Real-World Limitations On Bargaining Power, Not The Law Of Supply & Demand, Are The Primary Reasons For The Low Price For Unskilled Labor
Supply And Demand Are Only Two Of The Many Factors That Affect Bargaining Power, And Bargaining Power, Not Supply & Demand, Is The Main Factor That Determines Price
By David Grace (www.DavidGraceAuthor.com)
The “law” of supply and demand pricing doesn’t work as the theory predicts for a great many products and services. The purpose of this article is to discuss how products and services are actually priced in the real world.
To do that we need to start with a review of the basic theory of supply and demand pricing.
The Theory Of How Prices Are Set In A Market Economy
In the Market System “demand” means the number of units of a product or service that people both can afford to buy and also want to buy.
The main pricing mechanisms in a Market System economy are:
- market competition between sellers
- supply & demand pricing adjustments
- the relative bargaining power of buyers and sellers
The Market Competition Theory
The theory of market competition is that a seller’s primary motivation is to increase unit sales and therefore
- sellers will compete on price in order to sell more units, and
- this price competition will lower prices to some minimum level, the so-called “competitive price.”
The Supply & Demand Price-Adjustment Theory
The theory of supply and demand pricing is:
Buyers Respond To Changes In Price
When the price goes up, the quantity of a product sold goes down because buyers respond to the higher price by purchasing fewer units —demand drops.
When the price goes down the quantity of product sold goes up because buyers (both existing buyers and new buyers) respond to the lower price by purchasing more units — demand increases.
Product Shortage — Demand Exceeds Supply
When competing sellers fail to deliver enough product to meet demand then, in the short term, the sellers will take advantage of the increased demand by increasing the price.
The new higher price will reduce demand to the point that the new, lower demand will equal the lower available supply, thus balancing supply against demand without the need for rationing or shortages.
In the long term, either the existing sellers or new sellers will increase the supply to a level sufficient to meet the new, higher demand which additional supply together with price competition will result in the price falling back to the previous level.
Product Surplus — Supply Exceeds Demand
In the short term when demand falls below supply sellers will lower their prices in order to maintain their previous sales volume. The lower price will increase demand to the point where the new, higher demand will consume the available supply.
In the long term some sellers will leave the market or cut production to a level sufficient to decrease the supply to meet the lower demand and the price will rise back to its previous level.
Elastic Versus Inelastic Prices
Contrary to the claims of the price competition theory, sellers are not primarily interested in increasing sales volume. They are interested in increasing profits.
In the real world, sellers will not voluntarily reduce a price merely to sell more units. They will only voluntarily reduce a price if they believe that they will make more money by offering the product at a lower price.
Sometimes reducing a price and thus selling more units makes a seller more money and sometimes it makes the seller less money.
In order to understand if a seller will want to raise a price, maintain an existing price, or lower a price we have to understand when lowering a price will make the seller more money and when lowering a price will make the seller less money.
Economists refer to this aspect of price as “price elasticity.”
If a lower price will greatly increase sales volume in relation to the size of the price reduction then the seller will make more money by lowering the price — the price is “elastic.”
If a lower price will not greatly increase sales volume in relation to the size of the price reduction then the seller will make less money by lowering the price — the price is “inelastic.”
Whether a price is elastic or inelastic depends on how many new customers will enter the market and how many existing customers will increase their purchases in response to the lower price while taking into account the amount of the price reduction.
Expressed as a formula, the rule is:
For a reduction in price:
Price Elasticity = The Percentage Increase in The Quantity Sold / The Percentage Decrease in Price
For an increase in price:
Price Elasticity = The Percentage Decrease in The Quantity Sold / The Percentage Increase in Price
If the result of this calculation is greater than 1 the price is elastic. If the ratio is less than 1 then the price is inelastic. If the ratio is exactly 1 that is called “Unit Elasticity.”
For example, if the price of a pen falls from $1 to $.90 that’s a 10% decrease in price. If the volume of pens sold increases from 1,000,000 units to 1,250,000 that’s a 25% increase in volume so 25%/10% = 2.5. The price of pens is elastic.
If the price falls from $1 to $.90, a 10% decrease, and the volume increases from 1,000,000 to 1,100,000, a 10% increase that’s 10%/10% = 1. That’s Unit Elasticity.
If the price falls from $1 to $.90, a 10% decrease, and the volume increases from 1,000,000 to 1,050,000, a 5% increase that’s 5%/10% = .5 — the price is inelastic.
NOTE:
It should be noted that this formula assumes that all of the seller’s costs are variable costs which increase or decrease in direct proportion to the number of units sold. In the real world sellers have both fixed costs and variable costs. For this reason a price that is at Unit Elasticity under this formula will in fact be a price whose reduction will cause a seller to lose money.
For companies in the real world with fixed as well as variable costs, price elasticity calculated under this formula will need to be greater than 1 for a decrease in price to cause no change in the seller’s profits.
Whether a drop in demand will cause a reduction in the price depends on two factors:
- Do the sellers think the price is elastic or inelastic?
- If they believe that the price is inelastic, will one seller nevertheless lower his price, thus forcing the other sellers to match his new, lower price even though they don’t want to?
Let’s look as some examples.
Suppose a manufacturer was selling 1,100,000 pens a month at a dollar each but market demand for these pens dropped and the seller’s volume fell to 1,000,000 pens per month.
His variable labor and materials cost to manufacture a pen is $.50 and his overhead cost is $100,000/month for a burden cost of $500,000 + $100,000 ($600,000) or a profit of $400,000/month.
Believing the price is elastic, the seller decides to drop his price to $.90 which he thinks will both increase his sales and his profits. Let’s say that the drop in price causes consumers to buy an additional 250,000 pens and that they buy all of them from only this seller.
His sales volume goes up 1,250,000 pens month. The seller’s gross revenue increases from $1,000,000 to $1,125,000. The seller’s costs are 1,125,000 X $.50 ($562,500 labor and materials) + $100,000 overhead or $662,500.
$1,125,000 gross revenue — $662,500 costs = $462,500 profit, up from $400,000 even though the price declined. The seller correctly calculated that he would make more money by charging a lower price.
Because the seller made more money when he reduced the price, the price is said to be “elastic.”
But here’s what we always have to remember: The seller’s sales volume may have increased this much when he lowered his price because he either had no major competitors or all of his competitors kept their prices at $1/pen while his pens were the only ones priced at $.90 each.
But suppose the seller did have competitors and that they matched his new low price, then the new low price would increase the unit sales for both this seller and also for his competitors as well.
Because his competitors also reduced their prices they also shared in the sale of the additional 250,000 pens. In light of this competition at the new, low price, this seller’s sales volume only increased by 100,000 pens and his competitors sold an additional 150,000 pens.
1,100,000 pens X $.90 = $990,000 in gross sales.
1,100,000 X $.50 in labor and materials costs = $550,000 + $100,000 overhead costs = $650,000 total costs — $990,000 gross revenues = $340,000 in profits when he lowered the price and increased his sales instead of $400,000 at the old, lower sales volume and old higher price.
Because the seller made less money when he reduced the price even though his unit sales increased, the price is said to be “inelastic.”
NOTE: Under the price elasticity formula this price should have been at unit elasticity resulting in neither an increase nor a decrease in profit when the price was reduced. Because fixed costs were included in the profit calculation in addition to variable costs we can see that the price was actually inelastic.
Clearly, lowering the price as a response to the decrease in demand was a bad idea. If all the sellers had kept their prices at $1 they all would have made more money from fewer sales than they did when the price went down to $.90.
If a new lower price stimulates the sale of an additional 250,000 pens and all of those new sales go to me then the price is elastic and I will make more money.
If only 100,000 of the new sales go to me and 150,000 of the new sales go to my competitors who also lowered their prices then the price is inelastic and I will make less money.
If demand falls and the price is inelastic then if the seller can avoid reducing his price in response to the fall in demand that’s what he will do.
The question is not “How many total additional units will the universe of buyers purchase at the lower price?” but rather, “How many additional units will the universe of buyers purchase at the lower price from me?”
The question is not: “Is the price elastic for the market as a whole?” but rather, “Is the price elastic for me?”
If there were only three or four sellers of this type of pen it’s likely that they all would have known that lowering the price would lose each of them money and none of them would have done it.
Put another way, with only a few sellers who tend to mirror each other’s prices the decrease in demand would NOT result in a decrease in price.
If there were twenty or thirty sellers of this type of pen it’s likely that one of them would be foolish enough to break ranks and lower his price thus forcing the rest of the sellers to follow suit even though they don’t want to.
When you realize that higher unit sales don’t always mean more profits and that sellers only care about more profits not about more sales, then you understand why in many situations a reduction in demand will not result in a corresponding decrease in price because the sellers know that when the price is inelastic a reduction in price will mean lower profits.
The Conditions Needed For Supply/Demand Pricing To Work As The Theory Predicts
Several conditions are required for material changes in a product’s supply or demand to affect that product’s price in the way that the Theory of Supply & Demand predicts.
No Seller Joint Action Or Buyer Joint Action
The idea that a reduction in demand will always lead to a lowering of price in order to increase demand back to its original level assumes that the sellers are each acting independently and in competition with each other and that each seller is pursuing a goal of maximizing its sales volume rather than maximizing its profit.
If the sellers determine that the price is inelastic and if they formally or informally follow each other’s prices they can and will maintain the existing price in the face of lower demand because they will make more money that way.
Whether or not they uniformly refuse to lower the price will depend on several factors including:
- Whether or not the product is perishable or time sensitive,
- How badly the sellers believe the buyers need to buy the product, and
- How strongly the sellers believe the price is inelastic.
Similarly, if the buyers are formally or informally cooperating as a bargaining unit their bargaining power may be able to keep the price from increasing in spite of a rise in demand.
How successful their united price front will be will depend on how time-sensitive the product is and, ultimately, how badly the sellers need to sell the product.
For the supply/demand theory to work as predicted
- An overwhelming majority of the product must be provided by sellers who are not part of a formal or informal cartel where each member matches the other’s prices, and
- An overwhelming majority of the product must be purchased by buyers who are not part of a formal or informal group that negotiates lower prices, and
- If demand falls, there are enough sellers that, even though the price is inelastic, it is highly likely that one of them will break ranks and lower his price anyway thus forcing the rest of the sellers to follow suit and also lower their prices as well.
- If demand rises, there are enough buyers that it is highly likely that one of them will break ranks and offer a higher price thus forcing the rest of them to follow suit and also pay the higher price as well
No Other Material Factors Affecting Buyers’ Or Sellers’ Incentive to Purchase Or Sell
For the supply/demand pricing rules to work as predicted there can’t be other material factors that would overshadow the price-adjustment effects of a change in supply or demand.
The Product/Service Is Not Time Sensitive Or Perishable
If the product is perishable (medicines, food products) or time sensitive (airline seats, vacation rentals) those time factors will give the seller a strong additional incentive to quickly offer a much lower price in order to rapidly increase sales before the product spoils.
In other words, those time-sensitive/perishable factors will overshadow the price adjustment effects from a change in supply or demand so that only a small drop in demand may result in a big drop in price.
The Product/Service Is Not Mandatory
If the product/service is one that the consumer must have (gasoline, medicine, clean water, spare parts, etc.) then the potential lowering of the price because of a drop in demand may be overshadowed by the fact that the sellers know that the buyers must purchase the product even if the price is higher than the buyers want to pay.
When the product is vital to the buyers, all the buyers who can afford the product are already purchasers. The sellers know that it’s unlikely that there are a great many potential new customers and that all the current customers are buying all the product that they need, so a drop in price is unlikely to increase sales enough to compensate for the revenue lost from the lower price.
In other words, if the product is mandatory the sellers know that the price is probably inelastic and that lowering it will lose them money.
On the other hand, if the product is discretionary the price is more likely to be elastic and that lowering the price may make the sellers more money.
The class of products and services that meet all the above criteria (no unified action, non-perishable, discretionary not mandatory) required to closely conform actual prices with the results predicted by the supply/demand theory is limited.
Theory And Practice Are Two Different Things
Most people think that the price-competition mechanism coupled with the supply/demand rules both work perfectly and automatically to identically affect the prices for all products and all services all of the time.
That is not true.
At its heart,
- An increase in supply or a decrease in demand are just two of the factors that affect the intensity of the seller’s motivation to sell, and
- A decrease in supply or an increase in demand are just two of the factors that affect the intensity of the buyer’s motivation to buy.
The intensity of the sellers’ incentive to sell and the intensity of the buyers’ incentive to buy are only two of the components of each side’s bargaining power.
The ultimate elements that determine price are not the intermediate factors of supply and demand but rather all of the factors that together make up the bargaining power of the sellers compared with the bargaining power of the buyers.
The buyer’s ultimate goal is to use his bargaining power to get the lowest possible price.
The seller’s ultimate goal is to use his bargaining power to set a price that makes him the maximum amount of money.
The price where the seller makes the maximum amount of money is the unit elasticity price, the price point where any further increase in the price changes the price from inelastic to elastic, the point where any further increase in the price would cause sales to fall so much that the seller would suffer a reduction in gross revenue.
Bargaining Power Is Different For Different Products/Services
The balance between the sellers’ bargaining power and the buyers’ bargaining power is different for different products/services.
A small change in the demand for one product may greatly affect the buyers’ or the sellers’ incentive to buy or sell and therefore that small change in demand may trigger a large change in that product’s price, while an identical percentage change in the demand for another product might cause little or no change in the buyers’ or sellers’ incentive to sell or buy and thus that identical percentage of change in demand may cause little or no change in the price for that particular product.
Let’s look at a couple of examples.
Example 1: Wild Cat Oil Filters
Suppose there are three companies that manufacture the oil filters that fit the very expensive Wild Cat automobile. Let’s say that because all three manufacturers watch each other and each knows what the other charges and each knows that a price war will only lose them money that the price of all three filters is similar.
Let’s also suppose that the burden cost to manufacture and distribute the filters is similar for all three producers at about $10 per filter and that each sells their filters for about $15 for a profit to cost ratio of $5/$10 or 50%.
Let’s also say that a year ago The Wild Cat Automobile Company suddenly imploded and went bankrupt. The sellers are now seeing a 20% decline in sales volume. They have a lot of Wild Cat filters in their warehouse. Will they automatically reduce the price in response to this drop in demand?
No, of course not. Why?
- The filters are not perishable. Two or three years from now they’ll still be perfectly good and the cost of storing them is not high so there’s no time pressure on the sellers to immediately get rid of them.
- The sellers know that the current owners of Wild Cat vehicles must have oil filters. They can’t drive their cars very long without them, so the sellers know that the buyers are highly motivated to purchase the filters and that there will continue to be buyers for them for years into the future.
- The sellers know that the Wild Cat was a boutique car and that most of its owners are relatively wealthy. That means that spending a few dollars more or less for an oil filter won’t matter much to the people who own a Wild Cat car.
The facts that the existing Wild Cat car owners must have the filters and that they are wealthy taken together mean that the price is elastic, that a drop is price will lose the sellers money and that an increase in price will make the sellers more money.
The sellers know that they have very strong bargaining power and that the buyers have relatively weak bargaining power. The 20% reduction in demand does not provide much if any incentive to the sellers to reduce their prices. The price is elastic so they know that reducing their prices will only lose them money, not make them money.
The sellers might even exploit Wild Cat’s bankruptcy by threatening to take the filters out of production, frightening the buyers and motivating them to buy more filters as a hedge against a possible future shortage. One of the manufacturers might even exploit the buyer’s fears by raising the price, a price increase that the other two producers would likely quickly mirror because they will make more money by increasing the price rather than decreasing the price.
For this product, a unified group of sellers, an elastic price, and high sellers’ bargaining power completely overshadow any incentive to decrease the price because of a 20% drop in demand.
In summary, in spite of the drop in demand the sellers will not reduce the price because:
There are only a few sellers so it’s unlikely that anyone will break ranks and start a price war
The sellers customarily follow each other’s prices rather than aggressively price compete — the sellers are informally united and act similarly with regard to price.
In Summary:
- The product is not perishable
- This is a mandatory product in that the buyers require the product
- The buyers are isolated and have no material bargaining power
Example #2: Happy Cows Dairy
Let’s say that there are 300 dairy farms In a particular state. Almost all of them sell their milk to one of four large companies that process it into cream, milk, cheese, etc. and they then sell those products to three large supermarket chains and hundreds of independent grocery stores.
Farmer John has a contract with Happy Cows Dairy to buy his milk for $8/gallon and his burden cost is $6/gallon for a profit to cost ratio of 2/6 or 33%.
Because of young people drinking less milk, concerns over cholesterol, milk substitutes like soy and almond milk and other factors, Happy Cows has seen a 20% drop in milk sales over the last year. Happy Cows hired economists who calculated that if it could reduce the price of its milk to the supermarkets by $1/gallon, the lower cost would stimulate demand enough to bring total sales back to close to their previous level.
Happy Cows knows:
- that the other three processors are also lowering their prices, and
- that as a perishable product Farmer John has to either sell his milk or throw it away.
Seeing this situation as an opportunity to make extra money Happy Cows tells Farmer John that it will only renew his contract at a price of $6.50/gallon which will lower his profit as a percentage of burden cost from 33% to 8.3%.
Farmer John quickly calls the other three processors and asks if they will buy his milk. All of them have been experiencing similar declines in sales and all of them are lowering their prices to their regular dairy farmers. While some of them are paying $7/gallon and one is even paying $7.10/gallon they have more than enough supply from their existing farmers who have no choice but to go along with the price reductions.
Farmer John offers to sell his milk to each of the other producers at a lower price than they’re paying their other farmers but they are resistant because that would force them to terminate one of their other sellers with whom they’ve had a long-term relationship. Finally, one producer agrees to buy Farmer John’s milk but only if he makes it worth their while by agreeing to accept $6.75/gallon.
Knowing that he has no alternative Farmer John quickly goes back to Happy Cows and offers to sell to them for $6.75 instead of the $6.50 they offered. They agree.
Farmer John now sees a drop in his profit ratio from 33% to 12.5% and a drop in his price from $8 to $6.75.
This decrease in price was partially due to a 20% decrease in demand but it was also substantially due to the fact that (1) there were only four buyers and they all knew approximately what each of the other processors was paying and (2) the buyers all knew that the perishable nature of the product and lack of alternative customers gave them much greater bargaining power than Farmer John.
In summary:
- We have only a few buyers so it’s unlikely that anyone will break ranks and set a higher price
- We have buyers who customarily follow each other’s prices rather than aggressively price compete — the buyers are informally united and act similarly with regard to price.
- The product is perishable and therefore is a mandatory product for the sellers in that the sellers must sell the product
- The sellers are isolated and have no material bargaining power
Supply & Demand Are Not The Only Elements That Govern Price
We could go through other examples, but the end result would still illustrate the fact that the same percentage drop in demand for different products may have vastly different effects on the prices of those products.
In other words, changes in supply and demand are only two of several components affecting the price. Supply and demand are factors in determining the level of the party’s motivation to buy or sell which in turn is a component of that party’s bargaining power.
It’s Bargaining Power that’s the ultimate factor in determining price.
Price Changes Primarily In Response To Bargaining Power Which Can Overshadow The Effects Of Changes In Supply & Demand
Consider a factory that employs a thousand unskilled workers. Management sets the hourly wage on a take-it-or-leave-it basis. Few if any workers are financially able to quit and there’s no other potential employer available to them. The reduction in the supply of unskilled labor arising from the loss of those few workers who do quit isn’t sufficient to cause management to set a higher wage.
Now suppose that all the workers in that factory joined a union and threatened to strike if wages weren’t increased. After a few weeks of negotiations management agreed to pay a higher wage and the threatened strike was averted.
It might be argued that the price went up in response to a threatened reduction in supply in accordance with supply/demand theory.
But I don’t think that’s correct and here’s why.
In a supply/demand price change, an increase in demand or a decrease in supply causes an increase in price in order to reduce demand and thus bring the lowered demand into balance against the new, smaller supply.
In this example the higher price did not reduce the company’s demand at all and there was no balancing of a lower demand against a new, smaller supply.
In this case (1) the quantity of unskilled labor was not reduced and (2) the demand for unskilled labor did not increase. The demand for labor and the quantity of labor were the same both before and after the price increase.
Here’s what did change: initially we had one buyer bargaining with 1,000 sellers one at a time, and the buyer used that huge imbalance in bargaining power to set a low price.
After the formation of the union we had one buyer negotiating with one seller, an equalization of bargaining power, and that negotiation resulted in a substantially higher price without any changes in either supply or demand.
Let’s think about it this way:
I have ten soldiers. Let’s call me “Buyer” and we’ll call my soldiers “Demand.”
You have ten soldiers. Let’s call you “Seller” and your soldiers “Supply.”
We fight for possession of the battlefield. Let’s call that the “Market.”
Where that battle line between us ends up at the end of the campaign will depend on the relative strengths of your ten-soldier team and my ten-soldier team.
Let’s call the strengths of our teams our respective “Bargaining Power.”
On any given day my soldiers may be healthy or sick, have a lot or a little ammunition etc.
We battle until we’re tired and we call a truce or one side is defeated. At the time we declare a truce, we call the location of dividing line between our forces the “Price.”
If my ten-man team operates as a unified group versus your ten-man team operating as a unified group the dividing line will probably be someplace more or less in the middle of the battlefield.
But let’s say that your soldiers are stuck on the far side of a narrow gulch which they have to traverse to get to the battle. Because I can place all ten of my men as a unified group at the end of that gulch I can attack your men as they arrive one at a time. Now I have terrific Bargaining Power and you have terrible Bargaining Power.
My ten men acting as one unified group attack your men one at a time. I defeat your men in detail and I establish the dividing line between your territory and my territory, the Price, all the way at the far end of the battlefield.
I was able to do that not because of any changes in the number of my troops (Demand) or the number of your troops (Supply) but because I was able to always bring a unified, powerful, ten-man team (Buyer’s Bargaining Power) against your soldiers one at a time (Seller’s Bargaining Power).
If I’m one big buyer and I’m bargaining with 1,000 little individual sellers one at a time, my bargaining power is huge compared to theirs, and I can easily defeat them one by one.
I’m not defeating them because my demand for their labor is low or because the supply of their labor is excessive. I’m able to defeat them because my bargaining power is huge compared to their bargaining power.
On the other hand, when they unite and bargain as a group, it’s like my ten-man team as a group facing another ten-man team as a group and I’m no longer able to pick my opponents off one at a time.
What really happened in this factory example was not that supply changed or demand changed but rather that the answer to the question: “How unified are the sellers?” changed from “Not much” to “Highly” and the answer to the question: “How badly do the sellers want to sell?” went from “A great deal” to “Not so much.”
Irrespective of supply and demand, price is always, ultimately, determined by bargaining power.
In The Real World, Price Is Ultimately Determined By The Answers To Four Questions
The quantity of supply and the level of demand are not ultimate questions. They are intermediate questions.
A high or low supply and a high or low demand are factors that affect how motivated the seller is to sell and how motivated the buyer is to buy.
Those respective levels of motivation are each components of the seller’s and the buyer’s bargaining power.
Bargaining Power is determined by the answers to these four questions:
- Are the sellers acting independently or collectively?
- How badly do the sellers need to sell?
- Are the buyers acting independently or collectively?
- How badly do the buyers need to buy?
The Market Does Not Set “Accurate” “Correct” Or “Proper” Prices
There’s an unspoken belief that market prices are always the “correct” prices or the “right” prices or the “fair” prices. There’s a feeling of morality or at least propriety attached to market prices as if it’s “right” to pay whatever price the market sets and “wrong” to want to pay a price different from the one the market sets.
This is completely wrong. Market prices are inherently neither right nor wrong, correct nor incorrect.
This idea that the market always sets the “correct” price is, I think, rooted in the fallacy that market prices are set by the “law” of supply and demand. This notion is wrong for two reasons:
- The false idea that market prices are set by the law of supply and demand when, in fact, they are actually, primarily, set by the bargaining powers of the respective buyers and sellers, and
- The word “law” makes people feel as if the market price is determined by an immutable principle and that questioning the price set by the theory of supply and demand is like refusing to acknowledge the inevitability of the laws of nature.
It’s the feeling that a refusal to accept a price that you believe was set by the law of supply and demand is equivalent to standing on the sea shore and arguing that the tide should not come in.
Even if it were true that the “law” of supply and demand alone does actually set the price for all products and services (and it doesn’t), accepting the prices set by that “law” is not required as either a moral obligation nor as a sign of your obedience to the laws of Nature.
We’re all aware of the Law of Gravity. When an avalanche powered and directed by the law of gravity hurtles down a mountainside and destroys a village we don’t say, “It’s right and good that happened because that’s how the Law of Gravity works.”
If the village elders realized that an avalanche was immanent and they proposed breaking up the ledge of snow and defusing it or diverting the impending avalanche away from the village nobody would object with the argument that doing so would be wrong because it would be an attempt to disregard the Law of Gravity.
Just because we know that if left to themselves certain inputs will generally create certain outputs doesn’t mean that those outputs are beneficial, useful or desirable.
On the contrary, if we know that certain inputs will cause certain outputs that will be damaging, costly and undesirable, only a fool would argue that we should embrace those bad results because they flow from the operation of a law of nature and that therefore they are automatically right, proper, and good.
Just because the law of gravity says that if I fall out of a plane I will be killed is not a reason not to thwart the law of gravity by wearing a parachute.
In an economic context, for several years the market price for a device that injects epinephrine to counteract a life-threatening allergic reaction has been extremely high in relation to its cost of production and distribution. In no way would any rational person consider the price for that device to be a “correct” “proper” or “fair” price even though it is the Market Price.
You could say the same for the cost of insulin, digitalis, and numerous other products. The market price for the services provided by Fortune 500 CEOs now ranges from the dozens of millions to hundreds of millions of dollars over the course of only a few years of employment. In no sense are those prices “correct”, “proper”, or “fair” even though they are Market Prices.
Market Prices are the result of bargaining power. Bargaining power may be extreme on one side or the other depending on the factual situation.
A huge imbalance in bargaining power in favor of the seller will result in a very high price.
A huge imbalance in bargaining power in favor of the buyer will result in a very low price.
Fairness or correctness don’t enter into the market’s price calculations because neither fairness nor correctness are elements that determine the level of a buyer’s or seller’s bargaining power.
If you want to talk about a “fair price” or a “correct price” then you need invent a formula that objectively defines what you mean by the terms “fair price” or “correct price.”
If you want to define a “correct price” or a “proper price” or a “fair price” as a price that represents the total of the reasonable costs of production, overhead, research, and capital accumulation plus a profit component that equates to a profit-to-cost ratio of, for example, 25% then you could apply that formula to various products and services and you could say that according to your formula this particular Market Price is “fair” and that Market Price is “unfair.”
If there were such a definition of what is a “fair” or “correct” or “proper” price then we could accurately say that the market doesn’t always or even mostly set a fair or correct or proper price (under that definition) because market prices have little or nothing to do with the components of your pricing algorithm.
Unskilled Labor
Many people hold it as an article of faith that the price paid for unskilled labor is “correctly” set by competition and the supply and demand mechanism. For the reasons set forth above, this idea is false.
It is true that the market sets a low price for unskilled labor, but in the absence of a formula that defines what a “correct” price is, we have to recognize that the market price for unskilled labor is neither correct nor incorrect any more than it’s correct for a rose to be red or correct for an exploding hand grenade to be loud.
They just are.
The Price For Unskilled Labor Is Not Primarily Set By Supply & Demand But Rather By Bargaining Power
Now that we understand that bargaining power, not supply and demand, is the primary factor in setting prices, we can understand that the price for unskilled labor is primarily set by the relative Bargaining Power of the buyers of unskilled labor (employers) versus the Bargaining Power of the sellers of unskilled labor (workers).
It is because the sellers of unskilled labor have very low bargaining power that the market price for unskilled labor is low.
Why The Sellers Of Unskilled Labor Have Very Low Bargaining Power
Sellers of unskilled labor have exceptionally low bargaining power because:
- Buyers/Employers set the initial price for unskilled labor
- Unskilled workers cannot afford to withhold their labor from the market
- Unskilled workers can offer their services only within a small geographical area
- Unskilled workers have no unified bargaining unit
- Buyers/Employers are able to act as an informal but unified bargaining unit, and
- Buyers/Employers are financially able to resist paying higher wages
1. Employers Set The Initial Price For Unskilled Labor
The Normal Ratio Of Sellers To Buyers Is Reversed For Unskilled Labor
Unskilled labor is fundamentally different from most other services and that difference causes it to be priced lower than other services.
When we look at the general run of products and services whose prices are set by market competition and the supply & demand pricing mechanism we find that they have a relatively low ratio of the number of sellers to the number of buyers.
There may be fifty companies offering passenger vehicles for sale in the United States while there are at least ten million customers for passenger cars or a seller-to-consumer ratio of 1 to 200,000.
During the past year there may have been 5,000 orthopedic surgeons in California and between 500,000 and 1,000,000 orthopedic surgeries for a provider to consumer ratio of at least 1 to 100.
You can pick almost any major product or service and you will find that the number of sellers of that product or service will be a fraction of the number of the buyers of that product or service.
But unskilled labor is just the opposite. The number of sellers of unskilled labor is materially greater than the number of buyers/employers of unskilled labor.
There are several million unskilled workers in California and probably less than 200,000 businesses that employ unskilled workers. So, while the ratio of skilled-labor sellers to skilled-labor buyers might be in the range of 1 to 100, the ratio of unskilled-labor sellers to unskilled labor buyers is probably in the range of 10 or 20 to 1.
The Side Of The Seller/Buyer Equation With The Fewer Members Gets To Set The Initial Price
The side of the seller/buyer equation that has the smaller number of members has the upper hand in setting and maintaining the price for that product/service.
When you need to hire a lawyer he doesn’t ask you, “How much will you pay me?” He tells you, “This is how much you will have to pay me.” For any product or service where the number of sellers is materially less than the number of buyers, the seller sets the initial price.
If you’re going to buy a shirt or a hot tub or a bowling ball the seller doesn’t ask you, “What will you offer me for my shirt or hot tub or bowling ball?” No, the seller tells you what the price is.
When the number of buyers of a product or service is materially smaller than the number of sellers of that product, the buyers set the price. There are fewer buyers of unskilled labor than there are sellers of unskilled labor so the buyer, the employer, sets the price.
Having the power to set the price for unskilled labor generally presents the potential worker with a “take it or leave it” proposition and it gives the employer huge negotiating power.
The Initial Price Is Chosen Based On What Others Are Paying & Thus Preserves The Status Quo
The person who sets the initial price usually determines the general magnitude of that price by looking a what other people are paying or charging for that same product or service.
When Ford begins designing a new, small SUV it looks at the price Toyota is charging for the RAV4 and what Honda is charging for the CRV and it makes sure that the price it’s going to charge for its new model will be competitive with the price of those similar vehicles being sold by other manufacturers.
If a barber moves to a new town he will to check what other barbers in that community are charging for a haircut. If the standard hair cut in that town is $15 he’s not going to set an initial price of $30 nor a price of $8.
He’s going to set a price someplace between $12 and $18 because at much less than $15 he knows he would be giving away money because he would be charging less than people are willing to pay, and at more than $18 his price would seem so high compared to that of his competitors that without a special marketing advantage he wouldn’t get many customers.
Why The Initial Price For Unskilled Labor Is Important
The initial price for unskilled labor sets the benchmark price for unskilled labor in that geographical area. The uniformity of unskilled wages is maintained because employers know what other employers are paying and that’s what they offer to pay.
If most employers are paying $10/hour for unskilled labor then every job applicant knows that it will be a waste of time to apply for a job that’s advertising a wage of $10/hour only to demand $14/hour.
The uniformity of unskilled wages tells the unemployed unskilled workers that there’s no point in turning down a $10/hour job in the hope of finding a $14/hour one somewhere else.
Once the initial price is set, the amount of possible deviation from it is extremely limited. By setting the initial price the employer is able to severely limit or eliminate price negotiation.
The practice of the buyers of unskilled labor (employers) offering to pay what others are already paying results in these employers functioning like an informal cartel. All the buyers/employers of unskilled labor know what other employers are paying and they all have a strong incentive to hold the line and keep prices at that level.
Market theory says that if there is a shortage of unskilled labor that applicants will choose not to accept a low-wage job offer and instead they will withhold their services from the job market until the employers eventually raise the offered wages high enough to attract enough applicants to fill the vacant positions.
But in the real world the supply/demand mechanism doesn’t raise the price for unskilled labor as predicted because price is ultimately determined not by supply and demand but by bargaining power, and the unskilled workers have very little bargaining power.
2. For The Seller, Unskilled Labor Is A Mandatory Service
We generally think of products/services as being discretionary or mandatory from the point of view of the buyer. A Tiffany paperweight is a discretionary product for a buyer. For a diabetic buyer, insulin is a mandatory product.
Products/Services can, however, also be discretionary or mandatory from the point of view of the seller.
The dairy farmer can’t stop producing his milk and he can’t store the milk for any long period of time. He must sell his milk quickly or throw it away. From the seller/dairy farmer’s point of view, milk is a mandatory product. He has no real choice. He must sell it at the best price he can get or lose it.
The same is true for the seller of unskilled labor. The unskilled worker’s family has to eat. He has to pay the rent. Because his wages are low he has no savings. The only thing a worker has to sell is his/her time. Time that is uncompensated is time lost, time thrown away.
For most unskilled workers their service, unskilled labor, is a mandatory service. Like the seller of a perishable commodity, the provider of unskilled labor cannot afford to withhold his product/service from the market but rather he must sell it at any price he can get or lose all.
The unskilled worker has almost no bargaining power. With few exceptions he has to take the job at the offered price.
3. There Is A Small Geographical Area Where Sellers Of Unskilled Labor Can Market Their Services
The more skilled the service the wider the geographic area where that service can be sold.
A top doctor, lawyer, architect, executive etc. can market his/her services world-wide. A good doctor, lawyer, architect, plumber etc. may find customers for his/her services within an area dozens or even hundreds of miles in diameter.
Because of the low per-hour price of unskilled labor, an unskilled worker’s market is limited by travel time and travel cost to only a few miles.
4. Unskilled Workers Are Unable To Present A Unified Demand For Higher Wages
While an employer may control the hiring of dozens or hundreds of unskilled workers, each unskilled worker is on his/her own with no ability to bargain for anyone but himself/herself.
Further, because employers monitor what other employers are paying for unskilled labor they can act as an informal cartel where all major employers of unskilled labor informally set a uniform price.
Unless they form a union, which because of educational and financial issues they are unlikely to do, as a practical matter unskilled workers are unable to act as a unified bargaining unit.
5. Employers Are Able To Present A Unified Opposition To Higher Wages
No employer benefits from offering higher wages because employers know that offering a higher wage will just start a wage-war which will only end with all of them standardizing on the same new, higher wage. They know that they’re all better off holding the line and letting the occasional worker who won’t take the offered low wage walk away.
Sure, maybe Joe’s Burgers out on Route 6 may have such a hard time getting a new fry cook that they offer $10.75/hour instead of the $10/hour that Burger King and McDonalds are paying but they’re not going to offer $12 an hour. They don’t need to. The other employers have set the price at $10 so they only need to go a little above that to get the new worker they need.
6. Employers Have Greater Financial Resources Than Unskilled Workers
Without savings, unskilled workers have little ability to seriously threaten to withhold their services for any material period of time. Most employers of unskilled labor can easily afford to do without unskilled labor for far longer than the workers can afford to do without a paycheck.
The Consequences Of Low Wages For Unskilled Labor
When unskilled labor is compensated below the amount needed to feed, clothe, house, and support an unskilled worker the deficit in those living costs is made up by government subsidies such as food stamps, Medicaid, Section 8 Housing and the like.
The price for the products created by unskilled labor is lowered by food-stamp wages to the detriment of both the workers who create those products and also to the detriment of the other businesses that sell the products and services that those workers would have otherwise purchased if they had been paid a living wage.
Low prices for unskilled labor benefit the buyers of goods produced by unskilled labor to the detriment of the taxpayers who pay for the government subsidies given to unskilled workers to make up the difference between the low wages and their costs for food, housing, and medical care.
In economic terms, the low wages paid to unskilled workers are essentially a mechanism that transfers wealth from the taxpayers to the buyers of the products made with that unskilled labor.
- If you are against higher taxes you should be in favor of higher wages for unskilled labor.
- If you are against bigger government you should be in favor of higher wages for unskilled labor
- If you are against more government bureaucracy you should be in favor of higher wages for unskilled labor.
- If you are against government welfare programs you should be in favor of higher wages for unskilled labor
- If you are against the government paying for poor people’s medical care you should be in favor of higher wages for unskilled labor.
- If you are in favor of a more prosperous economy where more citizens have more money to spend as they choose (not as the government chooses) you should be in favor of higher wages for unskilled labor.
But in any event, unskilled workers don’t deserve to be paid low wages because that’s all their labor’s worth under the law of supply and demand. The law of supply and demand in no way sets prices that match what products or services are “worth” or what sellers are “entitled to” or “deserve.”
Prices are set by bargaining power and the side of the negotiation with the highest bargaining power, be it buyer or seller, doesn’t deserve any particular price and isn’t entitled to any particular price.
The winning side gets the price it gets through sheer power which exercise of power doesn’t make the eventual price deserved or undeserved, or good or bad, either for the parties to the transaction or for the economy as a whole.
–David Grace (www.DavidGraceAuthor.com)
