Austrian Economics Part Five – Prices

Matthew John Hayden

Human action is goal oriented behaviour, which leads me – a human who acts – to set goals and then make effort (work) to achieve those I find most achievable according to their relative difficulty of attaining. Each individual sees from their own unique frame of reference and so arrives at their own valuations, making value subjective. Trade takes place when two parties identify an opportunity for mutual profit. Yes, mutual profit. If either party doesn’t value their state after the exchange more than their state before they won’t enter into the exchange. This offers the groundwork from which to theorise as to the origin and nature of prices.

At the most basic mechanical level any particular price is just a ratio, or an exchange rate, between one good and another, usually expressed as the number of units of an accepted money currency needed to exchange for the good in question. But that’s just exchange rates. Money is not some magical or neutral stuff sitting outside of an exchange; it’s just a good like everything it can be exchanged for. This is why prices are just ratios; three spears to one pair of boots; two bags of M&Ms to six Cadbury’s Creme Eggs, et cetera. This does not tell us why people want prices they can understand at a glance. And why are prices delineated in units of currency rather than practical, useful goods? Why won’t I price a tractor in lawnmowers rather than dollars?

Measuring the cost of one uniquely useful good in terms of another is just silly, because most people do not value tractors or lawnmowers equally. Being a tenant in an urban household, I have little use for either. Money is the best unit of account and yardstick by which to measure prices because it has regressed from a regular good to one that is substantially only used in exchange for other goods. Having a good serving this purpose is very useful for showing clear prices, in the same units every time, that everybody can immediately understand. 100 dollars for a lawnmower or 50,000 dollars for a tractor makes much more sense than pricing the two machines against each other.

Price is a simplified abstraction of cost. While cost is subjective to every individual – the cost of the things you can do or get is anything you will have to forego as a result, and what constitutes an acceptable cost for a given end is a subjective, individual preference – price is an objective quantity in the external world. All this is despite the subjective perceptions and cognisance of the people who discover it. Prices are not arrived at arbitrarily. Exchange is entirely mutual. Both parties are entering into exchange for the same reason, or rather are both getting the same thing out of it; each is exchanging an existing, less satisfying state for a new, more satisfying one, passing over to the other side of the hill.

It’s easier to think of prices in any given, existing market by making the assumption that the ideal market price of a given good is already known, as in the diagram below. That diagram shows how shortages and surpluses will inevitably result from under- and over-pricing respectively. This is not the whole story, however.


The phrase ‘price discovery’ has come up a couple of times already. This deserves an explanation. There is an inescapable tendency, Chaos Theory-esque, of perpetual price discovery from the hustle and bustle of thousands of trades in every conceivable good taking place day by day, as every seller tries to maximise their value in terms of the highest selling price that lots of consumers will accept, and every consumer seeks the lowest possible price for the goods they wish to buy, since they desire to minimise opportunity cost.

In a way the diagram above is problematic because it only shows, statically, how many trades will take place at different price levels. This doesn’t express the actual process of price discovery whereby sellers seek that 30 cents sweet spot while never quite getting there before demand shifts and the ideal price moves. As Austrians, we dn’t believe in ‘efficient markets’ and so we don’t view markets as operating in some kind of perfect equilibrium, or perfect competition.

Rather, to the Austrian the market is the price discovery mechanism, and a free market is one characterised by complete freedom of sellers to set any price they want. Here’s the skinny on price discovery; it’s trial and error against a backdrop of already prevailing prices. The relative scarcities of all potential goods at any given time cannot be known at that time, even within just one market. It’s outside the scope of one human’s frame of reference. Instead, we are each fumbling in what would be total darkness but for price signals to direct our allocative decisions. This is because, as stated above, we use prices to determine, at a glance, the likely opportunity cost of buying whatever is in front of us.

So at any given time resources are constrained – including time itself, but also land, labour, and physical capital – for both consumers and producers, meaning they must order their potential choices in terms of urgency. Relative scarcities – that is, supply and demand – of goods and services give sellers the feedback they need to price appropriately so as to maximise their revenue by maximising their number of customers, and thus the number of satisfied consumers. That latter calculation may not be foremost on a capitalist’s mind, but that doesn’t matter because they are de facto servants of the public interest anyway, since they maximise profit by maximising value creation, which by definition goes both ways, to both buyer and seller.

Profit-maximisation leads to subjective value-maximisation, which means the greatest possible flourishing for as many people as possible. This is where understanding economics becomes so important in understanding the limited capacity of government economic policies to make life better. Hopefully more and more people will learn sound economic thinking in future and learn that any and all attempts to mess with the price system above are doomed to induce shortages and unwanted surpluses. It’s a beautiful anarchy every day and it’ll provide ever better things for all of us for a long time to come if we only let it. So let’s ease up on the boring old interventionism and learn from the wisdom of trial-and-error price bidding.

Notes: the image above was shamelessly ripped off the wiki article Free Price System, and is originally of Freeman provenance according to this wiki page.

3 thoughts on “Austrian Economics Part Five – Prices

  1. Only a few years ago I would have attacked this, saying…..

    “There is nothing specifically Austrian School about understanding why prices must be free – mainstream economists understand this also”.

    However, experience has taught me that I was WRONG – mainstream “economists” (including “Nobel” Price winners such as Krugman and Stiglitz) clearly have no basic understanding of the need for prices to be free – as the demented support of many of these “economists” for such things as minimum wage laws and rent controls (and on and on) shows.

    So posts such as this are clearly needed.

    • Cheers, Paul. I have been a student of economics in some form or other for six years now, and only after discovering the Austrian school did I really come to a meaty understanding of what the Hell’s going on to create the price levels all around us, and in what ways is that process being perverted by stupid regulations like price controls, production quotas, tariffs, subsidies and plain old taxes.

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