Economics 101: Who Sets Prices?

Since the advent of nineteenth-century socialism, politicians and economists in the centre ground have argued for a balanced approach, where vital services are provided by the state, and capitalism is left to provide the rest. Vital services in a modern economy are taken to include pensions, unemployment and disability benefits, healthcare and education. Most states also provide communications, such as rail and road infrastructure, electrical grids and perhaps telecommunications. They often own and operate on behalf of the people utilities, such as the railways, ports, electricity, and water.

The rest they regulate. There is hardly a product or service in the private sector unregulated by government. So far as the public is concerned, they see the benefit of a state acting in its behalf, protecting it from the uncertainties in life, and from unscrupulous profit-seeking businessmen. People do not stop to consider that the state and its necessary bureaucracy is less efficient at protecting individuals than the individuals protecting themselves. Nor do they understand the enormous burden on them of having the state act in an economic role.

The central question, why the state is less efficient than free markets, is answered by understanding prices. Should they be set by the state, or by the consumer? The consumer exercises choice. The state intervenes to restrict choice. This article seeks to demonstrate why government services always come at a higher cost than the same services provided by free markets.

The position of Austrian economists

Last week, the Mises Institute published an article by Robert Murphy, explaining why Ludwig von Mises described the consumer as sovereign, and why Murray Rothbard contradicted Mises and urged his followers to “reject the notion of consumer sovereignty as an inaccurate political metaphor”.^[i]

Rothbard’s criticism appears to be semantic, based on a purist argument that the phrase confuses a political statement for an economic one. What von Mises actually meant is that in a capitalist economy all production of goods and services is aimed at satisfying consumer demand, and it is the consumer who ultimately decides what is bought and at what price. And we are not just talking of the retail sector. Retailers through their demand for supplies from wholesalers, importers, and manufacturers pass the signals from consumers back up the chain, imparting valuations to the productive process and to the pricing of raw materials.

Rothbard agreed with this entirely. Rothbard’s criticism of consumer sovereignty appears to be a very minor poke at his mentor, but it also betrays a different approach to explaining price theory in his Man, Economy, and State from von Mises’s Human Action. We should bear in mind Rothbard addressed a predominantly neo-Keynesian audience when the first edition of his book was published in 1962. In the first part of his book, Rothbard deploys charts and examples to show relationships between price and quantity of goods and enters into a discussion of supply and demand schedules. No charts can be found in von Mises’s earlier Human Action, though taken as a whole, the message is the same.

It is easy to confuse Rothbard’s approach to prices with the mathematical one taught by the economic establishment. But the mathematical economists take us in the direction of a static market devoid of evolution and shorn of the dynamics of time. This is where Rothbard differs from today’s mainstream. 

The mainstream assumption is equational maths, illustrated by charts, is the way to go. If so, a computer replicating the calculus behind supply and demand curves could accurately model prices, something that is yet to be achieved, even allowing for developments in artificial intelligence. Those who think consumer demand can be replicated by algorithms fail to distinguish between a static economic model and the dynamic world which is ever-changing. This point is fully acknowledged by Rothbard in his approach. Furthermore, he understands, as von Mises did, that the British classical school with its theory, that prices are determined by costs of production, did not accord with reality. 

A different approach is found in European subjective value theory, originally developed by the scholastics in the Middle Ages, and taken up by the likes of Cantillon, Turgot and Say. It was Carl Menger, the founder of the Austrian school, who linked the two approaches by explaining that it was marginal supply, satisfying the least important use for a consumer, that sets the price of a good. Therefore, a greater level of supply, by satisfying less important uses leads to a fall in price, while a reduction in supply only satisfies more important uses, leading to a higher price.^[ii]

If it is use-value that sets prices, then clearly it is the needs and wants of consumers that decide them. Hence von Mises’s metaphor, that the customer is sovereign.

We are dealing with non-financial assets here. The buying and selling of financial assets should be regarded as a separate subject, where the roles of participants in an exchange are not so neatly delineated. But there is a crossover which must be mentioned: since Rothbard wrote his Man, Economy, and State the prices of commodities have become increasingly distorted by derivatives, which are no longer simply used to iron out seasonality in agricultural production. They represent an extra source of paper supply that is never consumed, but because little or no distinction is made between physical commodities and financial derivatives, an increase in the supply of the latter suppresses relatively prices of the real thing. 

Even putting derivatives to one side, it is clear that the question of who takes the lead in determining prices has become a broader subject than it was when the concept of marginal utility was established by Menger in 1871.^[iii] The subject, is of course, almost limitless. This article will be confined to some brief comments designed to put consumer subjectivity into a modern context.