How THE PRICE SYSTEM
WORKS
THE WHOLE ARGUMENT of this book may be summed up in the
statement that in studying the effects of any given economic
proposal we must trace not merely the immediate results but
the results in the long run, not merely the primary consequences
but the secondary consequences, and not merely the
effects on some special group but the effects on everyone. It
follows that it is foolish and misleading to concentrate our
attention merely on some special point—to examine, for example,
merely what happens in one industry without considering
what happens in all. But it is precisely from the persistent and
lazy habit of thinking only of some particular industry or
process in isolation that the major fallacies of economics stem.
These fallacies pervade not merely the arguments of the hired
spokesmen of special interests, but the arguments even of some
economists who pass as profound.
It is on the fallacy of isolation, at bottom, that the "production-
for-use-and-not-for-profit" school is based, with its
attack on the allegedly vicious "price system." The problem of
production, say the adherents of this school, is solved. (This
resounding error; as we shall see, is also the starting point of
most currency cranks and share-the-wealth charlatans.) The
scientists, the efficiency experts, the engineers, the technicians,
have solved it. They could turn out almost anything you
cared to mention in huge and practically unlimited amounts.
But, alas, the world is not ruled by the engineers, thinking only
of production, but by the businessmen, thinking only of profit.
The businessmen give their orders to the engineers, instead of
vice versa. These businessmen will turn out any object as long
as there is a profit in doing so, but the moment there is no
longer a profit in making that article, the wicked businessmen
will stop making it, though many people's wants are unsatisfied,
and the world is crying for more goods.
There are so many fallacies in this view that they cannot all
be disentangled at once. But the central error, as we have
hinted, comes from looking at only one industry, or even at
several industries in turn, as if each of them existed in isolation.
Each of them in fact exists in relation to all the others, and every
important decision made in it is affected by and affects the
decisions made in all the others.
We can understand this better if we understand the basic
problem that business collectively has to solve. To simplify this
as much as possible, let us consider the problem that confronts a
Robinson Crusoe on his desert island. His wants at first seem
endless. He is soaked with rain; he shivers from cold; he suffers
from hunger and thirst. He needs everything: drinking water,
food, a roof over his head, protection from animals, a fire, a soft
place to lie down. It is impossible for him to satisfy all these
needs at once; he has not the time, energy or resources. He
must attend immediately to the most pressing need. He suffers
most, say, from thirst. He hollows out a place in the sand to
collect rain water, or builds some crude receptacle. When he
has provided for only a small water supply, however, he must
turn to finding food before he tries to improve this. He can try
to fish; but to do this he needs either a hook and line, or a net,
and he must set to work on these. But everything he does delays
or prevents him from doing something else only a little less
urgent. He is faced constantly by the problem of alternative
applications of his time and labor.
A Swiss Family Robinson, perhaps, finds this problem a
little easier to solve. It has more mouths to feed, but it also has
more hands to work for them. It can practice division and
specialization of labor. The father hunts; the mother prepares
the food; the children collect firewood. But even the family
cannot afford to have one member of it doing endlessly the same
thing, regardless of the relative urgency of the common need he
supplies and the urgency of other needs still unfilled. When the
children have gathered a certain pile of firewood, they cannot
be used simply to increase the pile. It is soon time for one of
them to be sent, say, for more water. The family too has the
constant problem of choosing among alternative applications of
labor, and, if it is lucky enough to have acquired guns, fishing
tackle, a boat, axes, saws and soon, of choosing among alternative
applications of labor and capital. It would be considered
unspeakably silly for the wood-gathering member of the family
to complain that they could gather more firewood if his brother
helped him all day, instead of getting the fish that were needed
for the family dinner. It is recognized clearly in the case of an
isolated individual or family that one occupation can expand
only at the expense of all other occupations.
Elementary illustrations like this are sometimes ridiculed as
"Crusoe economics." Unfortunately, they are ridiculed most
by those who most need them, who fail to understand the
particular principle illustrated even in this simple form, or who
lose track of that principle completely when they come to
examine the bewildering complications of a great modern
economic society.
Let us now turn to such a society. How is the problem of
alternative applications of labor and capital, to meet thousands
of different needs and wants of different urgencies, solved in
such a society? It is solved precisely through the price system.
It is solved through the constantly changing interrelationships
of costs of production, prices and profits.
Prices are fixed through the relationship of supply and de-
mand and in turn affect supply and demand. When people
want more of an article, they offer more for it. The price goes
up. This increases the profits of those who make the article.
Because it is now more profitable to make that article than
others, the people already in the business expand their production
of it, and more people are attracted to the business. This
increased supply then reduces the price and reduces the profit
margin, until the profit margin on that article once more falls to
the general level of profits (relative risks considered) in other
industries. Or the demand for that article may fall; or the
supply of it may be increased to such a point that its price drops
to a level where there is less profit in making it than in making
other articles; or perhaps there is an actual loss in making it. In
this case the "marginal" producers, that is, the producers who
are least efficient, or whose costs of production are highest, will
be driven out of business altogether. The product will now be
made only by the more efficient producers who operate on
louver costs. The supply of that commodity will also drop, or
will at least cease to expand.
This process is the origin of the belief that prices are determined
by costs of production. The doctrine, stated in this
form, is not true. Prices are determined by supply and demand,
and demand is determined by how intensely people want a
commodity and what they have to offer in exchange for it. It is
true that supply is in part determined by costs of production.
What a commodity has cost to produce in the past cannot
determine its value. That will depend on the present relationship
of supply and demand. But the expectations of businessmen
concerning what a commodity will cost to produce in the
future, and what its future price will be, will determine how
much of it will be made. This will affect future supply. There is
therefore a constant tendency for the price of a commodity and
its marginal cost of production to equal each other, but not
because that marginal cost of production directly determines
the price.
The private enterprise system, then, might be compared to
thousands of machines, each regulated by its own quasi-
automatic governor, yet with these machines and their governors
all interconnected and influencing each other, so that they
act in effect like one great machine. Most of us must have
noticed the automatic "governor" on a steam engine. It usually
consists of two balls or weights which work by centrifugal
force. As the speed of the engine increases, these balls fly away
from the rod to which they are attached and so automatically
narrow or close off a throttle valve which regulates the intake of
steam and thus slows down the engine. If the engine goes too
slowly, on the other hand, the balls drop, widen the throttle
valve, and increase the engine's speed. Thus every departure
from the desired speed itself sets in motion the forces that tend
to correct that departure.
It is precisely in this way that the relative supply of
thousands of different commodities is regulated under the system
of competitive private enterprise. When people want more
of a commodity, their competitive bidding raises its price. This
increases the profits of the producers who make that product.
This stimulates them to increase their production. It leads
others to stop making some of the products they previously
made, and turn to making the product that offers them the
better return. But this increases the supply of that commodity
at the same time that it reduces the supply of some other
commodities. The price of that product therefore falls in relation
to the price of other products, and the stimulus to the
relative increase in its production disappears.
In the same way, if the demand falls off for some product, its
price and the profit in making it go lower, and its production
declines.
It is this last development that scandalizes those who do not
understand the "price system" they denounce. They accuse it
of creating scarcity. Why, they ask indignantly, should manufacturers
cut off the production of shoes at the point where it
becomes unprofitable to produce any more? Why should they
be guided merely by their own profits? Why should they be
guided by the market? Why do they not produce shoes to the
"full capacity of modern technical processes"? The price sys-
tem and private enterprise, conclude the "production-for-use"
philosophers, are merely a form of "scarcity economics."
These questions and conclusions stem from the fallacy of
looking at one industry in isolation, of looking at the tree and
ignoring the forest. Up to a certain point it is necessary to
produce shoes. But it is also necessary to produce coats, shirts,
trousers, homes, plows, shovels, factories, bridges, milk and
bread. It would be idiotic to go on piling up mountains of
surplus shoes, simply because we could do it, while hundreds
of more urgent needs went unfilled.
Now in an economy in equilibrium, a given industry can
expand only at the expense of other industries. For at any moment
the factors of production are limited. One industry can be
expanded only by diverting to it labor, land and capital that
would otherwise be employed in other industries. And when a
given industry shrinks, or stops expanding its output, it does
not necessarily mean that there has been any net decline in
aggregate production. The shrinkage at that point may have
merely released labor and capital to permit the expansion of other
industries. It is erroneous to conclude, therefore, that a shrinkage
of production in one line necessarily means a shrinkage in
total production.
Everything, in short, is produced at the expense of forgoing
something else. Costs of production themselves, in fact, might
be defined as the things that are given up (the leisure and
pleasures, the raw materials with alternative potential uses) in
order to create the thing that is made.
It follows that it is just as essential for the health of a dynamic
economy that dying industries should be allowed to die as that
growing industries should be allowed to grow. For the dying
industries absorb labor and capital that should be released for
the growing industries. It is only the much vilified price system
that solves the enormously complicated problem of deciding
precisely how much of tens of thousands of different commodities
and services should be produced in relation to each
other. These otherwise bewildering equations are solved
quasi-automatically by the system of prices, profits and costs.
They are solved by this system incomparably better than any
group of bureaucrats could solve them. For they are solved by a
system under which each consumer makes his own demand and
casts a fresh vote, or a dozen fresh votes, every day; whereas
bureaucrats would try to solve it by having made for the
consumers, not what the consumers themselves wanted, but
what the bureaucrats decided was good for them.
Yet though the bureaucrats do not understand the
quasi-automatic system of the market, they are always disturbed
by it. They are always trying to improve it or correct it,
usually in the interests of some wailing pressure group. What
some of the results of their intervention are, we shall examine in
succeeding chapters.
WORKS
THE WHOLE ARGUMENT of this book may be summed up in the
statement that in studying the effects of any given economic
proposal we must trace not merely the immediate results but
the results in the long run, not merely the primary consequences
but the secondary consequences, and not merely the
effects on some special group but the effects on everyone. It
follows that it is foolish and misleading to concentrate our
attention merely on some special point—to examine, for example,
merely what happens in one industry without considering
what happens in all. But it is precisely from the persistent and
lazy habit of thinking only of some particular industry or
process in isolation that the major fallacies of economics stem.
These fallacies pervade not merely the arguments of the hired
spokesmen of special interests, but the arguments even of some
economists who pass as profound.
It is on the fallacy of isolation, at bottom, that the "production-
for-use-and-not-for-profit" school is based, with its
attack on the allegedly vicious "price system." The problem of
production, say the adherents of this school, is solved. (This
resounding error; as we shall see, is also the starting point of
most currency cranks and share-the-wealth charlatans.) The
scientists, the efficiency experts, the engineers, the technicians,
have solved it. They could turn out almost anything you
cared to mention in huge and practically unlimited amounts.
But, alas, the world is not ruled by the engineers, thinking only
of production, but by the businessmen, thinking only of profit.
The businessmen give their orders to the engineers, instead of
vice versa. These businessmen will turn out any object as long
as there is a profit in doing so, but the moment there is no
longer a profit in making that article, the wicked businessmen
will stop making it, though many people's wants are unsatisfied,
and the world is crying for more goods.
There are so many fallacies in this view that they cannot all
be disentangled at once. But the central error, as we have
hinted, comes from looking at only one industry, or even at
several industries in turn, as if each of them existed in isolation.
Each of them in fact exists in relation to all the others, and every
important decision made in it is affected by and affects the
decisions made in all the others.
We can understand this better if we understand the basic
problem that business collectively has to solve. To simplify this
as much as possible, let us consider the problem that confronts a
Robinson Crusoe on his desert island. His wants at first seem
endless. He is soaked with rain; he shivers from cold; he suffers
from hunger and thirst. He needs everything: drinking water,
food, a roof over his head, protection from animals, a fire, a soft
place to lie down. It is impossible for him to satisfy all these
needs at once; he has not the time, energy or resources. He
must attend immediately to the most pressing need. He suffers
most, say, from thirst. He hollows out a place in the sand to
collect rain water, or builds some crude receptacle. When he
has provided for only a small water supply, however, he must
turn to finding food before he tries to improve this. He can try
to fish; but to do this he needs either a hook and line, or a net,
and he must set to work on these. But everything he does delays
or prevents him from doing something else only a little less
urgent. He is faced constantly by the problem of alternative
applications of his time and labor.
A Swiss Family Robinson, perhaps, finds this problem a
little easier to solve. It has more mouths to feed, but it also has
more hands to work for them. It can practice division and
specialization of labor. The father hunts; the mother prepares
the food; the children collect firewood. But even the family
cannot afford to have one member of it doing endlessly the same
thing, regardless of the relative urgency of the common need he
supplies and the urgency of other needs still unfilled. When the
children have gathered a certain pile of firewood, they cannot
be used simply to increase the pile. It is soon time for one of
them to be sent, say, for more water. The family too has the
constant problem of choosing among alternative applications of
labor, and, if it is lucky enough to have acquired guns, fishing
tackle, a boat, axes, saws and soon, of choosing among alternative
applications of labor and capital. It would be considered
unspeakably silly for the wood-gathering member of the family
to complain that they could gather more firewood if his brother
helped him all day, instead of getting the fish that were needed
for the family dinner. It is recognized clearly in the case of an
isolated individual or family that one occupation can expand
only at the expense of all other occupations.
Elementary illustrations like this are sometimes ridiculed as
"Crusoe economics." Unfortunately, they are ridiculed most
by those who most need them, who fail to understand the
particular principle illustrated even in this simple form, or who
lose track of that principle completely when they come to
examine the bewildering complications of a great modern
economic society.
Let us now turn to such a society. How is the problem of
alternative applications of labor and capital, to meet thousands
of different needs and wants of different urgencies, solved in
such a society? It is solved precisely through the price system.
It is solved through the constantly changing interrelationships
of costs of production, prices and profits.
Prices are fixed through the relationship of supply and de-
mand and in turn affect supply and demand. When people
want more of an article, they offer more for it. The price goes
up. This increases the profits of those who make the article.
Because it is now more profitable to make that article than
others, the people already in the business expand their production
of it, and more people are attracted to the business. This
increased supply then reduces the price and reduces the profit
margin, until the profit margin on that article once more falls to
the general level of profits (relative risks considered) in other
industries. Or the demand for that article may fall; or the
supply of it may be increased to such a point that its price drops
to a level where there is less profit in making it than in making
other articles; or perhaps there is an actual loss in making it. In
this case the "marginal" producers, that is, the producers who
are least efficient, or whose costs of production are highest, will
be driven out of business altogether. The product will now be
made only by the more efficient producers who operate on
louver costs. The supply of that commodity will also drop, or
will at least cease to expand.
This process is the origin of the belief that prices are determined
by costs of production. The doctrine, stated in this
form, is not true. Prices are determined by supply and demand,
and demand is determined by how intensely people want a
commodity and what they have to offer in exchange for it. It is
true that supply is in part determined by costs of production.
What a commodity has cost to produce in the past cannot
determine its value. That will depend on the present relationship
of supply and demand. But the expectations of businessmen
concerning what a commodity will cost to produce in the
future, and what its future price will be, will determine how
much of it will be made. This will affect future supply. There is
therefore a constant tendency for the price of a commodity and
its marginal cost of production to equal each other, but not
because that marginal cost of production directly determines
the price.
The private enterprise system, then, might be compared to
thousands of machines, each regulated by its own quasi-
automatic governor, yet with these machines and their governors
all interconnected and influencing each other, so that they
act in effect like one great machine. Most of us must have
noticed the automatic "governor" on a steam engine. It usually
consists of two balls or weights which work by centrifugal
force. As the speed of the engine increases, these balls fly away
from the rod to which they are attached and so automatically
narrow or close off a throttle valve which regulates the intake of
steam and thus slows down the engine. If the engine goes too
slowly, on the other hand, the balls drop, widen the throttle
valve, and increase the engine's speed. Thus every departure
from the desired speed itself sets in motion the forces that tend
to correct that departure.
It is precisely in this way that the relative supply of
thousands of different commodities is regulated under the system
of competitive private enterprise. When people want more
of a commodity, their competitive bidding raises its price. This
increases the profits of the producers who make that product.
This stimulates them to increase their production. It leads
others to stop making some of the products they previously
made, and turn to making the product that offers them the
better return. But this increases the supply of that commodity
at the same time that it reduces the supply of some other
commodities. The price of that product therefore falls in relation
to the price of other products, and the stimulus to the
relative increase in its production disappears.
In the same way, if the demand falls off for some product, its
price and the profit in making it go lower, and its production
declines.
It is this last development that scandalizes those who do not
understand the "price system" they denounce. They accuse it
of creating scarcity. Why, they ask indignantly, should manufacturers
cut off the production of shoes at the point where it
becomes unprofitable to produce any more? Why should they
be guided merely by their own profits? Why should they be
guided by the market? Why do they not produce shoes to the
"full capacity of modern technical processes"? The price sys-
tem and private enterprise, conclude the "production-for-use"
philosophers, are merely a form of "scarcity economics."
These questions and conclusions stem from the fallacy of
looking at one industry in isolation, of looking at the tree and
ignoring the forest. Up to a certain point it is necessary to
produce shoes. But it is also necessary to produce coats, shirts,
trousers, homes, plows, shovels, factories, bridges, milk and
bread. It would be idiotic to go on piling up mountains of
surplus shoes, simply because we could do it, while hundreds
of more urgent needs went unfilled.
Now in an economy in equilibrium, a given industry can
expand only at the expense of other industries. For at any moment
the factors of production are limited. One industry can be
expanded only by diverting to it labor, land and capital that
would otherwise be employed in other industries. And when a
given industry shrinks, or stops expanding its output, it does
not necessarily mean that there has been any net decline in
aggregate production. The shrinkage at that point may have
merely released labor and capital to permit the expansion of other
industries. It is erroneous to conclude, therefore, that a shrinkage
of production in one line necessarily means a shrinkage in
total production.
Everything, in short, is produced at the expense of forgoing
something else. Costs of production themselves, in fact, might
be defined as the things that are given up (the leisure and
pleasures, the raw materials with alternative potential uses) in
order to create the thing that is made.
It follows that it is just as essential for the health of a dynamic
economy that dying industries should be allowed to die as that
growing industries should be allowed to grow. For the dying
industries absorb labor and capital that should be released for
the growing industries. It is only the much vilified price system
that solves the enormously complicated problem of deciding
precisely how much of tens of thousands of different commodities
and services should be produced in relation to each
other. These otherwise bewildering equations are solved
quasi-automatically by the system of prices, profits and costs.
They are solved by this system incomparably better than any
group of bureaucrats could solve them. For they are solved by a
system under which each consumer makes his own demand and
casts a fresh vote, or a dozen fresh votes, every day; whereas
bureaucrats would try to solve it by having made for the
consumers, not what the consumers themselves wanted, but
what the bureaucrats decided was good for them.
Yet though the bureaucrats do not understand the
quasi-automatic system of the market, they are always disturbed
by it. They are always trying to improve it or correct it,
usually in the interests of some wailing pressure group. What
some of the results of their intervention are, we shall examine in
succeeding chapters.
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