Monday, January 27, 2014

Keynesians, Austrians, Demand, and Production

Keynesians think that demand and, above all, aggregate demand drive production and employment.

Austrians also think demand drives production but in a different way.

This passage by Mises shows how and why Keynesians and Austrians differ on how demand drives production:
“In allocating labor and capital goods, the entrepreneurs and the capitalists are bound, by forces they are unable to escape, to satisfy the needs of consumers as fully as possible, given the state of economic wealth and technology. Thus, the contrast drawn between the capitalistic method of production, as production for profit, and the socialistic method, as production for use, is completely misleading. In the capitalistic economy, it is consumer demand that determines the pattern and direction of production, precisely because entrepreneurs and capitalists must consider the profitability of their enterprises.

An economy based on private ownership of the factors of production becomes meaningful through the market. The market operates by shifting the height of prices so that again and again demand and supply will tend to coincide. If demand for a good goes up, then its price rises, and this price rise leads to an increase in supply. Entrepreneurs try to produce those goods the sale of which offers them the highest possible gain. They expand production of any particular item up to the point at which it ceases to be profitable.
If the entrepreneur produces only those goods whose sale gives promise of yielding a profit, this means that they are producing no commodities for the manufacture of which labor and capital goods must be used which are needed for the manufacture of other commodities more urgently desired by consumers.

In the final analysis, it is the consumers who decide what shall be produced, and how. The law of the market compels entrepreneurs and capitalists to obey the orders of consumers and to fulfill their wishes with the least expenditure of time, labor and capital goods. Competition on the market sees to it that entrepreneurs and capitalists, who are not up to this task, will lose their position of control over the production process. If they cannot survive in competition, that is, in satisfying the wishes of consumers cheaper and better, then they suffer losses which diminish their importance in the economic process. If they do not soon correct the shortcomings in the management of their enterprise and capital investment, they are eliminated completely through the loss of their capital and entrepreneurial position. Henceforth, they must be content as employees with a more modest role and reduced income.” (Mises 2006 [1931]: 156–157).
The Austrian view of how demand drives production is as follows:
(1) Consumers purchase what they desire and value, and businesses produce these products by following the wishes of consumers. This idea is strongly related to what Mises means by “consumer sovereignty” (a phrase apparently coined by W. H. Hutt [Benton 1999: 911]), which, he thinks, is a fundamental characteristic of markets:
“The consumers patronize those shops in which they can buy what they want at the cheapest price. Their buying and their abstention from buying decides who should own and run the plants and the farms. They make poor people rich and rich people poor. They determine precisely what should be produced, in what quality, and in what quantities. They are merciless bosses, full of whims and fancies, changeable and unpredictable. For them nothing counts other than their own satisfaction. They do not care a whit for past merit and vested interests. If something is offered to them that they like better or that is cheaper, they desert their old purveyors. In their capacity as buyers and consumers they are hard-hearted and callous, without consideration for other people.” (Mises 2008: 270);
(2) but for Austrians it is primarily “price signals” and free competition that drive production: demand for a product may emerge or increase, and the price of that product will rise because of the increased demand.

The higher “price signal” and higher profits available in that product line, as compared with other markets with lower profits, zero profits or losses, will cause businesses to move into the more profitable market and produce more of that good.

When new firms have entered that market, the resulting increase in the quantity of goods produced will drive prices down, and thereby bring a tendency towards supply and demand equilibrium;

(3) eventually the increased production will tend to drive prices down towards marginal cost, and, when the price reaches this point, businesses will cease to increase production, and look for better profit opportunities elsewhere.
To the extent that (1) a market really does have flexible prices caused by dynamics of supply and demand, (2) the good can be produced in a reasonably elastic way, and (3) freedom of entry is not difficult, the Austrian story, more or less, applies to a minority of markets, except for point (3) above, since marginal cost is usually irrelevant for most firms.

But, apart from point (1) (which itself requires qualification), the Austrian view is, generally speaking, wrong, because it fails to consider the role of mark-up pricing/administered price industries and businesses.

In reality, it is the Keynesian view of how demand drives production that describes most markets. That view is as follows:
(1) Consumers purchase what they desire and value, and businesses generally produce these products by following the wishes of consumers. However, advertising and sales promotion have a great role in creating demand in modern economies, over and above the effects caused by price reductions. In the modern world, many businesses will be heavily involved in actively creating and increasing demand for their products (Galbraith 1985: 215; Benton 1999: 912);

(2) in reality, it is not “price signals” but “quantity signals” – in the sense of the quantity of a good demanded – that drive a great deal of production and employment (Kaldor 1985: 25). This is because very many firms use mark-up pricing and generally shun flexible prices. Businesses will mostly keep the price of their products unchanged when demand changes, and instead will employ the following means (not necessarily in this order): (1) use inventories to meet changes in demand, (2) increase excess capacity utilisation, and (3) increase worker overtime and/or increase employment.

Even when stocks or inventories cannot be drawn upon, (2) or (3) are the normal responses. Some empirical evidence confirms this. In a survey of 654 UK businesses, the firms were asked: what does the business do when there is a boom in demand which cannot be met from stocks or inventories?

Most UK firms said they simply increase overtime of workers (as reported by 62% of firms), hire more workers (12%), or increase capacity (8%) to produce more output, rather than increase the price of their product (Hall et al. 2000: 442).

Only 12% said they would increase the price of their product (Hall et al. 2000: 442).

(3) So, first of all, a significant increase in demand will not generally cause a price increase, and so the Austrian view of how firms seek profit is grossly unrealistic in many markets.

Secondly, the widespread use of inventories, overtime, and excess capacity utilisation in many established markets means that severe barriers to entry exist. Existing firms will often meet increased demand without any need for new firms to enter the market, and very high demand can simply mean existing firms will build new plants and production facilities, rather than see new businesses enter their markets.

Nor will increased production drive market prices to marginal cost, because mark-up pricing firms will maintain their administered price based on total average unit costs plus a profit mark-up: marginal cost is irrelevant for most firms.
It follows from all this that most output and employment changes in modern market economies are liable to be driven by demand but by means of “quantity signals,” not price signals.

The Keynesian policy of stimulating an economy by increasing demand will then generally increase output and employment, and not simply prices. Although booms do indeed tend to be inflationary in modern economies, nevertheless the process of inflation in a mark-up pricing world is uneven, much less intense and quite different from any crude economic theory that holds that all or most prices are flexible and simply a function of supply and demand dynamics.

Benton, Raymond. 1999. “Producer and Consumer Sovereignty,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z. Routledge, London and New York. 911–914.

Galbraith, J. K. 1985. The New Industrial State (4th edn.). Houghton Mifflin, Boston.

Hall, S., Walsh, M. and A. Yates. 2000. “Are UK Companies’ Prices Sticky?,” Oxford Economic Papers 52.3: 425–446.

Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.

Mises, Ludwig von. 2006 [1931]. “The Causes of the Economic Crisis,” in Percy L. Greaves (ed.). The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala. 155–181.

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


  1. This post seems very imbalanced. I could just as easily write that pure quantity signaling only works in special cases.

    It's nice that the survey recipients think they will increase inputs in response to demand changes. But they are thinking micro. If the input supply curves are not flat, the price of the input will be bid up and marginal cost will increase.

    1. When quantity produced expands, then with fixed/overhead costs forming a significant part of costs, this means total average unit costs fall as demand rises and (as I said) quantity produced expands to meet that demand.

      Most firms have L shaped demand curves, not V-shaped ones, and marginal cost is mostly irrelevant:

    2. And I'm saying you're thinking micro rather than macro. In the macro, you need to consider the supply curves for various factors of production. Pure qty theories only apply if you think the supply curves are flat (increased qty transacted, same price).

      You are correct that any unsaturated "fixed cost" can expand this way for a while, because it is unsaturated. Once it is saturated, it too will be affected by it's supply curve since you will need to buy more of them.

  2. Aggregated demand depends on the level of available income not prices.

    if the demand of a good goes down, other good must see its demand raise. The same goes with prices, if price of a product goes down, either you buy more of that product and less of others, or you will demand less (in value) of that good and buy other goods with the money saved.

    Aggregated demand doesn't behave like a demand curve for a product, actually we can question the existence of a aggregated demand curve, because all the determinantes that make you travel in the curve (price changes, and quantaty demanded) in the end make both aggregated demand and supply shift,

  3. "Although booms do indeed tend to be inflationary in modern economies, nevertheless the process of inflation in a mark-up pricing world is uneven, much less intense and quite different from any crude economic theory that holds that all or most prices are flexible and simply a function of supply and demand dynamics."

    How does a cost+markup theory explain inflation in a boom ? Econ 101s says that increased demand for inputs pushes up prices (supply stays the same but demand increases) - but cost+markup theory rejects this as an explanation. So why are booms inflationary? Perhaps supply and demand only holds in an inflationary boom and not at other times.

    1. (1) flexprice sectors (such as commodities and other factors) might well experience inflation during booms

      (2) some of this factor input inflation enters the mark-up pricing sector when total average unit costs rise to an extent that a firm will want to raise prices (and assuming its competitors, if any, also do so).

      But that process is neither automatic nor necessary. It will be uneven, since many firms will have falling total average costs given fixed overheads and rising production quantities. That fall in unit overhead cots might cover rising direct/variable cost increases so that no price change takes place.

      Or the firm may be frightened that its competitors will not raise prices, and so they will not raise theirs.

      (3) it is likely that wage rises during booms might drive inflation too