The Function of Prices and Profits: Buyers Determine Prices
Profits are the heart of industrial life. From this fundamental idea, with which we began our discussion, we cannot stray far without losing our bearings. It is the admitted basis of fact upon which all intelligent criticism of the economic order, conservative or reactionary, must be founded. Whether for good or for evil, the mainspring of economic effort is the prospect of individual reward. The profit incentive is not merely one motive force among many that keep men at work creating wealth and thus determining standards of living, but the one force without which the others can scarcely function at all.
The industrial system, however, that is driven by this force is usually indicted on four counts: the penury of the workers; the relative luxury of the proprietary class; the dependence of wage-earners on those who own the instruments of production; and the unsoundness of the system as a means of producing and distributing commodities and services. These are the charges preferred by Sidney Webb, a member of the British Labor Cabinet. But discontent is not confined to those who forecast the decay of capitalist civilization. Even Hartley Withers, author of The Case for Capitalism, declares that, as a result of our haphazard economic system, a large part of mankind is underfed, ill-clad, and ill-housed; while 'a large part of the rest wearies itself in consuming things that it does not really want and vying with itself in vulgar ostentation and waste.' Indeed, nobody who faces the facts can be complacent. Every one deplores the periodic spectacle of millions of unemployed men, abundant tools to work with and materials to work upon, nations in need of the goods that these men are eager to make with these idle machines out of these surplus materials, while no immediate means are found of bringing the men, machines, and materials into such relations that they can go on with the world's work. This involuntary unemployment is cause enough for the unanimous conviction that all is not well with industrial society.
But here the unanimity ends. To the question what can be done, the answers are legion. The answer of Lenin and Trotsky, offered with the dramatic setting of a revolution, is simple and sweeping: To cure the ills of capitalism, you must kill it, root and branch -- production by private enterprise, distribution by the price system, wages, profits, money, everything. Here is a program that takes full account of the fourfold indictment. If this program does not make the poor richer, at least it makes the rich poorer; and if, in spite of its high purposes, it injures the instruments of production and the incentives to labor, until there is much less to distribute than formerly, at least it provides a radically different method of deciding who shall run such machines as there are, and who shall get whatever there is to distribute.
Most people, however, reject this program for a reason that is as simple and sweeping as the program itself, for they regard profit as the mainspring of industrial society; and all the eloquence of all the radical reformers has not convinced them that anything can entirely take its place. So they would not abolish profits. They would, however, gladly abolish the profiteer.
But before we abolish anybody, it behooves us to know just what he is doing and why. It is well for us to try to see who makes prices and who makes profits, and how it happens; what is the economic function of price, and what is the economic function of profit; what gives rise to excessive profits; what profits and prices have to do with each other, and how they can be regulated; in fine, how things came to be what they are in this world that vexes us, and what the alternatives are. To know this is as important for the man who is pleased with all things, as it is for the man who is pleased with nothing. And it is an indispensable groundwork for constructive reform. If those who are eager to forestall what they regard as excessive profits would first take the trouble to find out how they arise, less time and effort would be wasted in futile methods of reform.
In any event, we must answer this question before we can proceed with our discussion of the relation of profits to human welfare. Let us ask, then, how it happens that some men make very large profits. Let us try to find out which among innumerable kinds of profit are harmful to society and which, if any, are beneficial. Let us inquire who the harmful profit-makers are and just how they do harm. If there are any beneficent profit-makers -- men who in the process render service to society -- it cannot help matters to denounce them along with everybody else. It can do nothing but harm to condemn profitmakers indiscriminately, or wage-earners, for that matter, or politicians, or any other group.
Accordingly, before we abolish the profiteer, we must find out who he is. If we were to ask the man in the street to tell us, or even the man in the market-place, he would probably say that the profiteer is any one who makes unreasonable profits. And if we pressed him for a more definite answer, he would tell us that any profits are unreasonable that are much larger than most men are realizing. That is the sense in which we shall use the term 'profiteer.'
If this is the man we want to abolish, how are we going to do it? We cannot go about the business sensibly until we know how this man came to be so successful a profitmaker; and we cannot make sure of that until we know what profits are, and how they are made. First of all, then, we must note the fact that profits are the difference between cost and selling price; that is to say, what remains of business income after all expenses have been met, including wages of labor and management, the going rate of interest on investment, and all other costs. It follows that, in order to do away with the profiteer, while retaining a profit economy, we must somehow manage to control either his costs or his selling prices. But we cannot control either costs or prices until we know how costs and prices are determined. These questions we shall not attempt to answer fully. Fortunately, the statement of a few general principles which in the main hold true -- without mention of various exceptions that will occur to every one -is sufficient for our present purposes.
Usually Buyers Determine Prices
Who, then, determines prices? Is it not the profiteer himself? Strictly speaking, it is not; it is the buyer who makes the price. The price-level is determined by the sum total of individual purchases, and this sum total is determined by conditions with which individual buyers have very little to do; but on a given price-level the relative prices at which various commodities and services are sold are determined almost exclusively by the purchases of individual buyers.
According to the usual view, prices tend toward the level at which the quantity demanded is equal to the quantity supplied. 'Value,' says John Stuart Mill, 'always adjusts itself in such a manner that the demand is equal to the supply.' Accordingly, in current economic teaching, the prices for which goods are sold in a competitive market are said to be 'the outcome or resultant of the individual valuations of all who buy and sell in the market.' In other words, each individual trader is said to have 'a part in that collective supply and demand which makes the price whatever it happens to be.'
This statement is true in a general way; but one of the conclusions usually drawn from it is not true. Since prices are the resultant of supply and demand, it is said, buyers cannot possibly have any more influence over prices than sellers. This conclusion takes no account of a crucial difference between the position of the buyer and that of the seller. To discover this difference we must keep in mind the fact that the price of any commodity on any day is determined on that day in the very process of making sales. Now on that day the supply of each commodity that may be sold is virtually fixed and cannot be greatly changed. Consequently the relative supplies of all the commodities are fixed. On that day, however, the demand for any commodity can be changed instantaneously by the action of buyers. Consequently, the demand for each commodity in relation to the demand for other commodities can be changed. Thus buyers hold nearly all the options. The valuation placed on any commodity by the seller has comparatively little to do with the price at which it is sold. As a rule, he is obliged to sell whatever he has to sell for whatever buyers decide to pay, whereas the buyer is free to buy a substitute or, in many cases, not to buy at all. Thus, by determining every day the relative demand for fixed supplies of various commodities, buyers determine prices.
But, it is said, the supply, which is one of the factors in determining the price, is determined by producers. This statement is also true in a general way, as far as it goes; but the dominance of the buyer in determining prices is not made clear until we go one step further, and take account of the fact that producers necessarily adjust supply as accurately as possible to the actual and expected demand of the buyer. Thus, whether we look at the market from the supply side or the demand side, we find that the buyer is the dominant factor in determining prices.
But, it is said further, human beings are obliged to buy some things; they cannot live like the beasts of the field. Even so, the rule holds. No matter how necessary or how unnecessary a given commodity may be, no matter whether it is bread or beads, the price is made by those consumers who have money to spend and who spend it for that commodity instead of for some other commodity. The fact that there are widows who have no money to buy milk for their sick babies, while there are many mothers who could and would buy it at a hundred times the price, is evidence of an unfortunate distribution of wealth; but even with a more equitable distribution of wealth, buyers would still determine the price of milk.
Cases of monopoly, it is true, may call for measures of public control that are unnecessary for typical competitive enterprises -- measures that we shall not consider here. But even a monopoly -- in gas, anthracite coal, sulphur, aluminum, or any other commodity -- usually has to meet the competition of substitutes and, in any event, can sell a given output at no higher price than buyers decide to pay.
As an instance of what happens under open market and highly competitive trading, we may consider the part the buyer plays in making the price of pig-iron. Let us suppose the asking price to be seventeen dollars a ton, with many foundries out, factories shut down, and virtually nobody buying. Under these conditions, the price is merely nominal. Presently A finds a buyer at sixteen dollars and decides to accept his offer; but as B thinks that there will soon be buyers at a higher price, he declines to sell at sixteen dollars. So at that price, A gets nearly all the orders there are. After a while, however, buyers cannot get all the pig-iron they want from A; so they take part of what they need from B at the higher price. Then B puts his offering price up to eighteen dollars. Buyers naturally take all they can get elsewhere at lower prices, and then order from B, at eighteen dollars, only as much of their requirements as they cannot buy at a lower price. As soon as B thinks that buyers are ready to pay more, he advances the asking price to nineteen dollars, and so on. During this process, as some buyers put the price up, other buyers drop out. Some of thern have to drop out. Some makers of stoves, for example, when the price of pig-iron has reached a certain height, cannot make stoves and sell them at a profit. Therefore, they stay out of the pig-iron market. As the asking price goes higher still, other buyers decide to wait, until the time comes when, say at twenty-eight dollars, there are no buyers at all. B, however, does not reduce the offering price. He is aware that, as long as there are no buyers, the price at which goods are offered has little significance. It is nothing but a seller's price; there is no real market. So he waits until there is a real buyer to fix the price. He finds one, let us say, at twenty-seven dollars, and makes a sale at that price. In this way, step by step, the price goes down to, say, eighteen dollars, the price being determined at each step by what the buyer will pay rather than wait to see if he can buy at a lower price.
Failure to understand all this is due partly to the widespread belief that prices are made by the simple process of figuring costs and adding profits. That is, indeed, the way in which sellers would like to determine prices. But the prices at which goods are actually sold at any given time are not arrived at in this way; for the buyer cares little about either the costs or the profits of the seller. When a buyer offers twelve cents a pound for copper, it is useless for the miner to say, 'I cannot possibly produce it at that price.' The buyer is not interested in the troubles of the seller. If he buys at all, he buys at a price that suits him, regardless of the resultant profits or losses to the seller.
In the long run, it is true, prices tend to keep above production costs; for if the highest price that buyers will pay today is too low to yield a profit to the highest-cost producer, he is likely to go out of business, thus tending to reduce the supply and increase the price. But at any given time there is no necessary connection between costs and prices. Any one may arrive at an offering price in any way he chooses; but at no time is the selling price made by adding profits to costs. If selling prices were made in this way, most of what we said about the risks of business would have no point. The seller fixes merely the price at which goods are offered; the buyer fixes the price at which they are sold. No merchant ever suffers long under the delusion that he controls the price at which he can sell a given volume of goods. He soon finds that, in filling out his price tags, he must either guess right concerning the action of buyers, or guess again. His cash register lets him know when he guesses right.
All this may sound like nonsense to a man who has just bought a Ford car. He found the car already priced, and priced too high to suit him; but he had to pay the price or leave the car. Nevertheless, even Henry Ford is no exception to the rule. Millions of people, in deciding to buy or not to buy at a given price, tell Mr. Ford at what price he can dispose of his output. It is literally true that on every road in the country there is some driver who has had a part in fixing the price of Ford cars. In any department store today the prices of some things -- radio sets, perhaps, and the latest novelty in scarfs -- may seem high enough to yield large profits; and possibly they are. In any event, buyers have made the high prices; and in any event there is another side to the story. In the same store there are certain to be other things -- books, perhaps, and mah-jong sets -- which are priced below the cost of production. Again, they are priced as they are because buyers have so decreed. In another year, buyers may decide that radio sets and last year's scarfs must be sold at a loss.
Naturally, on any given day there are innumerable exceptions to general rules; economic forces do not produce their full effects instantaneously. Every day many commodities, including Ford cars, are sold in given quantities at prices lower than consumers would be willing to pay. In some cases this happens because the seller is committed to certain prices for a definite period of time. The largest mail-order houses, for example, cannot quickly adjust their prices to changes in demand, since it costs a million dollars or more to prepare and distribute a new price-list. In many more cases it happens because the seller misjudges the market. There are numerous other exceptions, but the rule still holds: the buyer is the dominant factor in determining prices.
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