The Economic Nationalist

Here is the first article in a planned short series on basic concepts of economic theory, introduced here.

The article, being pedagogical in nature, inevitably takes a lecturing tone, whereas lectures ill suit such a polemical journal as The Economic Nationalist. The writer asks the reader’s indulgence under the circumstance.

A citizen ought to discern good, limited economics from bad, overreaching economics, for economics is a tremendous science; but so to discern requires more than prudent judgment. To discern requires also some acquaintance with the basic, abstract concepts of economic theory. These basic concepts are what this necessary series is about. —HJH—

What is a price? You must already know the answer, of course: a price is how much one must pay for something.

In a market economy such as we have, what determines a price?

“Supply and demand,” comes the ready reply.

Very well. What are supply and demand, then?

This question is harder. If you feel unsure as to how to answer then let us back up a bit. In a market economy such as we have, what determines the price of, say, a gallon of gasoline?

That perks some interest. “Why, the oil industry’s monstrous profits!” comes the indignant reply from one quarter. From another quarter, more sophisticated perhaps, comes again the stoic rejoinder, “Supply and demand.”

Maybe both replies have merit. Sophistication after all is overrated. Besides, it can hardly be denied that, at the time of this writing, the oil business has indeed been rather profitable. However, such observations in themselves do not lead to economic understanding. We shall have to do better than this.

The set of factors that determines a price, plus the collection of effects a price has on production, distribution, consumption and capital, taken together, is what economists call the price mechanism. Half the idea is as follows. At any particular place and time, goods and services exist in finite quantities that can run short. A shortage of a thing prompts its price to rise, causing marginal consumers—consumers that would have bought the thing at the lower price but will not or cannot buy the thing at the higher—to leave the limited supply of the thing to those willing and able to pay more. Complementarily, a surplus of a thing prompts its price to fall, causing marginal nonconsumers to start consuming the thing and/or causing existing consumers to consume more of it.

The basic reason a gallon of gasoline costs what it costs is that gasoline sells well at that price but does not sell out. Have you noticed how uncommon it is for a filling station to run dry? The seemingly inexhaustible supply of gasoline at the station is a curious thing, and is the curiouser the more one thinks about it. It is unexpected. After all, why should filling stations so seldom run dry? Has a filling station a limitless reservoir of gasoline?

The answer naturally is no: a filling station’s reservoir is quite limited. The station nevertheless seldom runs dry because, when inventory runs low (as it often does), the station’s owner raises his price to reduce customer traffic and, simultaneously, to extract some extra profit from the last few gallons he has available to sell. Concurrently, the rise in price at the one station relieves owners of competing stations, who may take the opportunity to pad profits by raising their own prices a little, thus causing customers generally to find ways to use less gasoline.

This is what prices do.

Notice that the price mechanism, so described, requires no external intervention to function. No one tells the seller or the buyer how to behave. Rather, when inventory runs low, the seller independently raises the price and the buyer voluntarily buys less.

Supply runs short, prices rise, people conserve (or at least buy elsewhere), thus supplies seldom actually run out. This is how it works.

So, that is the basic idea. That is the price mechanism.

*  *  *

That, at least, is how the price mechanism is supposed to work. That is the basic pattern. In the real world, many factors can and do interrupt the basic pattern, obstructing the price mechanism’s orderly function. Such factors include error, governmental regulation, incomplete information, improper price-trend extrapolation, theft, fraud, vanity, generosity, the strategical building of market share, sentiment for a particular price believed to be fair, monopoly, price-fixing, corruption in the awarding of contracts, brand loyalty, avoidance of the perception of price gouging, intellectual property rights, collective labor bargaining, market positioning and so on. Whether such obstructing factors are usually bad or often good and, indeed, how pervasive such obstructing factors are are important economic questions this article—which treats only the basic mechanism—does not consider.

The foregoing factors mostly regard the price mechanism’s demand side. In the long run however the mechanism has a complementary half, the supply side, too, arguably even more significant. Inasmuch as sustained high prices can mean fat profits for producers of the thing to which the price applies, high prices (a) cause some producers to invest their profits toward expanding their production capacity and (b) entice entrepreneurs to get into the business, becoming new producers. It may take a while, but eventually high prices call forth additional supply, which has the effect of moderating prices. Low prices have the reverse effect. Low prices (a) cause some producers to limit their losses by reducing or idling production capacity and (b) warn entrepreneurs to stay away from the business.

*  *  *

If that were all there were to it, the price mechanism would be interesting but would probably not merit such an article as this. However, the price mechanism has an unexpected, highly significant side effect.

Prices connect producers with consumers, even when the producers and consumers in question have no knowledge of one another.

A brief example will suffice to explain. A car stereo includes a high-fidelity audio amplifier. Someone, somewhere manufactures this amplifier. Car buyers consume such amplifiers and, indirectly, pay for them, yet few car buyers know where the amplifiers come from or who makes them or how. A car buyer might not even know what an audio amplifier is, but this does not prevent him from consuming it or from enjoying its use. On the other side, the amplifier’s manufacturer has no idea who his end-consumers are. He does not know how to market to them. He might conceivably even be unaware that the amplifiers he sells are destined to be installed in automobiles. Certainly he does not understand that an order for twenty extra amplifiers comes to him because Avis auto rental has decided to expand its fleet in Atlanta. What he does know is that he has a proximate customer—the stereo manufacturer—who pays him a profitable price for amplifiers and wants twenty more.

Were the price on offer unprofitable, the amplifier manufacturer might decline to supply the additional amplifiers, whereupon the stereo manufacturer might raise his price and the automobile manufacturer might ship fewer cars with stereos. The beauty of it is that no one need explain to stereo manufacturers, auto manufacturers, auto rental companies or travellers the woes of the amplifier business. Each supplier in the chain need merely propose a price, which his proximate customer can weigh, and can accept or reject. At each link in the chain, it is a price that tells the proximate buyer whether he ought to acquire scarce resources for his own use or to leave them for someone else’s. The final customer, the traveller who rents the auto, is not asked to contemplate amplifiers—or tires, windshield wipers, engine manifolds, transmissions, etc.—for the operation of the market has aggregated all these factors in a single number, a price, which, if low enough, he will pay.

Naturally, the example’s supply chain can be extended, for the amplifier includes an inductive winding whose copper comes from a mine in South America; and (to add a side-link to the chain) a restaurant’s radio advertising may draw the traveller renting the auto. Does the farmer that raises the chicken served to the traveller drawn by the ad played over a radio that includes an amplifier with an inductive copper winding know anything about South American copper mining? No, of course the farmer does not, even though—it could be argued—it is the distant copper miner that has unwittingly created the demand for the chicken. Yet the copper miner is himself an economic agent in a yet further extended supply chain, for he wears steel-toed boots in the mine, made of materials from all over the world: steel, leather, hemp, rubber, and so on. The suppliers and transporters of each of these materials has had an unwitting hand in the traveller’s chicken sandwich, too. As to the transporters, if the steel for the boot’s toe has traveled to the shoe factory on a rail car, then who was it that made the rail car? Who made the locomotive that pulls the car, and all its many parts? Who maintains these things and keeps them in working order? If the locomotive mechanic quits his job, and the locomotive breaks down, and the steel does not reach the shoe factory, and the copper miner loses time adjusting the old boot he cannot yet afford to replace, and less copper is produced, and one fewer amplifier is manufactured, and Avis consequently decides not to expand its fleet in Atlanta this year, then will some traveller ultimately not get his chicken sandwich? Or will someone in the supply chain merely switch to a competing supplier? The answer to each of these questions, and more, depends largely on prices.

And so on it goes, in infinite regression. The farmer only knows the price he receives, which tells him whether to raise more chickens next time. No single person grasps the entire chain of supply, with its various links, options and interconnections. No one sets all the prices or decides how much of what shall be produced when by whom, but it is prices nonetheless that connect the chain.

This last effect of the price mechanism is so subtle, so pervasive and so effective that it can seem almost magical: prices connecting buyers and sellers that know nothing about one another.

So, that is the basic idea. That is the price mechanism.

*  *  *

The foregoing is rather interesting once one grasps it. Too interesting, really. It tends to go to one’s head, which is bad. You want to guard against that.

The price mechanism is an idea. It is an important idea, but an idea only, nevertheless. Many, many economic transactions are determined on bases other than those this article describes. Also, the price mechanism does not directly take into account externalities, which are costs and benefits that accrue to bystanders who are not part of the transaction (if you sell me a puppy that that barks and yaps and keeps my neighbor awake at night, then the neighbor will have suffered an externality of the transaction which, to him, is not reflected in the puppy’s price; for, if the neighbor could charge me for lost sleep, then I would have been less willing to pay you so high a price for the pup). Tithes and offerings at church are a significant part of the economy whose connection to prices is tenuous at best. A high price may prompt Intel to develop a new generation of microprocessors but can hardly show Intel’s engineers how to develop it. And so on. The price mechanism thus may or may not adequately explain what goes on in the real economy. It depends.

The price mechanism is just an idea. You need to understand it, but, more importantly, you need to understand that it is just an idea, a tool, a limited though often useful way of thinking about things economic. The price is not necessarily always a manifestation of deeper truth.

It is neat, though. If you don’t let it go to your head, it can explain rather a lot.

HJH

This entry was posted on Tuesday, August 19th, 2008 at 8:21 pm and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.