John Buell

Economics 101, Revised Edition

When the housing boom was well underway, mainstream pundits assured us that any worries about escalating prices were misplaced and revealed a lack of basic economics understanding. The boom in housing prices was a normal instance of supply and demand responding to demographic factors. Smaller families and growing numbers of family formation encountered a finite supply of buildable lots. Similarly when oil goes down, this is just another instance off supply and demand. Leave well enough alone.

These claims, however, are manifestations of two of the great myths of contemporary social policy, that the interaction of supply and demand determine the purchase price and quantity produced of most products and that these are generally quite stable and tend quickly toward an equilibrium position. Markets where supply and demand alone determine price are especially useful where goods are scarce. Economists generally go on to add that these free markets optimize human welfare. No one can be made better off without making someone worse off. If one does not like the moral outcome, that some less talented or less fortunate workers will live in poverty, then tax policies should be employed, but only after the market has done its perfect thing.

Yet as Irish economic journalist Philip Pilkington points out in a provocative post in the Naked Capitalist blog, both of these mantras are false. Most prices are not determined by supply and demand. And in those markets where they are, destructive volatility is the norm.

The price and quantity for a typical consumer durable like refrigerators is not determined by supply and demand. Prices are administered. A world of administered prices is very different from the classical model of free markets. In the classical market model, firms face a law of diminishing returns as they increase labor and raw material inputs into a plant operating at full capacity. Once the cost of producing the next good equals the increase in revenue from its sale, they cease expanding production. This is the intersection of the upward sloping supply curve with the downward sloping demand curve many of us encountered in those economics 101 texts.

In the real world, however, firms routinely maintain substantial spare capacity in case anything goes wrong. The supply curve is essentially flat or even downward sloping. Thus there is no market imperative to determine price and quantity. The company will figure average costs for a level it hopes to sell and then add a markup. Firms have considerable though not absolute discretion in this process.

Where administered prices prevail, as with refrigerators, on what grounds should we claim that labor has no right to insist that it too have a collective voice in setting its own price? If owners have some discretion in setting prices they also have discretion in wage determination. Mainstream economists claim that market forces will set wage rates at a level that reflects worker productivity. In practice, however, the wage level is largely a consequence of political negotiation. These negotiations affect both wages and productivity. University of Texas economist James Galbraith has commented: “The distribution [of income] before tax is substantially a regulatory outcome, it’s an artifact of ex ante social decisions. It has to do with, among other things, minimum wages and the structure of trade unions and a great many other things in society,…”

Even more basically, workers are not an inert commodity. Increases in labor costs, i.e. higher wages, can increase demand for the final product, as Henry Ford recognized long ago. Furthermore, the kind of worker one will attract and how that worker behaves on the job will be influenced by the wage structure.

There are markets where supply and demand interactions do set the price, but these are highly volatile and a source of considerable destruction.

Pilkington points out that the primary characteristic of housing and oil markets is finite or very limited supply. If an eager and innovative speculator were to try to corner the market on refrigerators, large corporations with considerable excess capacity would soon drive him/her into ruin. Oil and land markets are different. No producer has the ability or incentive to expand capacity rapidly to deal with speculative run ups. Speculators can compete with each other for the right to exploit monopoly advantages.

One reason the myth of the market prevails is that it discourages interventions on behalf of labor or environment while allowing corporations freedom to impose their own prices. It also encourages rampant speculations. But in addition to these factors the idea of a world of perfect individual freedom and harmony has an emotional, religious appeal. Powerful as this ideal is, it bears ever less relation to current economic practice.

The clear policy implications of recognizing how markets work in practice is a defense of some form of mixed economy. That supply and demand seldom prevails does not mean centralized government should set all prices. It does suggest a need for regulation in those few markets where speculation runs rampant and disrupt the entire economy. And equally, as John Kenneth Galbraith argued long ago, countervailing power in those realms where administered prices are the norm is essential. From the perspective of current policy, James Galbraith concludes that in the battle for economic justice, progressives would do well to de-emphaize taxes and address the social and political factors that generate wages, prices, and profits: “having an accepted pretax distribution that is fair is much more stable than trying to change things through the tax code, because you get an enormously powerful political resistance to doing that once you’ve allowed people to have the attribution of income to them pretax.”

John Buell lives in Southwest Harbor, Maine and writes on labor and environmental issues. Email Jbuell@acadia.net.

From The Progressive Populist, August 1, 2015

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