Tuesday, October 28, 2014

Hayek on Costs and Pricing

This comment that Hayek makes occurs in a discussion of Keynes’ General Theory, which I first quote merely for context:
“Now if there is a well-established fact which dominates economic life, it is the incessant, even hourly, variation in the prices of most of the important raw materials and of the wholesale prices of nearly all foodstuffs. But the reader of Mr. Keynes’ theory is left with the impression that these fluctuations of prices are entirely unmotivated and irrelevant, except towards the end of a boom, when the fact of scarcity is readmitted into the analysis, as an apparent exception, under the designation of ‘bottlenecks’. And not only are the factors which determine the relative prices of the various commodities systematically disregarded; it is even explicitly argued that, apart from the purely monetary factors which are supposed to be the sole determinants of the rate of interest, the prices of the majority of goods would be indeterminate. Although this is expressly stated only for capital assets in the special narrow sense in which Mr. Keynes uses this term, that is, for durable goods and securities, the same reasoning would apply to all factors of production. In so far as ‘assets’ in general are concerned the whole argument of the General Theory rests on the assumption that their yield only is determined by real factors (i.e. that it is determined by the given prices of their products), and that their price can be determined only by capitalising this yield at a given rate of interest determined solely by monetary factors. This argument, if it were correct, would clearly have to be extended to the prices of all factors of production the price of which is not arbitrarily fixed by monopolists, for their prices would have to be equal to the value of their contribution to the product less interest for the interval for which the factors remained invested. That is, the difference between costs and prices would not be a source of the demand for capital but would be unilaterally determined by a rate of interest which was entirely dependent on monetary influences. (Hayek 2009 [1941]: 374–375).
But the crucial passage is here:
“The reason why Mr. Keynes does not draw this conclusion, and the general explanation of his peculiar attitude towards the problem of the determination of relative prices, is presumably that under the influence of the ‘real cost’ doctrine which to the present day plays such a large role in the Cambridge tradition, he assumes that the prices of all goods except the more durable ones are even in the short run determined by costs. But whatever one may think about the usefulness of a cost explanation of relative prices in equilibrium analysis, it should be clear that it is altogether useless in any discussion of problems of the short period.” (Hayek 2009 [1941]: 375, n. 3).
Of course, the idea here seems to be that, in the long run, prices move towards marginal cost, so it is not modern mark-up pricing theory per se.

Nevertheless, Hayek is utterly wrong that many, even most prices, are not determined by costs of production in the short run. On the contrary, we now know, after many decades of empirical study, that most prices are cost-based or mark-up prices and are determined by total average unit costs plus a profit mark-up, not only in the long run but also in the short run. Therefore an economic theory that assumes this is how most prices are set is entirely realistic and correct, and it is marginalist pricing theory that is severely flawed and wrong.

BIBLIOGRAPHY
Hayek, F. A. 2009 [1941]. The Pure Theory of Capital. Ludwig von Mises Institute, Auburn, Ala.

14 comments:

  1. Are the costs you are counting retail, or wholesale? I think that effects the logic. If for instance I set up a business selling CDs that I order on demand with a mark up, then if my supplier changes the price for marginalist reasons, that lowers my cost and you would count that as a markup price. If there are two of us doing this then 2/3 prices here you count as markup, yet it is marginalism at work.
    So how do you deal with this point?

    Side questions. In years of "debate" at Murphy's I have never seen them raise this objection. Have they ever?

    And do you worship Lucifer like many who control US government policy? ��

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    1. (1) I am not sure I understand this point about costs.

      Yes, costs of production for a business will of course often be wholesale prices: say, when they buy in bulk.

      And, yes, total average unit costs change do change, including when wholesale prices change. But the way that the output prices may be adjusted -- or not -- as a result of costs changing is fully covered in conventional mark-up pricing theory.

      E.g., many businesses prefer not to cut prices at all when costs fall, so that they can just enjoy higher profits.

      (2) "And do you worship Lucifer like many who control US government policy? "

      lol.. have the religious nutters on bob's blog been saying this? Sorry I missed that!!

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  2. No, Bob Murphy has a post up arguing the Lucifer thing.

    As for prices, another example. My brother and I sell firewood door to door. We charge our cost plus 20%. The supplier we buy from prices in conformance with the purist marginalism. Just 5 minutes ago he dropped the price. So my brother and I, marking up, drop our price. You count 3 price changes, two being markup, and argue therefrom that marginalism is flawed. But the change in prices was all due to marginalism. Marginalism will correctly predict price changes here, despite your numbers. This seems a great hole in your argument.

    So, how do you patch it?

    I assume no Austrian has raised this. I mention that as a measure of their lack of serious engagement with your arguments.

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    1. The answer to this is quite simple: the empirical evidence shows that people who actually set their prices by pure marginalist principles are quite minimal, a minority. I do not see how it refutes my argument, because mark-up pricing theory doesn't deny that flexprice markets and prices set by marginalist principles exist, by the way -- just their extent and economic significance.

      Have a look at some of the empirical evidence:

      http://socialdemocracy21stcentury.blogspot.com/2014/07/blinder-et-al-on-us-price-stickiness.html

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    2. Also, I think you may have missed an important point: to be truly determined by marginalist principles of supply and demand, a price must be responsive to demand changes. Indeed, highly responsive, so that there is a tendency for supply and demand to be equated by flexible prices. But mark-up/cost-based prices are not generally responsive to demand.

      But even if mark-up prices are adjusted if prices of costs change (and where those costs prices are determined by marginalist principles), it doesn't follow that the mark-up prices are now governed by marginalist principles, for they will still, generally speaking, be unresponsive to demand.

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    3. Well it makes a complete hash of your majority of prices are mark up argument. Say Exxon sells oil through a million pump owners who charge 3% markup. Exxon tracks demand and adjusts prices every 5 minutes. There were 1,000,001 price changes 5 minutes ago. 1,000,000 of those prices were mark up, but in fact all the prices were determined by marginal considerations. The marginalists can explain this market perfectly despite the huge preponderance of markup prices. This proves the irrelevance of the preponderance in assessing whether marginalism can explain the prices. You have to look at the number of indpendent pricing decisions, which is a totally different thing.

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    4. Well it makes a complete hash of your majority of prices are mark up argument.

      Not sure how it does this, Ken B. Can you elaborate on this?

      Delete
  3. The whole thread evinces Murphy's continuing descent into paranoid religious nuttery, but the exchange here is especially revealing.
    http://consultingbyrpm.com/blog/2014/10/well-it-may-be-the-devil-or-it-may-be-the-lord.html#comment-1160806

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    1. Yah, that is crazy stuff.

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    2. Bob is also pretending that the ABCT is something it isn't:

      http://consultingbyrpm.com/blog/2014/10/yellen-and-the-end-of-qe3.html

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  4. "why not do it when the first black president is in the White House and the first woman is at the helm of the Fed?"

    Incisive economic argument!

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  5. over at Free Advice, the total moron bob roddis is, as usual, resorting to circular reasoning and, as usual, conflating economics with his political ideology (in his responses to you). The guy has absolutely no knowledge or understanding of economics and is shamelessly, pathologically stupid.

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    1. Yes, he is a shining example of the "vulgar" internet Austrian: largely ignorant of his Austrian theory and shamelessly proud of his ignorance.

      Delete