THE THEORY OF PRICE 3
By M. Northrup Buechner
February 5, 2013
Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.
Parts 1 and 2 of “The Theory of Price” established two facts: demand and competition—as facts that price-setters consider in deciding upon a price. Demand is the basic concept; it is how much people are willing to pay and in what numbers. Competition is the most important auxiliary factor directly affecting demand—which it does by offering alternatives to potential buyers.
Competing firms may offer (1) the same product at a lower price, or at the same price or at a higher price, or (2) an inferior good at a lower price or at the same price or at a higher price or (3) a superior good at a lower price or at the same price or at a higher price. There are nine different alternatives here, and this is just the beginning. There may be two or nine or a ninety different competitors, each of them offering a variation of the same product at a different price. However many there are, their prices and the quality of their products all together create the competitive context in which a businessman sells his products. In the face of this competitive context, the price-setter chooses a price which is his best estimate of people’s willingness to pay for his product.
However, there is a third factor that a businessman must consider in setting his price: his cost of production. The businessman has to cover his costs. How do costs affect price?
Suppose he is manufacturing yachts. He estimates that fifty people are willing to pay $1,000,000 for each yacht yielding a total revenue of $50,000,000. He also estimates that two hundred people would be willing to pay $500,000 for each yacht yielding a total revenue of $100,000,000. $500,000 appears to be the better price—but suppose it costs $750,000 to build each yacht. At a price of $1,000,000, he can sell fifty yachts, making $250,000 on each one for a total profit of $12,500,000. If he charges $500,000, he loses $250,000 on each yacht, and the more he sells, the more he loses.
Both demand and competition are clear causes of people’s willingness to pay. A higher demand means people are willing to pay a higher price. Higher quality and lower prices of competing products reduce that price. But the cost of production is not related to willingness to pay. Customers do not know what it costs to produce a product and have no reason to care. Since the cost of production affects the price set by a business, how can we integrate that fact with the principle that price measures willingness to pay?
The cost of production is a qualification on price as a measure of willingness to pay. Over the long run, total revenue must exceed total cost; that is, income receipts must exceed cost outlays; that is, the firm must make a profit. In addition, the profit must be sufficient to provide the funds necessary to replace plant and equipment when they wear out.
This is the businessman’s ABSOLUTE. He must on average make a profit year after year. He does not need to make a profit every day, week, or month that he stays in business. Businessmen frequently do things that they know will reduce their profits in the short run. But over the long run, a business either makes a profit or it vanishes from the economic scene.
So this is the integration: Every price measures willingness to pay, subject to the necessity of making a profit over the long run—where the businessman estimates willingness to pay based on the facts of the market in which he sells his product.
Next time we will take up Ayn Rand’s concept of “socially objective value” and define its relation to the objective theory of price.