In our previous videos entitled "The Value
of Things" and "Scarce Resources" we have
discussed how value is a subjective phenomenon.
Two diverse people can estimate value of the
same thing very differently.
Every time a man acts, he does so in accordance
with his own personal scale (or a ranking)
of values.
This is why he can value one thing more than
another, while his friend will value these
things inversely.
This is because people have different goals.
Human goals are also subjective, and means
of achieving them are evaluated in accordance
with their ability to realize these goals.
Regardless, we cannot precisely measure the
difference between values prescribed to any
two things by a valuing person.
Though it is possible to say that one may
value a family photo more than a bottle of
rum, we cannot determine if the former satisfies
one’s needs two or three times more than
the latter, or that it is five times more
valuable.
It would be as pointless as an attempt to
provide a numerical appraisal of how much
more we love our spouse than our parents (or
vice versa).
Yet it is correct to say that a man who paid
1000 dollars for a bicycle has valued the
bicycle more than having 1000 dollars.
When the exchange occurred, he was convinced
that the bicycle would bring him greater satisfaction
than the money.
Otherwise he would not buy the bike, and would
have made a different choice.
People engage in voluntary exchange in order
to improve their situation.
They give up less satisfactory goals (i.e.
cost) for more satisfactory ones.
If the value of the achieved goal in our assessment
exceeds the costs incurred, then we feel that
we have achieved a profit.
The profit also cannot be estimated objectively;
it is equal to the overall subjective satisfaction
felt by a man experiencing it, and can only
be assessed by him.
After this brief introduction we will discuss
the process of consumer goods’ price formation.
Where does such and such exchange ratio expressed
in money comes from?
Of course you may say that prices result from
supply meeting demand, but that does not explain
the process.
Demand and supply can be further analyzed.
Today we will inquire into the phenomenon
a bit deeper.
First of all, we will delineate assumptions
for such analysis.
Those are as follows:
- buyers and sellers have knowledge about
a realizable transaction.
The buyers know that sellers offer goods desired
by the buyers on the market.
This assumption is obvious; if the buyer did
not know about the good, the transaction could
not even be started.
- Market participants understand that participation
in the division of labor and in the exchange
benefits them.
When they do not see it as beneficial, they
do not proceed with the exchange.
- People prefer their benefit to be greater
rather than smaller.
Buyers prefer to buy cheaper, if possible,
and sellers prefer a higher profit.
- People prefer lower benefit than no benefit
at all.
This means that people prefer to exchange
rather than not, even when benefits of the
exchange are miniscule.
These are four very simple and above all realistic
assumptions to be used in the analysis of
market exchange.
Please note that we do not assume any unrealistic
model of perfect competition.
We are not saying that buyers and sellers
have perfect knowledge about everything that
happens in the market.
We also disregard any other unrealistic assumptions,
such as an infinite number of buyers and sellers
or a perfect divisibility of goods.
Our task is to explain the formation of realistic
market prices, not of some hypothetical prices
existing in market conditions impossible to
be achieved in reality.
Therefore, let's start with the simplest of
exchanges, the one taking place between two
people: a buyer and a seller.
Let's say that Matthew wants to buy an acoustic
guitar and that his friend Michael wants to
sell such a guitar.
In Matthew’s subjective assessment the guitar
is not worth more than 250 dollars.
Michael, in turn, believes that the exchange
will satisfy his needs only if he will get
at least 200 dollars for his guitar.
In other words, Matthew prefers to have a
guitar than to have money (up to the amount
of 250 dollars).
As for Michael, starting from the amount of
200 dollars he would rather have money instead
of a guitar.
If Michael demanded 300 dollars for the guitar,
then Matthew would not make the purchase;
and if Matthew offered only 100 dollars, then
Michael would not agree to sell.
This is why the market price must be established
somewhere between 200 dollars and 250 dollars.
Inside this bracket the price will be beneficial
for both parties.
Theory does not allow us to make our assessment
of the price any more specific than that.
The eventual specific price will be determined
by negotiating skills of both Matthew and
Michael.
We cannot specifically tell whether the price
will be 201 dollars or 249 dollars, but we
know the extent to which the transaction will
be mutually beneficial.
Now let us imagine the situation of unilateral
competition between buyers.
This means that there is only one seller -- Michael
-- but more people are willing to buy the
guitar.
Now Matthew is joined by four others willing
to buy it.
Each of them has a different maximum price
that they are willing to pay for the guitar.
Suppose that Darius is willing to pay up to
300 dollars for the guitar, while Martin will
pay 275 dollars, Matthew 250 dollars, Conrad
225 dollars, and Daniel only 200 dollars.
Michael still won’t sell the guitar for
less than 200 dollars.
How will this affect the price level?
We can guess that the guitar will be sold
to the one buyer who will offer the most,
i.e. to Darius, who is willing to pay up to
300 dollars.
Price will fall inside a bracket between Darius’
maximum price and the maximum price offered
by another buyer -- Martin -- who offers second
highest amount; that is between 275 and 300
dollars.
This is because in order to outbid all other
buyers Darius must offer more than 275 dollars.
Only then will he outbid his competition.
As for the upper limit, it is equal to the
maximum price Darius is willing to pay.
Of course, for Michael, this price will also
be satisfactory, as is any price above 200
dollars.
And now let us reverse the situation -- this
time it will be a one-sided competition between
the sellers.
A few additional sellers besides Michael will
now appear on the market where only Matthew
wants to buy the guitar for up to 250 dollars.
Michael still wants to get at least 200 dollars
for his guitar, but here at the scene enter:
Darius, who will be satisfied by a price of
190 dollars, Martin, who wants to get at least
180 dollars, Conrad, with a minimum price
of 170 dollars, and Daniel, with the minimum
price of 160 dollars.
The guitars in this example are identical
and in the same condition.
Who will sell the guitar and at what price?
The guitar will be sold by a person who appreciates
it the least, that is by Daniel.
Even though Matthew was indeed willing to
pay up to 250 dollars, he will of course try
to get it as cheaply as possible.
So Daniel, in order to get rid of his competition,
will have to fight for Matthew to be his customer.
He will be able to do so only by asking for
a price even lower than the minimum price
asked by the next person wanting to sell cheaply,
that is by Conrad, who would be satisfied
by a price of 170 dollars.
Thus the eventual price will fall somewhere
between 160 and 170 dollars.
Let us raise the difficulty of the example
a bit higher.
What happens in a situation of bilateral competition,
where there are more sellers and more buyers?
Let us say that we have five guitar buyers
and five guitar sellers.
In this example, it will be easier to use
numbers instead of names.
Let us call buyers B1, B2, B3, B4, and B5
(their price maximums are next to their names).
On the other side there are sellers S1, S2,
S3, S4, and S5, with their price minimums
next to their names.
The question is: who will have a guitar after
all of the transactions will take place, and
at what market price?
There are five guitars on the market.
The first thing we can do is to pair up buyers
with sellers.
We can see that 4 such pairs (in which buyers
appreciate the guitar higher than the seller)
can make mutually beneficial trades.
The last pair cannot proceed with the exchange,
because the seller values the guitar higher
than the buyer.
We can also arrange buyers and sellers in
one column according to their value assessments
from highest to lowest.
Here we can easily see that those who value
the guitars most are B1, B2, B3, S5, and B4.
On the market the product goes to people who
appreciate it the most.
This is why they are precisely the people
who will have guitars.
This fact entails that one of the guitars
will not be sold but will stay with its owner
who values it more than the money he can get
on the market.
We are left with only one question: what price
of the guitar will be eventually established?
? < P < ?
Böhm-Bawerk said that the price and quantity
are determined according to the values of
"marginal pairs".
We will also have some brackets here, but
their estimation will be somewhat harder than
in the previous examples.
The marginal pairs here, as defined by Böhm-Bawerk,
are the following ones: B4 and S4, and B5
and S5.
Now we can proceed with establishing our brackets.
A higher cap for the price is determined either
by the last buyer who managed to buy a guitar
(i.e. the one who offered the lowest price,
but was still able to buy the guitar), or
by the first potential seller who failed to
sell his guitar.
We always select the lowest of such two values.
In our example, the last buyer who managed
to buy the guitar was B4, and the first seller
who failed to sell was S5.
We are left with two values: 225 dollars and
230 dollars.
The lowest of these is 225 dollars -- this
will be the upper cap for the market price.
? < P < 225 dollars
The lower cap, in turn, is determined either
by the final seller who managed to sell the
guitar (i.e. the one who asked for the highest
price and still sold the guitar), or by the
first buyer who failed to buy it.
In our example, these two are seller S4 and
buyer B5.
S4 asked for 210 dollars and he still managed
to sell.
As for B5, he was the first of the buyers
to offer too little to make a purchase.
So again we have two values: 210 dollars and
200 dollars.
We always select the highest of the two.
As the higher one is 210 dollars, this will
be the lower cap for the market price.
210 dollars < P < 225 dollars
Thus, we were able to discover that given
the subjective valuations of buyers and sellers
as in the example above, 4 guitars will be
sold at a price between 210 and 225 dollars.
What can we learn from this analysis?
It is worth noting that throughout the entire
analysis of price formation we did not say
a word about costs of producing guitars, nor
of purchasing costs incurred in the past by
the sellers of guitars.
There is a good reason for this.
Prices of consumer goods depend only on the
subjective valuations imputed to those goods
by people evaluating them.
The prices of factors of production are formed
based on what entrepreneurs anticipate the
future prices of consumer products to be.
Value of the costs is thus imputed from this
anticipation of the final price of the product,
and not the other way around.
Future price is not determined by costs; it
is the anticipated price that determines them.
It sometimes happens that while releasing
a product on the market an entrepreneur will
mistakenly overprice it so no one wants to
buy it.
He is then forced to sell his product below
its cost of production to recover at least
some portion of the capital he invested in
its production.
Our analysis also explains why works of art
such as paintings are very expensive even
though the paint and the canvas needed for
their creation were relatively cheap.
Another interesting implication is that prices
are not determined solely by the sellers.
Equally important in the process of market
price formation are the buyers.
In no possible scenario is price determined
with complete freedom by the seller.
He must always take consumer into account.
Another thing worth pointing out is that thanks
to the fact that a certain price is being
settled for all transactions, the goods always
end up with people who value them most, and
those people who value those goods the least
are able to get rid of them.
When prices are freely formed, they also communicate
information.
They inform entrepreneurs about the accuracy
of their previous anticipations and investment
decisions.
They indirectly carry information about the
availability of resources as well.
When something is less available, it gets
more expensive and therefore less attractive.
Because of the existence of prices people
are saving less accessible resources, and
though people who really need them pay the
higher price, they are at least able to get
them.
Artificial inhibition of price increases for
less available resources, only causing shortages
and misallocation of these resources.
This is how the system of free prices works
on the market.
It allocates resources to where they are most
needed or where they can satisfy the most
urgent needs.
Such an allocation maximizes prosperity.
Any interference in the pricing system causes
worse allocation of resources than it could
have been, reducing satisfaction felt by participants
of exchanges.
You can find out more on this topic in the
video entitled "Price System - Free Market
vs. Government Intervention.”
The last thing to point out today is the fact
that prices are set by the so-called marginal
buyers and sellers.
This knowledge also applies to financial markets.
As Mark Skousen wrote in his book "A Viennese
Waltz Down Wall Street.
Austrian Economics for Investors":
“It takes only a marginal shift in investor
sentiment to change the direction of stock
prices.”
For more, visit econclips.com.
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