Reality versus Rothbard: Prices, Demand and Production in the Real World

If one reads Rothbard’s Man, Economy, and State with Power and Market: The Scholar’s Edition (2nd edn.; 2009), one finds a long discussion of prices, but so often the discussion is stated in terms of exchange ratios of goods in barter economies. The absurdity of such “barter” analysis is that it is simply irrelevant to a modern monetary economy, certainly one where extensive mark-up pricing exists.

But, more than this, at times when Rothbard was dimly aware of the reality of prices and production, he was still living in a fantasy world:

“The specific feature of the ‘clearing of the market’ performed by the equilibrium price is that, at this price alone, all those buyers and sellers who are willing to make exchanges can do so. At this price five sellers with horses find five buyers for the horses; all who wish to buy and sell at this price can do so. At any other price, there are either frustrated buyers or frustrated sellers. Thus, at a price of 84, eight people would like to buy at this price, but only two horses are available. At this price, there is a great amount of ‘unsatisfied demand’ or excess demand. Conversely, at a price of, say, 95, there are seven sellers eager to supply horses, but only three people willing to demand horses. Thus, at this price, there is ‘unsatisfied supply,’ or excess supply. Other terms for excess demand and excess supply are ‘shortage’ and ‘surplus’ of the good. Aside from the universal fact of the scarcity of all goods, a price that is below the equilibrium price creates an additional shortage of supply for demanders, while a price above equilibrium creates a surplus of goods for sale as compared to demands for purchase. We see that the market process always tends to eliminate such shortages and surpluses and establish a price where demanders can find a supply, and suppliers a demand.

It is important to realize that this process of overbidding of buyers and underbidding of sellers always takes place in the market, even if the surface aspects of the specific case make it appear that only the sellers (or buyers) are setting the price. Thus, a good might be sold in retail shops, with prices simply ‘quoted’ by the individual seller. But the same process of bidding goes on in such a market as in any other. If the sellers set their prices below the equilibrium price, buyers will rush to make their purchases, and the sellers will find that shortages develop, accompanied by queues of buyers eager to purchase goods that are unavailable. Realizing that they could obtain higher prices for their goods, the sellers raise their quoted prices accordingly. On the other hand, if they set their prices above the equilibrium price, surpluses of unsold stocks will appear, and they will have to lower their prices in order to ‘move’ their accumulation of unwanted stocks and to clear the market.

The case where buyers quote prices and therefore appear to set them is similar. If the buyers quote prices below the equilibrium price, they will find that they cannot satisfy all their demands at that price. As a result, they will have to raise their quoted prices. On the other hand, if the buyers set the prices too high, they will find a stampede of sellers with unsalable stocks and will take advantage of the opportunity to lower the price and clear the market. Thus, regardless of the form of the market, the result of the market process is always to tend toward the establishment of the equilibrium price via the mutual bidding of buyers and sellers.” (Rothbard 2009: 117–119).

Rothbard must think that this really is a fundamental and universal (or near universal) state of real world markets, in order for his reasoning to work:

“It is important to realize that this process of overbidding of buyers and underbidding of sellers always takes place in the market, even if the surface aspects of the specific case make it appear that only the sellers (or buyers) are setting the price. Thus, a good might be sold in retail shops, with prices simply ‘quoted’ by the individual seller. But the same process of bidding goes on in such a market as in any other. If the sellers set their prices below the equilibrium price, buyers will rush to make their purchases, and the sellers will find that shortages develop, accompanied by queues of buyers eager to purchase goods that are unavailable. Realizing that they could obtain higher prices for their goods, the sellers raise their quoted prices accordingly. On the other hand, if they set their prices above the equilibrium price, surpluses of unsold stocks will appear, and they will have to lower their prices in order to ‘move’ their accumulation of unwanted stocks and to clear the market.”

This is simply untrue as either a (1) universal or (2) even general description of what happens in the real world.

Now you can certainly find some markets where what Rothbard is saying does actually happen. But the extent of these markets is grossly exaggerated.

Try walking into any number of supermarkets or department stores that sell newly-produced goods, and attempting to haggle with the staff to bring the price of goods down. You might be able to do it in some limited cases (especially in second hand goods stores or where retail businesses try and match their competitors’ prices), but everyone knows it is a grossly unrealistic strategy and likely to be a waste of time in most cases. Most prices are not set in auction-like markets or by a mutual haggling process between buyers and sellers. The price displayed is the price you pay, or you cannot have the good.

Moreover, in the real world, most firms are mark-up pricing firms and as producers they have excess capacity and inventories to deal with demand changes so that they can, generally speaking, leave prices unchanged: if demand rises, many firms can simply ramp up production by increasing capacity utilisation, and draw down inventories, and leave the price unchanged.

The empirical evidence overwhelmingly confirms this. In a recent survey of 654 UK businesses, the firms were asked: what do you 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%), in order to produce more output, rather than increase the price of their product. Only 12% said they would increase the price of their product (Hall, Walsh and Yates 2000: 442).

Most service industries, too, experience fluctuations in demand on a daily basis that may not be trivial, but they leave prices unchanged. Excess demand in hair salons, dentists, doctors, locksmiths etc. does not normally induce businesses to change prices: instead, people simply wait their turn in line, and pay the same price for any given service. Temporary “shortages” in the economic sense are common in services, but hardly anyone thinks this is some disastrous crisis of production or some terrible economic “problem” that should be solved by flexible prices to clear markets. In fact, if you arrived at your local hair salon and found 10 people waiting in line and the barber announced he was going to auction off the next 5 haircuts for the next hour to the highest bidders, it would be bizarre and utterly atypical behaviour.

Furthermore, in many retail stores, if things get sold out, the store will maintain the price and will simply order more of the good and put up a sign: “Out of stock,” “Sold out,” or “This product is temporarily unavailable” – or words to that effect.

If the typical firm faces a period of slack demand during a recession, the normal action is to cut production, fire workers, and cut costs, while leaving the price unchanged.

During a recession, mark-up prices can stay the same or even increase. The proof of this can be seen in how, in virtually every recession since WWII, in most nations inflation continues during recessions: deflation is rare, and recessions tend to have disinflation (which is still a form of inflation).

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

Rothbard, M. N. 2009. Man, Economy, and State with Power and Market: The Scholar’s Edition (2nd edn.). Ludwig von Mises Institute, Auburn, Ala.

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.


BIBLIOGRAPHY
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.