The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups. -Henry Hazlitt, Economics in One Lesson, 1946

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Monday, September 28, 2009

EIOL How the Price System Works

Economics in One Lesson by Henry Hazlitt

How the Price System Works

The whole argument of this book may be summed up in the statement that in studying the effects of any given economic proposal we must trace not merely the immediate results hut the results in the long run, not merely the primary consequences but the secondary consequences, and not merely the effects on some special group but the effects on everyone. It follows that it is foolish and misleading to concentrate our attention merely on some special point-to examine, for example, merely what happens in one industry without considering what hap- pens in all. But it is precisely from the persistent and lazy habit of thinking only of some particular industry or process in isolation that the major fallacies of economics stem. These fallacies pervade not merely the arguments of the hired spokesmen of special interests, hut the arguments even of some economists who pass as pro- found.

It is on the fallacy of isolation, at bottom, that the " production-for-use-and-not-for-profit" school is based, with its attack on the allegedly vicious "price system." The problem of production, say the adherents of this school, is solved. (This resounding error, as we shall see, is also the starting point of most currency cranks and share-the-wealth charlatans.) The problem of production is solved. The scientists, the efficiency experts, the engineers, the technicians, have solved it. They could turn out almost anything you cared to mention in huge practically unlimited amounts. But, alas, the world is not ruled by the engineers, thinking only of production, but by the business men, thinking only of profit. The business men give their orders to the engineers, instead of vice versa. These business men will turn out any object as long as there is a profit in doing so, but the moment there is no longer a profit in making that article, the wicked business men will stop making it, though many people's wants are unsatisfied, and the world is crying for more goods.

There are so many fallacies in this view that they can- not all he disentangled at once. But the central error, as we have hinted, comes from looking at only one industry, or even at several industries in turn, as if each of them existed in isolation. Each of them in fact exists in relation to all the others, and every important decision made in it is affected by and affects the decisions made in all the others.

We can understand this better if we understand the basic problem that business collectively has to solve. To simplify this as much as possible, let us consider the problem that confronts a Robinson Crusoe on his desert island. His wants at first seem endless. He is soaked with rain; he shivers from cold; he suffers from hunger and thirst. He needs everything: drinking water, food, a roof over his head, protection from animals, a fire, a soft place to lie down. It is impossible for him to satisfy all these needs at once; he has not the time, energy or resources. He must attend immediately to the most pressing need. He suffers most, say, from thirst. He hollows out a place in the sand to collect rain water, or builds some crude receptacle. When he has provided for only a small water supply, however, be must turn to finding food before he tries to improve this. He can try to fish; hut to do this he needs either a hook and line, or a net, and he must set to work on these. But everything he does delay or pre- vents him from doing something else only a little less urgent. He is faced constantly by the problem of alternative applications of his time and labor.

A Swiss Family Robinson, perhaps, finds this problem a little easier to solve. It has more mouths to feed, but it also has more hands to work for them. It can practice division and specialization of labor. The father hunts; the mother prepares the food; the children collect firewood. But even the family cannot afford to have one member of it doing endlessly the same thing, regard- less of the relative urgency of the common need he sup- plies and the urgency of other needs still unfilled. When the children have gathered a certain pile of firewood, they cannot be used simply to increase the pile. It is soon time for one of them to he sent. Say, for more water. The family too has the constant problem of choosing among alternative applications of labor, and, if it is lucky enough to have acquired guns, fishing tackle, a boat, axes, saws and so on, of choosing among alternative applications of labor and capital. It would be considered unspeakably silly for the wood-gathering member of the family to complain that they could gather more firewood if his brother helped him all day, instead of getting the fish that were needed for the family dinner. It is recognized clearly in the case of an isolated individual or family that one occupation can expand only a t the expense of all other occupations.

Elementary illustrations like this are sometimes ridiculed as "Crusoe economics." Unfortunately, they are ridiculed most by those who most need them, who fail to understand the particular principle illustrated even in this simple form, or who lose track of that principle completely when they come to examine the bewildering complications of a great modern economic society.

Let us now turn to such a society. How is the problem of alternative applications of labor and capital, to meet thousands of different needs and wants of different urgencies, solved in such a society? I t is solved precisely through the price system. It is solved through the constantly changing interrelationships of costs of production, prices and profits.

Prices are fixed through the relationship of supply and demand, and in turn affect supply and demand. When people want more of an article, they offer more for it. The price goes up. This increases the profits of those who make the article. Because it is now more profitable to make that article than others, the people already in the business expand their production of it, and more people are attracted to the business. This increased sup- ply then reduces the price and reduces the profit margin, until the profit margin on that article once more falls to the general level of profits (relative risks considered) in other industries. Or the demand for that article may fall; or the supply of it may he increased to such a point that its price drops to a level where there is less profit in making it than in making other articles; or perhaps there is an actual loss in making it. In this case the "marginal" producers, that is, the producers who are least efficient, or whose costs of production are highest, will be driven out of business altogether. The product will now be made only by the more efficient producers who operate on lower costs. The supply of that commodity will also drop, or will at least cease to expand.

This process is the origin of the belief that prices are determined by costs of production. The doctrine, stated in this form, is not true. Prices are determined by sup- ply and demand, and demand is determined by how in- tensely people want a commodity and what they have to offer in exchange for it. It is true that supply is in part determined by costs of production. What a commodity has cost to produce in the past cannot determine its value. That will depend on the present relationship of supply and demand. But the expectations of business men concerning what a commodity will cost to produce in the future, and what its future price will he, will determine how much of it will be made. This will affect future supply. There is therefore a constant tendency for the price of a commodity and its marginal cost of production to equal each other, but not because that marginal cost of production directly determines the price.

The private enterprise system, then, might he compared to thousands of machines, each regulated by its own quasi-automatic governor, yet with these machines and their governors all interconnected and influencing each other, so that they act in effect like one great machine. Most of us must have noticed the automatic "governor" on a steam engine. It usually consists of two balls or weights which work by centrifugal force. As the speed of the engine increases, these halls fly away from the rod to which they are attached and so automatically narrow or close off a throttle valve which regulates the in- take of steam and thus slows down the engine. If the engine goes too slowly, on the other hand, the balls drop, widen the throttle valve, and increase the engine's speed. Thus every departure from the desired speed it- self sets in motion the forces that tend to correct that departure.

It is precisely in this way that the relative supply of thousands of different commodities is regulated under the system of competitive private enterprise. When people want more of a commodity, their competitive bidding raises its price. This increases the profits of the producers who make that product. This stimulates them to increase their production. It leads others to stop making some of the products they previously made, and turn to making the product that offers them the better return. But this increases the supply of that commodity at the same time that it reduces the supply of some other commodities. The price of that product therefore falls in relation to the price of other products. and the stimulus to the relative increase in its production disappears.

In the same way, if the demand falls off for some product, its price and the profit in making it go lower, and its production declines.

It is this last development that scandalizes those who do not understand the "price system" they denounce. They accuse it of creating scarcity. Why, they ask indignantly, should manufacturers cut off the production of shoes at the point where it becomes unprofitable to produce any more? Why should they be guided merely by their own profits? Why should they be guided by the market? Why do they not produce shoes to the "full capacity of modern technical processes"? The price sys- tem and private enterprise, conclude the "production-for- use" philosophers, are merely a form of "scarcity economics."

These questions and conclusions stem from the fallacy of looking at one industry in isolation, of looking at the tree and ignoring the forest. Up to a certain point it is necessary to produce shoes. But it is also necessary to produce coats, shirts, trousers, homes, 'plows, shovels factories, bridges, milk and bread. It would he idiotic to go on piling up mountains of surplus shoes, simply because we could do it, while hundreds of more urgent needs went unfilled.

Now in an economy in equilibrium, a given industry can expand only at the expense of other industries. For at any moment the factors of production are limited. One industry can he expanded only by diverting to it labor, land and capital that would otherwise he employed in other industries. And when a given industry shrinks, or stops expanding its output, it does not necessarily mean that there has been any net decline in aggregate production. The shrinkage at that point may have merely re- leased labor and capital to permit the expansion of other industries. It is erroneous to conclude, therefore, that a shrinkage of production in one line necessarily means a shrinkage in total production.

Everything, in short, is produced at the expense of fore- going something else. Costs of production themselves, in fact, might he defined as the things that are given up (the leisure and pleasures, the raw materials with alternative potential uses) in order to create the thing that is made. It follows that it is just as essential for the health of a dynamic economy that dying industries should he allowed to die as that growing industries should he allowed to grow. For the dying industries absorb labor and capital that should he released for the growing industries. It is only the much vilified price system that solves the enormously complicated problem of deciding precisely how much of tens of thousands of different commodities and services should he produced in relation to each other. These otherwise bewildering equations are solved quasi- automatically by the system of prices, profits and costs. They are solved by this system incomparably better than any group of bureaucrats could solve them. For they are solved by a system under which each consumer makes his own demand and casts a fresh vote, or a dozen fresh votes, every day; whereas bureaucrats would try to solve it by having made for the consumers, not what the consumers themselves wanted, but what the bureaucrats decided was good for them.

Yet though the bureaucrats do not understand the quasi-automatic system of the market, they are always disturbed by it. They are always trying to improve it or correct it, usually in the interests of some wailing pres- sure group. What some of the results of their intervention is, we shall examine in succeeding chapters.