Foundations of the Market Price System

INTRODUCTIONS TO CHAPTERS

Following is an outline of the main features and perspectives of each chapter and what I believe are their respective special qualities.

Chapter I

The primary purpose of this chapter is to prepare the reader for the concept of scarcity to be analyzed in the next chapter. Scarcity is the fundamental problem to which economics is addressed. However, the concept of scarcity requires advance preparation since it tends to strike the untutored as too abstract or ideological (e.g., a “bourgeois” rationalization).

Scarcity is the basic reason that man must engage in productive work, yet the institutions of modern complex society (e.g., the elaborate network of transfers and welfare programs) are ironically able to disguise the underlying reality of scarcity. Incidentally, this chapter also introduces Robinson Crusoe, that model of isolated man from whose bare and lonely existence in the bosom of nature we can learn so many of the fundamental concepts of economics.1

Also noteworthy is the fundamental categorical distinction between “economic means” and “political means,” the analysis of which enables us to argue the primacy of economic production as compared with the principle of governmental political power.2

Chapter II

This chapter is concerned not only with scarcity, the fundamental and unique problem of interest to economics, but it also establishes a conceptual framework for most of the remainder of the book (as illustrated in Figure 5).

Scarcity is analyzed primarily in terms of the wants-means connection (i.e., the ends-means connection) which comprises the twin aspects of the fundamental condition of human existence. In the first go-around we see how scarcity implies the necessity of production, an implication that is drawn both for (a) the case of Robinson Crusoe and other direct-use models of economy, and (b) the market mode of economy based on the social division of labor (Chapters II - IV). In contrast to the social or “macro” perspective of the latter is the fundamental individualist perspective (in Chapters V - VII) which draws out the implications of scarcity for individual choice or decision-making.

Economics remains the only social science preoccupied with scarcity and its implications. Nevertheless, the other social sciences can surely learn from the economists’ preoccupations. The analysis of decision-making in Chapter V is but one example. Even more significant is the variety of bold contributions being made by economists to the understanding of decision-making in traditionally non-economic areas, such as politics and social problems, under the heading of public-choice theory.3

Chapter III

Although this chapter assumes a historical approach, its purpose is analytical: to explain some important things that are too often taken for granted. Thus it tries to fathom the implicit rationality of the historical evolution of specialization, the social division of labor, and the invention of money. A social science like economics is necessarily concerned with the study of the fundamental elements that induce the interpersonal relations and transactions (i.e., exchange, trade) that underlie all market-place activity. Coincidentally, the analysis of money is unique since it is a topic usually treated only in macro-economic texts.

Chapter IV

On the one hand this chapter is concerned with the key concept of production and how it is immediately implied as the only relevant human response to unsatisfied wants. Thus it necessarily embraces the analysis of productivity, innovation, technological progress, and capital accumulation.

On the other hand, in the context of the social division of labor, production is necessarily centered in firms, those social-economic units that specialize in playing the role of intermediary between people as consumers and people as resource-owners (i.e., workers, savers, investors). This is a role that necessarily calls for entrepreneurship—decision-making in the face of uncertain market conditions. In this respect the chapter lays groundwork for Chapter IX, on the profit margin, and Chapter X, on consumers’ sovereignty.

It is this focus on the centrality of the firm—as producer and entrepreneurial intermediary—which alone enables us to appreciate how the so-called “impersonal” or “automatic” forces of market supply and demand operate not only to determine prices but also to coordinate the whole range of market-oriented decisions of households and firms. Chapters VI through X analyze in detail how profit-motivated firms provide the market its inherent tendency to relative stability.

A fruitful by-product of this analysis is the realization that, in the social division of labor, it is investment by firms that is the primary source of income earned by resource-owners. Contrary to prevailing orthodoxy, the primary generator of income in the modern economy is the investment by firms in production and employment of resources—not the Keynesians’ aggregate demand which, after all, is an abstract, synoptic concept.

Last but not least, this chapter introduces us to the nature of the “consumers’ sovereignty” problem, which receives its deserved full-length treatment in Chapter X.4

Chapter V

Superficially this chapter brings together a string of standard economic concepts that are all relevant to individual decision-making. On a more fundamental level, however, it seeks to connect those concepts in a logical chain whose links are systematically derived from the underlying premise of scarcity. It culminates in an elaborate treatment of both the maximization priniciple and the axiom of self-interest.

Original in the treatment of the maximization principle is the attempt to apply it to all cases, without exception, of decision-making. Treatment of self-interest is likewise unconventional in its argument that maximization and self-interest are, without exception, the sole and fundamental principles of motivation in human action. These constructions should broaden our appreciation of the unitary connection between so-called economic principles and human action in general, by helping to end the misconception that economics is narrowly confined to that phantom called “economic man,” and by showing that “economizing” behavior is intimately related to universally maximizing behavior.

In preparing this material the author found no little inspiration in the seminal but sadly neglected works of Ludwig von Mises and Philip H. Wicksteed.5 A brief passage from Wicksteed suffices to illustrate the perspective:

It follows that the general principles which regulate our conduct in business are identical with those which regulate our deliberations, our selections between alternatives, and our decisions in all other branches of of life. And this is why we not only may, but must, take our ordinary experiences as the starting point for approaching economic problems. We must regard industrial and commercial life, not as a separate and detached region of activity, but as an organic part of our whole personal and social life; and we shall find the clue to the conduct of men in their commercial relations, not in the first instance amongst those characteristics wherein our pursuit of industrial objects differs from our own pursuit of pleasure or of learning, or our efforts for some political and social ideal, but rather amongst those underlying principles of conduct and selection wherein they all resemble each other. . .6 (underlinings mine).

Thus the analysis proceeds from the premise of a common or unitary motivational principle in all human action—the “economic” as well as the “non-economic”—in which so-called economic action is regarded as a special case of human action in general, and whose motivations are consistent with those of human action in general.

In this connection the concept of subjective value is developed as the basic force that determines the degree of importance that we attach to our goals and purposes, on the one hand, and to the means of achieving them, on the other. Explored are two dimensions of influence on subjective value: preference-scale rankings and the supply of means (law of marginal utility); later, Chapter IX explores the third dimension of influence, people’s time-preference. In general, subjective value and its primary role in human action are sadly neglected topics in standard texts.

Chapters VI - VIII

This trio of chapters constitute the traditional core of technical analysis of the market—on how the “interplay” of demand and supply determines market prices. The market is the central nexus of the social division of labor; intertwined networks of markets comprise the market-price system; the latter in turn represents in principle the heart of so-called capitalism as well as the focus of this book. Although the three chapters run to about 120 pages, they are surely less than the subject deserves. However, compared with other introductory treatments, they are truly very ample.

One of the reasons for the elaborate analysis in this work is to counteract the tendency of texts to treat the market process of price determination somewhat mechanically, as though the market operates “automatically” and “impersonally”—a thoroughly illegitimate assumption. Real markets consist of blood-and-flesh human beings, not artificial constructs like “economic man,” and therefore behave neither automatically nor predictably. Analysis must take this realism into account, as this book attempts throughout.

There is also the need to amply demonstrate the centrality of the firm in the workings of the market process. This centrality was initially asserted in Chapters II and IV. Then in Chapters VI and VII, market demand is analyzed at sufficient length to comprehend all those relevant dimensions of demand (e.g., income, taste and preference, price elasticity) about which the firm must become informed. Mainly through market research and related studies, as well as through trial and error, can firms gain the knowledge needed to reduce the probability of error in its estimates and forecasts of market demand.7

In Chapter VIII, which ostensibly shows how the market determines prices, the analysis attempts to demonstrate that in reality it is not so much the “market” per se that establishes prices but rather it is the firm which sets them at all times. It is the firm that sets prices initially, and it is the firm that later adjusts prices (and quantities) in response to the market feedback of surplus or shortage. Even more significant, it is the firm, in its efforts to maximize profits (or minimize losses), that makes the price and quantity adjustments required to avoid disequilibria (surpluses, shortages), and thereby creates the market’s tendency toward stability of output and prices. The implication is clear: If the market process is shaped by a force that inheres toward stability, then the alleged “instability” and “anarchy” so glibly blamed on the market must be located elsewhere, in non-market sources.8

More specifically, Chapters VI and VII, on the demand side of the market, focus on two things: (a) those elements that determine the shape and location of demand, and (b) the ways in which the behavior of these elements can be made known to the firm (especially via the concept of elasticity of demand). It is precisely the economist’s task to isolate and describe those determinants of market demand whose impacts are discernable and knowable by the firm.

The text also assists the reader in understanding the partial-analysis method used by economists (e.g. the ceteris paribus proviso) as the necessary first step in unraveling the complex manifestations of reality. Also, Chapter VI offers an alternative explanation of why the demand curve slopes the way it does, and why the law of demand brooks of no exceptions, alleged or otherwise.

Noteworthy also is the lengthy Chapter VII on the elasticity of demand, which makes this significant concept realistic and practical, and avoids the mathematical (“percentage”) approach so typical of other texts. Thus it demonstrates that the law of demand (Chapter VI) is not enough, surely not for the firm; indeed, mere reliance on the law of demand can prove disastrous for the firm when it seeks to initiate a price raise or price cut. Thus, there are cases where a raise of price which, under the law of demand, would induce a drop in purchases, may actually result in increased dollar receipts for the firm! Conversely, there are cases where a cut in price which would induce increased purchases, may actually result in a drop in the firm’s dollar receipts! These perverse outcomes—perverse in the context of the law of demand—can only be understood by appeal to the concept of elasticity of demand. Throughout the chapter the treatment necessarily relies on the method of partial analysis noted above.

The exceptionally detailed treatment of elasticity of demand is also prompted by the desire to analyze the subject from the practical point of view of the firm, for whom the outcome of its decisions is measured in dollar terms. For this reason, the concept of elasticity of demand is analyzed exclusively in terms of the TR (total receipts) dollar dimension rather than in terms of the mathematical (percentage) approach of other texts. The analysis also avoids the customary treatment of elasticity in terms of whole demand curves (and their overall slopes); instead, it applies the more realistic “marginal” or incremental approach.

Chapter IX

Formally this chapter develops material outlined in Chapter IV and ostensibly seeks to justify the profit margin.9 In the ensuing analysis the following concepts play a fruitful role: the fact that production takes time and the firm must wait to sell its product before it can earn any profit; the realization that time preference (and the pure interest rate) become relevant as the basic component of the gross-profit margin; and the fact that the firm “works back from price” (see Chapter IV) by discounting the future expected selling price. This not only makes the firm a discounter of future values, but also means that “prices determine costs” rather than costs determine prices.

The analysis is then extended in order (a) to show the broad relevance of “imputation” processes to, for example, capital values and share prices, and (b) to provide a critique of both the Classical cost-of-production theory of pricing and the Marxian labor theory of value. There is a further implication, however, not developed in this book: the standard notion of the so-called normal rate of return on capital, which is usually treated as a cost, should be treated instead as an earning—as part of the gross profit margin.

Chapter X

This chapter pays homage to the fact that we are all consumers—every last one of us—and shows why this basic fact is far from being a trivial one. When Adam Smith, in his Wealth of Nations, declared that “consumption is the sole and end purpose of production,” he unwittingly pronounced the genesis of the consumers’ sovereignty problem. The emphasis is on the word “problem,” initially introduced in Chapter IV and now analyzed in this chapter. From the political-economic viewpoint, consumers’ sovereignty is arguably one of the most central issues facing the individual in the modern social division of labor.

If and when it ever comes up, the consumers’ sovereignty issue tends to be treated as an empirical question: To what extent is the consumer actually “sovereign” in the market place? In contrast, this chapter focuses on the practical question: If we assume that consumers should be sovereign, how can this sovereignty be optimally implemented?

In the ensuing analysis the workings of laissez-faire, free competition, and property rights in the means of production take on an integral unity of purpose, all in the service of consumers’ sovereignty and the free-market system. The analysis also serves to explode the perennially fallacious dichotomy of property rights versus human rights; it is argued that property rights in the means of production are not only a basic human right on its own merit but is, indeed, the prerequisite for other human rights.

In this perspective socialism is seen to be an essentially restrictive principle of economic organization and human rights, based as it is on the abolition of property rights in the means of production, and therefore destroys the basis of human rights in general. On the level of pure principle, it can be argued that those who believe socialism can in any way improve on free-market capitalism in the area of human rights are tragically under the spell of a chimerical vision. Clearly, socialism in practice does lose a great deal in the translation from vision to reality.

A note about the Appendix to this chapter. The argument that, on empirical grounds, the consumer is not at all sovereign in the market place was in recent decades spearheaded by John Kenneth Galbraith. It was his theory of the “dependence effect” that stimulated and nourished the widespread attack on advertising as a “waste,” and on the “excesses” of “consumerism,” if not on the very essence of market capitalism itself. The Appendix shows why the “dependence effect” is basically a fallacious—and insidious—concept.

Chapter XI

Every chapter but this last one is integrally related to the analytical framework outlined in Chapter II. This last chapter on the abstract model of “perfect competition” is the exception. Thematically this chapter is an odd-man-out as far as this book is concerned, but is being included for two reasons.

For one thing, the theory of perfect competition is a centerpiece in practically every textbook, so its omission might be too glaring. The decisive reason, however, is the smoldering need to subject this concept to extensive critical scrutiny. This chapter argues that perfect competition theory is a terribly flawed area of economics and without practical relevance to industrial capitalism; yet it remains a hallowed pillar of the intellectual edifice. Although economists have pecked away much of this pillar, it is long past time for a systematic dissection. Hence the chapter.10

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11An excellent example of the many fundamental concepts that we can learn in “Crusoe economics” are the first 62 pages in Murray N. Rothbard, Man, Economy, and State, 2 vols. (Princeton: D. Van Nostrand Co., 1962).

12A noteworthy attempt to apply the distinction between “economic means” and “political means” to the analysis of contemporary domestic issues is by James D. Davidson, The Squeeze (New York: Summit Books, 1980).

13A good example of this fruitful work is Richard B. McKenzie and Gordon Tullock, The New World of Economics (3rd ed., Homewood, Ill.: Richard D. Irwin, Inc., 1981).

14The author is indebted to Israel M. Kirzner, Market Theory and the Price System (Princeton: D. Van Nostrand Co., 1963) for insights developed in this and the next chapter.

15Ludwig von Mises, Human Action (New Haven: Yale University Press, 1949); Philip H. Wicksteed, The Common Sense of Political Economy, 2 vols. (London: Routledge & Sons, 1946).

16Philip H. Wicksteed, The Common Sense of Political Economy, Vol. I, p. 3.

17On the centrality of the firm and entrepreneurship in the market process see Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973) and his Perception, opportunity, and Profit (Chicago: University of Chicago Press, 1979).

18On the market’s inherent tendency toward avoiding disequilibria and achieving stability, as well as the role of government interventions and war as major destabilizing factors, see Gerald Sirkin, “Business Cycles Aren’t What They Used to Be—and Never Were,” Lloyd’s Bank Review (April 1972), pp. 20-34; Murray N. Rothbard, Man, Economy, and State (Princeton: D. Van Nostrand Co., 1962), pp. 661-890, and his America’s Great Depression (3rd ed., Kansas City: Sheed and Ward, 1975).

19This chapter owes much to insights provided by Rothbard, Man, Economy, and State, Chapters 6-8, and Raymond J. Chambers, Accounting, Evaluation and Economic Behavior (Englewood Cliffs: Prentice-Hall, Inc., 1966), passim.

20Key inspirations for this chapter, in addition to Rothbard’s Man, Economy, and State, were Joseph A. Schumpeter, Capitalism, Socialism, and Democracy, Part II (3rd ed., New York: Harper and Brothers, 1950), and Friedrich A. Hayek, “The Meaning of Competition,” in his Individualism and Economic Order (London: Routledge and Kegan Paul, Ltd., 1949), pp. 92-106.

• 1See Thomas Sowell, Knowledge and Decisions (New York: Basic Books, Inc., 1980) for an elaborate analysis of how—despite the complex structures and environments of the modern division of labor—the free society and its market-price system generate, transmit, and apply “authentic” knowledge in the realms of economics, law, and politics. For an earlier treatment, see Friedrich A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960).
• 2Excellent examples of this type of supplementary work are John C. Goodman and Edwin G. Dolan, Economics of Public Policy: The Micro View (2nd ed., St. Paul: West Publishing Co., 1982), and Walter E. Williams, America: A Minority Viewpoint (Stanford: Hoover Institution Press, 1982).
• 3A notable exception is the above-mentioned text by Goodman and Dolan which analyzes public issues in terms of moral, political and economic criteria.
• 4For a philosophical treatment of morality in interpersonal relations, see John Hospers’ Human Conduct (2nd ed., New York: Harcourt Brace Jovanovich, Inc., 1982).
• 5For a detailed study of these and related issues, see Murray N. Rothbard, The Ethics of Liberty (Atlantic Highlands, N.J.: Humanities Press, 1982).
• 6For a well-rounded “pluralist” approach to the capitalist system that includes analysis of its “moral-cultural” dimensions, as well as the political and economic, see Michael Novak, The Spirit of Democratic Capitalism (New York: Simon and Schuster, 1982).
• 7On the centrality of the firm and entrepreneurship in the market process see Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973) and his Perception, opportunity, and Profit (Chicago: University of Chicago Press, 1979).
• 8On the market’s inherent tendency toward avoiding disequilibria and achieving stability, as well as the role of government interventions and war as major destabilizing factors, see Gerald Sirkin, “Business Cycles Aren’t What They Used to Be—and Never Were,” Lloyd’s Bank Review (April 1972), pp. 20-34; Murray N. Rothbard, Man, Economy, and State (Princeton: D. Van Nostrand Co., 1962), pp. 661-890, and his America’s Great Depression (3rd ed., Kansas City: Sheed and Ward, 1975).
• 9This chapter owes much to insights provided by Rothbard, Man, Economy, and State, Chapters 6-8, and Raymond J. Chambers, Accounting, Evaluation and Economic Behavior (Englewood Cliffs: Prentice-Hall, Inc., 1966), passim.
• 10Key inspirations for this chapter, in addition to Rothbard’s Man, Economy, and State, were Joseph A. Schumpeter, Capitalism, Socialism, and Democracy, Part II (3rd ed., New York: Harper and Brothers, 1950), and Friedrich A. Hayek, “The Meaning of Competition,” in his Individualism and Economic Order (London: Routledge and Kegan Paul, Ltd., 1949), pp. 92-106.
• 11Add to this the obfuscations, deliberate or inadvertent, of those messianic types who would deliver us from all our travails by imposing their illusions, myths and Utopian visions on the rest of us—and it follows that the task of discerning and explaining the true nature of economic existence becomes so much more difficult,
• 12For the rest, for the purpose of greater illustration and application of analysis to public issues and policies, I defer for the most part to the numerous useful works devoted especially to this purpose. These works, including books of readings, provide ample supplementary materials that illustrate at length how economic theory or principles manifest themselves in practice and how economic analysis can be applied to practical problems.
• 13Before proceeding to the chapter-by-chapter introductions, it is necessary to point out that economic tracts—mainly because of materialist bias—usually omit the very important moral dimension, a dimension that is nevertheless relevant to economic reality—to economics in practice. First of all, economics as a social science is fundamentally concerned with exchange—“interpersonal transactions.” Exchange is inherent in every production and trade activity. Thus, the market-price system may be regarded as comprising multitudinous exchange transactions. Since exchange also infuses every interpersonal transaction in society at large, it also constitutes the basic coordinating mechanism of that most complex network of interrelationships called “society.”
• 14Exchange transactions regarded as interpersonal activity necessarily involve the elementary moral question: by what moral principle should exchange between party A and party B be governed? Here only two basic principles are relevant: either the principle of nonviolence (non-aggression) or its opposite, violence (aggression). Violence and aggression can be identified simply by such acts as theft, killing and fraud.
• 15From this perspective, the voluntary nature of market exchange transactions precludes violence or aggression, otherwise free exchange or trade would presumably not take place. Voluntary or non-violent mutual exchange respects the right of any party to a potential exchange (say, party A) not to be aggressed against, that is, not to be mugged, slain, or defrauded simply because someone else (say, party B) covets what A possesses. Thus, it is not to be taken for granted that free trade and interpersonal exchange will automatically occur without mutual respect for the moral precept of non-violence. Therefore, any sanction of violence and aggression in interpersonal relations would not only preclude real exchange possibilities but would give free rein to the law of the jungle and barbarism.
• 16Ultimately, all theoretical economic systems boil down in principle to only two: the free-market society and socialism. In that perspective, the present work on the free market-price system may also be regarded as a contribution, albeit introductory, to the study of comparative economic systems.
• 17There is also the need to amply demonstrate the centrality of the firm in the workings of the market process. This centrality was initially asserted in Chapters II and IV. Then in Chapters VI and VII, market demand is analyzed at sufficient length to comprehend all those relevant dimensions of demand (e.g., income, taste and preference, price elasticity) about which the firm must become informed. Mainly through market research and related studies, as well as through trial and error, can firms gain the knowledge needed to reduce the probability of error in its estimates and forecasts of market demand.
• 18In Chapter VIII, which ostensibly shows how the market determines prices, the analysis attempts to demonstrate that in reality it is not so much the “market” per se that establishes prices but rather it is the firm which sets them at all times. It is the firm that sets prices initially, and it is the firm that later adjusts prices (and quantities) in response to the market feedback of surplus or shortage. Even more significant, it is the firm, in its efforts to maximize profits (or minimize losses), that makes the price and quantity adjustments required to avoid disequilibria (surpluses, shortages), and thereby creates the market’s tendency toward stability of output and prices. The implication is clear: If the market process is shaped by a force that inheres toward stability, then the alleged “instability” and “anarchy” so glibly blamed on the market must be located elsewhere, in non-market sources.
• 19Formally this chapter develops material outlined in Chapter IV and ostensibly seeks to justify the profit margin. In the ensuing analysis the following concepts play a fruitful role: the fact that production takes time and the firm must wait to sell its product before it can earn any profit; the realization that time preference (and the pure interest rate) become relevant as the basic component of the gross-profit margin; and the fact that the firm “works back from price” (see Chapter IV) by discounting the future expected selling price. This not only makes the firm a discounter of future values, but also means that “prices determine costs” rather than costs determine prices.
• 20For one thing, the theory of perfect competition is a centerpiece in practically every textbook, so its omission might be too glaring. The decisive reason, however, is the smoldering need to subject this concept to extensive critical scrutiny. This chapter argues that perfect competition theory is a terribly flawed area of economics and without practical relevance to industrial capitalism; yet it remains a hallowed pillar of the intellectual edifice. Although economists have pecked away much of this pillar, it is long past time for a systematic dissection. Hence the chapter.