The Austrian School of Economics has been at the forefront of price theory. Beginning with Carl Menger, the founding patriarch, through others such as, Böhm-Bawerk, Mises, Hayek, Rothbard, Lachmann, Kirzner and more have advanced the theory of prices. It is generally accepted that prices are a function of supply and demand. But, there’s more.
Carl Menger discovered that prices are set at the margins. That is, sellers and buyers meet at a market clearing price which includes the most market participants. Eugen von Böhm-Bawerk laid the ground work that helped others to understand that production costs are adjusted to suit market prices. Not vice versa. F.A. Hayek explained that prices send information to entrepreneurs on how to adjust production costs and supply stock. That intervention into the price discovery process can lead entrepreneurs to malinvest and begin a business cycle. Ludwig von Mises reminds us that there are no current prices, just past prices. Prices are simply a snapshot of economic calculations in the recent past. Murray N. Rothbard stood firm in opposition to general equilibrium and perfect competition theorists. He held fast to the a priori understanding that the subjective value of millions of market actors cannot be reduced to mathematical equations. The great volume of work that these men and more have done in price theory cannot be summed up in a simple sentence. Nor does this article address the differences between them. What we are going to find is how the Austrians have built upon each other to give us a sound methodology into prices.
Wages and Prices
Recently, a bit of a stir arose after I published the article, “Schiff is Right and Wrong”. In the article we discussed that fast food businesses, when forced to raise wages by government intervention, will first adjust costs, not raise prices. It was Murray N. Rothbard who, in his article, “The Truth About Taxes” pointed out that costs are not shifted forward into prices. Businesses have already set their prices at the maximum profitable level. Any arbitrary price hikes can cause them to loose market share to their competitors. In the words of Sheldon Richman from his article, “How to Help Fast Food Workers”,
“Couldn’t a restaurant raise prices to cover the higher wages? It could try, but this would drive away customers, who would seek out cheaper meals at other restaurants. (Franchisee profit margins are already thin.) If they all raised prices, people would eat at home instead. What happens to the jobs then?”
What we understand is that wages are not set arbitrarily. They are set in accordance to a worker’s Marginal Productive Value. That is, how much a worker can add to a firm’s profitability. Businesses must operate at a profit in order to stay in business. They are not employment agencies. If a worker can only add $7.25 an hour of value to the restaurant, then paying him $10.10 an hour would be a $2.85 per hour loss to the business. Compound that by the total amount of minimum wage earners on a shift and the losses could easily be in the $20 to $40 per hour range. Because of thin profit margins, the amount of added customer volume needed to maintain profitability would be unrealistic. What if the owner tried to sneak in a hike of a few cents in menu prices and lay off a couple workers? How many cents? How many workers? Could he automate the business? How much capital would that cost? How long to recoup the cost? Would customers accept a kiosk instead of a cashier? When will the government increase wages again? How will this affect payroll taxes? What will the vendors charge if their workers received a minimum wage hike? What are the customers actually willing to pay for a meal? What’s the competition doing? There are so many things to consider for the owner to make proper economic calculations that saying he could just jack up prices is about as simple-minded as it gets.
One thing that we know for certain, a mandatory minimum wage law is a mandatory unemployment law. The signal that government sends to entrepreneurs is that it is illegal to hire anyone who doesn’t produce at a predetermined earning level. In chapter 36 of “Making Economic Sense”, Rothbard stated clearly,
“In truth, there is only one way to regard a minimum wage law: it is compulsory unemployment, period. The law says: it is illegal, and therefore criminal, for anyone to hire anyone else below the level of X dollars an hour. This means, plainly and simply, that a large number of free and voluntary wage contracts are now outlawed and hence that there will be a large amount of unemployment. Remember that the minimum wage law provides no jobs; it only outlaws them; and outlawed jobs are the inevitable result.”
Although there are a myriad of economic calculations to consider when wages are arbitrarily raised, the end effect is that low skilled workers are shut out of the labor market. Never is minimum wage legislation a good thing for these people. Like Lew Rockwell often says, “Whatever the government tells you, just believe the opposite.” When interventionists tout the minimum wage mantra, in reality, they are eliminating more low cost competition from the labor market for their union contributors. To learn more about minimum wage and union labor read, “How Special-Interest Groups Benefit from Minimum Wage Laws” by Gary Galles.
Intervention and Prices
“Economics does not say that isolated government interference with the prices of only one commodity or a few commodities is unfair, bad, or unfeasible. It says that such interference produces results contrary to its purpose, that it makes conditions worse, not better, from the point of view of the government and those backing its interference.”
Ludwig von Mises, Human Action
What the Austrians have given us is a rock solid understanding that prices are a phenomenon of market forces. They convey information to entrepreneurs in order for them to make proper economic calculations. In turn, they can better distribute resources where they will be put to their best use. When government intervenes in this process by fiat, they distort the information that prices provide. The result being the “economic calculation problem” which yields a cycle of boom and bust.
In his book, “A Critique of Interventionism”, Mises explains with each intervention the government causes a distortion that will bring about another intervention. Along with each new intervention, more factors of production become controlled by central planners. After time, what was once a private property economy more resembles a socialist economy. What Hayek later called “The Road to Serfdom”.
Murray N. Rothbard broke new ground by dividing intervention into different categories with his seminal work, “Man, Economy and State”. Here he describes the three types of intervention,
- Autistic Intervention: where the aggressor intervenes with the choices or property of a single individual. An example would be a land use regulation.
- Binary Intervention: where the aggressor compels an individual into an exchange with himself. He may even coerce a “gift” from the individual. Taxation is a form of binary intervention.
- Triangular Intervention: where the intervention involves an aggressor and two other people who are in an exchange. Our minimum wage law is a good example where the terms of a wage agreement is coerced by government and not by free individuals.
Because each intervention is an act of coercion, that is, the individuals would not have participated in the exchange voluntarily, it causes a distortion in each person’s utility. Easier to understand, the ends and means that people would have desired have now been involuntarily changed. We might say the intervener has caused dis-utility in society. This is hardly a free market when individuals, through the threat of violence, are forced into choices that they otherwise would not have made. In an economy of interventionism the intervener is the one who gains while the others are left worse off, better known as the zero sum game. Consider this when others call for more regulation because they believe free market capitalism is a “rigged game” of winners and losers. The government wins and the governed lose. This is no different than the relationship between a mugger and his victim. Big corporations understand this dynamic and buy themselves into the winning side of the equation. Thus, we find ourselves in a corporatist system. Ironically, those who rail against corporate greed actually increase this corruption with each new cry for more regulation.
Inflation and Prices
“What people today call inflation is not inflation, i.e., the increase in the quantity of money and money substitutes, but the general rise in commodity prices and wage rates which is the inevitable consequence of inflation.”
Ludwig von Mises, Planning for Freedom
Not surprisingly, intervention causes a distortion in prices. Peter Schiff has done an outstanding job emphasizing that inflation is not the rising of prices but rather the expansion of the money supply. The rise in prices is a side-effect of money inflation. The creation of new money reduces the purchasing power of each money unit. Those insiders who are closest to the new money benefit the most. The devaluation of the money increases as it makes its way through the economy down to consumers. The subjective values of buyers and sellers are then interfered with by this inflationary policy.
In a free market based economy individuals bid up prices for goods in accordance to their subjective preferences and valuations. They save money according to their personal time preferences. These savings, in turn, are loaned out to entrepreneurs in the form of commodity credit which are invested in both short and long term projects. This is how a stable economy grows, in a nutshell. The distortion caused by intervention manifests in different areas. When Keynesians call for government to increase spending, this causes prices to be higher than they would have been in a stable free market. The government becomes the highest marginal buyer on the market because sellers understand that governments can use the coercive power of taxation to repay sellers. If the government borrows rather than taxes, then the additional money created by the central bank and the additional inflation by private fractional reserve banks expanding circulatory credit causes interest rates to be set at a rate which is inconsistent with individual time preferences.
Entrepreneurs receive a distorted picture of economic conditions and invest into unsustainable long term, or round about projects. This boom of activity cannot be sustained for long as there isn’t the correct supply of real capital to support the new money and credit. The inevitable bust occurs and workers are displaced. It cannot be stressed enough as to how important prices are in relaying economic information to entrepreneurs. Ours is not a world of perfect competition or general equilibrium where all economic actors have perfect information all at once and at the same time. Such constructs have given us an economic system of disinformation, devaluation, rising costs and a lowered standard of living.
We see prices are not arbitrarily set by greedy entrepreneurs. There are many factors that influence both buyers and sellers in the market and thus prices. We cannot forget the fundamental basis for all prices, that being, the subjective values of consumers. We may build constructs to help us understand how a price was arrived at but let’s not forget that prices function in the world of reality. Austrian economics is a study of causal-reality based relationships of people in the market. Reducing these relationships to mathematical equations removes the subjectivity of consumer’s valuations. In so doing, economists receive a distorted picture of the truth which result in policies that harm consumers.
This short article only scratches at the mass volume of price theory that is available for the interested student. The Mises Institute is a great source for someone to continue studying the effect of price policy and price theory. As you study, notice that no matter how complicated the issue may seem, sound theory is always based on human action.
[image credits: Wikimedia Commons]