Austrian Economics Lessons

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Ludwig Von Mises

Minimum or Final Price

Through this process of profits and loses, it becomes clear that in a free market prices have only one way to go: down. However, it is also clear that for as long as there are people wanting a product, prices can only go one way: up. At some point in the marketplace prices will reach a point where they will remain steady should nothing else changes. What this means is that there will be some sort of Final Price which will be determined between the costs of capital goods and the demand for products. Should the price drops below this Final Price, the product will disappear from the marketplace (due to entrepreneurs going broke) thus creating a shortage and thus creating the opportunity for other entrepreneurs to fill-in the gap at a higher price. Should the price rise above the Final Price, the demand will decrease hence creating loses for entrepreneurs who will be forced to lower prices to maintain sales and thus profitability.

This is what mainstream economics calls equilibrium and it can be seen in action in the markets, where, absent any change, prices tend to remain stable.

But we know that the underlying reason why prices remain stable is human action. People determine moment-to-moment how much they are willing to pay for products, which means that there can never be a Final Final Price. Although prices will have the tendency to remain stable, they will also drift up or down as people make economic decisions with their money.

For this very same reason, although we would estimate that prices will remain within historical numbers, strictly speaking historical prices are just that: history. They cannot be used to forecast future prices but they can be used to perform economic calculations which are ultimately subjective guesses.

Because of this reason it is not possible to use statistics to determine the laws of the market place because statistics only represent the historical past and have no influence whatsoever on the future.

Think of it this way, would you purchase a basket of apples just because we can see statistically that its price has remained constant over time? Of course not. There are multiple reasons and motives that will go into this economic calculation such as whether or not you already have apples or even if you like apples!

Even when you believe that it would be a good idea to purchase apples today because their prices have been going up over time, there is no guarantee whatsoever that tomorrow the price will continue to climb. In strict terms we would say that there is no causal relationship between the prices at any given point in time and a different point in time.

One of the most clear examples of this process is what traders call Trend Trading. The trading strategy of this method is to watch for an elevation in prices and buy. Once the purchase is made, then traders would watch the price levels (hoping for a rise) until prices raise no longer; then they would sell. It is the old Buy Low and Sell High. However, at the very core of this methodology is an absolute agnosticism as to the reasons why prices rise and fall. No respectable trend trader would advance any theory of the sorts. They understand very clearly that prices will fluctuate without any specific reason. They understand that people determine prices, one purchase at the time.

Prices are Determined by their Utilities

We said before that humans act based on economic calculations. Entrepreneurs do the same. The economic calculation they perform is simple; they add all the costs to create a product (all the capital goods) and subtract it from the price they estimate customers will be willing to pay.

Should this difference be positive, they will estimate a profit and will proceed.

Should this difference be negative, they will estimate a loss and will not proceed.

This process is call Appraisement.

But at the core of the Appraisement is the guess as to what price customers will be willing to accept. In Austrian Economic terms we would say that this price is a valuation for direct utility. This is, customers evaluate what is that they prefer more, their money or the utility that a product will give them.

Note: One simple way to understand what utility means is to look at it as something that decreases uneasiness. The higher the utility the lower the uneasiness.

But if prices are determined by direct utility, this means that appraisements are simply guesses of direct utility judgements by consumers.

But if this is true, this means that all prices are the direct result of utility valuations.

But can prices be determined otherwise? No, because utility valuations are subjective. As such an entrepreneur adds all its costs and then guesses as to the price consumers are willing to pay. This is possible because all goods and services can be translated into money. However, values cannot as they are subjective. Thus, while it is possible to calculate the cost of all the components of a car, it is not possible to calculate the value of a car based on the value of its components.

This makes sense. We value a car for the utility the car will provide us. It will take us from Point A to Point B. However, if we look at all the components of a car plus the labour necessary to assemble the car, this "package" cannot take us from Point A to Point B and thus it is less desirable than an assembled car and thus our valuation diminishes.

At the core of a profit or loss rests the idea that valuations are subjective. Without this subjectivity neither profits nor losses are possible.

Many economists have tried the opposite in the past. For example they calculated how much energy went into the manufacture of a product and attempted to correlate this "expenditure" (translated into money) with actual market prices. All these experiments failed miserably precisely because prices are subjective because people execute value judgements and not money judgements.

We must remember that a value judgement is simply the preference of Product T over Product V and thus an opportunity to exchange one for the other arises and with it a price can be set through the action of exchange.

Note: please see the Glossary if you are unfamiliar with certain words.