Supply and Demand Equilibrium and Menger’s Price Theory

Carl Menger’s price theory can be read in an English translation in Principles of Economics (2011 [1st edn. 1871]; Eastbourne, UK), pp. 191–225.

But a debate has raged about whether Menger had a clear notion of economic equilibrium and tendencies to equilibrium (Tieben 2012: 315).

Some few have that held that Menger had some notion of supply and demand equilibrium via price coordination (Moss 1978), but most argue that Menger did not have any such theory (Streissler 1972, Kirzner 1978; Endres 1995). Indeed, even Hayek remarked on “the absence in Menger’s work of the conception of a general equilibrium” (Hayek 1992: 104).

So, fundamentally, compared to both modern neoclassical and modern Austrian price theory, Menger’s price theory appears undeveloped (and it is also different from Marshallian partial equilibrium analysis).

Streissler (1972: 276) contends that “market clearing by price adjustment was inessential to … [sc. Menger’s] theory of price formation.” (And, as an aside, nor does Menger seem to conceive of the competitive entrepreneurial process as operating with a tendency to drive profits to zero [Kirzner 1978: 33].)

Indeed, Tieben contends that

“[sc. Menger] … rejected the static notion of economic equilibrium – the equality between quantities supplied and demanded – as a starting point for theoretical analysis.

But also as a dynamic conception there was no role for the conception of economic equilibrium in Menger’s theory of prices. Menger addressed the relationship between competition and prices as a secular trend, but there is hardly any reference in his theory of price to the capacity of competitive markets to establish equilibrium between supply and demand. Surprisingly, Menger never stressed the capacity of the market process to safeguard the relative harmony of the exchange mechanism, a function that is usually associated with the tendency of prices to move towards a supply and demand equilibrium.” (Tieben 2012: 319).

Furthermore, Menger’s own analysis of multilateral exchange shows that negotiated prices can cause excess demand to persist (Tieben 2012: 322) – which is contrary to modern price theory in which flexible prices cause equilibration of supply and demand.

Moss argues that Menger thought of true “equilibrium prices” as the price that emerges when completely determined by the preferences of economic agents and not influenced by their relative bargaining strengths (Moss 1978: 28; Tieben 2012: 320) – a definition contrary to the usual idea of an “equilibrium price” as a price that equates quantity demanded with total quantity supplied for sale.

Menger’s actual process of market “equilibration” is also quite different from modern Walrasian general equilibrium theory or even Mises’s market coordinating tendency towards the “final state of rest”: Menger thinks that economic progress consists in transformation of monopolistic markets into competitive ones, which boosts economic welfare via greater supply, less abuse of market power, and a more equitable distribution of wealth (Tieben 2012: 323). (Menger, it should be noted, held that monopoly was a quite significant market phenomenon, perhaps even the rule rather than the exception [Kirzner 1978: 41; Streissler 1973: 168].)

Arguably, it was Eugen von Böhm-Bawerk who extended Menger’s price theory to stress the idea of demand and supply equilibrium in prices (a concept which was called Gleichgewicht in German), and the (alleged) tendency of the market process via price formation to equilibrate demand and supply in auction-like markets (Endres 1996: 96; Tieben 2012: 323), even if Böhm-Bawerk’s view is that market clearing in this sense occurs in a given range of possible equilibrium prices rather than a unique Walrasian point price (Endres 1996: 96).

This concept of market clearing is central to modern Austrian economics: it cannot be stressed how dependent modern Austrian theory is on this idea. Without a tendency towards demand and supply equilibrium via flexible prices, so much of Austrian economics – such as the belief in rapid and smooth recovery from recessions and Misesian economic coordination – is undermined and left without foundation.

But it is strange indeed that Menger – the founder of Austrian theory – did not conceive of the price system as equilibrating supply and demand.

BIBLIOGRAPHY
Endres, A. M. 1995. “Carl Menger’s Theory of Price Formation Reconsidered,” History of Political Economy 27.2: 261–287.

Endres, A. M. 1996. “Some Microfoundations of Austrian Economics: Böhm-Bawerk’s Version,” European Journal of the History of Economic Thought 3.1: 84–106.

Endres, Anthony. 1997. Neoclassical Microeconomic Theory: The Founding Austrian Vision. Routledge, London. 60–84.

Hayek, Friedrich A. von. 1992. “Carl Menger (1840–1921),” in P. G. Klein (ed.), The Collected Works of F. A. Hayek. Volume IV. The Fortunes of Liberalism: Essays on Austrian Economics and the Ideal of Freedom. University of Chicago Press, Chicago. 61–107.

Jaffé, William. 1976. “Menger, Jevons and Walras De-homogenized,” Economic Inquiry 14: 511–524.

Kirzner, I. 1978. “The Entrepreneurial Role in Menger’s System,” Atlantic Economic Journal 6.3: 31–45.

Menger, C. 2011. Principles of Economics (trans. Grundsätze der Volkswirtschaftslehre [1st edn. 1871] by J. Dingwall and B. F. Hoselitz), Terra Libertas, Eastbourne, UK. pp. 191–225.

Moss, L. S. 1978. “Carl Menger’s Theory of Exchange,” Atlantic Economic Journal 6: 17–29.

Streissler, Erich. 1972. “To What Extent was the Austrian School Marginalist?,” History of Political Economy 4.2: 426–461.

Streissler, Erich. 1973. “Menger’s Theories of Money and Uncertainty—A Modern Interpretation,” in J. R. Hicks and W. Weber (eds.), Carl Menger and the Austrian School of Economics. Clarendon Press, Oxford. 164–189.

Streissler, Erich. 1990. “The Influence of German Economics on the Work of Menger and Marshall,” in Bruce J. Caldwell (ed.), Carl Menger and His Legacy in Economics. Duke University Press, Durham.

Tieben, Bert. 2012. The Concept of Equilibrium in Different Economic Traditions: An Historical Investigation. Edward Elgar, Cheltenham, UK and Northampton, MA. pp. 315–319.

Tomo, S. 1987. Early Lectures on Economics by Böhm-Bawerk. Series no. 13, Centre for Historical Social Science Literature, Hitotsubashi University.

A Note on Prices and Say’s Law

In neoclassical theory, the equilibrium price is the price in a particular commodity market that equates the demand for that commodity with the supply, so that the market is cleared. It can be understood as a market-clearing price.

By contrast, in Classical economics, the equilibrium price (or natural price) is derived from costs of production (wages, other factor inputs, rent, and profits). That is, factor inputs are capital goods (where the return is profit), labour (the return is wages), land (rent) or raw materials (cost of purchase).

Now let us turn to how later Classical economists defined or formulated Say’s law, according to Thomas Sowell (1994: 39–41):

“(1) The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output [an idea in James Mill].

(2) There is no loss of purchasing power anywhere in the economy. People save only to the extent of their desire to invest and do not hold money beyond their transactions need during the current period [James Mill and Adam Smith].

(3) Investment is only an internal transfer, not a net reduction, of aggregate demand. The same amount that could have been spent by the thrifty consumer will be spent by the capitalists and/or the workers in the investment goods sector [John Stuart Mill].

(4) In real terms, supply equals demand ex ante [= “before the event”], since each individual produces only because of, and to the extent of, his demand for other goods. (Sometimes this doctrine was supported by demonstrating that supply equals demand ex post.) [James Mill.]

(5) A higher rate of savings will cause a higher rate of subsequent growth in aggregate output [James Mill and Adam Smith].

(6) Disequilibrium in the economy can exist only because the internal proportions of output differ from consumer’s preferred mix—not because output is excessive in the aggregate” [Say, Ricardo, Torrens, James Mill] (Sowell 1994: 39–41).

I have pointed out before that many modern studies have concluded that it was the Classical economists Adam Smith and James Mill who had a major role in developing Say’s law, in terms of the propositions listed above, not necessarily Jean-Baptiste Say himself.

Indeed Thweatt (1979: 92–93) and Baumol (2003: 46) conclude that Adam Smith was in fact the father of Say’s law in Classical economics, and that James Mill was the first to express it properly in 1808.

What is the significance of this?

It is as follows: propositions (1) and (4) above seem to me to show the influence of the Classical price theory: the notion that the equilibrium price (or natural price) is derived from costs of production, and indeed that prices are normally or generally equal to the costs of production.

For how else it is possible to argue, as in proposition (1), that the “total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output”? If this is supposed to mean the total factor payments received before the sale of a given volume (or value) of output, there is a problem.

That Say’s law does think in terms of Classical equilibrium price is confirmed by the way that sectoral imbalances are allowed and explained by the theory:

“There could be, Say argued, a temporary glut of some commodities, but this would result from the fact that market equilibrium had not been attained. Some prices would be too low and others too high, relative to their respective long-run equilibrium prices or costs of production. In this case, there would be a glut of those commodities whose prices were too high and simultaneously a shortage of those commodities whose prices were too low. The gluts and shortages would exactly cancel out in the aggregate.” (Hunt and Lautzenheiser 2011: 137).

But already before we get to other critiques of Say’s law, it is vulnerable to the observation that this is not how prices are formed in the real world: in many markets for newly produced goods and services, especially in industrial markets, prices are administered or set by corporations and businesses, according to normal production costs plus a profit markup. Because of the profit markup, there is some degree of stability of profits that results from price administration (Gu and Lee 2012: 461). Stable profits in turn allow stable margins for internal financing of investment (Melmiès 2012).

But once the profit markup is factored into real world prices, the Classical price theory falls apart: prices in the real world are seldom the Classical equilibrium prices derived from costs of production, but the prices for many commodities exceed the costs of production. In the aggregate, the sale price of the aggregate supply of commodities will be well above the costs of production, and so the idea that the “total factor payments received for producing a given volume ... of output are necessarily sufficient to purchase that volume ... of output” before actual purchase is false. It is also false to say that in “real terms, supply equals demand ex ante [= before the event],” if by this one means that aggregate costs of production including wages or purchases of factor inputs will equal the aggregate cost of the output when purchased. The latter – the aggregate cost of the output when purchased – will exceed the total factor payments before sale.

Of course, if one wants to define Say’s law as the idea that the income from aggregate sales plus factor payments is sufficient to purchase that output in a given period, perhaps one can evade this criticism, but the point is there seems to be ambiguity about how Say’s law is defined.

Are total factor payments received for producing a given volume of output defined as ex ante or ex post payments, i.e., before or after the actual sales of those products?


BIBLIOGRAPHY

Baumol, W. J. 2003. “Retrospectives: Say’s Law,” in S. Kates (ed.), Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Edward Elgar Pub, Cheltenham; Northampton, Mass. 39–49.

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

Melmiès, J. 2012. “Price Rigidity,” in J. E. King, The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 452–456.

Mill, James. 1808. Commerce Defended. An Answer to the Arguments by which Mr. Spence, Mr. Cobbett, and Others, have Attempted to Prove that Commerce is not a Source of National Wealth. C. and R. Baldwin, London.

Sowell, T. 1994. Classical Economics Reconsidered. Princeton University Press, Princeton, N.J.

Thweatt, W. O. 1979. “Early Formulators of Say’s Law,” Quarterly Review of Economics and Business 19: 79–96.

Lachmann and Post Keynesianism on Prices

Ludwig Lachmann wrote the following on the nature of prices that is of some interest:

“In different markets prices are formed in different ways. Not all pricefixing agents have the same interests. Here historical change plays its part. The decline of the wholesale merchant, whose dominating role Marshall took for granted, for instance in textile markets, and who naturally aimed at setting such prices as would permit him to maximize his turnover (a short-run consideration), reduced the range of markets with flexible prices. The rise of the industrial cost accountant as a pricefixer, with his interest in ‘orderly marketing’ (a long-run consideration) and his aversion to frequent price changes, has made most prices of industrial goods in our world Hicksian fixprices. In all markets dominated by speculation of course prices must be flexible. On the other hand, all bureaucracies, including those concerned with production planning in large industrial enterprises, naturally abhor flexible prices.” (Lachmann 1994: 166).

In Classical economics (from Smith to Mill), the equilibrium value of prices in the long run was essentially the cost of production. With the marginalist revolution, value was held to be subjective, and prices a consequence of the marginal utilities of market participants (Lachmann 1994: 165).

Yet, with the existence of “fixprices” in many markets, it is obvious that cost of production plus the profit markup must explain how prices are set in the real world.

That nobody can sell a product for which there is no subjective demand is obviously true, but after that the subjective theory of value has its limitations.

While economic “value” defined simply as the pleasure, utility or satisfaction we derive from commodities is subjective, it is a mistake to think that prices are therefore all subjective, or just determined by subjective utilities. One has to distinguish “price theory” from “value theory,” but curiously modern neoclassical economics has largely dispensed with “value theory.” As I. A. Kerr has pointed out,

“[m]ore recently, the attitude of neoclassical economists to the value/price distinction has been one of indifference, rather than hostility … value theory is virtually synonymous with price theory and many economists would be hard pressed to explain the difference between the two. In fact, the two terms are widely conflated by neoclassical economists” (Kerr 1999: 1218).

Yet that conflation is a mistake.

The existence of price setting/price administration is real.

You might wonder: where does this leave the idea held by neoclassicals and some Austrians of an economy with a strong tendency to a general equilibrium, in which prices gravitate to their equilibrium, market clearing levels? It leaves the idea looking highly suspect, to say the least.

From the perspective of Walrasian general equilibrium theory, all real world prices are “disequilibrium prices” (Lachmann 1994: 165).

While one can point to certain flexprice markets where eliminating excess stock leads to some flexibility in price, and we regularly see “clearance sales” by retailers to liquidate unsold stock, the notion of a general “market clearing, equilibrium price” in many other markets with fixprices/administered prices must be judged a myth. The empirical reality is discussed by F. S. Lee:

“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 negative enough to persuade enterprises not to try the experiment again … The absence of any significant market price-sales relationship in the short term has also been noted in various industry studies … Consequently, business enterprises do not utilize an inverse price-sales relationship when making pricing decisions and nor do they set their prices to achieve a specific volume of sales. Instead, the prices they set are maintained for a variety of sales volumes over time.” (Lee 1994: 319–320).

Lee concludes that this “necessarily means that 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 inference from this and empirical reality is, of course, that with really large falls in demand, businesses fire workers and cut production. Prices are not adjusted to clear markets with excess volume.


BIBLIOGRAPHY

Kerr, I. A. 1999. “Value foundation of Price,” in P. A. O’Hara (ed.), Encyclopedia of Political Economy, Routledge, London and New York. 1217–1219.

Lachmann, L. M. 1982. “The Salvage of Ideas: Problems of the Revival of Austrian Economic Thought,” Journal of Institutional and Theoretical Economics 138.4: 629–645.

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

Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. Don Lavoie). Routledge, London.

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.