Pricing Power

by Russ Roberts on September 30, 2005

in Prices

In this post, Don had some nice things to say about my talk on prices as an emergent phenomenon, the product of human action but not of human design.  What we call a market. 

But my talk and the essay it was based on, is missing a piece.  And that piece is the hurdle that the skeptic can’t seem to clear.  The argument is that prices aren’t set by the people who write down the numbers but by the complex interaction of buyers and sellers.  So when I sell my house, I don’t really set the price.  Rather it’s set by the alternatives–by the houses of similar quality, location, number of bedrooms, size of the lot, charm and so on.  I might like to get more than that.  But I can’t.  Buyers will turn to alternatives.

The problem with the argument is that it only works in one direction.  Market forces, the alternatives in competition with my house, keep me from raising the price of my house.  They don’t prevent me from lowering the price.  So when we argue that the price of a house is an emergent phenomenon and that my ‘choice’ of the price deceives because it’s the market not the seller that sets the price, we’re presuming that people act in their own self-interest and will choose the market price rather than giving away money to buyers.  We also understand that if we choose a price below the market price we’ll have lots and lots of potential buyers and that we’ll need some mechanism to choose among them.  So we’re pretty comfortable arguing that home owners who put their houses on the market will choose the market price rather than a price below it.

But what about Wal-Mart?  I argue that Wal-Mart doesn’t set its wages.  Its wages are set by the skill levels and the alternatives available to people with those skills.  But I suspect that people who hate Wal-Mart would argue that Wal-Mart should pay these people more anyway.  True, they can attract plenty of people when they pay $8 an hour.  But they should pay $12 anyway.  After all, Wal-Mart has plenty of money.

The easy answer to this criticism is that we don’t expect Wal-Mart to be a charitable organization any more than we expect customers to tip Wal-Mart employees a few bucks when they see them in the aisles to make up for their low skills and low wages.

A slightly better answer (and one I’ve used often) is that if Wal-Wart gives away some of its profits simply because it can because economic conditions are rosy today, then there is likely to come a day down the road when Wal-Mart finds itself losing money and jeopardizes its existence and the economic well-being of all of its employees.

But the deeper answer has to be that we don’t want Wal-Mart to be a charitable organization, that Wal-Mart works best at creating wealth and well-being for lots of people by finding the cheapest way to get stuff onto its shelves and selling it at the lowest price possible and paying the lowest wages consistent with attracting sufficiently talented employees.  But it’s striking to me how rarely this argument gets made by those of us who defend economic freedom.  In fact, the only good treatment I can think of is Milton Friedman’s 1970 New York Times Magazine article, "The Social Responsibility of Business is to Increase its Profits."

(John Mackey founder of Whole Foods disagrees with Friedman.  Their discussion (along with a response by T.J. Rodgers) is here.)

I like to say that reality isn’t optional–that you can’t control prices without unintended consequences.  This is true.  But the skeptic who doesn’t understand emergent phenomena would come on board more easily if instead of just saying there’s nothing we can do about prices we also made the case for why the world works better when the organizations involved in the emergent web called a market act in their own self-interest.  Surely, much of the answer is Hayekian–an understanding that information and knowledge is scarce and that the best way to have it used effectively is to simplify the tasks of decision-makers and to put the decisions in the hands of those with the knowledge.  But it has to be said a lot better than this.

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