Where Prices Come From: Menger Explains

Prices Reflect Exchange Ratios

Prices, as Menger points out in his Grundsätze, emerge as an accidental phenomenon. They are not the essence of economic activity. Prices are fortuitous insofar as they are the unintended result of an economic exchange that has subjective evaluations as its basis. Prices do not determine the exchange, but rather the individual exchange valuations determine the limits within which a negotiated price in terms of exchange ratios will be agreed upon. It is not prices that move the economy, but the endeavor of people to satisfy their needs as fully as possible. Out of this motive, people exchange, and prices appear as an accompanying unintended side effect (p. 172).

Prices show up on the surface as the visible portion of economic activities. Because prices are a constant companion of economic life and are observable as seemingly objective phenomena, many economists have assumed that they are also the most important portion of the economy and therefore of economics. Prices appear in the form of numerical quantities and thus it is an understandable error to take prices as the fundamental aspect of the economy. This mistake led to the blunder of regarding the quantities of goods that appear in an exchange as equivalents (p. 173).

Taking as their starting point of reasoning that trade is the exchange of equivalents, the classical economists put economics on an erroneous path and inadvertently laid the groundwork for the Marxian exploitation theory. These scholars presumed that labor is the factor with which the equivalence between the goods in exchange could be measured. As Menger explains, it is not equivalents that are exchanged in a trade, but rather inverse proportions of estimation are the underlying reason of an exchange. People exchange goods because it makes them better off. The inverse valuation of the goods between the trading partners determines the exchange ratio, and the resulting price reflects this exchange ratio (p. 176).

The essence of an exchange of goods and therefore of the prices that emerge from it is that the specific good that is at the disposal of an economic agent is of less value to him compared to a another good that is at the disposal of another person. For each person engaged in the exchange, the valuation of a good in terms of the other good under consideration has a limit. Prices reflect the specific exchange ratio of a deal that determines how many units of good X are the maximum one is willing to exchange for good Y and vice versa. The price will be settled between the limits given by these estimates of the trading partners (p. 177).

Principle of Price Formation

Menger begins his analysis of price formation with the example of an indivisible monopoly good. A monopolist offers one unit of a good (one horse) to eight potential buyers in the market (farmers that offer in descending order a specific number of units of grain in exchange). Menger illustrates his consideration with a matrix (table 1).

Table 1: Price Formation Matrix

Source: Menger, Grundsätze der Volkswirthschaftslehre, vol. 1 of The Collected Works of Carl Menger (Vienna: Hölder-Pichler-Tempsky, 1934), p. 187.

As illustrated in the table, the potential buyers have different value rankings for one specific good (columns) but also depending on the amount of units of this good (lines). The matrix shows eight potential buyers (B1 to B8) and their individual willingness to pay for the offered good in terms of units of grain. It is easy to see that the good goes to the buyer with the highest preference. When this monopolist offers more units of the good, the situation does not change fundamentally. The principle holds that the good goes to the highest bidder.

As shown in table 1, B1 has the highest preference for the good that is being offered on the market and he is willing to offer eighty units of grain in exchange, while B8 has the lowest preference, willing to offer only ten units of grain in exchange for the one horse that is on offer. The horizontal axis (I to VIII) represents the number of units being offered, and the various lines show that each potential buyer has a decreasing willingness to offer grain in exchange with an increasing number of horses on offer (I to VIII). Reflecting decreasing marginal utility, B1, for example, is willing to give eighty units of grain for one horse, but he would lower his willingness to exchange to ten units of grain for each horse if he were considering the acquisition of eight horses.

In the matrix, the individual farmers (B1 to B8) rank their preferences in terms of units of grain, and it is obvious that that the farmer who offers the highest amount of grain for only one horse will get it. In this case, the price in terms of grain would lie below the limit of eighty and above seventy and settle at a definite exchange ratio within this range according to the outcome of the negotiation between the trading partners.

The situation does not change in principle when the offered quantity of the good increases. In this case, too, the highest bidders will become the buyers. Should three units be offered, the price will be between sixty and seventy units of grain. Within these limits, B1 can improve his economic situation by buying two horses, while B2 will buy one horse. If six units are offered instead of three, one can similarly show that B1 would buy three, B2 would buy two, and B3 would buy one horse. In this case, the price of each unit would fall to between fifty and sixty units of grain (p. 187–90).

The same principle holds when competitors enter the market and different suppliers offer the same kind of good. In the case of two competitors, of whom supplier A1 offers one horse and supplier A3 two horses, a total of three units would be offered. Then, farmer B1 would buy two units and farmer B2 one unit, and the exchange ratio would settle between sixty and seventy units of grain. If A1 and A2 brought six horses to market, B1 would acquire three, B2 two, and B3 one unit on offer. In this case, the price would fall to between fifty and sixty units of grain (p. 204).

Monopoly and Competition

Menger shows by these examples that competition grows out of the monopoly. Increasing competition is the feature of economic development, as the number and variety of the supply of goods expands. The principle of price formation, however, remains the same. The quantity of goods offered for sale gets into the hands of those potential buyers who offer the most in exchange quantities irrespective of whether it is a monopoly or a competition. The goods get into the hands of those bidders who have the highest degrees of preference for the good.

Markets work according to the principle that the greater the quantity of supply, the smaller will be the number of excluded people on the demand side. Competition has the effect of increasing the satisfaction of the market participants, because less people are excluded the more units of supply enter the market. In all cases, the price formation takes place between the limits set by the respective quantities that the most interested potential buyer and the least interested is willing to give in exchange.

While the principle of price formation in a monopoly and with competition, the monopolist can increase his profit by reducing the offered amount. Menger (p. 208) gives the examples of a monopolist who has a thousand units of a monopoly good at his disposal. He could sell all of his units at price of six payment units for each, while selling only eight hundred would bring the price up to nine payment units. The profit-maximizing monopolist would choose the lower quantity at the higher price and simply do away with the excess goods.

When competitors appear, this privilege vanishes. While the monopolist makes large profits per unit with few customers, competition fetches low profits per unit but gains many customers. When more competitors enter the market, the overall quantity of goods on offer rises and the individual competitors can no longer increase their profit by limiting supply. In a competitive market, the suppliers cannot limit supply, and they also lose their ability of price segmentation for different groups of buyers. 

Conclusion

The aim of improving personal well-being lies at the heart of the economic activities and is the reason for economic exchange. An exchange of equivalents would not contribute to this goal and therefore would make no sense. Prices are not the essence of the economy but are a symptom of balancing the manifold human economic activities. Because people strive to improve their condition, they exchange goods, and in this sense, the prices are an unintended consequence of the human endeavor for betterment.

The principle of price formation is the same for monopoly and for competition. Competition means that the number of goods on offer will increase, and competition thereby eliminates the conditions for obtaining the extra profit of the monopolist. The appearance of more competitors is the mark of economic development.

This is the fifth part the series on Menger’s Principles of Economics which appeared 150 years ago, in 1871. The earlier parts of the series presented the definition of goods, Menger’s notion of the economy and the concepts of value and exchange.