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Why do Austrians say price is set by preference rather than production cost?

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Consumariat posted on Thu, Mar 24 2011 7:26 PM

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?

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Chris Pacia wrote:

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. 

This is highly true.  I happen to know a few things about the price of nickel ore, because my sister-in-law works for a nickel mining company in the Philippines.  Their chief client is China, who uses the nickel to manufacture consumer goods for the USA and other first-world clients.  Since 2008 the demand for consumer goods dropped, and the demand for nickel dropped.  Interestingly enough, the cost of production did not drop.  In fact, the cost of production rose slightly with the rise in fuel costs experienced in the Philippines.  (Philippines didn't get the gas price reprieve that the USA experienced from 2008-2010.)

What the Philippine nickle mine did was to decrease production, because they were only willing to sell a certain amount at the price the market would bear.  As you can see by this graph, the price has risen steadily.  Demand has also risen steadily, and the whole thing runs approximately parallel to the stock market, which is to be expected.  More companies make more money, and have more money to spend on Nickel, which raises the demand for Nickel, which raises the price.  Here is a graph of Nickel prices since January 2008:

What the Austrians are saying about demand being the most important factor is probably just misunderstood.  During the early years of the industrial revolution, production was probably a greater factor in the price of a good.  Demand was generally stronger than production would allow, and the innovations in automation drove prices down for most items.  After all, now you didn't have to hire a tailor to sew your suit by hand, your suit was made on a production line in a fraction of the time.  But now the cost of production is more stable than demand, and this is the reason demand is the key factor in the price of a commodity.

Today, if you are an engineer-entrepreneur and you come up with a way to make a widget at a lower cost than your competition, you will first consider your market share.  Out of all the widgets on the market, how many can my company produce?  You would then run some fancy formulas to optimize your output and price for the greatest expected profit margin.  If you can only produce a small portion of the market share, you may not need to undercut the average price at all and still manage to sell all of your widgets.  

But the larger your market share, the more demand you will be satisfying.  When a company has had its fill of your widgets, it will stop buying them, first the companies with the most capital to purchase your widgets, then companies with less capital.  When that happens, you cannot sell your widgets are the same price.  You must drop the price to entice companies with less capital to purchase your widgets.

So, I hope you can see that unless the innovator has a large proportion of the market share, a reduction in the cost of production will do little to effect the price.

This chart probably does a better job than my jabbering.  The two red lines represent the demand curve, one from before a dynamic demand shift, and the other after.

The price P of a product is determined by a balance between production at each price (supply S) and the desires of those withpurchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.
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While searching for a speech/article/book by Rothbard where he explained how Supply And Demand are just two sides of the same coin, I ran into this gem by Frank Shostak, "The Limits of Supply and Demand".  It covers all of the points being brought up and more (especially the costs of production view):

http://mises.org/daily/931

My long term project to get every PDF into EPUB: Mises Books

EPUB requests/News: (Semi-)Official Mises.org EPUB Release Topic

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So I take it by the OP's silence his questions have been answered and he has been convinced?

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The OP might want to check out this post I wrote in another, similar thread.

The keyboard is mightier than the gun.

Non parit potestas ipsius auctoritatem.

Voluntaryism Forum

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I think he may have actually already been convinced.

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Esuric replied on Fri, Apr 1 2011 11:22 PM

Consumariat:
Why do Austrians say price is set by preference rather than production cost?

Because we understand basic economic theory.

"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."

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filc replied on Sat, Apr 2 2011 12:27 PM

Esuric:

Consumariat:
Why do Austrians say price is set by preference rather than production cost?

Because we understand basic economic theory.

 

Woot! Good to see my man, Mr BA himself back at it!

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Econ 101:

Does OP understand that COST is short for opportunity cost: preferences unfulfilled by doing next best thing?

Demand derives from preferences and supply also from preferences, even before discussing how demand guides supply (because regardless how costly things are, if no-one wants them, their price is below cost, namely, e.g., 0).

Marginal productivity derives from price, and that is how much is then, afterwards paid for that factor of production. Mostly, then, wages and such fall if people produce what it not wanted, and cost decreases to meet price, but few people want to sell their factors of production at such low incomes. Whatever has higher price, then, get those factors.

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This thread may be too long to be an effective bump, but I felt it was worth a try for this article:

What's Cost Got to Do with It?

 

(Coincidentally, this is the exact same title as another Mises Daily I linked to earlier in the thread.  See the "repled on" link for the other one)

 

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Bawerk's marginal pairs might also be useful.

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