Monday, March 19, 2012

The Market and Market Prices The Nature of the Market

An Introduction to Austrian Economics

Thomas C. Taylor

The Market and Market Prices

The Nature of the Market

The tendency to ascribe to the market economy the characteristic of being something other than the events caused by the choices and actions of individuals is incorrect. The market arises as a result of the willingness of individuals to interact. Every development in the market is the outcome of purposive actions on the part of individuals who are seeking to improve their own state of affairs.
This process of economic interaction and cooperation is the essence of the market; the market is not something physical but a process. Through the consummation of market transactions, individuals seek to improve their situations, i.e., enhance their own subjective satisfactions. The prices that emerge in the market are not unexplainable; they always are the result of subjective valuations expressed by individuals who choose to buy or sell or to abstain from either action. Mises emphasizes the human quality of all market activities:
It is customary to speak metaphorically of the automatic and anonymous forces actuating the "mechanism" of the market. In employing such metaphors people are ready to disregard the fact that the only factors directing the market and the determination of prices are purposive acts of men. There is no automatism; there are only men consciously and deliberately aiming at ends chosen. There are no mysterious mechanical forces; there is only the human will to remove uneasiness. There is no anonymity; there is I and you and Bill and Joe and all the rest. And each of us is both a producer and a consumer.... There is nothing inhuman or mystical with regard to the market. The market process is entirely a resultant of human actions. Every market phenomenon can be traced back to definite choices of the members of the market society. [1]

Price Determination--Consumer Goods

The Demand Side
The underlying purpose of all productive effort in the market economy is the generation of goods and services to be consumed. Money prices for consumer goods and services occur continuously as possession of these goods and services moves from the producer to the consumer. A market price is the exchange ratio or relationship between a particular good and the medium of exchange. Although the conventional supply and demand explanation of how equilibrium prices tend to be set in order to clear the market of particular goods is legitimate, it is necessary to examine the real meaning behind the diagram of intersecting curves.
Each potential consumer allocates his money so that his most urgent wants are satisfied first. This means that for any particular good whose purchase he contemplates, there is a ranking within his scale of values. It must be remembered that his scale of values reflects the relative subjective importance that he attaches to each alternative use of his money. Each potential purchase has to compete with alternative potential purchases and with the possibility of his retaining his money. Thus an additional unit of a given consumable good will rank higher or lower than a given amount of money. If it is preferred over, say, six units of money, he is willing to purchase one unit of the good in exchange for six units of money. Conversely, if he prefers to retain six units of his money for some other use rather than acquire a unit of the good, he will not be willing to purchase it at a price of six money units.
Assume that he will pay six units of money for one unit of a given good. Assume also that his rankings entail his preference for a second unit of the good at any price between, say, four and one money units, and that at a price of one unit of money, he is willing to buy a third unit. This means that at a price of four, five, or six money units he will buy one unit; at a price of two or three units of money he is willing to buy two units of the good; and if the price reaches one, he wishes to acquire three units.
It is in this way that a hypothetical individual's so-called demand curve can be drawn illustratively for each particular good that he might consider buying at a given moment. At each possible price, he either purchases a certain quantity of the good or purchases none of it. Because of the diminishing marginal utility of the good, he will be willing to increase the quantity purchased only at lower and lower prices. This is the reason for drawing his demand curve downward-sloping to the right. The total demand for a particular good then becomes the summation of each prospective consumer's individual demand. And though each individual demand may be unique, each curve depicting an individual's demand will be downward-sloping to the right. Thus the curve depicting total demand for a particular good will have the same kind of slope, i.e., downward-sloping to the right.
What is crucial to the understanding of demand is that the principle of diminishing marginal utility is constantly operating in the consumer's purchasing decisions. Each additional unit of a given good is applied to a less important use than the former unit acquired. And while the marginal utility of the good continuously falls with each added unit, the marginal utility relating to the remaining money rises. Increases in quantity demanded must be accompanied by decreases in price.
The Supply Side
Though the usual discussion of demand recognizes the subjective nature of a consumer's buying decisions, the supply side of price analysis invariably fails to be related to subjective value, despite the great importance of subjective valuations in the selling decisions of producers.
Each individual producer who has a certain stock of some consumer good ranks the units of the good in the same manner that a prospective consumer ranks his stock of money. There are three possible uses to which he can allocate his stock: He can use the good directly; he can sell it now for money; or he can retain the good for future sale. He will place subjective valuations on these different possibilities, devoting the various units to the most important usages. Based on this allocation, he ranks on his value scale each unit (remember the term "unit" can embrace any number of smaller increments) to be sold and the amount of money to be received in return. For each possible unit price he will be willing to sell either a certain quantity of the good or none of it. He will have to decide whether what he gives up is less or more valuable to him than the price he receives.
It is likely that to specialized producers the value of the good in direct use is virtually nil. If his valuation of the good for purposes of future sale is also slight, he will be willing to sell nearly all of his stock at a meager price per unit, provided that the marginal utility of money falls slowly as he obtains more of it. To the extent that he values using some units for purposes other than immediate sale, there will be some prices that are too low for him. In the absence of any compensating nonmonetary factors, in no case would he be willing to sell more units for lower prices per unit than for higher prices per unit.
If there is little value in not selling his entire supply of goods, his supply curve will be more or less vertical, meaning that at any possible price throughout the relevant range of his supply curve he is willing to sell all units of the good. Otherwise the curve will be upward-sloping to the right, indicating that as some units are sold, the marginal utility of the good increases in terms of the value of alternative uses, thereby requiring more money in exchange for additional units. The seller's supply curve will never be upward-sloping to the left.
Assume a seller has a stock of eight units of a particular good. If six units of money is more valuable to him than each of the units of the good, considering their alternative uses, then he will want to sell his entire stock at the unit price of six units of money. But suppose that at a price of five units of money he is willing to sell only six units of the good. Each of the two remaining units has a greater value to him than five units of money. At a price of four money units, he will sell only four units; at a price of three units of money, he is willing to sell but one unit of his good. And, at a price of one or two money units, he will not sell any of his stock of goods.
The law of marginal utility explains the behavior of this producer. The utility of a unit of his good in uses other than current sale rises as he decreases his stock. He insists on a greater amount of money in exchange for additional units. His selling decisions rest on his subjective valuations in the same way that the buying decisions of a given consumer depend on his scale of values.
A total supply curve for the good would entail the summation of all of the individual supply curves, and, thus, its various segments would be either vertical or upward-sloping to the right.
The Tendency Toward Equilibrium Prices
The day-to-day tendency in the market is toward the establishment of an equilibrium price for each particular consumer good. Prevailing prices tend toward that price at which quantity supplied and quantity demanded are equal, a movement that attests to the price system's capacity to coordinate the actions of persons engaged in different activities. The typical depiction of this tendency on a graph shows the equilibrium price at the point at which the market supply-and-demand curves intersect. Any price above or below the equilibrium price cannot persist because such a price will result, respectively, in either frustrated sellers or frustrated buyers. Prices are reduced by sellers if the market price is too high to clear the quantity offered; prices are bid upward by buyers if the price is too low to induce sellers to offer a quantity ample enough to satisfy the buyers' demand.
Market rents for leased durable consumer goods are established by the same pricing process. Rents are prices paid for the service units obtained through the right to use someone else's property over a period of time. Thus there is a demand for and supply of services obtainable through leased goods. Rothbard has explained this market development in the following way.
Since any good is bought only for the services that it can bestow, there is no reason why a certain period of service of a good may not be purchased. This can be done, of course, only where it is technically possible. Thus, the owner of a plot of land or of a sewing machine or of a house may "rent it out" for a certain period of time in exchange for money. While such hire may leave legal ownership of the good in the hands of the "landlord," the actual owner of the good's service for that period is the renter, or tenant. [2]
It should be mentioned at this point that there is a connection between the expected rental prices in the future and the purchase price of the good as a whole. The market price of the good tends to equal the present value of the expected future rentals. If the present value of expected future rentals is greater than the price of the good as a whole, more people will want to own the good as opposed to renting it. Meanwhile, present owners will be more reluctant to sell. This excess demand for the good will cause the price of the good to be bid upward toward the present value of future rentals. On the other hand, if the present value of expected rentals is less than the price of the good, fewer will want to buy the good and owners will want to sell rather than rent the good. This oversupply of the good causes its price to be lowered to come more in line with the present value of expected rentals, and thus price relations are established in the market through the same forces of supply and demand. Since prices are subject to change, the predicted future rentals are not simply a multiple of present rental prices. The relationship between the market price of the good and future rents is only a long-run tendency. The explanation of what is going on in the pricing process is not served merely by diagrams, however. One has to think of the process in terms of acting individuals following their own particular subjective valuations. If the price is too high or too low relative to the equilibrating price, individuals behave purposefully to correct the situation. Every exchange requires two mutually benefited parties. As Mises has said, the process is not mechanical or inhuman.
When it is said that the market process tends to yield an equilibrium price for each good, no reference is being made to the pricing of all physically identical goods. If consumers view the offerings of a certain supplier as being different in some way from those of other sellers, the good is a different good for the purposes of economic analysis, even if its observable physical attributes are the same as those of other sellers' goods. What really counts is how consumers perceive the various supplies of goods brought before them. Similarly, goods situated a long distance away are not the same as goods a short distance from use. The "same good" means the units of the good are equally serviceable to the buyer. Goods that have to be transported from far away are less complete and, hence, less serviceable because transportation to point of acquisition is part of the production process.
Thus different market prices can prevail for goods that a hypothetical, neutral observer, focusing solely on physical qualities, would deem identical. This is what Mises means when he says that
the market does not generate prices of land or motorcars in general nor wage rates in general, but prices for a certain piece of land and for a certain car and wage rates for a performance of a certain kind. It does not make any difference for the pricing process to what class the things exchanged are to be assigned from any point of view. However they may differ in other regards, in the very act of exchange they are nothing but commodities, i.e., things valued on account of their power to remove felt uneasiness. [3]
It is important to emphasize in price analysis that the movement toward market equilibrium prices is a tendency that seldom reaches fruition because of the continuous changes that occur in people's subjective valuations and in the supply of each good. To assume that established prices will perpetuate themselves is to conceive value as objective and unchanging. But individuals, both buyers and sellers, experience constant change in their valuations, purposes, and acts. The very essence of action is change. The ceaseless changing of human choices and actions upsets the tendency in the market for the establishment of equilibrating prices. Yet, with the advent of every change in market data, the process sets out in a new direction toward a different equilibrium price. Price analysis resorts to the mental tool of equilibrium prices in order to explain the continuous tendency of the market process. Market prices are the result of the particular circumstances that existed at the time of their occurrence.
The changeability of prices makes inappropriate any reference in the strict sense to prices as present or current prices. As Mises says, "prices are either prices of the past or expected prices of the future."[4] To refer to prices as "current" prices is to say that immediate future prices will be the same as the historical prices of the most recent past, say half an hour ago. Since prices generally are not violently restructured from moment to moment in the market, recent past prices are useful starting points in the projection of future prices. But it is future prices that are of primary significance to each actor. Past prices convey directly no certain knowledge about future prices.

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