We teach Austrian Economics in a fun way!

Price Discovery | How prices are determined?

In our previous videos entitled “The Value of Things” and “Scarce Resources” we have discussed how value is a subjective phenomenon. Two diverse people can estimate value of the same thing very differently. Every time a man acts, he does so in accordance with his own personal scale (or a ranking) of values. This is why he can value one thing more than another, while his friend will value these things inversely. 

This is because people have different goals. Human goals are also subjective, and means of achieving them are evaluated in accordance with their ability to realize these goals. Regardless, we cannot precisely measure the difference between values prescribed to any two things by a valuing person. Though it is possible to say that one may value a family photo more than a bottle of rum, we cannot determine if the former satisfies one’s needs two or three times more than the latter, or that it is five times more valuable. It would be as pointless as an attempt to provide a numerical appraisal of how much more we love our spouse than our parents (or vice versa). Yet it is correct to say that a man who paid 1000 dollars for a bicycle has valued the bicycle more than having 1000 dollars. When the exchange occurred, he was convinced that the bicycle would bring him greater satisfaction than the money. Otherwise he would not buy the bike, and would have made a different choice. People engage in voluntary exchange in order to improve their situation. They give up less satisfactory goals (i.e. cost) for more satisfactory ones. If the value of the achieved goal in our assessment exceeds the costs incurred, then we feel that we have achieved a profit. The profit also cannot be estimated objectively; it is equal to the overall subjective satisfaction felt by a man experiencing it, and can only be assessed by him.

After this brief introduction we will discuss the process of consumer goods’ price formation. Where does such and such exchange ratio expressed in money comes from? Of course you may say that prices result from supply meeting demand, but that does not explain the process. Demand and supply can be further analyzed. Today we will inquire into the phenomenon a bit deeper.

First of all, we will delineate assumptions for such analysis. Those are as follows:

– buyers and sellers have knowledge about a realizable transaction. The buyers know that sellers offer goods desired by the buyers on the market. This assumption is obvious; if the buyer did not know about the good, the transaction could not even be started.
– Market participants understand that participation in the division of labor and in the exchange benefits them. When they do not see it as beneficial, they do not proceed with the exchange.
– People prefer their benefit to be greater rather than smaller. Buyers prefer to buy cheaper, if possible, and sellers prefer a higher profit.
– People prefer lower benefit than no benefit at all. This means that people prefer to exchange rather than not, even when benefits of the exchange are miniscule.

These are four very simple and above all realistic assumptions to be used in the analysis of market exchange. Please note that we do not assume any unrealistic model of perfect competition. We are not saying that buyers and sellers have perfect knowledge about everything that happens in the market. We also disregard any other unrealistic assumptions, such as an infinite number of buyers and sellers or a perfect divisibility of goods. Our task is to explain the formation of realistic market prices, not of some hypothetical prices existing in market conditions impossible to be achieved in reality.

Therefore, let’s start with the simplest of exchanges, the one taking place between two people: a buyer and a seller. Let’s say that Matthew wants to buy an acoustic guitar and that his friend Michael wants to sell such a guitar. In Matthew’s subjective assessment the guitar is not worth more than 250 dollars. Michael, in turn, believes that the exchange will satisfy his needs only if he will get at least 200 dollars for his guitar. In other words, Matthew prefers to have a guitar than to have money (up to the amount of 250 dollars). As for Michael, starting from the amount of 200 dollars he would rather have money instead of a guitar. If Michael demanded 300 dollars for the guitar, then Matthew would not make the purchase; and if Matthew offered only 100 dollars, then Michael would not agree to sell. This is why the market price must be established somewhere between 200 dollars and 250 dollars. Inside this bracket the price will be beneficial for both parties. Theory does not allow us to make our assessment of the price any more specific than that. The eventual specific price will be determined by negotiating skills of both Matthew and Michael. We cannot specifically tell whether the price will be 201 dollars or 249 dollars, but we know the extent to which the transaction will be mutually beneficial.

Now let us imagine the situation of unilateral competition between buyers. This means that there is only one seller — Michael — but more people are willing to buy the guitar. Now Matthew is joined by four others willing to buy it. Each of them has a different maximum price that they are willing to pay for the guitar. Suppose that Darius is willing to pay up to 300 dollars for the guitar, while Martin will pay 275 dollars, Matthew 250 dollars, Conrad 225 dollars, and Daniel only 200 dollars. Michael still won’t sell the guitar for less than 200 dollars. How will this affect the price level?

We can guess that the guitar will be sold to the one buyer who will offer the most, i.e. to Darius, who is willing to pay up to 300 dollars. Price will fall inside a bracket between Darius’ maximum price and the maximum price offered by another buyer — Martin — who offers second highest amount; that is between 275 and 300 dollars. This is because in order to outbid all other buyers Darius must offer more than 275 dollars. Only then will he outbid his competition. As for the upper limit, it is equal to the maximum price Darius is willing to pay. Of course, for Michael, this price will also be satisfactory, as is any price above 200 dollars.

And now let us reverse the situation — this time it will be a one-sided competition between the sellers. A few additional sellers besides Michael will now appear on the market where only Matthew wants to buy the guitar for up to 250 dollars. Michael still wants to get at least 200 dollars for his guitar, but here at the scene enter: Darius, who will be satisfied by a price of 190 dollars, Martin, who wants to get at least 180 dollars, Conrad, with a minimum price of 170 dollars, and Daniel, with the minimum price of 160 dollars. The guitars in this example are identical and in the same condition. Who will sell the guitar and at what price? The guitar will be sold by a person who appreciates it the least, that is by Daniel. Even though Matthew was indeed willing to pay up to 250 dollars, he will of course try to get it as cheaply as possible. So Daniel, in order to get rid of his competition, will have to fight for Matthew to be his customer. He will be able to do so only by asking for a price even lower than the minimum price asked by the next person wanting to sell cheaply, that is by Conrad, who would be satisfied by a price of 170 dollars. Thus the eventual price will fall somewhere between 160 and 170 dollars.

Let us raise the difficulty of the example a bit higher. What happens in a situation of bilateral competition, where there are more sellers and more buyers? Let us say that we have five guitar buyers and five guitar sellers. In this example, it will be easier to use numbers instead of names. Let us call buyers B1, B2, B3, B4, and B5 (their price maximums are next to their names). On the other side there are sellers S1, S2, S3, S4, and S5, with their price minimums next to their names. The question is: who will have a guitar after all of the transactions will take place, and at what market price? There are five guitars on the market. The first thing we can do is to pair up buyers with sellers. We can see that 4 such pairs (in which buyers appreciate the guitar higher than the seller) can make mutually beneficial trades. The last pair cannot proceed with the exchange, because the seller values the guitar higher than the buyer. We can also arrange buyers and sellers in one column according to their value assessments from highest to lowest. Here we can easily see that those who value the guitars most are B1, B2, B3, S5, and B4. On the market the product goes to people who appreciate it the most. This is why they are precisely the people who will have guitars. This fact entails that one of the guitars will not be sold but will stay with its owner who values it more than the money he can get on the market.

We are left with only one question: what price of the guitar will be eventually established?

? < P < ?

Böhm-Bawerk said that the price and quantity are determined according to the values of “marginal pairs”. We will also have some brackets here, but their estimation will be somewhat harder than in the previous examples. The marginal pairs here, as defined by Böhm-Bawerk, are the following ones: B4 and S4, and B5 and S5. Now we can proceed with establishing our brackets. A higher cap for the price is determined either by the last buyer who managed to buy a guitar (i.e. the one who offered the lowest price, but was still able to buy the guitar), or by the first potential seller who failed to sell his guitar. We always select the lowest of such two values. In our example, the last buyer who managed to buy the guitar was B4, and the first seller who failed to sell was S5. We are left with two values: 225 dollars and 230 dollars. The lowest of these is 225 dollars — this will be the upper cap for the market price.

? < P < 225 dollars

The lower cap, in turn, is determined either by the final seller who managed to sell the guitar (i.e. the one who asked for the highest price and still sold the guitar), or by the first buyer who failed to buy it. In our example, these two are seller S4 and buyer B5. S4 asked for 210 dollars and he still managed to sell. As for B5, he was the first of the buyers to offer too little to make a purchase. So again we have two values: 210 dollars and 200 dollars. We always select the highest of the two. As the higher one is 210 dollars, this will be the lower cap for the market price.

210 dollars < P < 225 dollars

Thus, we were able to discover that given the subjective valuations of buyers and sellers as in the example above, 4 guitars will be sold at a price between 210 and 225 dollars.

What can we learn from this analysis?

It is worth noting that throughout the entire analysis of price formation we did not say a word about costs of producing guitars, nor of purchasing costs incurred in the past by the sellers of guitars. There is a good reason for this. Prices of consumer goods depend only on the subjective valuations imputed to those goods by people evaluating them. The prices of factors of production are formed based on what entrepreneurs anticipate the future prices of consumer products to be. Value of the costs is thus imputed from this anticipation of the final price of the product, and not the other way around. Future price is not determined by costs; it is the anticipated price that determines them. It sometimes happens that while releasing a product on the market an entrepreneur will mistakenly overprice it so no one wants to buy it. He is then forced to sell his product below its cost of production to recover at least some portion of the capital he invested in its production. Our analysis also explains why works of art such as paintings are very expensive even though the paint and the canvas needed for their creation were relatively cheap.

Another interesting implication is that prices are not determined solely by the sellers. Equally important in the process of market price formation are the buyers. In no possible scenario is price determined with complete freedom by the seller. He must always take consumer into account.

Another thing worth pointing out is that thanks to the fact that a certain price is being settled for all transactions, the goods always end up with people who value them most, and those people who value those goods the least are able to get rid of them. When prices are freely formed, they also communicate information. They inform entrepreneurs about the accuracy of their previous anticipations and investment decisions. They indirectly carry information about the availability of resources as well. When something is less available, it gets more expensive and therefore less attractive. Because of the existence of prices people are saving less accessible resources, and though people who really need them pay the higher price, they are at least able to get them. Artificial inhibition of price increases for less available resources, only causing shortages and misallocation of these resources. This is how the system of free prices works on the market. It allocates resources to where they are most needed or where they can satisfy the most urgent needs. Such an allocation maximizes prosperity. Any interference in the pricing system causes worse allocation of resources than it could have been, reducing satisfaction felt by participants of exchanges. You can find out more on this topic in the video entitled “Price System – Free Market vs. Government Intervention.”

The last thing to point out today is the fact that prices are set by the so-called marginal buyers and sellers. This knowledge also applies to financial markets. As Mark Skousen wrote in his book “A Viennese Waltz Down Wall Street. Austrian Economics for Investors”:

“It takes only a marginal shift in investor sentiment to change the direction of stock prices.”

The script was based on:
Peter G. Klein lecture: “Fundamentals Of Economic Analysis: A Causal-Realist Approach – 3. The Determination of Prices”
https://mises.org/library/3-determination-prices-1

Percy L. Greaves, Jr., “How Prices Are Determined”
https://mises.org/library/how-prices-are-determined

2018-04-21T11:50:22+00:00