Principles of Economics by Karl Menger - HTML preview

THE THEORY OF PRICE

owever much prices, or in other words, the quantities of goods actually exchanged, may impress themselves on our senses, and on this account form the usual

object of scientific investigation, they are by no means the most fundamental feature of the economic phenomenon of exchange. This central feature lies rather in the better provision two persons can make for the satisfaction of their needs by means of trade. Economizing individuals strive to better their economic positions as much as possible. To this end they engage in economic activity in general. And to this end also, whenever it can be attained by means of trade, they exchange goods. Prices are only incidental manifestations of these activities, symptoms of an economic equilibrium between the economies of individuals.

If the locks between two still bodies of water at different levels are opened, the surface will become ruffled with waves that will gradually subside until the water is still once more. The waves are only symptoms of the operation of the forces we call gravity and friction. The prices of goods, which are symptoms of an economic equilibrium in the distribution of possessions between the economies of individuals, resemble these waves. The force that drives them to the surface is the ultimate and general cause of all economic activity, the endeavor of men to satisfy their needs as completely as possible, to better their economic positions. But since prices are the only phenomena of the process that are directly perceptible, since their magnitudes can be measured exactly, and since daily living brings them unceasingly before our eyes, it was easy to commit the error of regarding the magnitude of price as the essential feature of an exchange, and as a result of this mistake, to commit the further error of regarding the quantities of goods in an exchange as equivalents. The result was incalculable damage to our science since writers in the field of price theory lost themselves in attempts to solve the problem of discovering the causes of an alleged equality between two quantities of goods.¹ Some found the cause in equal quantities of labor expended on the goods. Others found it in equal costs of production. And a dispute even arose as to whether the goods are given for each other because they are equivalents, or whether they are equivalents because they are exchanged. But such an equality of the values of two quantities of goods (an equality in the objective sense) nowhere has any real existence.

The error on which these theories were based becomes immediately apparent as soon as we free ourselves from the one-sidedness that previously prevailed in the observation of price phenomena. The only quantities of goods that can be called equivalents (in the objective sense of the term) are quantities which, at a given point in time, can be exchanged at will— that is, in such a way that if one of two quantities of goods is offered, the other can be acquired for it, and vice versa. But equivalents of this sort are nowhere present in human economic life. If goods were equivalents in this sense, there would be no reason, market conditions remaining unchanged, why every exchange should not be capable of reversal. Suppose A had exchanged his house for B’s farm or for a sum of 20,000 Thalers. If these goods had become equivalents in the objective sense of the term as a result of the transaction, or if they had already been equivalents before it took place, there is no reason why the two participants should not be willing to reverse the trade immediately. But experience tells us that in a case of this kind neither of the two would give his consent to such an arrangement.

The same observation can also be made under the most highly developed conditions of trade, and even with respect to the most saleable commodities. Let anyone buy grain on a grain exchange or securities on a stock exchange and try to sell them again before a change in market conditions occurs, or let him try to sell and buy separate units of the same commodity at the same time, and he will easily be convinced that the difference between supply prices and demand prices is no mere accident but a general feature of social economy.

Thus commodities that can be exchanged against each other in certain definite quantities (a sum of money and a quantity of some other economic good, for instance), that can be exchanged for each other at will by a sale or a purchase, in short, commodities that are equivalents in the objective sense of the term, do not exist—even on given markets and at a given point in time. And what is more important, deeper understanding of the causes that lead to the exchange of goods and to human trade in general teaches us that equivalents of this sort are utterly impossible in the very nature of the case and cannot exist in reality at all.

A correct theory of prices cannot, therefore, have the task of explaining an alleged “equality of value” between two quantities of goods when such an equality does not, in truth, exist anywhere. In this setting, the subjective character of value and the nature of exchange would be completely misunderstood. A correct theory of price must instead be directed to showing how economizing men, in their endeavor to satisfy their needs as fully as possible, are led to give goods (that is, definite quantities of goods) for other goods. In this investigation, I shall proceed in accordance with the methods followed generally in this work, beginning with the simplest phenomena and gradually passing on to the more complex phenomena of price formation.

In the previous chapter, we saw that the possibility of an economic exchange of goods is dependent on an economizing individual having command of goods that have a smaller value to him than other goods at the command of another economizing individual who values the two goods in reverse fashion. The mere statement of this condition, however, strongly implies the existence of limits within which price formation must, in any given instance, take place.

By way of illustration, we will suppose that 100 units of A’s grain have the same value to him as 40 units of wine. It is clear from the beginning that A will, under no circumstances, be prepared to give more than 100 units of grain for 40 units of wine in an exchange, since if he were to do so, his needs would be less well provided for after the exchange than before. He will agree to an exchange only if it enables him to make better provision for his needs than would be possible without the exchange. He will be willing to exchange his grain for wine only if he has to give less than 100 units of grain for 40 units of wine. Thus whatever the price of 40 units of wine may eventually be in an exchange of A’s grain for the wine of some other economizing individual, this much is certain, that it cannot, owing to the economic position of A, reach 100 units of grain.

If A can find no other economizing individual to whom a smaller quantity than 100 units of grain has a greater importance than 40 units of wine, he will never be in a position to exchange his grain for wine. In this event, the foundations for an economic exchange of the two goods would not be present so far as A is concerned. But if A does find a second economizing individual, B, to whom only 80 units of grain, for example, have a value equal to 40 units of wine, the prerequisites for an economic exchange between A and B are certainly present (provided the two men recognize the situation and no barriers stand in the way of execution of the exchange), and at the same time a second limit is set to price formation. If it follows from the economic situation of A that the price of 40 units of wine must be below 100 units of grain (since he would otherwise derive no economic gain from the transaction), it follows from the economic situation of B that a greater quantity than 80 units of grain must be offered for his 40 units of wine. Hence, whatever the price that is finally established for 40 units of wine in an economic exchange between A and B, this much is certain, that it must be formed between the limits of 80 and 100 units of grain, above 80 and below 100 units.

It is easily seen that A could provide better for the satisfaction of his needs even if he should have to give 99 units of grain for the 40 units of wine, and that B would be acting economically on the other side if he were to accept as little as 81 units of grain in exchange for his 40 units of wine. But since there is an opportunity for both economizing individuals to exploit a much larger economic advantage, each of them will direct his efforts to turning as large a share as possible of the economic gain to himself. The result is the phenomenon which, in ordinary life, we call bargaining. Each of the two bargainers will attempt to acquire as large a portion as possible of the economic gain that can be derived from the exploitation of the exchange opportunity, and even if he were to try to obtain but a fair share of the gain, he will be inclined to demand higher prices the less he knows of the economic condition of the other bargainer and the less he knows the extreme limit to which the other is prepared to go.

What will be the numerical result of this price duel? It is certain, as we saw, that the price of 40 units of wine will be higher than 80 units and lower than 100 units of grain. But it appears equally certain to me that the outcome of the exchange will prove sometimes more favorable to one and sometimes more favorable to the other of the two bargainers, depending upon their various individualities and upon their greater or smaller knowledge of business life and, in each case, of the situation of the other bargainer. In the formulation of general principles, however, there is no reason for assuming that one or the other of the two bargainers will have an overwhelming economic talent, or that other circumstances will operate more in the favor of one than the other. Under the assumption of economically equally capable individuals and equality of other circumstances, therefore, I venture to state, as a general rule, that the efforts of the two bargainers to obtain the maximum possible gain will be mutually paralyzing, and that the price will therefore be equally far from the two extremes between which it can be established.
In our case, the price for a quantity of wine of 40 units upon which the two bargainers will finally agree will lie within the limits of 80 and 100 units of grain, with the further restriction that it must be higher than 80 and lower than 100 units. As concerns its position between these limits, if the two bargainers are otherwise equally situated, it will be equal to 90 units of grain. But if this equality in their situations does not prevail, an exchange at another price between the two limits would not be economically impossible.
What has been said of price formation in this case holds in a similar fashion for every other. Wherever the foundations for an economic exchange of two goods between two economizing individuals exist, the nature of the relationship itself sets definite limits within which price formation must take place if the exchange is to have economic character at all. These limits are given by the different quantities of the goods that are equivalents for each bargainer (equivalents in a subjective sense). (In the example just considered, for instance, 100 units of grain are the equivalent of 40 units of wine for A, and 80 units of grain are the equivalent of the same quantity of wine for B.) Within these limits, the price tends to be determined at the average of the two equivalents (and hence, in our example, at 90 units of grain, the average of 80 and 100 units).
The quantities of goods that are given for each other in an economic exchange are therefore precisely determined by the economic situation obtaining in each case. It is true that human caprice has some degree of influence on the result since varying quantities of goods may be exchanged, within definite limits, without a resultant loss of the economic character of the exchange operation. But it is equally certain that the opposing efforts of the bargainers to derive the greatest possible gain from the transaction will balance out in most cases, and that prices will therefore have a tendency to settle at the average of the extreme possible limits. If other factors, founded on the personalities of the two economizing individuals or on other external conditions affecting the transaction, enter the picture, prices can deviate from this natural middle position between the limits explained earlier without causing the exchange operations to lose economic character. But these deviations are not economic in nature, being founded on personal characteristics or on special external causes that are not of an economic character.

In the previous section, I directed attention to the fact that price formation and the distribution of goods conform to definite laws by first considering the simplest possible case in which an exchange of goods takes place between two economizing individuals who are not influenced by the economic activity of other persons. This case, which could be termed isolated exchange, is the most common form of human trade in the early stages of the development of civilization. Its importance has survived to later times in sparsely populated backward regions and it is not completely absent even under advanced economic conditions, since it can be observed in highly developed economies wherever an exchange of goods that have value only to two economizing individuals takes place, or where other special circumstances economically isolate two persons.

But with the progress of civilization, instances in which the foundations for an economic exchange of goods are present merely for two economizing individuals occur less frequently. If, for example, A owns a horse that has a value to him equal to the value of 10 bushels of grain if he were to acquire them, he would be better able to provide for the satisfaction of his needs even if he were to exchange the animal for but 11 bushels of grain. To farmer B, on the other hand, who has a large stock of grain but lacks horses, a horse if acquired would be an equivalent for 20 bushels of his grain, and he would be better able to provide for the satisfaction of his needs even if he were to give 19 bushels of grain for A’s horse. Farmer B₂ would be prepared to give 29 bushels of grain for the horse and farmer B₃ to give 39 bushels. In this case, according to what was said before, not only does a foundation exist for an exchange of the two goods between A and one other farmer, but A can, in an economic exchange, give his horse to any one of the grain farmers, and any one of the latter can economically acquire it in exchange.

What has just been said becomes still more evident if we consider the case in which foundations for economic exchange operations with the grain farmers exist not only for A, but also for several other owners of horses, A₂, A₃, etc. Suppose that only 8 bushels of grain for A₂, and but 6 for A₃, would, if acquired, have a value equal to one of their horses. There can be no doubt that, in this case, foundations for economic exchanges would exist between each of the animal breeders and each of the grain farmers.

In both these cases we have to deal with much more complicated relationships than the one presented in the first section of this chapter. In the first case, foundations for economic exchange operations exist between a monopolist (in the widest sense of the term) and each of several other economizing individuals who, in their efforts to exploit the exchange opportunities confronting them, are in competition with each other for the monopolized good. In the second case, the foundations for economic exchange operations are present simultaneously on the one side for each of several owners of one good, and on the other side for each of several owners of another good; on each side, therefore, these persons are in competition with one another.

I shall begin with the simpler of the two cases, in which there is competition between several economizing persons for a monopolized good, and later pass on to the more complicated case of price formation when there is competition on both sides.

A. Price formation and the distribution of goods when there is corn petition between several persons for a single indivisible monopolized good.

In the description of price formation in isolated exchange (p. 194), we saw that in each particular case there is a certain range of indeterminacy within which price formation can take place without the exchange losing its economic character, and that the extent of this range depends upon the nature of the particular exchange situation. We also saw that the price that tends to be formed is one that divides the economic gains that can be obtained from exploitation of the relationship confronting two bargainers between them equally, and that there is thus, in each given case, a certain average toward which the price tends to move. But in this connection, I pointed out that economic influences do not in any way, within this range of freedom, fix the point at which price formation must, of necessity, take place.

If, for example, an economizing individual, A, has a horse that has a value to him no higher than 10 bushels of grain if he were to acquire them, while to B, who has had a rich harvest of grain, 80 bushels have a value equal to a horse if he were to acquire one, it is clear that the foundations for an economic exchange of A’s horse for B’s grain are present, provided that A and B both recognize this relationship and have the power actually to perform the exchange of these goods. But it is equally certain that the price of the horse can be formed between the wide limits of 10 and 80 bushels of grain and can approach either of the two extremes without causing the economic character of the exchange to disappear. It is, of course, extremely improbable that the price of the horse will settle at 11 or 12 bushels or at 78 or 79 bushels of grain. But it is certain that no economic causes whatsoever are present that exclude completely the possibility of the formation of even these prices. At the same time, it is also clear that the transaction can take place naturally only between A and B only as long as B finds no competitor in his endeavor to acquire A’s horse by trade.

But suppose that B₁ does have a competitor, B₂, who either does not have as great an abundance of grain as B₁ or requires a horse less urgently. Still, B₂ values a horse as highly as 30 bushels of grain, and could thus provide better for the satisfaction of his needs if he were to give 29 bushels of grain for A’s horse. It is clear that the foundations for an economic exchange of a horse for some quantity of grain exist between B₂ and A as well as between B¹ and A. But since only one of the two competitors for A’s horse can actually acquire it, two questions arise: (a) With which of the two competitors will the monopolist A conclude the exchange transaction? and (b) What will be the limits within which price formation will take place?

The answer to the first question arises from the following considerations. The value of A’s horse to B₂ is equal to 30 bushels of his grain. He would thus provide better for the satisfaction of his needs if he were to give as much as 29 bushels of his grain to A for his horse. This is not, by any means, to say that B₂ will immediately offer A 29 bushels for the horse. But it is certain that he will decide to make even this offer to meet the competition of B₁ as far as possible, since he would be acting very uneconomically if, as a last resort, he would not be satisfied with even as small a gain from trade as he could derive from an exchange of 29 bushels of grain for A’s horse. On the other hand, B₁ would obviously be acting uneconomically if, in the competition for A’s horse, he were to permit B₂ to acquire it for the price of 29 bushels of grain, since the economic gain of B₁ would still be considerable if he were to give 30 bushels of grain or more for the horse and thereby economically exclude B₂ from the exchange transaction.²

Thus the fact that there is a price range within which an exchange transaction would have become uneconomic for B₂ but still be economic for B₁ places B₁ in a position to obtain for himself the gains resulting from the exchange by making the transaction economically impossible for his competitor.

² When I say that B₁ ^{economically excludes} B₂, I do not mean that B2 is excluded from the exchange by the use of physical force or because of legal incapacity. The distinction is important, since B₂ could easily own several hundred bushels of grain and thus have the power, physically and legally, to acquire A’s horse and still not choose to acquire it. If he does not acquire it, his reason must be economic in nature—that is, by giving up a larger quantity of grain than 29 bushels, he would not provide better for the satisfaction of his needs than he would without the exchange.

Since A would certainly be acting uneconomically if he did not transfer his monopolized good to the competitor who is in a position to offer him the highest price for it, nothing is more certain than that the exchange transaction will, in this particular economic situation, take place between A and B₁.

As concerns the second question (the limits within which price formation will take place), it is certain that the price that B₁ will give A cannot reach 80 bushels of grain since at this price the transaction would lose its economic character for B₁. Nor can the price fall below 30 bushels of grain. For price formation would then fall within the limits where the exchange transaction would still be advantageous for B₂, who would therefore have an economic interest in competing until the price should again reach the limit of 30 bushels. In our case therefore, the price must, of necessity, be formed between the limits of 30 and 80 bushels of grain.³

Thus the effect of the competition of B₂ is that price formation, in the exchange of goods between A and B₁, will no longer take place between the wide limits of 10 and 80 bushels of grain, as would otherwise have been the case, but between the narrower limits of 30 and 80 bushels of grain. For only if the price is fixed between these limits does an economic gain from the transaction accrue to A and B₁ simultaneously with an economic exclusion of the competition of B₂. The simple relationship of the isolated exchange thus reappears, the only difference being that the limits between which price formation takes place have become narrower. Aside from this difference, the principles already explained for the case of isolated exchange become fully applicable here.

³ The opinion could arise that instead of the price in the case we have been discussing being formed between 30 and 80 bushels of grain it will be established at exactly 30 units. This conclusion would be correct if we were dealing with an auction sale in which no minimum price had been set in advance or if it had been set below 30 bushels of grain. In either case A would be compelled by the very nature of an auction to be satisfied with the price of 30 bushels, and the causes of the unusual price formation in auctions in general are to be sought in analogous relationships. But if economizing individual A does not bind himself from the beginning with an auction contract and can pursue his interest with complete freedom, there is no economic reason why the price of a horse should not reach 79 bushels of grain in an exchange between A and B, just as there is no reason why it should not be set at 30 bushels.

Suppose now that the two previous competitors for A’s horse, B₁ and B₂, are joined by a third competitor, B₃. If the value of the horse to this third individual would be equal to 50 bushels of grain, it is clear from what has just been said that the transaction again will take place between A and B₁, but the price will be formed between the limits of 50 and 80 bushels. If a fourth competitor, B₄, appears, to whom A’s horse would hate a value equal to 70 bushels of grain, the transaction will still take place between A and B₁, but the price will be formed between the limits of 70 and 80 bushels.

Only when a competitor, for instance the economizing individual B₅, appears on the scene, to whom the monopolized good has a value of as much as 90 bushels of grain, will the transaction take place between A and this last competitor and the price of the horse be fixed between 80 and 90 bushels of grain. It is clear that the new competitor will exploit the exchange opportunity confronting him to his economic advantage, and that he will be in a position economically to exclude all other competitors (including B₁) from the exchange. Price formation will take place between 80 and 90 bushels of grain because, on the one hand, the competitor B₁ can only be economically excluded from the transaction by a price of at least 80 bushels of grain, which prevents the price from falling below this level, and because, on the other hand, the price cannot exceed or even reach 90 bushels of grain, since the transaction would then lose its economic character for B₅.

What has been said is valid for every other case in which the foundations for exchange operations exist between a monopolist exchanging an indivisible good for some other good offered by several other economizing individuals. Summarizing, we obtain the following principles: (1) When several economizing individuals, for each of whom the foundations for an economic exchange are present, compete for a single indivisible monopolized good, the competitor who will obtain the good will be the one for whom it is the equivalent of the largest quantity of the good offered for it in exchange. (2) Price formation takes place between limits that are set by the equivalents of the monopolized good in question for the two competitors who are most eager, or who are in the strongest competitive position, to perform the exchange. (3) Within these limits, the price is fixed according to the principles of price formation already demonstrated for isolated exchange.

In the preceding section we selected as the subject of our investigation the simplest case of monopoly in which a monopolist brings a single indivisible good to market, and in which the process of price formation takes place under the influence of the competition of several economizing individuals for the good.

The more complex case that I wish to discuss now is one in which the foundations for economic exchange operations exist simultaneously between a monopolist who has command of a quantity of a monopolized good on the one hand and several economizing individuals on the other hand who have quantities of some other good at their disposal.

Suppose that a newly acquired horse would have a value to farmer B₁, who has a large quantity of grain but no horses, equal to 80 bushels of his grain. To farmer B₂ a newly acquired horse would have a value equal to 70 bushels of grain, to B₃ 60, to B₄ 50, to B₅ 40, to B₆ 30, to B₇ 20, and to B₈ only 10 bushels of grain. A second horse would have a value, to each of these farmers of 10 bushels less than the value of the first, a third a value of 10 bushels less than the second, and so on, each additional horse having a value of 10 bushels less than the preceding one (provided in each case that an additional horse is needed at all). The essential features of this economic situation can be presented in a table (see next page).

If the monopolist A brings only one horse to market, it is certain, in accordance with the argument of the previous section, that B₁ will acquire it at a price somewhere between 70 and 80 bushels of grain.

To B₁ 80 70 60 50 40 30 20 10 To B₂ 70 60 50 40 30 20 10 To B₃ 60 50 40 30 20 10
To B₄ 50 40 30 20 10
To B₅ 40 30 20 10
To B₆ 30 20 10
To B₇ 20 10
To B₈ 10

But suppose that the monopolist brings not merely one but three horses to market. Here we are concerned with the case that f