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Distinguishing Prices From Market Values

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Let’s assume that Bill O’Reilly sincerely believes [2] that oil companies were unjustified in raising the price of gasoline during the hurricane-ravaged Fall. Such an assumption makes me yearn to know what he must be thinking – what’s going on in his brain.  So I try very hard to understand.

I suspect that his reasoning has something to do with the fact that at one level – the level most obvious to the pedestrian (or perhaps I should here say ‘the driver’) – prices are ultimately set by human beings. I don’t mean here that O’Reilly is thinking that prices are “the result of human action but not of human design.” Instead, I suspect that O’Reilly believes them to be the result of human action and of human design because some person or group of persons does indeed decide to post a price for each good or service.

That is, someone (or a committee of someones) at ExxonMobil actually decided to raise the price of a gallon of refined gasoline sold to retailers, and each retailer actually decided to change the meter in his pumps so that each gallon of gasoline pumped by mom into her minivan costs her more $$$. And then, of course, more recently that same someone at ExxonMobil actually decided to lower the price charged to retailers, and some real, flesh-and-blood retailer actually lowered the price per gallon that his pumps register when consumers fill their tanks.

ExxonMobil could have chosen not to raise the prices it charges. Ditto for other oil companies. Ditto for each gasoline retailer. The fact that such choices were humanly possible is taken by O’Reilly as proof that prices are determined by business people.

If the above does describe what’s going on in O’Reilly’s mind, I see two things wrong with his thought processes.

First, this way of looking at prices ascribes too much power and influence to sellers and too little to buyers. Yes, some seller chose to ask “$3.79” per gallon of gasoline – a seller who could have physically, morally, and lawfully asked, say, only “$2.79” per gallon. But each buyer chose to pay $3.79 per gallon – each one of whom could have physically, morally, and lawfully chosen not to pay that price per gallon.

Does the seller or the buyer “set” the price? Isn’t the price more accurately reckoned as being set by both the seller and the buyer?

Second, and more importantly, O’Reilly confuses market value and price – or, rather, he fails to see that the correct price is the one that most accurately reflects market values. Market values are not set by flesh-and-blood decision-makers in the same way that prices are.

When hurricane Katrina destroyed much oil- and gasoline-producing capacity in the gulf south, the supply of gasoline fell. This sudden fall in supply made the market value of each gallon of gasoline rise. No one – no flesh-and-blood person – no oil-company executive, no bureaucrat, no consumer, no one – chose for this rise in market value to happen.

Prices, of course, typically adjust to reflect market values.  (Or perhaps we should say instead, “prices typically are adjusted to reflect market values.”)  Because the economist recognizes that prices serve their purpose best when they accurately reflect market values  – and because the economist recognizes also that the incentives in private-property markets generally lead participants in those markets to set prices in accordance with market values – when the economist says “supply and demand determine prices,” what he or she means is that underlying supply and demand conditions determine market values and that the incentives confronted by sellers and consumers prompt each to agree to exchange each product at a price that reflects its market value.

So while prices can be kept above or below the market values of the products in question, market values are not subject to such manipulation.

The economist understands that prices are best that reflect market values; the non-economist too often overlooks this fact.

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A final note: economics textbooks sport long discussions of externalities – situations in which sellers and buyers are not led by market forces to set prices to reflect market values. There’s near-unanimous agreement among economists that such situations are undesirable. Indeed, these situations are called “market failures.”

When people such as O’Reilly call for firms to charge prices that are below market value, they are really calling for firms to create market failures.

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