There are essentially four ways to set prices.
1 The seller can set his price, and the buyer decides whether he wants to pay the price or not buy it.
2 The buyer can set his price, and the seller decides whether he wants to take the price or not sell it.
3 An auction, where -- in essence -- the market sets the price while both buyers and sellers choose whether to deal at that price or not deal.
4 Negotiation.
Generally, retail sales are type 1 and wages are type 2. Auctions are common in theory, but fairly rare in practice -- when they do exist, as in art auctions, they often differ from theory in that the pieces auctioned are subjectively unique. Negotiation is common in situations where the buyer and seller have somewhat equal power -- genereally, fairly great market power.
We'll look more deeply at each, and what that means for the behavior of the economy, after the jump.
Let's start with the auction in economic theory. Sellers bring goods to market, and buyers bid for them. The price which every seller receives is the price which clears the market, that is, the price at which nothing more is offered at that price because everybody who is willing to sell at that price has done so, and nobody is left wanting to buy at that price because everybody who is willing to pay that price has done so.
Everybody who is willing to sell at a lower price gets that price -- and is, therefore, happy. Everybody who is willing to buy at a higher price pays that price and is, therefore, happy. People who are only interested in paying lower prices (would you buy a new Cadilac for $10?) are disappointed. People who would produce the good if the price were higher are disappointed.
While this is rare in practice, it's clear why it tempts theoreticians. It is an easy-to-analyze model which bears some relationship to actual markets. If the sellers set the price, then the buyers are in in a quite similar situation to the buyers in he auction market. If they are willing to pay that much, they are satisfied; if they are willing to pay more, they are happy; if they are unwilling to pay that much, they do not participate in that market.
Similarly, people who sell their work for wage experience something similar to what they would experience in a wage-auction market. If they will take the prevailing wage, they work; if not, they don't do that work.
When one side announces the price, and the other side says 'yes' or 'no,' howerver, it is clear that the side announcing the price is extremely unlikely to choose a price worse for its interest than the auction price would have been.
In particular, sellers who announce a price will announce a price no lower than the price which covers their costs. Will they announce a higher price?
They have every reason to do so. There are, of course, reasons restricting their prices:
- The customers can always say no. Nobody prices a hamburger at $1,000.000.
- They run the danger of somebody already in the business underselling them.
- They run the danger of some newcomer entering the business and underselling them.
Monopolists run the first risk. If it is extremely unlikely for some firm to announce a price lower than the auction price ("competitive price" in economic jargon, but economists define competition much more narrowly than businessmen do), so is it extremely unlikely to set a price higher than a monopoly would.
The risk of some existing competitor underselling them is obviously (or it is obvious to everyon but the most determined neoclassical economist) greater when the company raises prices than when it neglects to lower them. In most national manufacturing markets, the raising of prices is a dance conducted gingerly. Often, one firm is the "price leader." when they raise their prices, the others are likely to follow suit. But "likely" doesn't mean "certain." Any firm in the market can delay following the leader to see how much sales advantage that will bring. So the price leader tends to wait until the situation makes a price rise look reasonable.
The daily-newspaper market in Chicago contains -- essentially -- two firms. For years, those firms raised their prices in tandem. Then, one time, the Chicago Tribune raised its price and the Chicago Sun-Times declined to follow suit. They have different prices (the same prices as back then) to this day.
In general, firms assume that a price cut will be matched by other firms in the market. That leads to "ratchet pricing," prices go up but don't go down. There are standard exceptions to this rule -- a new electronic gadget will sell for a high price on introduction, but that price will come down; manufacturers plan on that, and calculate their prices on that basis. The price of any model of automobile will drop after the next year's model is introduced. These are complications of the general rule, but not signs that the rule is about to disappear. That you can buy Christmas cards at half price in January is no sign that they wll cost less next December.
While conventional wisdom is always bitching and moaning about slow inflation, the rule that prices go up and don't go down not only explains the causes, it reveals one advantage. If none of the prices of manufactured goods FALL, relative prices can only adjust by some prices rising.
While Murray Lincoln reveals himself to be quite politically conservative in many ways, his The Lincoln Electric Story points out that the Lincoln Electic Company manufactured two goods, both in competition with other, much larger, firms which manufactured a greater assortment of goods. They matched his prices for elecric welding machines, but their prices for other products quite similar to welding machines was significantly higher than their prices for welding machines. And the market price for gas welding rods was higher -- although they were much easier fo manufacture -- than the market price for electric welding rods.
If firms avoid competing by lowering prices, they try hard to build brand loyalty. That means that GM wants you to prefer Chevies to Fords (and Toyotas, and ...). Then they'll be imune to price competion.
And brand loyalty is one reason that the potential of a new entry is much smaller than the economics textbooks pretend. The new automobile companies in the US are foreign firms which built a manufacturing base and a loyal customer base in their own countries before penetrating the US market. Most of the largest new companies in the USA arrived as small makers of new products which grew with the market for those products.
I didn't really mind dropping a billion dollars in the auto market, but I did expect to make a bigger splash.
Henry J. Kaiser
If you go into the widget business because you think the widget makers are charging too much, you take the risk that they will stop charging too much. This is especially true if some of them make other products as well. Any firm's management can always decide: "We'll take our profit from the other lines until this brash interloper goes broke." And, since they can decide that, the interest rate you pay on borrowed start-up cash has to cover the risk that they will. And, when you underprice them, you'll still have to catch up to their brand loyalty with advertising of your own.
If prices announced by sellers are almost always higher than the auction price -- with the only question being how much higher -- the prices announced by buyers are almost always lower than the auction price. These are mostly wage prices, and I'll deal with them in my diary tomorrow.