How the Price System Works

The art of economics consists in looking not merely at the immediate, but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group, but for all groups.

This is an ongoing series of posts on Henry Hazlitt’s Economics in One Lesson. You can access the Table of Contents here. Although written in 1946, it still touches on many of the issues we face in 2017, particularly the fallacies government economic programs are built upon.

 

The whole argument of “Economics in One Lession” could be summed up by the quote at the top of each of my articles.

Hazlitt thought it foolish and misleading to concentrate attention merely on some special point without considering what happens in all. The major fallacies of economics stems from a persistent and lazy  habit of thinking only of some particular industry or process in isolation. These fallacies pervade the arguments of the hired spokesmen of special
interests, but even economics are often caught up in the arguments.
The fallacy of isolation supports “production for-use-and-not-for-profit” school of thought, with its attack on the allegedly vicious “price system.” Adherents of this school will claim that the problem of production is solved by scientists, efficiency experts, engineers, and technicians. These folks could create anything you want in practically unlimited amounts, but the world isn’t run by engineers. Oh, no, the businessmen get involved and they think only of profit. They order the engineers to create stuff only so long as there is profit in doing so, leaving the wants of many unsatisfied and the world crying for more goods.

The central error here is a failure to see that all industries exist in relation to other industries. Every important decision made affects and is affected by decisions made in other industries.

Hazlitt invited his readers to consider Robinson Crusoe, stuck on his desert island. His wants would be endless.He’s needs shelter, food, water, warmth, protection from animals and someplace to sleep. It is impossible for him to satisfy all these needs at once because he lacks time, energy, and resources, so he focuses on the most pressing need first.

Thirst would be the most important need. He hollows out a place in the sand to collect rain
water, or builds some crude receptacle. When he has provided for only a small water supply, however, he must turn to finding food before he tries to improve this. He can try to fish; but to do this he needs either a hook and line, or a net, and he must set to work on these. But everything he does delays or prevents him from doing something else only
a little less urgent. He constantly faces the problem of alternative applications of his time and labor. A Swiss Family Robinson, perhaps, finds this problem a little easier to solve. It has more mouths to feed, but it also has more hands The father hunts; the mother prepares the food; the children collect firewood. But even the family cannot afford to have one member of it endlessly doing the same thing, regardless of the relative urgency
of the common need he supplies and the urgency of other needs still unfilled. When the children have gathered a certain pile of firewood, they cannot focus on increasing the pile. One of them must be sent for more water. The family too has the constant problem of choosing among alternative applications of labor, and, if it is lucky enough to have acquired guns, fishing tackle, a boat, axes, saws, and so on, of choosing among alternative applications of labor and capital.

In a survival situation, it would be ludicrous for the wood-gathering member of the family to complain that they could gather more firewood if his brother helped him all day, instead of getting the fish that were needed for the family dinner. Division of labor would imperil survival.

Believe it or not, there are folks who ridicule the recognition of such illustrations as “Crusoe economics.” Often those who do the ridiculing are the ones who most need to learn the lesson.

Consider modern society. There are thousands of different needs and wants with varying levels of urgency. Society solves this interconnected web of conflicting desires through the price system which constantly changes the inter-relationships between costs of production, prices and profits. Prices are fixed through the relationship of supply and demand. When people want more of an article, they offer more money for it. The price goes up. This increases the profits of those who make the article. Because it is now more profitable to make that article than others, the people already in the business expand
their production of it, and more people are attracted to the business. This increased supply then reduces the price and reduces the profit margin, until the profit margin on that article once more falls to the general level of profits in other industries.

Conversely, the demand for that article may fall; or the supply of it may be increased to such a point that its price drops to a level where there is less profit in making it than in making other articles. It could even be that the price falls so low that the producer suffers an actual loss in making it. “Marginal” producers (those that are less efficient or whose cost of production is higher) will be driven out of business altogether. The product will now be made only by the more efficient producers who operate at lower costs. The supply of that commodity will cease to expand and might even drop. This process is the origin of the belief that prices are determined by costs of production.

The doctrine, stated in this form, is not true. Prices are determined by supply and
demand, and demand is determined by how intensely people want a commodity and what they have to offer in exchange for it. It is true that supply is in part determined by costs of production, but what a commodity has cost to produce in the past cannot determine its value. That will depend on the present relationship of supply and demand. But the expectations of businessmen concerning what a commodity will cost to produce in the future, and what its future price will be, will determine how much of it will be made. This will affect future supply.

There is constant tension between the rice of a commodity and its marginal cost of production, but the cost of production does not directly determine the price.

The private enterprise system is comparable to thousands of machines, each regulated by its own quasi-automatic governor, all interconnected and influencing each other, so that they act like one great machine. This is similar to how the relative supply of thousands of
different commodities is regulated under the system of competitive private enterprise. When people want more of a commodity, their competitive bidding raises its price. This increases the profits of the producers who make that product. This stimulates them to increase their production. This sometimes leads others to stop making some of the products they previously made, and turn to making the product that offers them a better return. This increases the supply of that commodity at the same time that it reduces the supply of some other commodities. The price of that product therefore falls in relation to the price of other products, and the stimulus to the relative increase in its production disappears. If the demand falls off for some product, its price and the profit in making it goes lower, and its production declines.

And then ill-informed people denounce the price system, accusing it of creating scarcity. Why, they ask indignantly, should manufacturers cut off the production of shoes at the point where it becomes unprofitable to produce any more? Why should they be guided merely by their own profits? Why should they be guided by the market? Why do they not produce shoes to the “full capacity of modern technical processes”?

The production-for-use philosophers subscribe to a form of “scarcity economics,” stemming from looking at one industry in isolation. They’re paying a lot of attention to one tree while ignoring the forest.

Yes, we need shoes, but we also need coats, shirts, trousers, homes, plows, shovels, factories, bridges, milk and bread. It would be silly to focus only on shoes when hundres of more urgent needs go unfulfilled.

In an economy in equilibrium, a given industry can expand only at the expense of other industries, but often shrinkage in one industry releases labor and capital to be invested in other industries.

It is erroneous to conclude, therefore, that a shrinkage of production in one line necessarily means a shrinkage in total production. … Costs of production themselves … might be defined as the things that are given up (the leisure and pleasures, the raw materials with alternative potential uses) in order to create the thing that is
made.

It follows that it is just as essential for the health of a dynamic economy that dying industries should be allowed to die as that growing industries should be allowed to grow. The dying industries absorb labor and capital that should be released for the growing
industries.

The price system solves the enormously complicated equations deciding precisely how much of tens of thousands of different commodities and services should be produced in relation to each other. It does this quasi-automatically by the system of prices, profits, and costs.

This system is incomparably better than any group of bureaucrats could devise because it allows each consumer to make his own demand. Every day, the consumer can cast a fresh vote, or a dozen fresh votes, for what they want and need. Bureaucrats would try to solve it by deciding what they think is good for the consumer, preferrably with very little input from the consumer.

Bureaucrats do not understand the quasi-automatic system of the market, but they are always disturbed by it, trying to improve or correct it, usually in the interests of some pressure group. In future chapters, Hazlitt looked at some of the consequences of this bureaucratic intervention.