Imagine that a generic drug becomes available for the treatment of a condition, no substitute good is available (inslulin might be a good example), and the elasticity of demand is low .Say that there are multiple companies producing this drug and competing with each other for customers.
Assuming no real differences in quality, competition should surely bring the price down to the level at which profits are around zero. So why do Austrians talk of prices being purely about preferences? Obviously a commodity won't sell if it isn't wanted, but that is just stating the obvious. What insight does this statement provide?
I'll let others get into the meat and potatoes of the answer, but as a student of Austrian economics you should know that few things are "obvious" to most people.
"Humans act" may also seem ridiculously obvious to the point of a waste of breath...but on the contrary, it is no trivial insight...
few things are "obvious" to most people.
Who would object to the statement "people buy things because they want/need them"?
I understand the relevence 'humans act' statement because of what Austrians claim can be deduced from it. But what is the equivalent deduction from above the statement regarding wants/needs?
The cost of production is a part of the price function but in order for prices to be formed the most important factor is the valuation of the consumer.
"the most important factor is the valuation of the consumer"
Maybe for an upper limit to price, but in a competitive market prices would fall, and the lower limit would be production cost. Does this mean that consumer valuation only really becomes important in a monopoly situation when prices are set by the producer?
Production costs are irrelevant. They are sunk. After the product has been produced you sell it for what ever you can get for it. If the most you can get for it is less than your costs...well then you earn a loss.
It is consumer demand in the face of the scarcity of the product that determines the price. Costs only play a role in the price in the sense that producers pick a quanitity of production that will result in a price higher or equal to their costs.
Your analysis is actually very close to the pre-marginal revolution analysis of classical economists.
At least he wasn't a Keynesian!
After the product has been produced you sell it for what ever you can get for it. If the most you can get for it is less than your costs...well then you earn a loss.
But producers that do this will go out of business leaving those who sucessfully sold above production cost - this is surely mechanism that makes production cost important in the setting of market price? What you are saying may be valid for an individual price at a given moment, but wouldnt the movement of prices across the sector tend towards production cost via the weeding out of loss-makers?
Costs only play a role in the price in the sense that producers pick a quanitity of production that will result in a price higher or equal to their costs.
This seems quite an important role.
"in a competitive market prices would fall"
True
"the lower limit would be production cost"
I dont see why you couldnt set the price lower than that, even if it's a loss for the entrepreneur, if thats the only way to sell the product partial loss is better than total loss.
"Does this mean that consumer valuation only really becomes important in a monopoly situation when prices are set by the producer?"
No, why would you think that?
Prices are never exclusively set by the producer or the consumer but in reality they are an statistic of the relative need of the consumer for a determined product at a given time.
Consumariat:Who would object to the statement "people buy things because they want/need them"? I understand the relevence 'humans act' statement because of what Austrians claim can be deduced from it. But what is the equivalent deduction from above the statement regarding wants/needs?
Perhaps it would help to answer your question if you could provide an example of where "Austrians talk of prices being purely about preferences". It would be much easier to provide an explanation if we knew what we were supposed to be explaining.
That's a good question. I am really only talking about what I have heard libertarians say about price rather than anything I have read in economic literature. For example, the above few posters comments.
By the way, I should clarify my definition of 'price of production'. I am refering to the price at which is is currently possible to produce a good, not the price at which it did cost to produce a good with a previous set of technical capabilities.
Here's Rothbard explaining it. It's from his Chapter on J. B. Say.
Prices of productive factors must be high for a reason; they are not preordained to be high...
But where do 'costs' come from? And why are they somehow fixed, exogenous to the market system itself? How are they determined?...
On the valuing or pricing of the services of the factors (or as Say would put it, 'agents') of production, Say adopted the proto-Austrian in direct contrast to the Smith-Ricardo tradition. For since subjective human desire for any object creates its value, and reflects its utility, productive factors receive value because of their 'ability to create the utility wherein originates that desire'.
In other words:
costs are determined by selling price rather than the other way round...
Ricardo, writes Say, believes 'that the value of products is founded upon that of productive agency', i.e. that the value of products is determined by the value of their productive factors, or their cost of production.
[In other words, the value of a car or refrigerator comes from all the steel put into making it]
In contrast, Say declares, 'the current value of productive exertion is founded upon the value of an infinity of products compared one with another ... which value is proportionate to the importance of its cooperation in the business of production ...'.
[In English, the value of steel lies in it's usefulness in making cars and refrigerators]
In contrast to consumer goods, Say points out, the demand
for productive factors does not originate in immediate enjoyment, but rather in the 'value of the product they are capable of raising, which itself originates in the utility of that product, or the satisfaction it may be capable of afford- ing'.
In short, the value of factors is determined by the value of their prod- ucts, which in turn is conferred by consumer valuations and demands.
The causal chain, for Say as for the later Austrians, is from consumer valuations to consumer goods prices to the pricing of productive factors (i.e. to costs of production).
[=the right way of looking at it]
In contrast, the Smithian, and especially the Ricardian, causal chain is from cost of production, and especially labour cost, to consumer goods prices.
[= the wrong way]
If you look into that chapter, you will see the policy consequences of the two points of view.
Book is available here for free: http://mises.org/books/histofthought2.pdf
EDIT: Thinking a bit about it, I notice it's just a restatement of the law of supply and demand. By the universally recognized Law of Supply and Demand, factors of production have their price determined by demand for them. They are in demand to the extent that profits can be made using them to make cars and refrigerators. Those potential profits, in turn, are there only because individual consumers want to buy the cars and refrigerators. Seems inevitable, no?
My humble blog
It's easy to refute an argument if you first misrepresent it. William Keizer
The costs of factors of production are imputed backwards from the price consumers are willing to pay (subjective preferences) on the final product.
http://mises.org/rothbard/mes/chap1c.asp
Murray Rothbard: For example, suppose that cigars suddenly lose their value as consumers’ goods; they are no longer desired. Those cigar machines which are not usable in any other capacity will become, valueless. Tobacco leaves, however, will lose some of their value, but may be convertible to uses such as cigarette production with little loss of value. (A loss of all desire for tobacco, however, will result in a far wider loss in the value of the factors, although part of the land may be salvaged by shifting from tobacco to the production of cotton.) Suppose, on the other hand, that some time after cigars lose their value this commodity returns to public favor and regains its former value. The cigar machines, which had been rendered valueless, now recoup their great loss in value. On the other hand, the tobacco leaves, land, etc., which had shifted from cigars to other uses will reshift into the production of cigars. These factors will gain in value, but their gain, as was their previous loss, will be less than the gain of the completely specific factor. These are examples of a general law that a change in the value of the product causes a greater change in the value of the specific factors than in that of the relatively nonspecific factors.
Suppose, on the other hand, that some time after cigars lose their value this commodity returns to public favor and regains its former value. The cigar machines, which had been rendered valueless, now recoup their great loss in value. On the other hand, the tobacco leaves, land, etc., which had shifted from cigars to other uses will reshift into the production of cigars. These factors will gain in value, but their gain, as was their previous loss, will be less than the gain of the completely specific factor. These are examples of a general law that a change in the value of the product causes a greater change in the value of the specific factors than in that of the relatively nonspecific factors.
Consumariat:That's a good question. I am really only talking about what I have heard libertarians say about price rather than anything I have read in economic literature. For example, the above few posters comments.
In that case you may just be misrepresenting/misinterpreting what is a simple attempt to promote the subjective theory of value and denounce the labor theory or some other flawed notion. You must realize that so many of the objections (and therefore arguments) that take place between free market economists and mainstream/keynesian/marxist ignoramuses have already been had before...so you'll come across a lot of the same language again and again, mostly just dispelling the same perpetuated myths.
I think what your question shows that you are missing is the overall picture of the price structure of the entire economy. Remember, prices (of everything) are simply a communication of those preferences of individuals. This includes the prices of the inputs that make up the production cost of any finished product (like your hypothetical pharmaceutical.) The price mechanism simply enables individuals to coordinate their plans for all available resources across the economy. Remember that a "cost" is simply someone else's "price."
Peter Schiff illustrates this in his book on the economic collapse:
Rising prices got labeled as inflation because the government wanted to divert the public‟s attention from what caused prices to rise in the first place.[...] Think about the concept of “cost-push inflation” for a moment. For an automobile manufacturer, the cost of steel is the price the steel manufacturer sells it for. Cost and price are, in reality, two words that describe the same thing, only from different perspectives.[...] One might as well argue that prices rise because prices rise.
Rising prices got labeled as inflation because the government wanted to divert the public‟s attention from what caused prices to rise in the first place.[...]
Think about the concept of “cost-push inflation” for a moment. For an automobile manufacturer, the cost of steel is the price the steel manufacturer sells it for. Cost and price are, in reality, two words that describe the same thing, only from different perspectives.[...]
One might as well argue that prices rise because prices rise.
So it is at least a little redundant to say "why do you say prices are set by preference rather than production cost"...because what you're really asking is "why do you say prices are set by preferences rather than other prices?" The answer to that is of course when someone talks about prices being set in terms of preferences, they are looking at the overall economy.
Hayek and other prominent Austrians wrote extensively on the price mechanism. For more detail I recommend his essays:
The Use of Knowledge in Society
The Price System as a Mechanism for Using Knowledge
And of course his treatise on the subject:
Prices and Production
"The value of steel lies in it's usefulness in making cars and refrigerators"
This here is a good example to illustrate my point. Imagine a society with no cars. Someone invents the car and it becomes really popular. People climb over each other to try and get one, and as a result the car manufacturers order more steel to step up production. Here is a clear example of hightened demand leading to a higher price.
However, the new price of steel makes it more profitable, and so businesspeople are incentivised to enter into the market of steel production. The supply of steel increases and competition between producers lowers the price again. So the higher price - set by the increased demand - was just a temporary moment of price varience. The claim that price is set by consumer valuation is a static analysis that ignores the effect of current prices on the future behaviour of entrepreneurs.