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All posts by Dan Whalen,
Providence, RI (resume)

Thursday, August 25, 2011

How are 'prices' determined?

Where do prices come from?  Why do things cost what they do?

It seems like a pithy, kind of silly question.  But it’s one that has dogged economists for centuries.  It’s a much more complicated question than you might expect. 

If I tried to sell you a stack of wood and sticks as a kitchen table “with some assembly required,” I’d doubt you’d be too excited about the deal.  But if I knocked those chunks of wood together into a table first, suddenly I'd have something of value. 

Somewhere in the late 1700s, some philosophers looked at this scenario and concluded that it must be people’s labor that made things worth more money.  This idea is called the Labor Theory of Value, and is economics' earliest attempt to explain prices. 

If we follow the theory to its logical conclusion, it would tell us that any two items made from the same starting material would have prices directly related only to the amount of time spent working on those materials.

Of course, there’s a ton of problems with the concept.  If the labor required to produce an object was the only determinate of it’s worth, a table that was made in 2 hours would always sell for exactly double what a table made in 1 hour would.  A generic plush mouse made from the same amount and types of materials as a Mickey Mouse doll would fetch identical prices, given that both take exactly the same amount of time to make.  This is observably untrue.

More importantly, is there anything that can be produced using labor alone?  The table maker needs tools, training, materials and a work space, as well as his time to create a valuable table out of scraps of wood. 

In the 1890s, the economist Alfred Marshall pointed out that unless they are pulling carbon and nitrogen out of the air one atom at a time, and attaching them to each other in tiny chains, even farm laborers aren’t the sole producer of their products' value.  Nothing is truly created though the force of labor only.

The Labor Theory of Value had a decent run, say from about the 1770s to the later 1800s.  But by 1900 it drops out of mainstream economics entirely. 

Today, economists acknowledge that labor is definitely a factor of the end price of an item, as it is part of the cost of making it.  But it is clearly not the only determinate.

Any other guesses?  What is it that determines the price of something?

Ok, how about the price of something is one of those things "that just is"?  That is to say all goods and services have some sort of objective, intrinsic value?

If this were true than whale blubber would still be fetching top dollar on amazon.com, stocks in the East India company would be selling like hotcakes, and every department store in the US would be well stocked with typewriters and wheat threshers. 

Prices are completely subjective in the long-run.  At any given point in history, an item is only "worth" what buyers are willing to pay for it.  The price of a good or service fluctuate dramatically over long periods of time, a major stumbling block for any proponent of an "permanent, intrinsic value" view of the world.

Lets try this, then: rare items are worth a lot of money because there are fewer of them, so consumers "bid up" the price?

Not quite, but you’re getting there. 

Locks of my hair are rare.  But how much would you pay for one?  Rare things that are in high demand (for any reason) are worth crazy amounts of money, see diamonds or software engineers for more on that.  The uncommonness of items that everyone wants/needs can push the going rate up to astronomical heights, for sure.  But the item's uncommonness alone has no bearing on what people are willing to pay for it. 

In America right now, there are way more watertight buckets for sale than leaky ones.  All the same, I wouldn't suggest opening a leaky bucket factory.  You may find the market's not as hot as you anticipated.

Than it must be the producers/sellers.  They charge what they want and the consumer just pays it.

It's almost a reflex to mumble about how Mobil can charge us “whatever they want” to fill up at the gas station.  But if that were true, the price of gas wouldn’t go up some days and down others like it always does.  It would only ever go up!  In fact, if the gas stations or oil companies truly could charge “whatever” they wanted, gas would cost $100 a gallon.  Or $1 million! 

If the price of gas really does creep up to $6 or $7, we’d make good on the threats we’ve been making all summer and actually start riding our bikes to work.  At the same time, if they only ask me for $3 for a gallon, when I was ready to pay $3.05, well, Mobil just left money on the table.  

Mobil knows this, hence their upward and downward fluctuations in price.  Always trying to eke out top dollar, but without turning people off from their product.

Alright Mr. Smartypants, I give up.  Where do prices actually come from?

The explanation that we rely on in contemporary economics is one called The Law of Supply and Demand.  It's really a catch-all phrase for any interaction between four elements (two functions and two variables, for all you mathy people out there).  They are:

1) The supply of a good - how much of a good producers are willing to produce (given the price they can sell it for)
2) The demand for a good - how much of it consumers are desirous of acquiring (given the price it's going for)
3) The quantity of the good in the market - how much of the good there winds up being available (given the supply and demand)
4) The price of the good - what the consumer is willing to give up in exchange for a good (given the quantity and their own demand)

Each of the four elements push and pull each other in ways that are sometimes explicit, sometimes ephemeral and sometimes downright mysterious.  Each one influences the other three while simultaneously being influenced by the others.  I know is all sounds very Cosmic SoCal New-Age, but honestly it's the best explanation we're ever going to get.

Here's an illustration:

Let’s imagine a sandwich shop.  Josh, the shop owner, sells sandwiches for $5.  And lets say that price he’s able to sell 50 a day, for a revenue of $250 ($5 x 50 sandwiches = $250). 

"Well hey," says Josh, "I’m doing great business!  But I could be making even more money if I charge more for my product.  I'll raise my prices, and then I’ll really be raking it in!"

So he ups the price on his sandwiches to $6, thinking he’s in for $300 of revenue per day ($6 x 50 sandwiches = $300).

But, then something unexpected happens.  Maybe the public thinks his sandwiches are great…but not six dollars great.  Maybe his clientele love his sandwiches, but they just don’t have a lot of disposable cash these days, and $6 is out of their price range when it comes to take out. 

For our purposes, it doesn't exactly matter why, but let's imagine that right after Josh ups the price, suddenly his sandwiches aren't selling like they used to. 

So with the increase in price, Josh sees a drop in sales.  For argument's sake, I'll say he only sells 40 a day now at the new price.  His daily revenue drops to $240!  He actually was pulling in more money by charging a lower price.   

As soon as he realizes this, since Josh is a good businessman, he’ll bring the price back down to the original $5.  If he does not, some sandwich shop down the block, some upstart competitor, might very well start selling $5 subs, and Josh will eventually lose all his customers and go out of business.

Basically, Josh (and all the other sandwich makers of the world) is constantly “haggling” with the sandwich buying public, just not on a person to person basis. 

This happens in real-life constantly.  Every time I turn around, Subway is back to its “$5 foot longs” campaign.  They aren’t reducing the price because they inherently enjoy feeding the public, and are willing to bear the cost of lost revenue for the privilege of doing so (if that were true then their subs, of course, would simply be free).  They are reducing the price because it ends up increasing their revenue. 

In the end, producers can price their wares for just as much as the market will bear, a fancy way of saying they can "jack up the price until they lose so many customers that they wind up losing money."

Discussions of the laws of supply and demand in most econ textbooks are either short, hand-wavy and unsatisfying, or long, dense and inaccessible.  But maybe you can now see why.  It's a hard thing to put into words, so economists tend to either not bother, or put way too much effort into it.

That's why I've invented my own term for this super complex four way interaction of nontangible entities and forces: "Wikihaggling."  Not only is it an awesomely fun word to say (say it out loud.  I'm not kidding, do it.), but I think it describes well whats going on here.

Consumers, as a collective, with no leader or plan (I guess the right word would be "herd") communicate the prices they are willing to pay for an item through their purchase quantities at specific prices.  Producers tell us what quantity they'll produce given the prices we offer them through our purchasing habits. 

With no plan or direction from any particular source on either side, buyers and sellers are still able to come to some agreement on price and quantity.  No one individual entity in the market decides, yet it's decided by the aggregate behavior of all the individual's in the market. Hence: "Wikihaggling."

PS - The Wikihaggling system has one major kryptonite: "market power."  Market power is when one entity in a market has an atypical advantage or position that allows them to skew the four elements in some way that favors them.  Some examples include monopolies, oligopolies or monopsonies.

If Josh's sandwiches were the only food in town, he could probably jack the prices up well above $6 and still sell his 50 a day.  If Mobil raised their price to $3.05 a gallon, and I'd be much more comfortable paying $3, too bad for me.  I have to get to work.  I'll shell out the extra nickel.  If I was able to ban any other person but myself from buying tables, I can tell that carpenter exactly how much he's getting for his handiwork.

One of the most popular economic misconceptions out there is the belief that when economists talk about a "competitive market" that they are talking about an "unregulated market."  What they are actually referring to is a market where the four forces are free to move and settle where they would naturally, with no undue outside influence.  It refers to a curbing of "market power" and may actually require quite a bit of government regulation to maintain.

HOWEVER, you don't want the government to inadvertently exert its own influence on supply and demand either.  A government that breaks up monopolies is probably doing a lot of good for the competitive market.  But government that refuses to let its consumers buy products from abroad may wind up causing catastrophic damage to their own economy. 

It's all about finding the perfect balance.  And it's a fine line that regulators walk.

Regulation for the sake of regulation hurts everyone, and so can the completely hands off approach.  But specific, effective, targeted regulation can be of great help an economy flourish.  The government serves as the referee of the complex games that take place in our markets.  We need a ref who's perfectly fair, yet lets the players play the game the best they can.  That's a pretty tall order. 

This is why regulation can become such a contentious and controversial issue.  It can be very difficult to do right (when there are major problems identified in a market, economists often spend as much time arguing about the cause as they do the appropiate solution) and the stakes are often incredibly high.  It's no easy task, but then again, the important ones never are, are they?

*Below is a passage from one of my favorite adventure stories, Jeff Smith's Bone.  I thought it was pretty funny, but its also a weirdly spot on explanation of the origin of values and prices. 



3 comments:

  1. "If I tried to sell you a stack of wood and sticks as a kitchen table “with some assembly required,” I’d doubt you’d be too excited about the deal."

    That's what IKEA does.

    ReplyDelete
  2. You just blew my mind.

    Inspiration moment: If people are already accepting the "IKEA model," I think I could undercut that, and shave off EVEN MORE and still sell. I'm going to put a sign on the tree in my yard that says "Lovely set of chairs. Some Assembly required. $500" and see what happens...

    ReplyDelete
  3. Lol IKEA.

    Thanks for writing this Mr. Whalen! Your better than my econ teacher! Ive been trying to write my thoughts out on the issues of a free market or a regulated market on my tumblr. This post helped me immensely! I quoted your explanation of the Law of Supply and Demand because I just couldn't do justice to the reality you explain in my own words. I'd love to hear your comments on the post.

    http://dj4sjus.tumblr.com/post/42038623256/free-for-all-over-the-free-market

    My email is dj4sjus@gmail.com and again thank you!

    ReplyDelete