Where Do Prices Come From
Where Do Prices Come FromMarket prices don't just appear out of thin air, companies set them. If there's no functional competition, I don't see why companies and governments would be different, beyond the former demanding higher profits. However, it seems our disagreement is more about how possible functional competition is.
Your premise is incorrect, but your mistake is a common one. In no industry (save that of government fiats) do companies set prices. Consumers set prices and companies either provide goods at those prices or they don't. Think of it this way: What company can arbitrarily double its price and expect to make the same absolute profit level? As long as consumers have choices and substitutable goods (i.e. the consumer condition of a functioning market exists), no company can arbitrarily set prices. In a capitalist economy, consumers are always the final arbiter of price.
Consumers choose from among the prices given to them. If nobody offers a viable choice, goods may disappear from the market - but not if they are something essential, as electricity and oil are in modern societies. In those cases, companies may effectively set prices, as has occurred repeatedly.
Agreed that consumers choose among the prices and goods given to them. This necessary implies that consumers are effectively the ones in control of the producer. We can consider the following cases and show that consumers effectively control production in each case:
If consumers are happy with the good that is provided by a single supplier at the offering price, then any move upward in price will necessarily make them less happy. The consumers are in control because any attempt by the supplier to move the price higher will result in the following scenario.
Consumers are presented with a good from one supplier at a high price
In this scenario, either the good can be offered at a lower price or it can't. If the good cannot be offered at a lower price, then consumers will stop purchasing the good, either opting to do without or use a substitutable good. If it can be offered at a lower price, entrepreneurs will enter the market and offer the good at the lower price, in which case we have the following scenario. In both of these cases, the consumer has effectively controlled the producer by forcing them out of business or forcing them to deal with competition.
Consumers are presented with equal goods from different suppliers at different prices
Obviously, if consumers cannot make any distinction between goods from different suppliers, then they will choose the lowest price. In order to compete, producers must either lower their prices or make distinctions in their goods. If they lower prices, the consumers have effectively dictated a lower price. If the producer succeeds in making a distinction in their good, we have the next scenario.
Consumers are presented with similar, but different goods at the same price
In this case, consumers express their individual tastes by choosing the goods that most directly meet their demands. The producer succeeds in winning consumers only by offering particular distinctions that meet individual tastes. The consumer is the ultimate arbiter of the nuances in the good that make it more or less desirable than similar goods thus the consumer controls the goods' destinies. As producers learn what intricacies are more valued by consumers than others, they can adjust the goods or the prices appropriately. If they choose to adjust their goods, the goods from each supplier either becomes more like other suppliers' or less. In the first case, we end up back in the first scenario and in the second, we remain in the current scenario with more variety. In each case, the consumers are in control of the process. If, however, the producers choose to alter the price of their goods to account for the difference in consumers' valuations of the nuances, we move to the next scenario.
Consumers are presented with similar, but different goods at different prices
This scenario matches most of our realities. To simplify the analysis of the scenario, assume that a consumer is presented with two goods, A & B that matches their ultimate desire to different degrees. Let U(x) be the utility that the consumer derives from any basket of goods and assume that U(A) > U(B). Let P(x) be the price of a good and assume that P(A) > P(B). The ultimate decision that the consumer is faced with is U(A) - U(B) > or < U(P(A)-P(B)) [Good economists realize this is an ordinal analysis, not a cardinal one]
No matter what the consumer decides, the information of that decision is communicated back to the producers in the form of currency moving from the consumer's wallet to a particular producer's. The information is available to understand the relative trade-offs that consumers are willing to make between the cost of a good's nuances and the value that they bring to consumers. Either an individual producer uses that information or it doesn't. In the first case, the consumers control the producers' behavior by further tailoring the nuances of the goods that are produced and the relative prices of those nuances. If the producer does not use the information, other producers will be drawn into the market to better serve the consumer's demands again putting the consumer in charge of the process.
Degenerate case
Of course, producers can choose their own destinies, but either their destinies fit one of the scenarios above or a degenerate scenario: the good is not desired by any consumer. The ultimate result of that scenario is an exercise left to the reader ;)
In every case, the consumer is ultimately in control of what is produced and, in any meaningful sense, the price at which the good is offered. Producers have no control in the free market except to choose to offer a good at the price which consumers demand or not. The only circumstances under which producers have control is when either suppliers are forbidden from entering or leaving a market or when consumers are prevented from entering or leaving a market.
How do any of the above explain the continued rise in gas prices?
According to classical economics, in a free market (whether monopolistic, oligarchical, or competitive) prices come from an interaction between the supply curve and the demand curves, which plot the marginal benefit vs the marginal cost of each additional unit of whatever is being produced. Neither is "in charge", both simply maximize their personal economic profit.
I'm not sure that it's so obvious that consumers are always the final arbiter of price.
Many important advances in economics in recent years have come from considering areas where the assumptions underlying classical free markets break down. Instances are information asymmetry between different market participants (Amartya Sen got the Economics Nobel for this in 1998), informal pricing agreements between producers/vendors, and high entry costs to a market either as a buyer or a seller. These violated assumptions help explain the gap between the frictionless, perfect-information free market of classical theory and the inefficient markets of reality.
So the answer to the original question is, "it depends". If the market satisfies the assumptions underlying classical economics, then you get Pareto-optimised allocations and all the rest (e.g. everyone is participating at a pricing level that they are "happy" with in some sense). But many (some would say most) markets fall well short of these assumptions. For example: does every player in the stock market have access to perfect/complete pricing information? And if not, how might this cause prices to deviate from those suggested by classical economics?
Note that I'm not saying classical economics is useless: that would be absurd! But AllAbstractionsLie, and this is as true in economics as anywhere else.
Easy counter-example: If consumers really do set prices, then it follows that consumers must be aware of what price they are paying. Now, survey the people who bought an Intel box with Microsoft Windows installed on it last year and ask them how much they paid for Windows. They have no idea.
Your example would depend on this axiom being true: "If consumers set prices, then they know the separate price of every component of a package that they pay for." First off, there's no such thing as "separate price": Price and cost aren't the same thing, and if you weren't quoted a separate price for Windows then it doesn't exist. They didn't pay for Windows; they paid for the entire package. Yes, of course, you can buy Windows separately, but then it's not pre-installed, and service is a very important part of a product, so that price would be for a different product. Secondly, even if you're talking about cost as opposed to price, there are lots of things that people buy without knowing the cost of individual components. How much did the tires on your car cost? How much did the rubber in those tires cost? -- francis
Heh. You know better than that. Microsoft wants you to believe that the Windows in your Intel box (and first InternetExplorer and now the MediaPlayer? in Windows) is an inseparable essential component, like the rubber in your tires, or the tires on your car. We all know that's not true, but JoeConsumer? has been snowballed into believing it. This successful deception on the part of the supplier is another illustration of ways in which free-market conditions can be manipulated and eventually broken down so that companies can, in fact, set prices.
Well, if you had the choice of what tires to put on your car when you bought it (maybe you do, I haven't bought a car in years), how much time would you spend on the decision? How much do you know about tires? How much do you trust yourself to make the right choice, vs just taking what the manufacturer recommends? -- francis
In no industry (save that of government fiats) do companies set prices. Consumers set prices and companies either provide goods at those prices or they don't.
This premise is painfully naive. In any industry that has a significant entry cost, companies can and do set prices through various manipulations of market share. A familiar example is to "dump" product at very low prices long enough to drive competitors either out of the market or out of business, then raise the prices above their previous level. The modern world is filled with "consumer" products covering a diverse range of price elasticity, from almost completely elastic (razor blades) to virtually inelastic (health care). Microsoft is a monopoly because it has very successfully made it impossible to effectively compete in various areas - internet browsers, word processors, and media players come to mind. Meanwhile, consumers would never pay the true cost of air travel were it not so heavily subsidized. The relationships between prices, consumers, suppliers, and governments (or quasi-governments) are far more complex than this bromide acknowledges.
Companies do set prices and usually have a specific process for determining the price to be set. Please note that the price is often determined well before the good is produced or the service rendered and is used to determine whether to proceed. The only option given the consumer is to either pay the price or do without.
The big problem I see with market defined price is the delay in calculating use and disposal costs. A company knows how much it costs to produce and market a new pesticide before it ships the first unit, but the cost of using and disposing it (health risks, environmental impact, etc.) can remain unknown for decades. By that time the company may have ceased to exist (for example, Dow Corning and silicone breast implants).
In the gas price category, there isn't that free a market. Gas is a limited resource, and that resource is controlled by a group of multinationals that can, in effect, set their own prices - they are a (near) monopoly. No new entrepreneur can enter the market with a cheaper competing product, because he would have to go and either find a new source for gas (unlikely, as most possible sources of oil/gasoline are already owned by the current oil miners), or buy it from the people that raised the price in the first place.
The consumer has only two real choices: continue using the gas at the rising prices, or stop buying gas. The cost of not using gasoline is rather high, but there are alternatives that lower the cost (http://www.greasecar.com/products.cfm). If gasoline prices go too high, those alternatives will get enough popularity to eliminate the market for oil-based fuel.
-- AlexAusch?
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