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Saturday, September 8, 2012

Free Prices Clear the Market

“The member of Parliament who supports every proposal for strengthening this monopoly is sure to acquire not only the reputation of understanding trade, but great popularity and influence with an order of men whose numbers and wealth render them of great importance. If he opposes them, neither the most acknowledged probity nor the highest rank, nor the greatest public services, can protect him from the most infamous abuse and detraction, from personal insults, nor sometimes from real danger, arising from the insolent outrage of furious and disappointed monopolists.”
1. Free Prices Clear the Market
In the preceding chapters we have carried our analysis of the mechanism of our nonsocialist economic system to the point where we can now understand why the formation of prices on the different commodity markets is the process which directs and regulates the whole, a process to which every economic problem must be inevitably referred. It is now our task, proceeding from the simple to the complex, to concentrate our inquiry into this process.
The best procedure will be to take as our starting point the popular axiom which states that market price at a given moment is determined by supply and demand. In so doing we shall be making our first near approach to the problem. The axiom states that increasing supply and decreasing demand cause prices to fall, and that decreasing supply and increasing demand cause them to rise. We may express this simple and familiar relationship by saying that prices vary directly with demand and inversely with supply. Therewith we have by no means exhausted all the interconnections of supply, demand and price, however. It is important to note that not only does price depend upon supply and demand but that, conversely, supply and demand depend upon price. This dependence, too, is one with which we are all familiar. We may express it, axiomatically, by saying that supply varies directly and demand inversely with price.
These two observations lead us to a third, namely that demand, supply and price are mutually interdependent. The mechanism of price formation based on these interrelationships functions in its simplest form as follows: when there is a disparity between supply and demand, the price rises or falls until, under the counterinfluence of price, supply and demand are brought into equilibrium. The price which results is the equilibrium price which will not vary so long as the market situation does not change. This price is characterized by the fact that no seller or buyer prepared to accept it will leave the market unsatisfied. Until the price has found this level, it will continue to fluctuate. The equilibrium price is that price which clears the market. This is one of the most important and elementary of the whole body of economic principles; it should be fixed firmly and indelibly in our minds.1
A natural consequence of this elementary axiom is that the expressions “supply” and “demand” must always be used in a relative sense. A good is not simply offered or demanded, but offered or demanded in relationship to a certain price. If the price changes, supply and demand change with it. This does not mean, however, that supply and demand depend only upon price. It goes without saying that even if the price remains the same, more of a given commodity will be supplied if a technical improvement (for example) results in a lowering of its costs of production; likewise, the demand for a commodity will increase (its price remaining constant) as it grows in favor with the buying public. It remains true that supply increases with rising prices and that demand increases with falling prices, but the level at which this occurs will meanwhile have changed. It is customary to describe such movements as shifts of the supply and demand schedules (or of the curves of supply and demand). Consequently, an increase in supply may result equally from a rise in prices (the supply curve remaining unchanged), or from a shift in the supply curve (prices remaining unchanged), or from both at once; inversely, a fall in prices, or a shift in the supply curve, or a combination of both can bring about a decrease in supply. The same holds true for an increase or decrease of demand. Hence, all these expressions have a double meaning which should not be lost sight of. Our first elementary axiom applies only in the case where the curves of supply and demand are given. Should these change, a displacement of the equilibrium price takes place. If we were to seek the causes of this displacement we would be led to analyze on the one hand, every circumstance which figures in the buying public’s valuation of a good, and on the other, the manifold conditions governing supply. This would lead us into complications which, at this juncture, can only be hinted at.
The elementary relationships thus far exposed are exemplified in striking fashion in every attempt of government to establish, by decree, a price other than the equilibrium price. An example of this with which we are by now familiar is the “ceiling price” policy which, during both World Wars, attempted to prescribe a price lower than the equilibrium price. The prices of the basic subsistence goods rose in wartime as a result of inflation but also and quite naturally because supply diminished while demand increased. In this situation, the understandable but nevertheless superficial view prevailed that consumers were being arbitrarily exploited and that to put an end to this abuse it was required simply that a system of maximum prices be imposed by government fiat. The result was that the regulatory function of the free formation of prices was arrested, provoking the now familiar chain reaction in which the unsatisfied segments of demand produced first the queue and finally rationing. Simultaneously, disturbances developed on the supply side, remedies for which were sought in forcible interventions in production (compulsory deliveries of goods, compulsory crop-planting, etc.). The lesson for the future yielded by these experiments is that the mechanism of price formation is such a vital cog in the greater mechanism of our economic system that it cannot be tampered with without forcing us to enter upon a path which ends in socialism pure and simple.
The experiences with the system of maximum prices had their parallel in the results observed with the opposite system of minimum prices which was in effect following World War I. Just as the scarcity of goods during the war led to efforts to protect consumers by setting maximum prices, so too the surpluses existing in many categories of goods during the Great Depression resulted in efforts to insure producers against further sharp price declines by establishing and enforcing minimum prices. The artificially high prices which ensued prevented the clearing of the market through the lowering of supply and the augmenting of demand. The surpluses which resulted from the imposition of these artificial prices could not be disposed of other than by having the state purchase them and store them at great expense (valorization, parity price policy). And thereby hangs a tale—of woe. As was demonstrated in every instance, e.g., the valorization of Brazilian coffee, the maintenance of high prices not only prevented the adaptation of production to the market situation but, under the incentive of the prices offered by the state, actually caused an extension of production. The more the warehouses bulged, the higher rose the costs and the more the market groaned under the pressure of this latent supply. Thus it was that the valorization of Brazilian coffee, to take this one example, ended in a lamentable debacle, leaving to the state huge debts and mountains of unsold coffee, a part of which was ultimately dumped into the sea. It would be well if those who continually reproach “capitalism” for its destruction of coffee would keep in mind that it was precisely a planned-economy correction of “capitalism” which provoked this chain reaction whose end result appears, and rightly so, as so senseless.
It could perhaps be objected that an economy of minimum prices might succeed if the spade were pushed deeper and the control over supply extended to the entire apparatus of production. The objection is doubtless valid but serves only to illustrate once again the principle that interferences with the price mechanism lead to ever more drastic and extensive interferences culminating in the completely planned economy of socialism. We have also to notice that the application of the planned economy to production as, for instance, in the various species of crop control, in the rationing of output and similar measures, leads in turn to still other and greater problems. If, for example, one country restricts the production of a given commodity in order to keep its export price high, the result will be that other countries will simply increase their production of that commodity. This explains why restrictions placed on rubber cultivation in the English colonies after World War I ended in a fiasco and why, at a later date, similar consequences were observed to flow from the cotton policy of the United States.
Still other problems are generated by market interventions. Thus in agricultural production, where the above difficulties have been most in evidence, truly effective control of production is very difficult to realize so long as the whole of agriculture has not been collectivized according to the somewhat unattractive Russian model. But it is to just such a result that this whole policy can lead if the state is compelled to apply its planned-economy interferences on an ever wider scale. One circumstance, in particular, tends to accelerate this tendency, namely, that when a restriction is placed upon the production of one agricultural commodity, farmers will tend to increase the production of another by as much. In fine, disorder breeds disorder, requiring in the end an ever more comprehensive control of production according to planned-economy methods. In this situation, it would be strange if the state should not try to solve the dilemma by forcibly increasing demand just as it had forcibly restrained supply. We have, in fact, witnessed in recent decades the development of a special technique for this purpose, a notable example of which is the compulsory use of alcohol as an ingredient in motor-fuel mixtures.* If we add that the agricultural policies of many countries during recent decades have evolved along similar lines, it becomes sufficiently plain that the formation of prices is the regulator of our economic system and that it cannot be tampered with without requiring, in the end, a reconstruction of the entire economic system. It is doubtful whether all those who recommend interferences with the formation of prices appreciate the fact that the magnetic pole of such a policy lies in Moscow (and, we should have added a while back, in National Socialist Berlin). “With the first step we are free, with the second we are serfs."

Economics of the Free Society

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