Price Formation and Economic Calculation

Presentation in two parts:Price Formation

Economic Calculation

From simple to complex• We will show how the relation between

individual choice and social planning works.• Statement: when (and only when) individuals

are free to choose social coordination becomes possible.

• The Austrian School of Economics is characterized by methodological individualism: starting from the observation of simple realities and „gradually passing on to more complex phenomena”.

• We start from the simplest form of exchange.

Bibliography: 4 Treatises• Carl Menger, Principles of Economics, 1871• http://mises.org/etexts/menger/principles.asp

▫ Chapter IV: Theory of Exchange, Chapter V: Theory of Price, pp. 175-225.

• Eugen von Böhm-Bawerk, Capital and Interest, 1884-1912 • http://mises.org/document/164/Capital-and-Interest

▫ Volume II, Book III, Ch. II The Basic Law of the Determination of Price, pp. 215-235.

• Ludwig von Mises, Human Action, 1949• http://mises.org/document/3250

▫ Ch. XVI Prices, p. 324.• Murray N. Rothbard, Man, Economy and State, 1963,• http://

mises.org/document/1082/Man-Economy-and-State-with-Power-and-Market▫ Ch. 2 Direct Exchange, pp. 79-187.

Menger: Principles of Economics

• (Subjective Value, Value Scale.)• Prerequisites of Exchange:

p. 180:” The principle that leads men to exchange is the same principlethat guides them in their economic activity as a whole; it is theendeavor to ensure the fullest possible satisfaction of their needs.The enjoyment men derive from an economic exchange of goodsis the general feeling of pleasure they experience when someevent permits them to make a better provision for the satisfactionof their needs than would otherwise have been possible. But thebenefits of a mutual transfer of goods depend, as we have seen,on three conditions: (a) one economizing individual must havecommand of quantities of goods which have a smaller value tohim than other quantities of goods at the disposal of anothereconomizing individual who evaluates the goods in reverse fashion,(b) the two economizing individuals must have recognizedthis relationship, and (c) they must have the power actually toperform the exchange of goods. The absence of but one of theseconditions means that an essential prerequisite for an economicexchange is missing, and that an exchange of goods between twoeconomizing individuals is economically impossible.”

Cows, Wine, Horses, Grain

• The treatise tradition proceeds in 4 steps to discover the law of price formation:

• 1: Isolated exchange• 2: One-sided competition among buyers• 3: One-sided competition among sellers• 4: Two-sided competition

Isolated exchange•Principles: economizing behavior

(rationality, increasing one’s satisfaction):▫1: if he can exchange to advantage▫2: will exchange to a greater advantage in

preference to exchanging to lesser advantage

▫3: will exchange to lesser advantage in preference to not exchanging at all.

Value scales meet

• Smith has 5 horses and no cows. • Jones has 5 cows and no horses.• Their value scales are represented below.• How will they exchange?

Smith JonesResult of previous situation: 2 exchanges and a new structure of propertySmith: 3 horses and 2 cowsJones: 2 horses and 3 cows

Where is the price going to be set?

Law: the price will be determined within a range which has as its upper limit the buyer’s subjective valuation of the good, and as its lower limit the seller’s valuation.

One-sided competition among buyers•Seller A has 40 barrels of wine (single

indivisible good) that he would give up for at least 600 bushels of grain.

•Buyers prefer it to (B1) up to 800 bushels of grain and (B2) up to 1000 bushels of grain.

•Where is the price going to be set?•800-999 bushels.•Where actually?•Bargaining

Where is the price going to be set?

Law: The price is going to be set within a range of which the upper limit is the valuation by the most capable purchaser and the lower limit of which is the valuation by that one among the excluded competitors who has the greatest capacity for exchange.

One sided competition among sellers• A is the only willing buyer• Five sellers of horses

▫ B1: 100 bushels▫ B2: 120 bushels▫ B3 150 bushels▫ B4: 200 bushels▫ B5: 250 bushels

• Where is the price going to be set?• 100-119 bushels• Law: the price is going to be determined in a range having

the lower limit the valuation by the seller and the upper limit the valuation of the most capable excluded seller.

Two-Sided CompetitionWilling Buyer

Valuation of one horse

Willing Seller

Valuation of his horse

A1 300 B1 100A2 280 B2 110A3 260 B3 150A4 240 B4 170A5 220 B5 200A6 210 B6 215A7 200 B7 250A8 180 B8 260A9 170

A10 150

Where is the price going to be set?

In the range 210-214

How many horses will be traded?

Which are the marginal pairs?

5 horses, between 5 pairs of traders.

Least capable: A5, B5.Excluded: A6, B6

Another exampleWhere is the price going to be set?

89

How many horses will be traded?

Which are the marginal pairs?

5 horses

Least capable: X5, Z5.Excluded: X4, Z6

Law of price formation on the market

• The upper limit is determined by the valuation by the last buyer to come to terms and the valuation by the excluded willing seller who has the greatest capacity for exchange.

• The lower limit is determined by the valuation by the last seller among those who come to terms, and the valutation by that excluded willing buyer who has the greatest capacity for exchange.

Mises: Human Action, The Pricing Process and Money• p. 324:

The recurrence of individual acts of exchange generates the market step by step with the evolution of the division of labor within a society based on private property. As it becomes a rule to produce for other people's consumption, the members of society must sell and buy. The multiplication of the acts of exchange and the increase in the number of people offering or asking for the same commodities narrow the margins between the valuations of the parties. Indirect exchange and its perfection through the use of money divide the transactions into two different parts: sale and purchase. What in the eyes of one party is a sale, is for the other party a purchase. The divisibility of money, unlimited for all practical purposes, makes it possible to determine the exchange ratios with nicety. The exchange ratios are now as a rule money prices. They are determined between extremely narrow margins: the valuations on the one hand of the marginal buyer and those of the marginal offerer who abstains from selling, and the valuations on the other hand of the marginal seller and those of the marginal potential buyer who abstains from buying.

CAPITALISMThe Economy as a Conglomeration of Markets

•Optimal satisfaction of needs•Optimal realization of percieved value•Optimal distribution among owners•The constellation of prices is made

possible•The possibility of planning on a social

scale•Intertemporal cordination•The structure of production•Formation of capital•Economic harmony

Mises: Human Action, Monetary Calculation as a Method of Thinking• p. 230:

Monetary calculation is the guiding star of action under the social system of division of labor. It is the compass of the man embarking upon production. He calculates in order to distinguish the remunerative lines of production from the unprofitable ones, those of which the sovereign consumers are likely to approve form those of which they are likely to disapprove. Every single step of entrepreneurial activities is subject to scrutiny by monetary calculation. The premeditation of planned action becomes commercial precalculation of expected costs and expected proceeds. The retrospective establishment of the outcome of past action becomes accounting of profit and loss.

• p. 231:Our civilization is inseparably linked with our methods of economic calculation. It would perish if we were to abandon this most precious intellectual tool of acting. Goethe was right in calling bookkeeping by double entry "one of the finest inventions of the human mind."

SOCIALISM Central Planning as Negation of the Economy•No property•No exchanges•No markets•No prices•No constellation of prices•No costs for alternative investment options•No possibility of anticipating profit or loss•Navigation in the dark•Accumulation of losses and capital destruction•Poverty and irrationality taken to extremes