1.2.2 Determination of prices exclusively by the supply side

For the past 150 years, there has been a debate on whether the price is determined by the supply or by the demand. There are two extreme positions. At one side we have David Ricardo, the price is determined exclusively by the costs, or on the supply side. At the other side, we have Carl Menger, the price is exclusively determined by the demand.

We will discuss this topic several times throughout this manual, but actually, it is kind of a phantom debate.

The answer is actually very simple and was already given by Alfred Marshall. We will briefly summarise what Alfred Marshall said about the topic and discuss the topic more in detail later. In the short run, it is the demand side that determines the prices, in the long run, the supply side. In the short run, there is no adaptation of the amount of goods produced to the demand, it is, therefore, obvious that a change in demand, due to the preferences of the people or change in the underlying economic structure leads to a new price, because an adoption through a change in the amount is not possible. To illustrate that with an example: On a fish market, there is a certain amount of fish that must be sold at the end of the day. Therefore, the sellers of fish will make the price that allows them to sell all their fishes. It can happen that for some sellers this price not even covers their costs. Therefore, they will stop fishing, and the price will rise again.

This is valid as well for any kind of commodity that can't be produced, a picture of Picasso for instance, raw materials whose amount is fixed by nature and so on. However, there are only a few commodities whose amount is fixed. Most of commodities are produced, and the amount can increase or decrease in the long run.

Production needs some time to adapt itself. If for instance there is a sudden increase in the demand for cars, the prices will raise. However, these high prices will induce other producers to produce this product. The amount will increase, and prices will fall.

We will see in the chapter about Vilfredo Pareto and Léon Walras that all the authors who argue in favour of the theory that the demand determines the prices argue with a market where products are only changed, but not produced. The analysis of this kind of market is irrelevant because this kind of market is not typical for a market economy.

Actually, the discussion is a little bit more complex regarding David Ricardo because the price of a commodity is actually defined by the amount of labour needed to produce it; and the waged paid to workmen will never exceed the subsistence level. In other words, even if the prices fall, the workmen wouldn't have more, because the wages will fall as well.

We have already said, see natural price / market price, that Adam Smith is contradictory. His concept of the work accumulated in an item doesn't fit with the concept of the natural prices/market prices. However, his version of the accumulated labour is only the light version of this concept.

If we compare the version of Adam Smith with the version of David Ricardo, we see clearly that the concept of the accumulated labour was radicalised.

EVERY MAN IS RICH OR POOR according to the degree in which he can afford to enjoy the necessaries, conveniencies, and amusements of human life. But after the division of labour has once thoroughly taken place, it is but a very small part of these with which a man’s own labour can supply him. The far greater part of them he must derive from the labour of other people, and he must be rich or poor according to the quantity of that labour which he can command, or which he can afford to purchase. The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labour which it enables him to purchase or command. Labour therefore, is the real measure of the exchangeable value of all commodities. The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it. What every thing is really worth to the man who has acquired it and who wants to dispose of it, or exchange it for something else, is the toil and trouble which it can save to himself, and which it can impose upon other people. What is bought with money, or with goods, is purchased by labour, as much as what we acquire by the toil of our own body. That money, or those goods, indeed, save us this toil. They contain the value of a certain quantity of labour, which we exchange for what is supposed at the time to contain the value of an equal quantity. Labour was the first price, the original purchase money that was paid for all things. It was not by gold or by silver, but by labour, that all the wealth of the world was originally purchased; and its value, to those who possess it, and who want to exchange it for some new productions, is precisely equal to the quantity of ’ labour which it can enable them to purchase or command.

Adam Smith, Wealth of Nations, Book I, Chapter V

This concept is radicalised by David Ricardo. David Ricardo is a little bit difficult to understand because any sentence is only understandble if one has his basic assumpitons in mind.

If the shoes and clothing of the labourer, could, by improvements in machinery, be produced by one fourth of the labour now necessary to their production, they would probably fall 75 per cent; but so far is it from being true, that the labourer would thereby be enabled permanently to consume four coats, or four pair of shoes, instead of one, that it is probable his wages would in no long time be adjusted by the effects of competition, and the stimulus to population, to the new value of the necessaries on which they were expended. If these improvements extended to all the objects of the labourer's consumption, we should find him probably at the end of a very few years, in possession of only a small, if any, addition to his enjoyments, although the exchangeable value of those commodities, compared with any other commodity, in the manufacture of which no such improvement were made, had sustained a very considerable reduction; and though they were the produce of a very considerably diminished quantity of labour.

David Ricardo, On the Principles of Political Economy and Taxation, Chapter I, On value

The difference between Adam Smith and David Ricardo is that the former didn't precisely give the value of labour in absolute terms while David Ricardo defines it: The value, or what is to be paid for work, is the subsistence level. However, this leads to another contradiction. David Ricardo and Karl Marx make a lot of effort to prove that a difficult labour is nothing else than a multiplied simple work. The problem is, there is no need for precisions of this kind under their, obviously wrong, assumptions. If all the labour, whatever the quality, is remunerated with a wage equivalent to the subsistence level, any kind of work is actually equal.

In the example of David Ricardo, productivity has been improved by 3/4 with the result that the same amount can be produced with 3/4 of labour less.

(It is interesting that this technological progress happened without any costs. This is actually plausible in reality, because when one machine is substituted by another one, in general, the new machine is more efficient than the old one without an increase in prices. That what happens since 30 years with computers. However in the world of David Ricardo, this is a strange kind of assumption because this technological progress comes out of "nothing". If it is just know how it is to assume that the progress is at the head of the workmen, and the capitalist must pay for it.)

This will have in the long run two effects. The first effect is that capital will flow into this sector which is no more profitable, and the prices decrease again. At the same time, other companies will copy the new technology with the same effect on prices.

For some time, it is possible that the workers earn more in real terms. They get the same wage, but prices are lower. In the long run, this is the crude logic of David Ricardo, the supply of workforce will increase, because every time the wage is above subsistence level, the population increases. The final effect is that technological progress will not have any impact on the real wage. This theory has one big problem. It doesn't fit at all with reality. In the last 150 years, real wages have increased dramatically

Under this very strange assumption, it is true that the demand doesn't play any role because the demand grows with the supply. Any increase in the supply will lead to a rise in the demand.

However, even under these strange assumptions, his conclusions are not true because even, in this case, it is the demand that decides what is produced. A change in the underlying economic structure, in his example technological progress, leads to a reallocation of capital. However, this happens only, if the goods produced in a more efficient way can be sold if there is a demand. His theory might be true for the total output, but not for the structure of this output.

Therefore, this statement is wrong. Totally wrong!

It is the cost of production which must ultimately regulate the price of commodities, and not, as has been often said, the proportion between the supply and demand: the proportion between supply and demand may, indeed,for a time, affect the market value of a commodity, until it is supplied in greater or less abundance, according as the demand may have increased or diminished; but this effect will be only of temporary duration.

David Ricardo, On the Principles of Political Economy and Taxation, On the Influence of Demand and Supply on Prices

Formulated this way, it is obviously wrong even under his strange assumptions. If technological progress would make the production of watches cheaper, the amount of produced watches wouldn't increase because, under his strange assumption, workmen get only a wage at subsistence level and can't buy watches. There will be no increase in the demand and, therefore, no increase in the supply. Nobody will produce more watches if he can't sell them.

We can put aside all his strange assumptions, and then we get a correct statement: In the long run, the costs determine the market price. A change in the underlying economic structures will lead to a reallocation of resources until the products are produced in the most efficient way possible given a certain technology, a certain size of the market, a certain intensity of competition, a certain qualification of the people, a certain organisational structure. However, in the real world, this optimum will never be achieved because before it is achieved, the underlying economic structures will change again.

With the expression "for a time" he acknowledged himself that the demand determines in the short run the price until the adoption to the new circumstances is finished. That the prices decrease afterwards to their initial level is completely another story.

Changes can be induced by the supply side, in his example technological progress, or by a change in the preferences. If the workmen, for instance, buy more potatoes than bread because they are cheaper, more potatoes will be produced and less corn for bread.

His example with the hats proves the opposite than what he wants to prove.

Diminish the cost of production of hats, and their price will ultimately fall to their new natural price, although the demand should be doubled, trebled, or quadrupled. Diminish the cost of subsistence of men, by diminishing the natural price of the food and clothing, by which life is sustained, and wages will ultimately fall, notwithstanding that the demand for labourers may very greatly increase. The opinion that the price of commodities depends solely on the proportion of supply to demand, or demand to supply, has become almost an axiom in political economy, and has been the source of much error in that science.

aus: David Ricardo, On the Principles of Political Economy and Taxation, On the Influence of Demand and Supply on Prices

It is true that the price of hats will fall if the costs of production diminish. (Given enough competition.) However, it is equally true, that the price of hats will raise, if the demand doubled, trebled or quadrupled. It is hard to see why the seller of hats will not raise their prices if people are willing to pay more. If the amount of hats is fixed, only those who are willing to pay higher prices than others will get a hat. That an increase in prices will, in the long run, lead to a rise in production of hats and that therefore the prices will fall again is another story.

The narrow version of the thesis that supply exclusively determines the price, the value of a commodity is determined by the amount of labour materialised in this commodity, is obviously wrong. That is the fundamental error of David Ricardo and Karl Marx.

The broader version, in the long run, the supply depends on the costs, the thesis is correct. It is obvious that people can buy more if the prices, in relationship to their income, fall.

If we abstract from the demand side, there is no steering mechanism. We have to see that this affects not only the demand side in the narrow sense, the preference of the people and what they buy, but the production structure as well. Commodities can be produced in a lot of different ways and the resources used to produce them depend on their costs in relationship to the outcome. If for instance, in the future electric energy is disposable in abundance, it can happen that aluminium competes with steel in the production of cars.

Whether the resources can be optimally allocated without taking into account, the demand side is not a theoretical question, but a very practical one. In a country like the defunct East-Germany, it could happen that bread was cheaper than corn, with the result that swines were fed with bread instead of corn. If we abstract from the demand, prices don't contain information and nobody knows what is to be produced and how it is to be produced.

The fact that David Ricardo didn't see the problem is because he was not aware of the basic economic problem a market economy resolves best. What is to be produced, how it is to be produced and for whom it is to be produced.

He assumes that the capital, without the interference of an entrepreneur, flows automatically in the most profitable use. Allocation of resources is not considered as a problem. This misconception will have tragic consequences in his follower: Karl Marx.

David Ricardo had no clue, similar to his academic colleagues nowadays, of the complexity of markets. In his mind and in the mind of Karl Marx market economies are so simple, that there is no decision-making necessary. Capital and labour flows alone to the most profitable use.

Is it worth to think about the theories of David Ricardo? Yes, it is because we find similar errors in any textbook about economics and on a daily basis in the newspapers.

The case of Adam Smith is different. In the work of Adam Smith, we find as well the misleading concept of labour materialised in commodities, but he didn't define the absolute value of this labour as David Ricardo did. The subsistence level is an absolute value.

At the other side, the concept of natural price/market price describes quite well a central pillar of market economies, although this concept doesn't fit with the labour materialised in commodities. If the demand for a commodity rises, the price of the specific labour needed to produce this commodity will increase as well. People will qualify for these jobs until the price falls again to the natural price.

There is no doubt that competition will lead to a fall in prices in the hat industry if for any reason they can be produced at lower costs. However, that doesn't mean that the demand for hats increases, and if the demand for hats doesn't increase, some producers, the less efficient or the ones who need more time to adapt themselves to the change in the production structure, will go bankrupt. If the amount of sold hats don't increase, some people will save money they spent on other things, where demand and production will increase.

By the way, David Ricardo assumes that more people will buy hats if the prices for hats fall. A general fall in prices will allow people to have more children. Actually, it is hard to see why people can have more children it the prices of hats fall and people buy more hats

The misleading idea that resources flows automatically and without effort to the most profitable use impeded him to see that his concept of the rent on land can be applied to any product. If the underlying economic structures changes, some producers will adapt themselves faster than others to these changes, they will produce at lower costs, but there will be only one market price. For at least some time they will get a rent or a producer surplus, how Alfred Marshall called it.

[We will see later on when discussing Alfred Marshall that the terms consumer surplus and producer surplus make only sense if we consider a certain period. The producer surplus will vanish if all producers have the same cost structures. That will happen after a while, otherwise, the less efficient producers will go bankrupt.]

He had the same problem than his colleagues has today. If labour is a homogeneous productive factor, know how is irrelevant. If the know-how is irrelevant, the productive structure will be the same everywhere. If the productive structure is the same everywhere, there are no producer surplus.

For David Ricardo, only rent is only possible for land because land can't move and nature determines its quality. Differences in the land can therefore never vanish. Concerning capital and labour, rents do not even vanish in the long run, because they are considered homogeneous factors, they not even exist. We will return to the topic in the chapter equilibrium in the short run and in the long run.

[The same problem we have with the total equilibrium. The concept of natural price/market price and the theory of Léon Walras describe perfect equilibriums. In the perfect equilibrium, a reallocation of resources won't happen because all resources yield the same profit in any kind of use. The perfect equilibrium is, therefore, a state that can be achieved only in the (very) long run. (Actually never, because before it is achieved, the underlying economic structures will change once again.). The partial equilibrium of Alfred Marshall with the producer surplus is a short run perspective.]

In the world of David Ricardo and later in the world of Karl Marx there is no risk. The risk is always due to a lack of information, but in the world of these two guys, the productive factors move alone, without any interference of a human being, immediately and without any effort. It is obvious that under these conditions, an economy can be planned by a central planning commission. (Actually, there is not even a lot to plan.)

The problem of how to allocate the resources is so trivial, that Karl Marx did not even mention the problem in his book of more than 3,000 pages. In practise, it was a very serious problem.

However, we will see later on that most of what we find nowadays in textbooks about microeconomics has the same problem. The basic assumptions of modern microeconomics, perfect information and homogeneous products abstract from the problem that is resolved best by a market economy. If the problem is assumed to be inexistent, we don't need a market economy.

In case of perfect information, there is no need for entrepreneurs who reflect about alternatives, take risks or try to gather the information needed etc. Perfect information means that a central planning committee can plan the economy. No need to rely on the somehow chaotic market mechanism if everything can be planned. The problem is that the real world is not that simple

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1.2.2 Determination of prices exclusively by the supply side

David Ricardo: The beginning of the farewell from the market economy