THE THEORY OF PRICE I

By M. Northrup Buechner

January 21, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

 

Every price is set by someone. This proposition appears in Objective Economics, but I did not give it the emphasis there that I would give it today. Everything in economics depends on recognition of this basic fact. Every fact of economics must be integrated with this fact.

Every price is set by someone. This is not a self-evident proposition, but it is close. Because what would be an alternative? The ocean waves write the price in the sand? The clouds form the price in the sky? Any alternative that one might think of is essentially silly.

Modern economists do not recognize this proposition. They hold instead that prices are created by many people acting together in a social confluence called the law of supply and demand. The official doctrine of modern economics is that supply and demand are impersonal market forces, independent of any individual human being—that these forces generate prices and impose them on individual men and women, who have no choice but to charge the price the forces give them. [I described and answered this viewpoint in “The Law of Supply and Demand V: The Modern Economists’ Answer.” It can be found in Archive/February, 2012.]

There is no justification for this viewpoint. Nothing in reality corresponds to it. If knowledge of reality is our goal, the modern interpretation of the Law of Supply and Demand must be abandoned.

Every price is set by someone. This is the starting point for any plausible theory of price. Theorists may disagree about particulars and details, but if we are going to get anywhere in our understanding of economics, we have to agree about this. Every price originates in the mind of an individual human being. There really is no alternative.

Now let us specify a realistic context in which a price is set. Suppose that a young man has saved enough money to open a retail dry-cleaning business. He finds an elderly owner of such a business who wants to retire, they negotiate a price, and the young man buys the business. Now he is a businessman.  What does he do?

There are many things he may need to do in order to make his new business competitive: advertising, redecorating, installing new equipment, hiring clerks, hiring an accountant, and so forth. The previous owner had a price list posted on the wall, and the new owner decides to go with that. This list then becomes the first prices he sets. But the first report from the accountant tells him he is losing money. What should he do? Raise his price? Lower his price?

He takes a walk through his neighborhood to see what the other dry-cleaners are doing? (This is probably the first thing he should have done.) He finds that the going price for men’s shirts, for example, ranges from $2.00 to $3.00. He has been charging $2.25. As further research, he takes his laundry to different dry-cleaners to see the quality their work.

He decides that his work is a little better than average, and he raises his price to $2.50 a shirt, and similarly for his other services. This price is a reflection of two important facts that are at the basis of every price. One is demand. That is the businessman’s estimate of the quantity he can sell each week at the price he has chosen. If he expects to clean 400 shirts a week, his expected demand is $1000.

The second fact he has to consider is the competition: primarily their prices and the quality of their products. The businessman’s ability to sell his product depends on how his product and price compare to the other dry-cleaners competing for his customers. Our dry-cleaner has done his research and raised his prices while keeping then within the range of the prices charged by his competitors. He did this partly because of the quality comparison he made and on the basis of which he concluded that the quality of his work was better than average. (Let us note that it is unusual for the businessman to be objective on this point. Almost every retail businessman I ever heard of thought his product was the best.)

Next time we will consider a third fact that is universal among businesses of which account must be taken.