I wrote about supply and demand curves here yesterday. I said that the ideas implicit within them are total nonsense, as the claims in the basic model - the only one anyone ever recalls - are based on economic functions.
Then it was suggested in a comment that:
There are serious teachers and lecturers on the supply and demand curve with examples of when they don't meet, when the meeting point moves around, how they can be made to move around and then going onto teach the interesting variations from their initial ‘rule'. It's taught in business studies too although possibly not very well.
Anyways, my query is this – are all these teachers genuine in their beliefs that the model is a useful approximation to some of reality as a starting point, so they are at least sincere, or are they in the direct or indirect pay of big oil?
Let me offer four answers:
- If they are genuine in their belief, they have no clue how the real world works.
- If they are genuine, but then believe they have to offer a whole range of excuses for why the model does not work in practice, why don't they go out and find out what really happens and teach that instead?
- Many are not genuine; they are just teaching what the syllabus demands and can't be bothered to argue in the interests of an easy life, and don't care what the student ends up thinking, even if it is wrong.
- I do not know where Big Oil comes into this.
To put it another way, they're stupid, they lack inquisitiveness, or they're lazy. The good ones teach something else, or do another job altogether.
What really happens?
So, the real question is what those talking about pricing by business should actually be talking about. This is something I know about from a great deal of practice and no small amount of accounting theory.
The important thing to note is that, almost entirely contrary to what the economic theory of supply and demand curves suggests, the vast majority of prices in the real economy are chosen rather than imposed. That is because, contrary to the assumptions of microeconomics;
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No one knows everything. In fact, most people retain remarkably little price information about the things they buy, even when they buy them quite often. I know there are exceptions, especially when money is very tight, but my observation is true of most people, for most products, most of the time.
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Very few goods are identical, almost anywhere. Even the same product (think of a branded box of tea, as an example) in two supermarkets half a mile apart is not the same. They are not just in different locations, but few people buy tea in isolation, so the price of a box of tea is not independent of the price of other products in each store.
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There aren't countless sellers of anything, and since most vendors still serve small geographic areas, there aren't limitless buyers either.
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The consequence of these facts means that most vendors of almost any product have some degree of market power: they can choose prices, at least within the limits of what they know about their markets, although it should be noted that their own knowledge of that will definitely be incomplete.
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There are both fixed and external costs for any institution that they will always want to cover: they do not, almost ever, think in marginal terms, contrary to what economists suggest.
There is no invisible hand
As a result, almost no firm will ever wait for an invisible hand to tell them what to charge. Instead, they set prices. To do so, they use cost accounting, desired profit margins, and corporate strategy to direct their decision-making.
The consequence of all that is that supermarkets, builders, manufacturers, airlines and many other sectors use targeted mark-up pricing based on the estimated costs of supplying a product plus a desired profit percentage, and stick to that price until competitive or regulatory pressures force a change. Even when they adjust, it is usually to protect margins rather than to find a mythical equilibrium.
What is more, administered or regulated prices are everywhere, including utilities, pharmaceuticals, telecoms, and transport. Governments themselves set prices in sectors such as energy, rail, and student education, whilst central banks fix the most important price of all, the cost of money.
Prices reflect power
Prices are not, in that case, neutral signals of scarcity; they are the outcomes of bargaining power and institutional design.
Employers suppress wages because labour markets are not competitive.
Landlords can raise rents because tenants have nowhere else to go.
Global corporations can charge what they like because we have allowed markets to consolidate into oligopolies.
Price setting, in other words, is not an issue determined by markets, but is instead a political process. It expresses who has the ability to impose their preferred outcome on others.
Expectations and stories shape the rest
The exception to this "normal" process of price setting for goods and services is to be found in financial and speculative markets, where prices bear almost no relationship to underlying cost. The price of oil rises because traders expect war, not because there are fewer barrels available. Stock markets move on belief, not the real value of companies. House prices rise because people believe they will keep growing, until they don't.
Prices in these cases reflect what might be best called the momentum of the underlying narrative. The tidy intersection of curves on a graph tells us nothing about this behaviour.
Money matters
In a monetary economy, the ultimate constraint on prices is not physical scarcity but purchasing power, but even this is not determined by markets. If governments inject more money through spending or banks expand credit, more money chases the same goods. When the state withdraws money through taxation or banks tighten lending, demand falls.
Fiscal and monetary policy, therefore, frame the entire pricing system. Pretending that the market sets prices without acknowledging the monetary environment is a category error; it confuses outcome with context.
What follows from this?
If prices are not imposed by market power, or discovered by businesses and consumers as a consequence, but are instead chosen or administered and are shaped as much by power, government policy and the availability of credit rather than supply and demand, then the task of economic policy is to manage the institutions with most influence on this process, and not to chase imaginary microeconomic equilibria.
That means:
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Regulating monopolies and oligopolies properly.
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Supporting unions and wage bargaining to rebalance power.
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Using fiscal and monetary policy together to stabilise prices and incomes.
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Accepting that price stability is a social goal, not a mathematical accident.
The fact is that prices are social constructs. They tell us less about scarcity than about who decides. And the neat intersection of supply and demand curves, which has misled generations of economists, probably deliberately hides the real lesson, which is that every price is a reflection of power. If we want fairer prices, we need more equitable power. That is the economics that Funding the Future is about.
This post will be included in the Funding the Future glossary under the heading pricing.
It is also being included in the economics myths series.
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I made an earlier post which may have been lost when my internet went down
Can anyone explain the logic of Petrol Pricing?
Why dont I always use the cheapest and why can some filling stations charge quite significantly higher prices than others in the same area especially now there are price comparison websites
That one is not here John, sorry.
And the answer is:
A) Location
B) Not knowing
C) Time indifference (which is another way of saying location, but also suggests the saving is not worth the effort)
D) Habit
I used to work in retailing and for my sins, managed a supermarket petrol filling station in the early 1990s. This was in the days of 3 digit prices.
It was made clear to me from the start the petrol pricing my employer used was a ‘loss leader’, sold at a loss meant to get punters into the main supermarket where the profit margin on say a yoghurt was 200-300%% – where the profit really was. This is why a lot of supermarkets stopped buying from the big oil producers and bought it from the open market in places like Rotterdam to reduce the losses.
We then started to get complaints from drivers with blocked fuel filters about our fuel being dirty. Some of the early tankers we had deliveries in were ancient; fuel refinery standards on the open market were not as high as the big petrol suppliers.
Pricing as power? Absolutely. But also look at the consequences.
You’re selling something at high volumes and cheap that was polluting – not very sensible.
A tanker drive working for Esso or Total would be on a really good wage – £35K plus a year. The inhouse retailer branded provider drivers were on as low as less then £20K a year for doing the same job and always complaining about it. Social costs of competition eh?
What cost retail competition? Someone pays somewhere don’t they. Always. All total bollocks in the grand scheme of things like the planet and wages. Cheap food is not really cheap when you think about it. Pricing in supermarkets is a joke.
My view is that all we need is the wages to pay the real cost of everything.
Agreed
Sorry I could have put it better but it and your reply shows the theory of pricing doesn’t always or ever ever apply
What follows is “chucking something in the pot to be stirred around”.
Price discovery. In my (energy) collective it is something we are very interested in – with respect to power generation.
Large amounts of network-connected renewables are built via the process of: auction (organised by gov) & then (due an unreformed elec market) contracts for difference which is the mech that allows the project owner to sell the elec to market and still make a return.
Most auctions attract more offers than the amount of renewables (usually in MW) up for auction. UK has been running “Auction Rounds” for a number of years.
Key point: auctions of this sort allow for “price discovery” – the RES tech used is mostly the same (same PV in the PV auctions, same wind in the wind auctions).
This leads to outcomes that match bid prices quite closely to “real” levelsed costs of electricity”. Or to put it another way: the price/demand curve cross is usually the auction clearing price.
Key Point: government organised, competition between a significant number of companies using similar technologies. Gov wants lowest price, consistent with companies making an OK return. This approach has worked well in the Uk and EU countries (e.g. Spain, Germany, NL etc).
This is miles away from e.g. (very small number of) supermarkets who act as price gatekeepers wrt e.g. farmers and obvs their victims oops, I meant customers.
Marketing boards: time they came back.
This is an exceptional, and as you note, government created scenario, though, Mike
The price charged to/paid by NHS for drugs is a case-in-point.
Wes Streeting, his donors, and US Big Pharma don’t seem bound by a fixed set of supply/demand equations there.
https://duckduckgo.com/?t=fpas&q=the+price+paid+for+nhs+drugs&ia=web
I didn’t choose a single link, because each article comes to different conclusions, depending on their own interest.
Excellent, you’ve taken a sharp implement and pruned away all the dead wood. When CEO pay has rocketed, wages of most people have stagnated, and share prices have climbed upwards through much of my adult life, I’ve assumed we’re being squeezed as much as the sellers of goods and services dare. Hearing how economics teaching explains pricing is shocking. And as consumers we are aware that producers are often squeezed on price – whether it is minerals, bananas or British farm produce. Power is at play, if we want supplies, we have to pay the price demanded, or go without.
Mildly amusing case of pricing having unintended consequences. Some years ago my aunt was friendly with an interior designer who offered services to the reasonably wealthy and decorated their rooms or even homes given examples of their tastes. She charged quite a lot – and deliberately so. She got overwhelmed with work so raised her prices very significantly to deter customers and make her workload more reasonable. This didn’t work! What actually happened was that the seriously wealthy stepped in and (assuming high price meant high quality) demanded her services even at the elevated level. However, with so many possible customers, she was able to be more selective over who she chose to work with. Which also (ironically) made her more desirable to the now very wealthy clients who had noticed her. She was able to retire early on this basis.
I have witnessed this.
A good analysis; thank you.
In my field (banking) we see the obsession with the “sacred” nature of price discovery… with bad consequences.
Why did the BoE engage in Quantitative Easing (QT) as it did? Its fundamental starting point was that the BoE should never dictate price in the open market; it feared that fixing the price would lead to it having to intervene (buy) without limit at that price. In 1992 this did not end well but this was in FX where the UK had limited reserves with which to buy sterling…. and they ran out. In the gilt market this is simply not true (as you have often pointed out in this blog) because money (pounds) can always be created to keep buying without limit….. but this obvious fact passed them by with their neo-liberal blinkers on.
So, rather than fix the price they fixed the Quantity (hence the term QE)…. and long dated gilt yields went to absurdly low levels because the supply/demand theory was wrong. The consequences were not good as rates rose.
This might seem a bit niche in, what is, a very general article about pricing – but if the “theoretical model” fails so badly in the gilt market then it must fail everywhere.
Much to agree with
In a survey of US industries (“Asking About Prices”, Blinder et al, 1998), 90% reported falling or constant marginal costs, and targeted mark-up pricing strategy. Most were unfamiliar with ‘marginal cost pricing’, and repudiated the idea when explained to them.
By “supply and demand”, most people mean the distribution of pricing power. They do not mean perfect competition where no one has pricing power, and profit is maximised at marginal cost since there are always countless buyers at a unique equilibrium price – ideas they find absurd.
I learned an valuable lesson soon after setting out in business (as a classic car restorer) in the mid-1970s. I was always busy but never seemed to have any money. Fortunately, one of my customers, who worked for one of the big London accountants, agreed to look at my books (for nothing). I did have a well developed double entry system because I was taught it by a girl friend who was a bookkeeper. The accountant concluded that I was charging what I thought the market would bear rather than what a needed to turned a profit. So I increased my labour rates and thrived without losing any customers until I was brought down in the mid-Thatcher period when work dried up.
What baffles me these days is that there is supposed to be competition in the supermarkets, yet they make vast profits.
Bizarrely the supermarkets claim to make very small profits of about 4% despite the scale of their businesses. Are they employing some kind of accounting ‘trick’ or are the numbers real?
No, that is real. But they sell vast amounts of stuff of enormous value.
“The fact is that prices are social constructs. They tell us less about scarcity than about who decides. And the neat intersection of supply and demand curves, which has misled generations of economists, probably deliberately hides the real lesson, which is that every price is a reflection of power. If we want fairer prices, we need more equitable power. That is the economics that Funding the Future is about.”
Sorry for lifting the whole paragraph, but this explains the reality of life, for many, so well. Power is very important in economic and financial relationships, as it is in all areas of life. There needs to be more of this in textbooks, and less rubbish about it being an equal and fair relationship between the buyer and seller!
Thanks