Why do Austrians say price is set by preference rather than production cost?

Economics Economics Questions
1

Imagine that a generic drug becomes available for the treatment of a condition, no substitute good is available (inslulin might be a good example), and the elasticity of demand is low .Say that there are multiple companies producing this drug and competing with each other for customers.

Assuming no real differences in quality, competition should surely bring the price down to the level at which profits are around zero. So why do Austrians talk of prices being purely about preferences? Obviously a commodity won’t sell if it isn’t wanted, but that is just stating the obvious. What insight does this statement provide?

2

I’ll let others get into the meat and potatoes of the answer, but as a student of Austrian economics you should know that few things are “obvious” to most people.

“Humans act” may also seem ridiculously obvious to the point of a waste of breath…but on the contrary, it is no trivial insight…

3

few things are “obvious” to most people.

Who would object to the statement "people buy things because they want/need them"?

“Humans act” may also seem ridiculously obvious to the point of a waste of breath…but on the contrary, it is no trivial insight…

I understand the relevence ‘humans act’ statement because of what Austrians claim can be deduced from it. But what is the equivalent deduction from above the statement regarding wants/needs?

4

The cost of production is a part of the price function but in order for prices to be formed the most important factor is the valuation of the consumer.

5

“the most important factor is the valuation of the consumer”

Maybe for an upper limit to price, but in a competitive market prices would fall, and the lower limit would be production cost. Does this mean that consumer valuation only really becomes important in a monopoly situation when prices are set by the producer?

6

Production costs are irrelevant. They are sunk. After the product has been produced you sell it for what ever you can get for it. If the most you can get for it is less than your costs…well then you earn a loss.

It is consumer demand in the face of the scarcity of the product that determines the price. Costs only play a role in the price in the sense that producers pick a quanitity of production that will result in a price higher or equal to their costs.

Your analysis is actually very close to the pre-marginal revolution analysis of classical economists.

7

After the product has been produced you sell it for what ever you can get for it. If the most you can get for it is less than your costs…well then you earn a loss.

But producers that do this will go out of business leaving those who sucessfully sold above production cost - this is surely mechanism that makes production cost important in the setting of market price? What you are saying may be valid for an individual price at a given moment, but wouldnt the movement of prices across the sector tend towards production cost via the weeding out of loss-makers?

Costs only play a role in the price in the sense that producers pick a quanitity of production that will result in a price higher or equal to their costs.

This seems quite an important role.

8

“in a competitive market prices would fall”

True

“the lower limit would be production cost”

I dont see why you couldnt set the price lower than that, even if it’s a loss for the entrepreneur, if thats the only way to sell the product partial loss is better than total loss.

“Does this mean that consumer valuation only really becomes important in a monopoly situation when prices are set by the producer?”

No, why would you think that?

Prices are never exclusively set by the producer or the consumer but in reality they are an statistic of the relative need of the consumer for a determined product at a given time.

9

Perhaps it would help to answer your question if you could provide an example of where “Austrians talk of prices being purely about preferences”. It would be much easier to provide an explanation if we knew what we were supposed to be explaining.

10

That’s a good question. I am really only talking about what I have heard libertarians say about price rather than anything I have read in economic literature. For example, the above few posters comments.

11

By the way, I should clarify my definition of ‘price of production’. I am refering to the price at which is is currently possible to produce a good, not the price at which it did cost to produce a good with a previous set of technical capabilities.

12

Here’s Rothbard explaining it. It’s from his Chapter on J. B. Say.

Prices of productive factors must be high for a reason; they are not preordained to be
high…

But where do ‘costs’ come from? And why are they somehow fixed,
exogenous to the market system itself? How are they determined?..

On the valuing or pricing of the services of the factors (or as Say would put
it, ‘agents’) of production, Say adopted the proto-Austrian in direct contrast
to the Smith-Ricardo tradition. For since subjective human desire for any
object creates its value, and reflects its utility, productive factors receive
value because of their 'ability to create the utility wherein originates that
desire’.

In other words:

costs are determined by selling
price rather than the other way round…

Ricardo, writes Say, believes 'that the value of products is founded
upon that of productive agency’, i.e. that the value of products is determined
by the value of their productive factors, or their cost of production.

[In other words, the value of a car or refrigerator comes from all the steel put into making it]

In contrast, Say declares, 'the current value of productive exertion is founded upon
the value of an infinity of products compared one with another … which
value is proportionate to the importance of its cooperation in the business of
production …'.

[In English, the value of steel lies in it’s usefulness in making cars and refrigerators]

In contrast to consumer goods, Say points out, the demand

for productive factors does not originate in immediate enjoyment, but rather
in the 'value of the product they are capable of raising, which itself originates
in the utility of that product, or the satisfaction it may be capable of afford-
ing’.

In short, the value of factors is determined by the value of their prod-
ucts, which in turn is conferred by consumer valuations and demands.

The causal chain, for Say as for the later Austrians, is from consumer valuations
to consumer goods prices to the pricing of productive factors (i.e. to costs of
production).

[=the right way of looking at it]

In contrast, the Smithian, and especially the Ricardian, causal
chain is from cost of production, and especially labour cost, to consumer
goods prices.

[= the wrong way]

If you look into that chapter, you will see the policy consequences of the two points of view.

Book is available here for free: http://mises.org/books/histofthought2.pdf

EDIT: Thinking a bit about it, I notice it’s just a restatement of the law of supply and demand. By the universally recognized Law of Supply and Demand, factors of production have their price determined by demand for them. They are in demand to the extent that profits can be made using them to make cars and refrigerators. Those potential profits, in turn, are there only because individual consumers want to buy the cars and refrigerators. Seems inevitable, no?

13

The costs of factors of production are imputed backwards from the price consumers are willing to pay (subjective preferences) on the final product.

14

In that case you may just be misrepresenting/misinterpreting what is a simple attempt to promote the subjective theory of value and denounce the labor theory or some other flawed notion. You must realize that so many of the objections (and therefore arguments) that take place between free market economists and mainstream/keynesian/marxist ignoramuses have already been had before…so you’ll come across a lot of the same language again and again, mostly just dispelling the same perpetuated myths.

I think what your question shows that you are missing is the overall picture of the price structure of the entire economy. Remember, prices (of everything) are simply a communication of those preferences of individuals. This includes the prices of the inputs that make up the production cost of any finished product (like your hypothetical pharmaceutical.) The price mechanism simply enables individuals to coordinate their plans for all available resources across the economy. Remember that a “cost” is simply someone else’s “price.”

Peter Schiff illustrates this in his book on the economic collapse:

So it is at least a little redundant to say “why do you say prices are set by preference rather than production cost”…because what you’re really asking is “why do you say prices are set by preferences rather than other prices?” The answer to that is of course when someone talks about prices being set in terms of preferences, they are looking at the overall economy.

Hayek and other prominent Austrians wrote extensively on the price mechanism. For more detail I recommend his essays:

The Use of Knowledge in Society

The Price System as a Mechanism for Using Knowledge

And of course his treatise on the subject:

Prices and Production

15

“The value of steel lies in it’s usefulness in making cars and refrigerators”

This here is a good example to illustrate my point. Imagine a society with no cars. Someone invents the car and it becomes really popular. People climb over each other to try and get one, and as a result the car manufacturers order more steel to step up production. Here is a clear example of hightened demand leading to a higher price.

However, the new price of steel makes it more profitable, and so businesspeople are incentivised to enter into the market of steel production. The supply of steel increases and competition between producers lowers the price again. So the higher price - set by the increased demand - was just a temporary moment of price varience. The claim that price is set by consumer valuation is a static analysis that ignores the effect of current prices on the future behaviour of entrepreneurs.

16

what you’re really asking is "why do you say prices are set by preferences rather than other prices?

This is a pretty good point actually. You could also ask ‘what determines effective demand other than wages, which are simply the price of labour?’. So on and on we go around in circles. “The price of labour sets effective demand, effective demand effects the price of production, the price of production sets the price of the final good, and the price of the final good effects how much is demanded”.

I will make an effort to read up the links you provided so that I get a better picture of what AE says about price, but from what I have heard so far I am still bewildered (maybe even more so than when I started the thread ).

17

No, only the price consumers are willing to pay on the final good determines to what point an entrepeneur would be willing to pay on inputs (labor, steel, factory, tires, etc.) to create the output. The prices of factors of production are imputed backwards from how consumers are willing to pay on the final product. See Rothbard’s example on cigars which I quoted.

18
19

@consumariat

The subjective theory of value says that things have differenet values to different people. If a merchant sets a price on what he is selling, he puts the price that he thinks is the best.

It is how much that thing is valuable to him. He might consider what others would pay, or what his production cost was, but it is still him who decides what the price will be.

At the same time, the same thing might have lower value to other people - they will not buy it willingly. Some people, on the other hand, might think it is a bargain and will buy.

So while there are enough of the people from the secon group to keep the merchant happy, he will probably not change his prices.

No linear causality.

20

You’re still missing it. Lemme put it another way…What is “demand” but a representation of market valuation? Individuals each have a level of demand for various things, and the prices are simply a result of the relative demand for those things…relative to the supply. Prices are a metric by which the preferences of all individuals participating in the economy (i.e. “the market”) are communicated. And by “preferences” we mean the subjective priority values placed on all resources (and their respective uses) within the economy. In other words, prices are a mechanism that allows the coordination of all available resources to be utilized in the most efficient and effective ways…based on the preferences of all the individuals in the market.

Put more simply, as long as you are able to turn a profit, it is a signal to you and the rest of the economy that you are utilizing resources in a favored way. (And that you should continue to do that, and in fact others should do what you’re doing). If you become no longer profitable, it is a signal to you (and everyone else) that you are not utilizing the economy’s resources in a preferred way. You are destroying wealth (meaning, you are combining capital in a way that the finished product is actually less preferred by the market overall than what was consumed/occupied to create it.)

So instead of thinking “prices of finished goods are determined by the prices of what goes into making them”, scale back and ask “well…what determines the prices of those inputs?” And the answer is of course, the same thing that determines the prices of anything: supply and demand.

So look at it this way: Suppose gold were fetching a high price. That would mean there is a decent enough demand for it, and a limited enough supply. But what is the nature of the demand? What exactly do the people want the gold for? In what form do they prefer that resource to be placed? Do people want the physical gold itself? Or do they want it to be made into watches? Or do they want rings? Or does everyone just want authentic astronaut helmets with the gold lining in the visor?

Whatever the answer is, it will be shown in the prices for all of those items…because the prices (including the price of gold) are determined by consumer preferences. In other words, the question that prices answer is: “of all the things every single resource in the economy could be used for…what is most preferred? And how does that rank in terms of everything else?” And if you think about it, that’s a pretty complex question to answer…considering every single product or service you could purchase (including all the raw materials that go into making all those things). And don’t forget, a lot of different items require the same raw materials…so there are an uncountable number of subsets of tradeoffs being made. And this only grows with the size and technological advancement of the economy in question.

See, the astronaut helmet may be really expensive…but at the same time few people would be willing to pay that high price. There isn’t a very high demand for the helmet…but all the resources (i.e. time, labor, raw materials, manufacturing work, etc) that went into creating the helmet…there is a high demand for all that. The helmet fetches a high price not because everyone wants a helmet…but because the helmet consumed and occupied a bunch of resources that could have gone to other things a lot of people do want. (This is of course the “opportunity cost” in economics). The only reason the helmet gets sold is because someone finds it more valuable than the price he is paying to get it. But suppose no one (not even NASA) wanted a helmet like the one you made. It may have cost you $10,000 (worth of plastic, gold, machine time, labor, etc.) to make it…but if you can only sell it for $5,000 it means you have sustained a loss…why? Because you combined all that capital in a way that actually destroyed value. All that time and energy and resources was much more valuable before you turned it into a helmet. So the fact that you sustained a loss is the market’s way of telling you “don’t use our resources like that. That’s not what we want.”

But if you were able to sell it for $20,000 however, then you have made a profit…you have combined capital in a way that increased wealth…you have taken resources and created something that the market values even more than what you consumed to make it.

Because remember, there is a limited amount of resources, and there is virtually a limitless amount of wants (meaning there is an infinite amount of things every single resource could be used for, and by every single person on the planet.) So what prices do is allow a communication of all the preferences of everyone so that all the resources can be coordinated in a way that maximizes value. There is no way any person or group of people could know the most efficient way to use the limited resources available to best provide for all the subjective wants of so many individuals. This is why the Soviets waited 4 hours a day in lines just to get bread…because when you purport to set prices, what you are really saying is “Not only do I know exactly what people want, I know exactly how badly they want it in relation to everything else they want, as well as exactly the resources that are available and exactly the productive capacity we have to satisfy all those wants and how best to go about executing all that.” This is why Hayek called it “The Fatal Conceit.”

Now that I think about it, the best read for you at this point might be Peter Schiff’s How an Economy Grows and Why it Crashes. It’s an update and expansion of his father’s book of a similar title. You’ll have to check out a library or bookstore to get the former, but the latter is available in pdf here, and our own Nielsio posted a nice reading of it here.