How The Price System Works

0:00Well, this is Jeffrey Tucker. I'm here again with another installment in our series on Economics in One Lesson. We're going chapter by chapter. And this morning we have Guido Hülsmann, the author of Mises, The Last Night of Liberalism. So it's a great pleasure to have you, Guido. It's a great pleasure to be with you, Jeffrey. And so we're talking this morning about how the price system works, and it's always occurred to me that this is the most underrated of all market institutions, the price system. Hardly anybody really understands it, and yet we use it every day, right? That is true, and Hazlitt explains very well that it's not only how prices work, but the interrelations that exist between prices, and in particular between industries.

0:54If one industry flourishes, for each single industry its fate depends on the relationship between its cost expenditure and its selling receipts, which must be good. But precisely the crucial point is that both costs and selling receipts are independent with the costs and selling receipts of all other industries. So if one industry flourishes, for example, because there is an additional consumer demand for it, so there is additional spending going on in this industry, so it can expand its It means that consumers who spend more money on this must necessarily spend less money elsewhere in the economic system. So other industries experience a decrease in their selling receipts relative to cost expenditure, so their activity shrinks. It is of course possible to have the general growth of all industries, which results from savings, as Hazlitt explains in other chapters of his book.

1:48But the crucial point is that in order to properly understand the economic system, we always need to keep in mind the interdependencies that exist between all parts of the economic system and not just look on one part of it. Can you give us a definition of the word price? What is a price? The price is an exchange ratio in which two quantities of goods are being exchanged and one of them is money. Can we imagine a world without prices? Sure, we can imagine a world without prices. We can imagine a world of individuals living in isolation from one another and just caring for their own business, not cooperate with other people, never exchange a single bit.

2:37But, of course, such a world could not be very populous, because people would live in great misery, as we can understand. If they live at all. Yeah, well, in some particularly well-endowed areas, Africa, Latin America and so on, some parts of the United States where nature is generous and so on, there people could live off just the fruits hanging on the trees and so on, so live a hand into the mouth existence. but most other areas of the world where precisely Western civilization has emerged, Europe, Northern America and so on, it would not be possible to live such a life. So any kind of extended or complicated form of human cooperation requires prices? Does require price, right? The only other logical alternative would be to imagine that we organize a division of labor by a central plan.

3:35in the Soviet Union and its satellites, and economic theory, Ludwig von Mises' theory, has explained, and as historical experience has shown, this doesn't work. Who makes prices? People exchanging on the market. Every single one. You go to a bakery shop and pay a bread. You create a price. Who creates the price, the consumer? So who creates the price? The consumer? It's the consumer and the seller. The price is never just fixed by one person. Sometimes we say it's a colloquial way of speaking. There's some price fixing going on by the companies, which means in practice that the companies say, well, we will not sell our commodity at any other price but this one.

4:23But then, of course, that by itself does not yet give them the opportunity to really exchange it. Only if they find customers who are willing to pay this, so who agree with this price, then the price comes into being. I could say, well, I set up a shoe factory and say, well, my shoes are so nice, I mean, their price is a million dollars. Okay, and that's not the price. It's just a slip of paper that I attach to my shoes and it says one million dollars. But that's not a price. A price comes into being once one appreciative gentleman such as yourself, for example, So the price is established in real exchange. It has to actually happen. Otherwise, it's an offer or it's a proposal.

5:10It's just hot air. Hot air. Now, I was at the bakery a couple of days ago and there was a sign that said, We very much regret that we've had to go up slightly on our prices, and I thought that was intriguing, because of course the bakery doesn't really want to go up on its prices, it wants more revenue, but it knows that any increase in price causes fewer of its goods to be stored. So you can interpret this sign in various ways. They might actually regret themselves. We regret ourselves very much to have to increase our prices, to still have a margin as compared to our cost. And then they cannot be sure that they still will have enough business to create them some profit. And consumers, of course, always and everywhere want to pay how much for all their goods and services?

6:01Excuse me? How much do consumers want to pay? Well, we cannot generalize this. The fundamental fact is that consumers have to choose between different items that they would like to buy shoes and clothing and food stuff and they have to pay for housing and so on. And the price that they are ready to pay for any one item, of course, depends on the prices they have to pay for other things. I was once buying a car and this car salesman said to me, well, how much do you want to pay for this car? And my answer was, I mean it was a very obvious answer, zero, right? Good answer. It might have reminded him of some essentials of economics. And I was perfectly aware that he wanted to charge a billion dollars for this car.

6:46Yes, yes. So the problem was finding something... So he had a good laugh and then you got to the matter. Yeah, I guess that's it. Now, what about this idea, or you'd already mentioned central planning, but why can't an agency set a price? Why can't some external third party coercively just attach a price to a particular good or service? Well, again, they can of course say, well, this object, This commodity may only be exchanged at this or that rate, and you may call this a price. I think we would have to make the distinction between a market price and a fiat price.

7:31So why doesn't this work for all goods? Well, precisely because all goods are interdependent with one another, and their proper relationship cannot be determined by purely theoretical means. It's a very important insight that comes from Austrian economics. It's not an engineering problem where we have a certain number of variables and then you plug this into a model and you get a certain result. Because in Human Action we have the fundamental problem of anticipating future conditions. Most of our markets are not actually markets for consumer goods, but are markets for producer goods. So we're talking here about the cost side of production in relation to consumer goods industries. But, of course, producer goods markets are, let's say, 80% of the economy. Consumer goods markets are just about 20%.

8:22Now, the prices for producer goods have to be determined in regard to what you expect to be the case in the future. So, ultimately, it's a judgment that we have to make on the future. We do not have a scientific model that would allow us to predict or to determine exactly the future. Now, there are certain conventions, aren't there, in the business world, about what a price will be. You calculate all your costs, you figure out what kind of margin revenue you need, what kind of margin revenue you need to make this continue to be profitable, and you set it. And that's a convention, right? You can call it that way. It's a practice that is informed by business schools, for example, for example, standard teaching, economics and so on.

9:10Or even just if you're just a regular businessman. Yes, yes. But again, it's not accounting that gives you the proper price. Account is the other way around. The proper way to evaluate the assets that you have on your balance sheet is to first look what is the monetary value of the product that can be generated with the help of these assets in the future. Now this judgment is just that. It's a judgment, it's not something that results from a scientific inquiry, but it's your good guess as an entrepreneur, it's your bet on the future. Now, precisely because we have no possibility to do this with a mathematical model, but because we have to bet, there's only one way to make this betting process responsible, namely by creating property rights Rights and by making sure that the consequences of a bad choice fall back on the person who makes it.

10:05Yeah. Okay. Now, you mentioned fiat prices versus market prices. Yes. Very interesting. Yeah. Now, if a government agency, for example, the post office, well, let's pick a different one. Let's say you have a housing agency that's building houses and putting them on the market. and they use what they consider to be a business convention to establish what the prices are. You know, they might observe, well, the housing industry tends to buy things at this price and sell things at this price and will just do the same thing. But you're saying that that really ultimately is an arbitrary judgment. Well, if they impose these supposed exchange ratios on the entire industry, whatever the particular conditions are, yes, that would be an improper way of handling this.

10:53And then what happens? Well, then we get to the chapter in which Hans-Heléat deals with price controls. If the price is set arbitrarily at a level different from the level it would attain in the free market exchange economy, then you get surpluses and shortages. What is meant by this idea that all prices are past prices? Well, it means that as long as we do not actually perform the exchange, we do not know what the price is. And then, of course, as soon as we know the price, well, it's a past price. We go to the bakery shop and you buy the bread for a dollar. Only once you've actually paid the price and got the bread, you know what the price for the bread is, and then it's already a past price.

11:42Let me mention also in this context that what businessmen are most concerned about is not necessarily the price, it's the total selling proceeds and the total cost expenditure. So we should not forget that the price is relevant because it determines also the quantities that are being exchanged. What the businessman is really interested in is the volume generated as compared to the volume that he needs to expand. And this is true whether it's a medium-sized business, a huge business, or a lemonade stand. Or we have a true economic principle. It's the same thing no matter what size the business is. And in this sense, the bigger business has no real advantage, does it? No. I mean ultimately it's just a matter of you just adding more zeros onto the same problem.

12:30The problem is always to properly anticipate what is the total selling proceed that you can realize with a given investment. And then in relation to this, go on the market and try and see whether you can buy the factors of production necessary to bring this result about, hire the proper workers, rent the right office space at the right location and so on. Now, Hazlitt wrote this chapter in 1946, which wasn't too many years, well, let's say it was before Hayek's work on prices, and it was after Mises' detailed work on economic calculation. So, would you say that Hazlitt's presentation of these chapters is based on a Misesian perspective of prices?

13:22Hayek published a famous article on the use of knowledge in society in 1945, which was a year before the first publication of Hazlitt's essay. So you could say that this might have had an impact, especially since he knew of course Hayek, at least by correspondence. Hayek actually did come to the US for the first time in 1945, I believe, to promote his book, The Road to Serfdom, or in 1946, I don't remember very well. The personal contact was not very frequent, not very strong, so probably Mises had a much more definite impact on his thinking. Again, if you look at these chapters, how price determines the economy, it's very Boehm-Bawerkian, a great subject of Boehm-Bawerk's Capital and Interest, a great treatise, Capital and Interest, in which he stresses this point.

14:14The great contribution of Boehm-Bawerk to Austrian economics was to create an analysis of the economy as a whole. Carl Menger had just analyzed the process of price formation for individual prices and talked not very much about the relationships between different prices. That was a great contribution of Boehm-Bawerk's and Mises was of course the most important disciple of Boehm-Bawerk and you find these central ideas reflected in all of his works. Well, that's interesting. So you'd say that Hazard's chapter here is more Boehm-Bawerk-ier? It's very Boehm-Bawerk-ier. And of course, that's a fundamental contribution of Austrian economics that is unfortunately totally neglected by the mainstream today, was not neglected in the early 20th century when Boehm-Bawerk was still widely read among economists all over the world, and so on.

15:09Unfortunately now, with this unfortunate concentration on partial equilibrium analysis, so the unilateral focus on individual prices, individual industries, this whole message gets lost. What about the next chapter, we're talking about stabilizing commodities? It's a subject that becomes again of great importance in our day. We only need to think of the oil industry and the rants against the speculators on the market. It's an eternal subject. You know what the most important field of literature was in economic literature up to 1850, say? What the most important economic policy problem was? Declining prices? No, it was wheat, the wheat market.

15:56Oh, interesting. And how to stabilize the wheat price and could the market do it or not. This was about 40% of all economic writings concerning this problem. So that's very, very interesting because I don't know if you've had a chance to pick up this, and I highly recommend it, this Garrett novel called Satan's Bushel, which deals entirely with the whole wheat problem. But you do get the sense when you're reading that how this wheat stuff is, that this wheat problem is a big deal because farmers felt like they couldn't really make a living, They try to sell at a high price, but since they all sold at once, then the market will be flooded and the prices will go down. So they're trapped by the market and the government needs to protect them. And did. You need loan programs that allow the poor farmers to hold back their wheat and sell it at a more proper point of time and so on.

16:50And there are wheat cartels, like the farmers are trying to get together, but there is always invariably one or two that would break the price by secretly adding their bushels to the market. Yes, and it is really not necessarily to the... it might be to the advantage of the sub-marginal, that is to the inefficient producers, but it's never in the interest of the efficient producers and of the consumer. Well, the Garrett book deals specifically with the advent of futures markets as the way to deal with the price problems. But what has its argument is that stabilizing prices is not really, stable prices is not an ideal that we want to try to seek to achieve, right? Yes, because prices should of course reflect the changing conditions on the market.

17:39If you have one market segment that becomes increasingly important, let's say now the computer industry in the past 25 years, then you do not want to keep the prices where they were in 1980. They should reflect the ongoing changes in the volume of demand, for example, and the type of good that is being offered there. But the general perception is that we can't permit an industry that's absolutely critical to the overall macroeconomic structure to just go through some sort of enormous upheaval suddenly, for example, housing, because that will drag the economy down with it. Well, that's of course precisely the opposite way around. The more important an industry is, the more important it is that prices be flexible.

18:24Of course, we should not forget, and that's the point that is also stressed by Hazlitt, that the question how important a good is, is not liable to find a general answer. It is answered by each individual, each household differently. So each household needs to be determined how much money do I want to spend on housing, how much money do I want to spend on food and so on. We cannot say this, I mean, your budget should be 30% on housing, then and 20% on food and various other items. There are people who have completely different preferences. I always think in this context of a good friend of mine during my university years when I was a student. And so we were all very poor, of course. And some of them, they spent 50% of their budget on theatre tickets. So what do you do about this? Do you want to impose on them?

19:12Say, well, you've got to spend 50% on housing. You have to have a better apartment. They were living in a very shabby place. This underscores the absurdity of something like speaking of a price level for the whole economy, doesn't it? Well, what is important for the functioning of an economy is not the level of prices. Of course, we can always construe a mathematical average of all prices, and that's possible. We can observe the evolution of this aggregate of this basket throughout time. That is possible. But what is important for the functioning of the economy, for its operation, are the relations between prices and again more precisely the relations between spending streams.

19:57An industry flourishes not if the price level is high. An industry flourishes if the level at which it has its selling receipts is superior to the level of cost expenditure, whatever the segment of the economy. Therefore, an economy can function very well at a high level of expenditure, at a low level of expenditure, at an increasing level of expenditure and at a decreasing level of expenditure. It never matters what the level is, it always matters only if there is a positive spread between selling prices and buying prices. And that requires absolute freedom of adjustment of prices. And precisely if you have variations, if you have systematic changes, increases of the price level, for example in decreases, the market must be free in order to adjust to this.

20:45And so there are many markets, probably fewer it seems than in the past, in which the government fixes the price. Maybe this is more common in France than in the US. It seems like price fixing is not so much practiced in this country, except for the government provided goods and services. Yes. Of course, you have rent control and things like that. It is not important today in 2008 as it has been, say, in 1975. Yeah. So in those days, of course, we had very high inflation rates and in America you had the Nixon administration imposing a system of price and land control. Bad things are always tried out again and again.

21:30What Hegel, the German philosopher, once said, the only thing that you learn from history is that you never learn from history. People never learn from history. So, therefore, also the importance of theoretical instruction, good economic training, because it's the principles that allow us to orient ourselves in a changing historical context. And there are, of course, always the emergency situations where the politicians threaten price controls and then don't actually impose them and intimidate producers. Have you seen this? The effect is actually the same. To the extent that they take this serious, it has very similar effects to an actual price control.

22:22That's very interesting. This goes on all the time. I've wondered in the past how this affects certain markets. What is the prospect that there will be investigations, a prospect that there will be, for example, bad press, you know, can have an impact? Oh yes, especially in financial markets, for example, and therefore our government, both here in the US and in Europe, our governments try to massage the news. So they have public relations agencies their own, and they also hire private public relationships to produce good news about capital markets in particular. But we do have odd views, don't we, about prices. We carry around this view, for example, in the United States, everybody is convinced that the price of oil should be far lower than it is.

23:13But the price of housing should be far higher than it is. And we just carry around these views without much thought as to what it implies and just how arbitrary this is. Why is it that the price of oil should be lower? From a psychological point of view, of course, it's understandable. Everybody wants to sell at a high price and buy at very low prices. So we would like to have the oil price to be low because it allows us to drive very large and gas-consuming cars. We would like to have the housing price very high because our wealth increases with it and so on. It's understandable. And we had a situation in the past six or seven years in which precisely the sap and housing went up The gas prices stayed at a fairly stable level, so there is a temptation for people to think that's the normal state of affairs, and it should always be that way. Well, but things are not always that way.

24:08And in fact, from the point of view of Austrian economic analysis, this situation was rather illusory, was an artificial result of government interventionism in the economy that created a wrong impression for people. And led to some degree of malinvestment. Led certainly to too much investment in the housing market, too much consumption, because people believed that the increase of their housing value would be permanent, Now, one of the things that seems to be missing from these chapters that you wouldn't normally find in a regular economics text is some kind of graphical analysis.

25:02This is just words. Do you think that the exposition suffers any, for its lack of... Not in the slightest. I believe that it's slightly irritating for those who have economic training today, because they're precisely used to be confronted with graphical exposition in economic textbooks and in economic explanation. But for all others who come from other strands of life, no, I don't think so at all. They orient themselves perfectly, and for them it's actually more difficult to find themselves, to orient themselves in a diagram. Right, and hazardous writing is a narrative. Crystal clear and rigorous, it's a step by step. Yes, and it shows precisely that we do not really need this.

25:50Think for example of the typical exposition of price control in a neo-classical or mainstream textbook. It first of all illustrates an equilibrium situation on the housing market, for example, and then there's now, let's suppose the government fixes the price below the equilibrium price, and then you can show with demand curves and supply curves that there is a non-intersection between the two curves at this point, so demand is higher than that supply and you call this then a Now, strictly speaking, that's not correct, because the market is actually never in general equilibrium and any single individual market is virtually never in equilibrium. So the proper way to present the economic law, the principle that is here at stake, is to say a price control has these consequences if it fixes the price below what the market would have established.

26:48Well, thank you very much, Guido, for your wonderful presentation. Great pleasure to be with you today.

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