Often discussions of the role that prices and profits play in a market economy are framed in terms of how they serve the interests of those who are selling the goods at a particular price and making a profit off of those sales. The assumption frequently seems to be that prices are set by the unilateral power of sellers and that profits are a reflection of their ability to exploit vulnerable consumers. This view implies that there are no desirable or socially necessary functions that prices and profits perform. Unfortunately, this view is mistaken, as prices and profits play a key role in a market economy: they provide the knowledge and incentives necessary for us to know what to produce, how to produce it, and how much of it people want. Where prices and profits are absent or cannot move freely, producers and consumers are blinded and economies cannot produce with the efficiency necessary to improve the lives of everyone.
Prices are not arbitrary numbers set by sellers. They are the largely unintended consequence of millions of individual decisions by buyers and sellers all over the world. As prices change, they provide the information and incentives we need to alter our behavior in response to changes in the degree to which others want the good or changes in how much of the good is available. When the demand for a good rises because people value it more, its price rises. The rising price both informs sellers of that rising value and provides an incentive for them to go out and find new supplies to meet the new demand, which is what we would ideally like to happen. Rising prices also tell buyers that they need to think carefully about just how much they want the good in question and provide them the information and incentives necessary to consider possible substitutes.
We see all of this happening right now with gasoline prices, as increased demand from China and India is one key factor driving up prices. The result is that suppliers are trying to find new sources of oil, or realizing that they have to draw down their reserves, and consumers are starting to cut back on their consumption and look for more fuel-efficient alternatives via public transportation or smaller cars. Rising gas prices are not fun, but they perform an incredibly valuable social function in signalling that a resource is more valuable and encouraging us to conserve it.
Profits work much the same way. Rather than being evidence of exploitation, profits earned in the market are, in the words of the economist W. H. Hutt, “proof of social service.” When firms earn profits, it reflects the fact that they took a bunch of raw materials and turned them into a finished product that consumers value more than they did the total of the raw materials. Put differently, profits in the market demonstrate that firms have created value by transforming one set of goods into a different good. Economic activity cannot change the number of atoms in the world, but it can rearrange them in ways that humans find more valuable, and profits are the evidence that firms have done so.
But more important than the role they play in telling us how well we’ve done something in the past is the role profits play as guides to the future. When a firm’s activities are profitable, it tells the firm to keep on doing more of what it’s doing. When profits fall or if the firm suffers losses, it tells the firm that it needs to make changes. Firms will look at the prices of what they sell and their raw materials and attempt to determine what they need to change to become profitable. Here is where prices and profits intersect: profits and losses are really just the summed up result of a whole bunch of prices. Without individual prices and their summarized changes in profits and losses, we as a society would not be able to figure out what to produce, how to produce it, and how much of everything people want.
People who want to freeze prices or “take the profit out” of certain activities may think that they are trying to give a heart to the cold, calculating Tin Man of capitalism, but what they are really doing is much more like Oedipus gouging out his own eyes, leaving himself, as would be the economy, blind and helpless.
Hannes Edinger email -
Hannes Edinger
Dr. Horowitz, I really do enjoy the clarity and conciseness that an Austrian perspective brings to this sort of topic. My question is more a question about the Austrian school itself, rather than one concerning profits and prices. I find all of the arguments (that I have come across) from the Austrian school very compelling but I sometimes wonder why this school of thought seemingly exempts itself from its own analysis. A profound belief in efficient markets seems to require that this mechanism could also be applied to the study of economics. Why is it that the Austrian school remains on the fringes if it is, in fact, correct in the areas in which it diverges from the mainstream? Is the sum of current economic thought not an example of an emergent order that would most closely approximate some sort of objective truth? or is there some sort of systemic bias? Thank-you Hannes.
Running on Empty email -
Fascinating article Steven. What do you think of recent oil prices? Is it merely a reflection of supply and demand - or is there some sort of manipulation of the market by OPEC?
Steve Horwitz says:
Well its not OPEC because they are feeling the pinch too. With demand for gas leveling off or falling, OPEC is thinking about increasing production. I think the biggest factors in the price increase are:
1. Steadily growing demand from China and India. This is a good thing as it is the result of their economic growth and the improvement in millions and billions of peoples lives.
2. The lower US dollar. International oil markets are denominated in dollars, so when the US dollar weakens, the price of oil rises as each dollar is worth less.
3. Political uncertainty in the Mideast, combined with uncertainty about the next US president. Political uncertainty makes investments in oil more risky, running up the price.
4. Some degree of speculation. With prices climbing, theres always people, like with housing, who buy to make money by selling later. Eventually, the underlying supply will pull this back, and some analysts are predicting that were near the top of the speculative run with oil prices.
Hafiz email -
Welcome to this month's Ask the Professor live chat. We are very fortunate to have Steven Horowitz, the Charles A. Dana Professor of Economics at St. Lawrence University in Canton, NY, join us today! Please post your questions, and periodically refresh your browser to see a response.
I look forward to another great discussion!
Steve Horwitz email - myslu.stlawu.edu/~shorwitz
Thanks for having me. I know that there were a few questions submitted in advance and I'll fire off some quick answers to those right now.
Victoria Wells email -
Hi Steven, I am from Vancouver, and like many other big cities in North America - housing prices continue to soar. I read an article a week ago that said that in Vancouver alone, there are approximately 30,000 units of housing left empty by foreign investers. So my question would be, is this a problem, or is it simply the market at work? And if you do see this as a problem, how can it be solved/alleviated? look forward to hearing your response -Viki
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Steven Horwitz says:
Well Victoria, I think its a variety of factors at work. In the US, the ways in which the Federal Reserve has implicitly promised to bail out banks and other institutions after asset bubbles collapse has led many to extend loans they shouldnt have. But more generally, the rise in housing prices over the last decade or so started as a genuine market response to increasing wealth. But as those prices rose, lots of folks thought theyd never stop rising and you see the sort of speculative house buying like you describe, where people bought never intended to live there but as an investment. Im not sure its a problem, and to the extent it is, it will likely self-correct as prices level off or even fall. In the US, I should note, the housing crisis is largely confined to the major cities. I live in a small town and housing prices here are actually up from a year ago.
Justin Abele email -
you say "profits in the market demonstrate that firms have created value by transforming one set of goods into a different good" Isn't this definition far too simplistic?
Steve Horwitz says:
Nope, as long as its suitably qualified by in the market. For example, firms that get a government-granted monopoly will make profits most likely, but not because theyve created value, but because consumers have no choice. The same thing is true with military contracts and the sort of rebuilding that Halliburton is doing. But where firms genuinely operate in a competitive market, their profits are proof of having created something that consumers value more than they did the raw inputs. Thats what profit means in a market context.
Raphael Mortiz email -
You mention that with an increase in price, people will consider alternatives. Can you explain why industry has not made a more significant shift towards alternatives to the standard gasoline powered engine over the past decade?
Steven Horwitz says:
Good question! There are two aspects to the answer. First, governments tend to subsidize oil in a variety of ways, which gives energy companies and others a strong incentive to stick with oil. I think thats bad policy. Get rid of the subsidies and lets see what markets really think is better. Second, and more important, until the last year, gas and oil prices simply havent been high enough to make enough of a dent to get people to really change their behavior. Were seeing it now though. Here in the US, people are driving 3.3billion fewer miles than this time last year, and theres lots of anecdotal evidence about people looking for hybrids and electric cars, or trading in their gas-powered lawnmowers for alternatives. If the price of oil continues to stay high, and people start looking for alternatives, the profit to finding those alternatives will rise and we should see more investment in alternative forms of energy.
Steve Horwitz email - myslu.stlawu.edu/~shorwitz
Hannes Edinger
Dr. Horowitz, I really do enjoy the clarity and conciseness that an Austrian perspective brings to this sort of topic. My question is more a question about the Austrian school itself, rather than one concerning profits and prices. I find all of the arguments (that I have come across) from the Austrian school very compelling but I sometimes wonder why this school of thought seemingly exempts itself from its own analysis. A profound belief in efficient markets seems to require that this mechanism could also be applied to the study of economics. Why is it that the Austrian school remains on the fringes if it is, in fact, correct in the areas in which it diverges from the mainstream? Is the sum of current economic thought not an example of an emergent order that would most closely approximate some sort of objective truth? or is there some sort of systemic bias? Thank-you Hannes.
Steve Horwitz says:
Great question. First, I should note that Austrians do not believe in efficient markets in the technical sense of the term. We dont believe that markets are always perfectly efficient. The economy is, in fact, constantly in disequilibrium. Markets are just better than other institutions at correcting those mistakes, but they never come close to getting it exactly right.
And academia is hardly a free market. Most obviously, there is a lot of government involvement, especially in terms of what government agencies choose to support with grant money. That distorts the directions that research take away from any truly emergent order.
But more interestingly, the weak position of Austrian economics might be because we havent done a good enough job in making a product that people want. Yes, it might be the case that we have the best explanation of how the economy works, but it might also be the case that we havent communicated that very well. Science is a human enterprise; its not about pure truth winning out. Communication matters. It also could be that Austrian ideas arent as good as we
Steve Horwitz email - myslu.stlawu.edu/~shorwitz
Finishing off my response to Hannes:
think! For people who do work like I do, we have to constantly think about how we might make a better product. Finally, like other human endeavors, including markets, academia is subject to fads and fashions. The belief that economics has to look like physics or math is one that make it hard for Austrian ideas to get accepted. Overcoming those fads and fashions is hard, but its part of the process.
That said, Austrian ideas are way more influential than when I started graduate school 20 years ago, so perhaps there are signs of hope. In general, one has to be careful with the analogy of the marketplace of ideas.
Jeffrey Resnick email -
I agree with you in saying that losses are a clear signal to a firm to make changes. However, can this argument be made when a company is unable to make a profit due to outside factors such as a global recession?
Steve Horwitz says:
Great question Jeffrey. Even in a recession, losses should signal to firms that they need to change their behavior. If consumer spending slows down as a result of the recession, that spending likely changes its composition, perhaps as people buy more "necessities" and fewer big screen TVs. If so, firms who sell the latter need to adjust to the new situation.
It's important to remember that it losses don't mean the firm itself has done something wrong. Losses can happen through no action of the firm's, but just because demand for its product changes, for whatever reason - including a recession. If so, then those firms have to adjust. You could have been the most "efficient" maker of horse-drawn buggies but once the automobile came into being, you were going to start making losses and would have to adjust.
T.J. Parsons email -
It seems to me that people continue to buy certain items despite the cost. For instance, cigarettes. Am I correct in saying that people would continue to buy such products despite sudden increases to its price?
Steven Horwitz says:
This is the question of what we call "price-elasticity of demand." That is, how much does people's demand respond to a change in price?
Things like cigarettes, gasoline, and alcohol are described as "inelastically" demanded because people don't react strongly to price. If the price goes up, they cut back their purchases, but just a little. (This, btw, is why all of those are so heavily taxed - adding the tax on top of the prices doesn't lead people to just stop buying the good.)
But even for these goods, people still cut back when the price goes up, just not a lot. The recent increase in gas prices is evidence: in the US, people are driving billions of miles less this year than last and buying less gas. Not a lot less, but some. So even in those cases, people do respond to prices, and the longer period of time you consider, the more "elastic" or stronger their response.
Adam Silver email -
I have an aunt who lives in the United States, and she tells me that healthcare is simply not affordable for many Americans. Why is this the case? How can the price of medical services in the US be lowered?
Steven Horwitz says:
Well, this could be a blog or a book on its own. Let me pick a few things we could do. Healthcare prices in the US are higher than they could be thanks to a variety of government regulations that limit who can perform certain medical services, including the cartel that doctors have over getting a license.
Another problem is that you cannot buy health insurance from a seller in another state. That limits competition and keeps prices higher than they need to be.
A further problem is the connection of employment and insurance, which is also the product of government policies that treat non-monetary benefits differently, making it profitable for firms to offer insurance rather than paying people more. With so many people covered by insurance, individuals don't often know how much things cost and can't make more individualized decisions about how to spend. With a third party paying for health costs, there's little "price awareness."
Basically, the US health care industry is FAR from a free market. That said, it's still pretty good and we don't have the problems with queues that you do in Canada, as the number of folks crossing the border going south (except in Windsor, where they go north ;) ) testifies to.
Hafiz email -
Great discussion so far! We have less than 20 minutes remaining in the chat, so if you have any more questions or would like to respond to one of Professor Horwitz's answers, please do so now.
Hafiz email -
This concludes our discussion. Thanks for your participation in this month's chat. Please join us again in July!
