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Supply and demand fallacies
Dr Frank Shostak
One of the few things that economists agree upon is that prices are determined by supply and demand. This is summarised by means of supply and demand curves, which describe the relationship between the prices and the quantity of goods supplied and demanded.
Accordingly an increase in the price of a good is associated with the fall in the quantity demanded and an increase in the quantity supplied. Conversely a decline in the price of a good is associated with the increase in the quantity demanded and in a decline in the quantity supplied. In short, the law of supply is depicted by an upward sloping curve while the law of demand is presented by a downward sloping curve.
Observe that both consumers and suppliers are confronting a given price i.e. at a given price both consumers and producers are demanding and supplying a certain quantity. The equilibrium price is established at the point where the quantity supplied and demanded is equal. At the equilibrium price the market is "cleared". In this framework neither the consumer nor the producer has anything to say as far as the origin of a good's price is concerned. The price is just given. In brief both consumers and suppliers are reacting to a given price which they have no influence over.
The rationale for this way of thinking goes back to Adam Smith, David Ricardo and Karl Marx. They believed that prices were set by the cost of production. Thus the more labour required to make a particular good the higher the price of a good will be. The cost of production inserts the price, so to speak, into the good.
As the price is inherent in the good, it is one of the good's attributes. It is held that over time prices of goods converge towards the inherent or the intrinsic price. In other words, supply and demand only determine prices in the short to medium term but not in the long run.
However, the cost of production theory runs into trouble when attempting to explain prices of goods that are not produced — goods that are simply there like undeveloped land. Likewise the theory cannot explain the reason for the high prices of famous paintings. According to M. N. Rothbard: "Similarly, immaterial consumer services such as the prices of entertainment, concerts, physicians, domestic servants, etc., can scarcely be accounted for by costs embodied in a product."
Carl Menger however, held that the value of goods and services has nothing to do with the cost of production. Value arises from man's needs and it is not imbedded in the goods themselves. Menger wrote: "Needs arise from our drives and the drives are imbedded in our nature. An imperfect satisfaction of needs leads to the stunting of our nature. Failure to satisfy them brings about our destruction. But to satisfy our needs is to live and prosper. Thus the attempt to provide for the satisfaction of our needs is synonymous with the attempt to provide for our lives and well being. It is the most important of all human endeavours, since it is the prerequisite and foundation of all others."
The value of a good doesn't spring out of man's mind, regardless of the facts of reality. The importance of a satisfaction to us is not the result of an arbitrary decision, but rather is measured by the importance, which is not arbitrary, that the satisfaction has for our lives or for our well being.
In other words, in order to accommodate their lives and well being people's ends cannot be arbitrary, but rather carefully thought out. The value also does not originate from the good itself, regardless of man's mind. But it is the product of a man's mind judging the facts of reality. Man assesses the usefulness of a good as a mean to support his life and well being.
Value is thus nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well being. Hence value does not exist outside the consciousness of men. It is therefore, also quite erroneous to call a good that has value to economizing individuals a "value", or for economists to speak of "values" as of independent real things, and to objectify value in this way."
Since price is not inherent in a good this means that there is no such thing as "the price of a good". Price can only emerge in a transaction between two individuals at a particular place at a particular point in time. It is therefore meaningless to talk about "the price of a good" that exists independently of individuals' judgments. The value of a good is always a value to a particular individual in a given context as far as the individual is concerned. On this Mises wrote:
A market price is a real historical phenomenon, the quantitative ratio at which at a definite place and at a definite date two individuals exchanged definite quantities of two definite goods. It refers to the special conditions of the concrete act of exchange. It is ultimately determined by the value judgments of the individuals involved. It is not derived from the general price structure or from the structure of the prices of a special class of commodities or services. What is called the price structure is an abstract notion derived from a multiplicity of individual concrete prices. The market does not generate prices of land or motorcars in general nor wage rates in general, but prices for a certain piece of land and for a certain car and wage rates for a performance of a certain kind.
The framework of supply-demand curves rests on the assumption of unchanged consumer preferences. But in the real world, consumer preferences are not frozen. Furthermore, this framework assumes that prices are given, which is erroneous. Obviously then, that the supply-demand framework does not describe the facts of reality. Mises wrote: "Furthermore it is important to realize that we do not have any knowledge or experience concerning the shape of such curves."
Yet economists heatedly debate the various properties of these unseen curves and their implications on the outcome of government policies. The supply-demand framework is contrary to the fact that human actions are conscious and purposeful. In this framework there are no entrepreneurs, it is the shift of the curves in response to various factors that sets prices.
For instance it is held that a shift in the demand curve to the right for a given supply will lift the price of a good. The price will also increase if for a given demand curve the supply curve shifts to the left. In other words the supply-demand framework doesn't deal with human beings but with goods and services and equilibrium prices. However, "Economics is not about goods and services, it is about the actions of living men. Its goal is not to dwell upon imaginary constructions such as equilibrium."
In the real world the price setting is never mechanistic and automatic. It is up to the producer entrepreneur to assess whether it is a good or a bad idea to raise prices. After all, the thing that matters to him is making a profit. So if an entrepreneur's assessment indicates that despite the increase in the demand the correct strategy is to keep the price unchanged, then this would mean that the quantity supplied would have to increase to accommodate a greater consumer demand.
In short, it is entrepreneurial appraisal of consumers' responses that determines prices and not supply-demand curves. By buying or abstaining from buying consumers ultimately determine the prices of goods and services. Producers in this regard are at the total mercy of consumers, notwithstanding the fact that producers set the prices.
Equilibrium in the context of a conscious and purposeful behaviour has nothing to do with the intersection of supply and demand curves. Equilibrium is established when individuals' ends are met. When a supplier is successful in selling his supply at a price that yields profit he is said to have reached equilibrium. Similarly consumers who bought this supply have done so in order to meet their goals. According to Hoppe:
Every action on the market must already imply the goal, or end-state, of that action. The action, or 'process', already implies the equilibrium state, even if that state is never fully reached.
Once economists make the assumption that the “price of a good” is something that exists regardless of transactions this permits them to construct the supply and demand for the whole economy. Using the supply-demand framework economists create an independent entity called "the economy", which is separate from human beings. Consequently one could differentiate between the activities of individuals and "the economy".
It is argued that what is good for individuals might not be good for "the economy" and vice versa. According to this thinking "the economy" is paramount while individuals are barely mentioned. In fact one gets the impression that it is "the economy" that produces goods and services. Once the output is produced by "the economy", what is then required is its distribution among individuals in the fairest manner.
Furthermore it is held that the ideal situation emerges once the economy reaches the equilibrium point where the supply and demand curves intersect. Any other situation is regarded as bad news and therefore must be acted upon. Needless to say, the supply- demand framework provides the rationale for government and central bank interference with businesses.
For example it is held that boom-bust cycles are the outcome of unstable consumer demand, which can be rectified by "suitable" monetary policies controlled by the central bank. The supply-demand framework also provides the justification for various imaginary monopolistic theories, which provide the rationale for the government destruction of successful businesses.
Dr Shostak is a former professor of economics who now works in the private sector
BrookesNews.Com
Monday 5 December 2005