevant to reality, since the real world obviously departs from Mises’s ideal.

If Mises refers to the real world, then he is straightforwardly wrong.

To see this, we need only review what Mises means by “the interplay of the forces … [sc. of] demand and supply.” This is quite clear from the rest of his writings, such as the following:

(1) “The characteristic feature of the market price is that it equalizes supply and demand. The size of the demand coincides with the size of supply not only in the imaginary construction of the evenly rotating economy. The notion of the plain state of rest as developed by the elementary theory of prices is a faithful description of what comes to pass in the market at every instant. Any deviation of a market price from the height at which supply and demand are equal is – in the unhampered market – self-liquidating.” (Mises 2008: 756–757).

(2) “It is ultimately always the subjective value judgments of individuals that determine the formation of prices …. . Market prices are entirely determined by the value judgments of men as they really act.

If one says that prices tend toward a point at which total demand is equal to total supply, one resorts to another mode of expressing the same concatenation of phenomena. Demand and supply are the outcome of the conduct of those buying and selling. If, other things being equal, supply increases, prices must drop. At the previous price all those ready to pay this price could buy the quantity they wanted to buy. If the supply increases, they must buy larger quantities or other people who did not buy before must become interested in buying. This can only be attained at a lower price.

It is possible to visualize this interaction by drawing two curves, the demand curve and the supply curve, whose intersection shows the price.” (Mises 2008: 329–330).

(3) “The market interaction brings about a price at which demand and supply tend to coincide. The number of potential buyers willing to pay the market price is large enough for the whole market supply to be sold. If government lowers the price below that which the unhampered market would set, the same quantity of goods faces a greater number of potential buyers who are willing to pay the lower official price. Supply and demand no longer coincide; demand exceeds supply, and the market mechanism, which tends to bring supply and demand together through changes in price, no longer functions.” (Mises 2011: 101).

(4) “Competitive prices are the outcome of a complete adjustment of the sellers to the demand of the consumers. Under the competitive price the whole supply available is sold, and the specific factors of production are employed to the extent permitted by the prices of the nonspecific complementary factors. No part of a supply available is permanently withheld from the market, and the marginal unit of specific factors of production employed does not yield any net proceed. The whole economic process is conducted for the benefit of the consumers.” (Mises 2008: 354).

So real world prices must be determined by the “interplay of the forces ... [sc. of] demand and supply” in this sense. (That is, Mises is not simply using “demand and supply” in a weak and trivial sense of saying that a good must be demanded and valued by a consumer as a precondition of him buying it and physically supplied for him to do so.)

But real world capitalist economies have many prices – and in many cases a majority of prices – that are set by price administration. Such “administered prices” (or mark-up prices, average-cost prices, full-cost prices, normal cost prices, or cost-plus prices) are set by businesses based on average costs of production per unit plus a profit mark-up. For the empirical evidence on this, see the links in Appendix 1 below.

Administered prices (or mark-up prices) are not set by the conventional forces of supply and demand. They are not even intended to be market-clearing prices. They remain relatively inflexible with respect to demand, especially downward. Often they will not be changed for up to a year. When costs do rise, they might change or they might not: even price rises need not necessarily happen if businesses feel their competitors will not raise prices.

Such mark-up prices can be found in both consumer goods markets and intermediate goods and wholesale markets (Parker, pp. 6–7).

In short, these are prices that do not confirm to Mises’s strident statement about how prices are determined. And the empirical evidence shows that they normally account for the majority of business prices in most first world nations.

(2) Mises states that

“At the bottom of many efforts to determine nonmarket prices is the confused and contradictory notion of real costs. If costs were a real thing, i.e., a quantity independent of personal value judgments and objectively discernible and measurable, it would be possible for a disinterested arbiter to determine their height and thus the correct price.”

According to Mises, the notion of “real costs” is “confused and contradictory.” But it seems that Mises is inventing a straw man.

Even though any given costs as measured in money prices might well be related in some sense to subjective personal value judgments, it is still the case that money prices are an objective phenomenon that are “discernible and measurable.” If two people see the price of a good displayed, they might well disagree profoundly about why or if they subjectively value it, but they cannot disagree about the stated money price, without one of them being wrong or both being wrong. The money price is an objective thing in this sense.

Moreover, Mises’s statements here seem to contradict what he says elsewhere.

For example, Mises says that “[e]conomic calculation always deals with prices, never with values” (Mises 2008: 332). Prices are always money prices, and effective calculation of profit and loss via costs occurs via money prices:

“Prices are always money prices, and costs cannot be taken into account in economic calculation if not expressed in terms of money.” (Mises 2008: 349).

But that requires that money prices have a type of objectivity.

(3) Finally, we get this gem:

“The question is: market economy, or socialism? There is no third solution. The notion of a market economy with nonmarket prices is absurd. The very idea of cost prices is unrealizable. Even if the cost price formula is applied only to entrepreneurial profits, it paralyzes the market. If commodities and services are to be sold below the price the market would have determined for them, supply always lags behind demand. Then the market can neither determine what should or should not be produced, nor to whom the commodities and services should go. Chaos results.”

The idea of “cost prices” is definitely not “unrealizable.”

Such “cost prices” – prices based on total average unit costs plus profit mark-up – have long existed throughout the capitalist world. The existence of widespread administered prices has been documented since the 1920s.

It follows from Mises’s analysis that all advanced capitalist economies from at least the 1920s onwards should be in a permanent state of “chaos”: for in most of them probably the majority of prices are relatively inflexible, not properly set by supply and demand, nor set to converge to market-clearing levels.

According to Mises, we should have “chaos” where “supply always lags behind demand” in these markets.

But we do not have chaos, nor do we see such chronic supply problems in capitalist nations.

Mises is contemptibly ignorant of real world capitalism: a world where most firms set their mark-up price based on average unit money costs of production, and then adjust production to match demand, while keeping inventories and significant unused capacity at factories and plants available to meet increases in demand. When demand falls, businesses fire workers and cut production.

Businesses generally determine what to produce via demand and quantity signals.

Mises – and modern Austrians – are guilty of fantasy world economics.


APPENDIX 1
“Two Marketing Studies on US Administered Prices,” November 16, 2013.
This cites two marketing surveys that found that from the 1980s to the 1990s mark-up pricing accounted for roughly 70% to 85% of US industrial prices.

“Administered Prices in the Eurozone: Some Empirical Data,” October 16, 2013.
This cites the wide-ranging survey of Fabiani et al. (2006) on prices in the Eurozone. The average for mark-pricing throughout the Eurozone is 54%.

“Administered Pricing in the United Kingdom,” October 19, 2013.
This cites a survey from the UK that found that cost-based pricing with variable mark-ups accounted for 58% of firms surveyed.

“Mark-up Pricing in Norway,” November 23, 2013.
This cites a survey of 725 Norwegian firms that found that 69% of Norwegian businesses use mark-up pricing.

“Mark-up Pricing in Ireland,” November 22, 2013.
This cites a survey of 1000 Irish firms and finds that the largest type of pricing is mark-up pricing at 44% of firms. Other evidence suggests that the real percentage is higher than this.

“Mark-up Prices in Iceland,” November 25, 2013.
This cites a survey of 580 Icelandic firms and finds that mark-up pricing is the largest type of pricing at 45%. Evidence suggests that more mark-up prices are concealed in the other categories in the survey, so that real percentage is higher than this.

“Mark-up Pricing in Japan,” November 29, 2013.
This cites a survey of 630 Japanese companies. As interpreted by Fabiani et al. (2007: 190), the data suggests that least 54% of Japanese firms use mark-up pricing.

“Mark-up Pricing in New Zealand,” November 30, 2013.
This cites a survey of 5,300 New Zealand firms that finds that mark-up prices account for about 54% of business prices.

“Mark-up Pricing in Australia,” November 30, 2013.
This cites a survey of around 700 Australian firms that finds that mark-up prices account for at least 49% of firm prices. Once we add likely mark-up prices concealed in the other categories in the survey, the percentage possibly rises to 60%.

“Downwards Rigidity of Prices and Mark-up Pricing,” November 22, 2013.

“Lee on Post Keynesian Price Theory in The Oxford Handbook of Post-Keynesian Economics,” October 15, 2013.


BIBLIOGRAPHY
Fabiani, S., M. Druant, I. Hernando, C. Kwapil, B. Landau, C. Loupias, F. Martins, T. Mathä, R. Sabbatini, H. Stahl and A. Stokman. 2006. “What Firms’ Surveys tell us about Price-Setting Behavior in the Euro Area,” International Journal of Central Banking 2.3: 3–47.

Mises, L. von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von. 2011. A Critique of Interventionism. Mises Institute, Auburn, Ala.

Murphy, Robert P. and Amadeus Gabriel. 2008. Study Guide to Human Action. A Treatise on Economics: Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Parker, Miles. “Price-Setting Behaviour in New Zealand”
https://cama.crawford.anu.edu.au/amw2013/doc/Parker,Miles.pdf