Old Inflated Inflationary Fallacies (I)

Here in Argentina we are facing an extremely high inflation in comparison to the rest of the world. In 2012 the annual rate was (at least) 25.6%, according to the Congress of this country. You need to understand this first: In this country, the ultra-interventionist government is so arbitrary that in 2007 (actually several months before that year) intervened the INDEC (the argentine equivalent to BLS) so it can manipulate the CPI at will. As result, “official” inflation is less than half than what is reported by any other estimation. The manipulation was so obvious that government persecuted any other economist who dare to defy what government says is the “real” inflation. No layman in this country believe in government statistics, only government-paid Goebbellian propagandists and government “economists” think they are real. Not surprisingly, Argentina’s money supply increases at an annual rate around 20-30%, part of it is to finance public sector deficit.

Now in order to not take the blame, the government and its minions have revived a lot of old fallacious explanations about inflation. Only one of them is the “blame big-business” fallacy. According to government, there are “price formers” that abuse workers and consumers by rising prices. That is just an unscientific and ridicule denomination for a most “serious” theory that tries to explain inflation without recurring to money supply. That is the fallacious theory called “administered price” or “control over price”. According to Hazlitt and Sawyer, this term was invented by Gardiner C. Means in 1935. However it has already been refuted.[1]

This theory says that a big company has an unrivaled power to raise price, it can even defy the Law of supply and demand. The theory implies that only by setting a selling price is enough to realize that “manipulated” price in market. So if price level goes up it is possible that this firms are charging “too high prices” and creating inflation. It is not a surprise that some of its supporters use it to deny the existence of demand-supply price determination. Now this theory has so many problems that it is amazing it can be taken seriously.

In the real world free market there is no such thing as a “control over price”. However somebody will say...

-“They control us!”

No they don’t. In a voluntary exchange nobody “controls” price. The main reason why a price emerges is because there is another part, it’s a mutual phenomenon, Robinson Crusoe alone in his island cannot exchange with anyone. In a free exchange, each part has no control over the other part. If seller cannot control the buyer then all he can do is to induce him to buy. If buyer cannot control the seller, all he can do is to induce to sell him the good or service. Now in order to induce each other in a nonviolent way, both parties can a) try to hypnotize the other part b) try to convince the other part to give away the good c) offer something in exchange. In any case there must be a common factor that is a necessary and sufficient condition for exchange to exist: both parts must win.[2]

Option c) will be chosen in the great majority of cases because is the least expense and the most efficient. If this happen, then in order for the buyer to ensure he will get the good, he will have to give a quantity of another thing he can offer. If the quantity (price) he offers (or the one the seller ask) satisfy his subjective valuations (i. e. is valued less than the goods he expect to receive) and at the same time the quantity asked by the seller (or offered by buyer) satisfies him, then the exchange will be fulfilled.[3]

Assume you want to sell your old car. You can ask one jillion dollars for it if you want. But if nobody buys it, then you can lower the price or not sell the car at all. It is possible that, in an incredible coincidence, your old car was Marilyn Monroe’s first car and someone actually pays that money. It could happen, as well as there are people that ask a ridicule high price because they are not desperate to sell. 

All this demonstrate that in an exchange there is no control over price, an exchange is voluntary and the price emerges as mutual valuations interact each other. The seller can raise the price as much as he wants and the buyer can lower it as much as he wants, but as long as one part cannot control the other part, he cannot get the maximum or minimum price he would desire. 

-“Yeah yeah, voluntarism sounds good. But what about the big ones!” 

This argument states: Look at Ford, Microsoft, Walmart, General Motors, they are so big! How can you compare them with a farmer, a little kiosk or retailer, or some small business? They are price takers! They have to face a given price while Ford can control price. It is big, it has scale, it has a branches and a name. Even if they don’t have an absolute monopoly, they have a degree of monopoly power.

Sounds convincing, but guess what? Both the big and the ultra-small business can actually have absolute control over the quantity they are willing to produce and the price they ask. Both groups of sellers can ask hyper-higher prices and restrict their production. But none of them can control how much buyers are willing to pay. Could Ford have asked one million dollars for each Ford T he made? Yes he could, he probably could have produced 5 cars a year. Can the farmer ask five times the market price? Yes he can. Are there people willing to pay that knowing that they can obtain the same good at lower price from another farmer? Hardly. But you may say: “Don’t be a fool. You are comparing a competitive atomized market like wheat with an evil big monopoly corporation like Ford, you have no alternative to buy another car, only Ford’s. In wheat market however you have millions of farmers selling the same good” Of course you have alternatives even assuming that car’s price is “administered” too high! You can ride a bicycle, a horse or a bus. In general when you buy a car you are buying individual transportation, the reason you buy it is because you expect the benefits of using your own car surpass the costs of purchase and the costs of other alternatives. If its price is too high, you can use the individual transportation you have been using like your bicycle or your own legs. Or you can use a public bus or subway. The good you are looking for is, in general[4], transportation, not the car itself. The car is just a form of transportation, so it is not true that “you have no other alternative than buying Ford’s cars to transporting yourself”. It is not crazy at all to compare an “atomistic-competitive market” and Ford. In both cases they can ask extremely higher prices and in both cases you are not forced at all to pay them.

A seller cannot control buyer’s willingness to buy and (mutastis mutandi) viceversa! All that both can control is the price they ask, but they cannot control that the other part pays what they want (maybe the Hypnotoad can, but nobody else!).

The ultimate fact that confirms this is that every single one of us (including big business men, presidents, scholars, professionals, wage earners, everyone!) would like to sell our goods or services (wages, salaries, rents, interest, price of goods, etc.) at a higher price. What prevent that to happen? The fact that our buyers will not pay those prices (and the fact that the “control over price” is totally false!)

-"Have you ever gone to Walmart? The prices are there! Walmart determined them!"

Yes! When you go to Walmart the prices are there “fixed”. But the one who set the price is not determining the price. A big enterprise can set the price, but the ones that corroborate that price are the consumers. The ones that determine prices are the consumers. It is a totally irrelevant technological question how or how often prices are set. Whether you are in an auction, in a supermarket, eBay, etc.; it is always subjective valuations what determine price. Institutional arrangement does not at all alter the fact that prices are determined by value scales of suppliers and demanders. What would happen if Walmart set a 40” Full HD LCD price at U$S1? I think you know the answer: a lot of people will run to Walmart to buy one. When the avalanche of people arrives and Wal-Mart sell the first 100 TVs, it will have to a) restrict the quantity of TVs to sold unless they want to confront an imminent shortage or b) raise the price in order to stop the avalanche. Obviously option b) is the most convenient, Walmart want to earn more knowing that it can sell all existence at a higher price rather to sell less at the same hyper-lower price. Actually it is even possible that customers themselves will offer a higher price, everyone knows that even offering to pay $20, instead of $1, it is still a great deal to buy a 40” LCD. There you have it: The great super big transnational oligo/monopolist Walmart having no choice but to adjust itself to the Law of supply and demand.

Another example is offered by Salerno here (around minute 40:00): the first week in which a movie is released, you see people lining up in cinema. In this first week the cinemas could raise price and dispense the line. Why don’t they do that? Because they will lose “good will” that is worth more than the money they can earn that week by raising price. Despite the fact that cinema can raise price and make profit from it, it will not do that because business men know that people will think: “Do these guys think I’m going to pay more today to see a movie that I can see next week cheaper? Besides, why I should pay a higher price today? This people are trying to exploit my need to see that movie.” Moreover a line is very useful to the cinema because draw attention, is a form of advertising. But you must note that the cinema cannot control the price without violating consumers sovereignty. Raising price to deal with the great demand from the first week of the movie has a cost: the cinema loses “good will”. It will lose clients acting by that way. So it must adapt itself to what consumers want. There is a hidden non-monetary cost which is the subjective valuation of the cinema's owner who estimates that he will lose clients by raising prices the first week of a premier. We still see perfectly well how subjective valuations of sellers and buyers determine cinema ticket price. There is no “administered price” here, not even in this example of an apparent non-maximizing monetary profit behaviour of the firm which could have earned more by raising price. Even here we see consumers approving or not firm’s “fixed price”, even here we see consumers approving or not business price.

As Shostak correctly explains:

“Producers set the price, but consumers, by buying or abstaining from buying, are the final decision-makers as to whether the price set will lead to a profit. Producers in this regard are at the total mercy of consumers.”

And as Greaves explains and refutes:

“Businessmen experiment with various prices on a trial and error basis. Experience and market studies furnish some clues, but the best they can do is to select a tentative price for their good or service on the basis of their best estimate of what consumers will pay per unit. This becomes their "asking price." This "asking price" may appear to be "fixed" or "administered." They may print this "asking price" on their product's label, list it in advertisements and even instruct their salesmen to quote this price to potential buyers on a take-it-or-leave-it basis. However, this "asking price" is actually just the first step in trying to bring about a trade that will be mutually satisfactory. If a businessman wants to sell his entire stock eventually, if he wants supply and demand to come out more or less even, his "asking price" cannot be considered as permanent or "fixed." Nor can he "administer" prices. If he does not enjoy a specially privileged position, protected by government from competitors, it is the businessman's potential customers who can say "take it or leave it," refuse to buy from him and look for substitute goods and services. Thus if the businessman wants to sell, he must remain flexible and willing to raise or lower his "asking price" according to the wishes and whims of consumers, as they express them on the market.  

Whether the would-be seller of a product is a large corporation, be it General Foods or General Motors, or a peddler in a Middle East bazaar, he is always at the mercy of consumers on a free market.”

-"But I mean that Ford is so large that his actions affect great part of the market, so he can control the price."

This only means accepting the fallacious doctrine of monopolistic competition.

-"Come on! Have you seen how prices are determined in a company? They are cost-determined prices."

The theory that establishes “costs determine prices” has been refuted many times, as well as the myth of “cost-push inflation”. Böhm-Bawerk specially deals with the problem that our daily experience apparently sees that any business set the price by just making a summation of all costs and adds a margin. However, and this is a very fundamental thing, a business man have been willing to incur in costs today because he expect to sell the product at a future price that covers his costs and give him a margin. It is the (expected future) price what determined his (past incurred) costs, costs do not and cannot determine prices. A producer of a good has spent $450 only because he expected to sell the good in future at a price of, say, $500 or more. If he expected to sell it at a price of $400 he would not have incurred in costs, the expected price determined his spending (or not spending) in costs. He estimated that price according to his anticipations about subjective valuations of his potential demanders. He is estimating how much his customers would pay; but he is not making them pay. According to his estimation of future prices, entrepreneurs spend today (or not) in costs. Actually they are willing to incur in costs only up to the price they expect to obtain, the expected price is the limit. As Bawerk says: “It runs, in the clearest possible way, in an unbroken chain from value and price of products to value and price of costs—from iron wares to raw iron, and not conversely.”

What we observe in some business is the rule of thumb of adding costs and putting a mark-up, so they apparently “fix price” the good. But that is not controlling price! You can put the price you want, but until a guy comes along and put the dollar to pay what you ask, there is no price that is worth. It is totally irrelevant the price that the firm fix. If after 3 weeks he have not sold the product, either because consumers buy it cheaper in other place or decided to not buy at that high price, he cannot remain obstinate and he will have a decision to make: either he reduces the price until people come to buy or he goes bankruptcy. Big companies do not “fix prices”, they usually have price departments that are continually alert about how stocks moves (which product have been bought a lot and which have not), and change prices (up or down) accordingly. By “trial and error” they are permanently estimating the price which is in accordance to the subjective valuations of marginal pairs. What superficial observers see as “controlling or fixing” price is actually a method to estimate a price determined by subjective valuations of “marginal pairs”.[5] Not only is this process in completely agreement with consumer sovereignty, this “society of one-price” is an institution created to avoid the enormous costs of negotiation in an isolated exchange, it saves time that could have been used in negotiating each price. Big business introduced this “ask price” system in the beginning of century and was such a success that it has become a daily reality. This institution facilitates to find the market price determined by subjective valuations of marginal pairs. Only a very superficial observation can make someone to think that it is business which fixes prices.

But even a very little quota of common sense can demonstrate the wrongness of the “administered price” doctrine. If world were so easy that any company just have to make a cost + profit (mark up) = price equation and just sell, then all of us (workers, landlords, etc.) would be big business men. I myself would start a company that produces pencils and fix myself a $10.000.000 (or 100.000.000! why not?) monthly wage. I would contract all my friends and people I like and I would pay them $200.000 to work with me, and of course I would hire this secretary at a wage of $4.000.000 monthly. Notice that, with this “structure” of costs, the pencil I would sell should have to have an extremelly expensive price (especially because I would add a 500% rate of profit to the costs, why not?) and I doubt all my friends are good enough at the tasks that the production of a pencil would require. So despite the extreme price, the quality of the pencil would not be so good. Now, does anyone think that the above scenario is feasible or probable? Is someone going to buy the pencils? Of course not! All I did was to use the cost + profit = selling price formula to do business. The fact that everyone agrees that the above example is ridicule is the best prove that entrepreneurial activity is not just about passing cost + profits value to consumers. It does not matter how many costs you add to produce a good, if people does not pay for it, you do not control its price. Contrary to this theory, it is consumers' willingness to buy what decides that the price set will lead to profits or not. In adjusting price to this, the producer must adjust his costs to make a profit.

[1] For an Austrian refutation see Shapiro, Milton. M. Foundations of the Market-Price System (1974) pages 261-63, Rothbard, M. N. "The Bogey of "Administered Prices"" (1959), Man, Economy and State (1963) pages 661-65, Hazlitt, Henry. What You Should Know About Inflation (1965) pages 88-90, Haberler G. Inflation: Its Cause and Cure (1960) 42-5, Poirot, Paul L. "Cost-Plus Pricing" (1971), Howard, Irving E. "Will the Real Price Administrator Please Stand Up!" (1966), Shostak, F. "The Limits of Supply and Demand" (2002), Greaves, P.L. (Jr.) Understanding the Dollar Crisis (1973) pages 66-8, Greaves, Bettina B. Free Market Economics A Syllabus (1975) pages 37-53, Fleming, H. Ten Thousand Commandments: A story of the Antitrust Laws (1951) pages 74-83, 99-106, 180-5.

[2] If this is not the case, then they will not engage any exchange for none of the three reasons because the part which think he will lose will not be available to trade.

[3] As we will see, the seller can have sink costs on the good, but this is not an impediment at all to get a price below past costs. Costs do not determine prices. Of course he will be better if he can obtain a price above his pasts costs, but he also will be better off if he get a price 1000 times above the price he think he can get, both wishes are irrelevant because the one that finally pays the price is another person.

[4] It is possible that you buy a car only because you are a collector and you like the car itself, without use it.

[5] Of course in the real world the estimated price is NOT the “equilibrium” price in neoclassical terms. Subjective valuations changes all time. As Mises said: “The entrepreneurs take into account anticipated future prices, not final prices or equilibrium prices. They discover discrepancies between the height of the prices of the complementary factors of production and the anticipated future prices of the products, and they are intent upon taking advantage of such discrepancies.”(italics are mine). Human Action (1949) page 326.