Reclaiming Economics Part 3

In Part 2 of this series I looked at the way orthodox economics defines Value in subjective terms. That is, it sees Value only as being what the individual determines a good to be worth at any moment in time as defined by the quantities of other goods they are prepared to sacrifice for it. In doing so, it goes out of its way to deny, and remove from this equation, the most important aspect of how the individual arrives at this particular valuation in a market economy, that is the price or exchange value of that good!

I now want to look at the extension of this argument in terms of the way it proceeds from this to explain how price is determined. Again, for the purpose I am using the textbook produced by Alchian & Allen, “University Economics”, as the vehicle to expound the orthodox argument.

In Chapter 7 on page 95 in a section entitled “The Cost-Push Illusion”, they proclaim,

“The avenue from increased demand to higher exchange-equilibrium prices often is concealed by inventories in the distribution chain from producer to consumer. As a result, many prices appear to be set by costs of production instead of competition among consumers. The cause of this widespread illusion is illustrated in the following example of an increased demand for meat.”

We will see exactly where the illusion resides here.

In their example, they put forward a rise in demand for meat arising through a change in consumer preferences. Because, butchers carry inventories, this initial rise in demand can be met at existing prices. But, then Butchers seek to replenish their inventories in addition to their normal requirements resulting in an increase in demand to packers. In turn the packers raise their demands from the cattlemen, but given the nature of meat supply this increased demand cannot be met, so the cattlemen raise prices to ration this demand. Consequently, the cost to packers rises, and this rise is passed on to butchers who in turn raise the prices to end consumers.

A&A’s argument here is that the cost of production of meat has not risen, but the price of meat has. The rise in price at the new equilibrium level is not due to a rise in costs, but is due to the competition between consumers, which is only to say that consumers have raised their personal valuations for meat vis a vis other goods. There are so many things wrong with this argument that it is difficult to know where to begin deconstructing it.

I’ll begin by presenting the argument A&A give graphically.



Figure 1 shows the effect of a shift in demand shown by the movement of the Demand Curve to the right from DD, to D1D1. The fixed Supply is shown by the vertical Supply curve SS, indicating that whatever happens to prices there is no change in Supply. The consequence is that the equilibrium level of Supply and demand remains the same, but the price rises from P to P1.

I suppose that the first thing to say is that orthodox economics NORMALLY begins by analysing the market in terms of an unrealistic vision of a perfect market, where there is completely free movement of factors of production – land, labour and capital – and perfect information. Here the very opposite is assumed! By defining supply as being completely fixed, what they have presented us with is effectively a situation of monopoly! Is this situation realistic? No, consider all the facts that A&A remove from their example. If, the cost of production of meat remains the same as they insist, then the higher prices, must result in higher profits for at least the cattlemen. It may be that due to the nature of cattle rearing this higher profit cannot in the immediate term raise supply, by other Capitalists employing their Capital in this sphere – presumably those Capitalists whose Capital has been freed as a result of consumers switching from their products to buy meat – but, it is likely, that these or other Capitalists will see the potential profit to be made by, for example, importing meat from some other economy! Indeed, it may be that at this new higher level of demand for meat, not only does it become profitable to import meat, but it may even be that meat can be imported from an economy where the cost of production is lower. By importing a large quantity of this lower cost meat, and spreading the transportation cost over this much larger quantity they may even be able to undercut, not just the current price charged by the cattlemen, but the old price!!!!

In those conditions, the price of meat resulting from a large increase in demand will not be an increase in prices, but a lower price. And the lower price will be a result, precisely of those lower costs of production!!! I will come back to this later to show that we do not even have to rely on the existence of such foreign imports to arrive at this conclusion.

Before that, however, let us look at exactly what the example as presented tells us. As I said in Part 2, there is nothing in the theory of Marginal Utility, which can tell us why consumers should place a higher value on commodity A than Commodity B, when, in fact, the market places some other value upon them. Even less can it tell us why any or all of these consumers Demand X units of Commody A, at price Y, rather than X+1. It can only present us with a description of the fact that they do. Given the central role that Marginalist Theory gives to this individual subjective valuation this is rather a severe limitation for a theory whose purpose should be to explain rather than simply describe human behaviour!!!

But, we see the same thing here in relation to the other side of the equation – Supply. A&A tell us that the Supply of meat is fixed at a level of Q. But, why is it fixed at this level? It is hard to believe that this fixed quantity is fixed for ever and ever amen! As shown above, a simple resort to imports would prevent it from being fixed in the short term. Later I will show that it will not be fixed even without imports in the longer term. So, why is it fixed at this level? The simple reason, again has to do with costs. If demand has been steady for some time, then suppliers will know what that level is likely to be in the future. If they supply to that level, this will imply a given set of costs of production. Furthermore, the difference between those costs and the selling price will determine the profit of the cattlemen. If this produces a rate of profit higher than the average for the economy then they will either increase their production in order to make more profit, or else other Capitalists will engage in this line of production to obtain that higher rate themselves. The Supply will increase, and prices will fall. If the profit produced resulted in a lower rate of profit then the opposite would be true, supply would contract, and prices would rise until the average was attained.

So, there is undoubtedly an interaction between Supply and Demand here, but it is costs, and the average rate of profit – what Marx calls the Price of Production that is the determinant, NOT consumer preferences or some unknown individual subjective valuations. Moreover, the explanation provided by A&A, only tells us that the change in demand has resulted in a change in price – something which a Marxist is happy to concede is the consequence of changes in demand and supply – but, it does NOT tell us why the original equilibrium Price was P, and is now P1. It can only explain the movement, not the absolute level. It cannot do that without explaining why the original level of Supply was fixed at Q at price P, and it can only explain that by referring to costs and average profits!

But, what does that come down to. The costs of machinery, buildings, raw materials come down themselves to these same costs, and the profits of the Capitalists. That is Constant Capital (machinery, buildings raw materials), the cost of Labour Power in terms of Wages, or Variable Capital V, and the profit of the Capitalist S. And, the profit of the Capitalist can only arise if he is able to purchase something, which creates for him greater value than he pays for. That cannot be Constant Capital, because if all Capitalists robbed each other in the process of exchange the result would be zero! It can only be the purchase of Labour Power, which enables the Capitalist to pull off this trick.

Let me explain this in very basic terms. Somewhere – I have been trying to find the exact reference I think it may be in Theories of Surplus Value, if anyone knows the actual reference I’d be grateful – Marx says that the most basic exchange is not man with man, but Man with Nature. This he then outlines is the basis of Value. He distinguishes here Value from either Use Value, or Exchange Value. A man can produce 20 lbs. of potatoes or 40 lbs of carrots from 10 hours work. He can produce either potatoes or carrots in varying proportions determined by the technically determined limits.



Fig 2.

If the man likes carrots, but does not like potatoes he can spend all his time producing carrots. Suppose his preference for carrots falls and increases for potatoes, does this decrease in utility, in his subjective value of carrots cause the price of carrots to fall? No. The price to him of carrots, measured either by the quantity of potatoes he has to give up, or what is actually the same thing the amount of time he has to spend growing carrots remains exactly the same. In order to obtain 4 lbs of carrots he has to give up 2 lb of potatoes or 1 hour of labour just as he did previously.

However, instead of this one man we can substitute society. It can be argued that society is made up of millions of individuals all of whom have different preferences for carrots and potatoes. That is true, but all of those preferences can be aggregated in order to obtain an overall average. It is no different than if we were to assume that our one man has different preferences over say a 10 year period. Over this time his preferences can be aggregated in order to obtain an overall figure for the 10 years, his demand, if you will, for carrots and potatoes during that time, which would be no different than if these preferences were those of 10 individuals in a single year.

But it could be further argued that the individuals that make up society have varying levels of skill and ability, some are more productive than others. True, but the same argument applies. All of these different degrees of productivity can be aggregated to give a total figure of the productive capacity of the labour of the society, in our example, the capacity to produce a given quantity of potatoes or carrots, guns or butter. This is the basis of the determination of value, the amount of labour required on average to produce a particular good.

In fact, at a macro level, orthodox economics itself accepts this presentation recognising that it is ultimately, the amount of labour-time available, which determines not just the total quantity of guns and butter that can be produced, but also, therefore, the actual exchange relationship between the relative costs – the Opportunity Costs – of the two products! It is at the micro-economic level that orthodox ignores this basic relationship, in order to define Value in subjective rather than objective terms.

If we return to our potatoes and carrots example, and now assume that the land on which they are grown is owned by a second person then the nature and connection between Value and Surplus Value can be identified. Our original producer not only has a set of preferences between carrots and potatoes, but has physiological needs for consumption of either or both products. In other words, unless he eats a given quantity he cannot live, or have the energy to work. Let us assume that this quantity is 5 lbs of potatoes, and 10 lbs of carrots. The owner of the land says, I will allow you to work on my land and produce the carrots and potatoes you need in order to live, provided that you give me the remainder of your production, that is the other 5lbs of potatoes and 10lbs of carrots. The worker who does not want to starve thinks this is not much of a bargain, but aware that their may be others who would accept it, resigns himself to the deal. The landowner might wish to have even more of the produce to himself, but were he to reduce the workers wages of carrots and potatoes, the worker would not be able to work, his output would fall, and eventually he would die from lack of sustenance. The landowner recognises his long term interest in not bringing such a situation about.

Similarly, the landowner may be a kindly soul who would really like to take nothing from the worker at all, but he needs to have the quantities of carrots and potatoes he takes, in order to exchange them on the market for other goods required for the maintenance of the land and its enhancement, without which its productivity would decline – fertilisers, drainage equipment and so on – which would ultimately result in a similar decline in the position of both worker and landowner.

The value of neither potatoes nor carrots has changed as a result of this new social relationship. They remain determined by the relative quantities of labour required to produce them. The total amount of Value produced in the society has not changed it remains what it was before. The only thing that has changed is the distribution of this Value, the way in which the products of the society are shared out. Now, the worker is paid a wage equal to his Value – the labour-time required for his own production as a worker (5lbs of potatoes and 10lbs of carrots or 5 hours work), but he continues to work for 10 hours as before, handing over this other 5 hours work to the land owner for free. As Marx says, this absolute minimum always sets a floor under the Value of Labour Power, and as time goes on this minimum itself will necessarily rise. More developed production will require workers to be educated to a certain level, and so the cost of this education will form a part of that basic minimum. Capitalists will require that their workers are relatively healthy in order to maintain some stability especially as population growth slows, so the cost of some basic level of healthcare will be included in that minimum. Moreover, as part of the natural process of development for Capitalism, its increasing productive potential means that existing levels of demand get satisfied for products, leading Capitalists to seek new products from which to derive profits by stimulating new demand. They can only do this if workers are encouraged to widen their horizons, and expand the range of Goods and Services they buy – this is what Marx called the “Civilising Mission” of Capital, because it necessarily leads to a raising in workers real living standards, and the opening to workers of the types of cultural, educational and leisure activities that will enable the workers to become class conscious, and to become the new ruling class.

These new goods and services that, over time, become included in the minimum level Marx refers to as the historical and cultural component. At the same time, Capitalists cannot allow wages to simply rise to swallow up all of the Surplus Value for the reasons set out above. In the short-term, especially in periods of Long Wave boom, where demand for Labour is relatively strong, and workers militancy is higher, class struggle can push wages higher, and surplus value lower than it would have been. But, it is precisely under these conditions that the absolute volume of profit is rising, where productivity gains may mean that higher wages and real living standards can rise, and still accommodate a higher rate of profit, that Capitalists are likely to make such concessions. But, competition BETWEEN Capitalists even then may set a limit to this. At a time when new production techniques, new types of machines are being introduced rapidly, and where therefore, Capitalists need to invest more money in order to remain competitive, they will ultimately seek the funds for this investment from that very surplus value. Similarly, in the downturn Capitalists may look at the return available on their Capital from productive investment and deem it inadequate for the risks to be undertaken, and remove their Capital to invest it overseas, or in works of art, or other forms of speculation. The falling demand for Labour Power will then cause wages to fall back.

As Marx pointed out to Weston, class struggle cannot result in a lasting rise in wages at the expense of Capital. It can only result in a temporary advantage for workers. The real reason for the rise in workers real living standards over the last 200 years is not class struggle, but that “Civilising Mission of Capital”. Class struggle has merely been a means by which it has manifested itself. It is why, as Marx pointed out, class struggle seen in terms of a Trade Union struggle for higher wages within the confines of the system can never be a solution for the workers problems.

This then sets the real conditions under which the level of Supply is determined, costs plus the average rate of profit. If we return then to the example given by A&A we can add more reality to it. Not only is it unlikely that Supply will be completely fixed in the short term-because there is often unused resources, and there is certainly the potential for imports, but this view is only true if we treat the economy as being completely static, as being just a snapshot rather than a moving picture! In reality, the higher profits that cattle men receive will prompt them to invest in more production of cattle, precisely because in doing so they will increase their absolute volume of profit without the rate of profit falling below the average. If they do not do so, other Capitalists will! So, supply will rise, and prices will fall back, once more demonstrating that it is costs of production and rate of profit, that determine these prices, and not individual subjective values for meat by consumers.

Again as stated above in relation to imports. If, this higher level of output results in lower costs – for example as a result of economies of scale – then far from an increase in demand resulting in higher prices, it may well result in LOWER prices. A good example, is almost any kind of electronic equipment you can think of. I remember back in the 1970’s when calculators first appeared. Despite being very basic they were very expensive. But, as demand for them rose, producers could increase production runs, and achieve economies of scale, production costs tumbled, and prices tumbled with them. Demand escalated to levels way beyond its initial level, yet prices continued to fall. The same thing can be seen today in relation to things such as solar cells. They started off very expensive, but increasing demand led to higher levels of output, and falling costs, which resulted in lower prices, which caused more demand, which resulted in more supply, and further cost reductions and so on.

If instead, of the unlikely assumption made by A&A of a vertical Supply curve, meaning a fixed amount whatever the price, we assume the far more likely scenario of a horizontal Supply curve, showing that at any price, Supply can be increased indefinitely – in fact, empirical evidence showing that firms continue to enjoy economies of scale as production is increased i.e. Marginal Costs continue to fall, we could draw a Supply curve that would result in falling equilibrium prices as demand shifts to higher levels – then as Fig 3. shows the subjective valuations palced on the commodity can change as much as you like without it having any consequence for the actual market price!



Fig 3.

So, once again, it turns out that using the very example that A&A present, the illusion they claimed arose from believing that it is costs which determine prices, turns into its opposite. The real illusion is that prices are determined by the individual subjective valuations of consumers. The reality is that in the longer-term at least, prices are indeed a function of costs and the average rate of profit, or the Price of production as Marx called it. The individual preferences of consumers merely determine the relative levels of demand for commodities at those prices just as our worker determined to produce more potatoes than carrots, but could not escape the fact that the price of carrots was determined by how many potatoes he had to give up to produce the carrots, and that ultimately the real price of both carrots and potatoes was determined for him by how much labour he had to give up to produce either.

Back To Part 2

Forward To Part 4