The Market Price Is Not Necessarily The Correct Price For An Efficient Economy
A Large Imbalance Between The Buyer’s Bargaining Power & The Seller’s Bargaining Power Can Result In A Price That’s Damaging To The Economy As A Whole
By David Grace (www.DavidGraceAuthor.com)
Prices are the end result of the competition between the seller’s bargaining power and the buyer’s bargaining power. The mere existence of a market is no guarantee that the seller’s bargaining power and the buyer’s bargaining power will be always be more or less equal. In many cases they are extremely unequal.
When either side, the seller or the buyer, has massively more bargaining power than the other, the resulting price will either be extremely low or extremely high.
Both extremely low prices and extremely high prices can distort the economy and, from an economic system point of view, result in waste, inefficiency and a misallocation of resources.
This column is a discussion of:
- When a price is so low that it is damaging to the economy/society as a whole
- When a price is so high that it is damaging to the economy/society as a whole
- Mechanisms that might counter these damagingly low or damagingly high prices.
Price In A Market Economy
The basic role of an economic system is the efficient allocation of resources. In a market economy, resources are primarily allocated through the buying and selling of those resources at market-negotiated prices by parties motivated by the desire for profit.
In a market system, the bargaining power of the buyer is pitted against the bargaining power of the seller and a “Power-Struggle” price for each good and service emerges from those bargaining-power contests.
The price for each good and service in relation to the prices for other goods and services in the market comprises the system where the buyers and sellers, motivated by the desire for profit, self-allocate goods and services between themselves based on those prices.
But, the bargaining-power competition between the buyer and the seller can only consider the costs and benefits of a particular price to the buyer and the seller today.
This bargaining process cannot factor into today’s market price the collateral costs to the parties, the economic system itself, and to the society as a whole of an exceptionally low or high price on
- The buyer and seller months or years in the future
- Other participants in the economy today
- Other participants in the economy months or years in the future
Because this Power-Struggle Price cannot consider how that price will affect future benefits and costs to the buyer and seller, nor can it consider present or future costs to third parties, the Power-Struggle Price is not necessarily always the most efficient or effective price for the economic system as a whole or for the society as a whole, either today or in the future.
This power-struggle price may be so low or so high that, in fact, it introduces inefficiencies into the society or the economy as a whole, that is, it may be so high or so low that it leads to a misallocation of resources, inefficiencies, or to a decrease in the types, quality or quantities of the products and services that the economy produces both now and in the future.
A Fundamental Life Rule — Penny Wise & Pound Foolish
We know that we should avoid doing things that are “Penny Wise & Pound Foolish.” Instead, we know that we will profit over the long term when we follow the rule that “A Stitch In Time Saves Nine.”
In other words, paying less today may cost us more tomorrow.
Translating this wisdom to the issue of pricing in a market economy, we know that the lowest price today may have negative, present collateral effects and negative long-term effects and that the lower price today may end up costing many of the participants in the economic system more tomorrow.
In our personal lives we observe the Penny Wise & Pound Foolish Rule all the time.
Suppose you’re going to buy your spouse a birthday present. You could buy her a bottle of Walmart perfume or him a box of Walmart golf balls. You know your spouse isn’t going to divorce you for doing that. You could get away with it in the short term. But you have to ask yourself, “How is that thrifty choice today going to affect my relationship with my spouse in the long term?
“Yes, I saved money today by spending the least amount possible, but what will be the secondary and tertiary long-term effects of that thriftiness?”
We can also see the Penny Wise & Pound Foolish Rule at work in a business setting.
Suppose you’re going to hire a cashier for your restaurant. You could find someone who would take the job for the minimum wage, no sick leave, no benefits. How hardworking an employee do you think you’ll get for the lowest possible wage? How trustworthy? How much training will that person require? How reliable will they be? How long are they likely to stay before you have to replace them and train someone else?
Good, intelligent, hard-working, reliable employees make you money. The opposite kinds of employees lose you money.
If you consider issues of training costs, reliability, trustworthiness, work ethic, willingness to go the extra mile, etc. you realize that you’re likely to make more money in the long run by paying the person who runs the cash register and has access to your vendors and inventory substantially more than the minimum wage.
So, if the minimum wage is $10/hour, a smart employer would consider these other long-term factors and realize that in the long run he will likely make more money by paying a higher wage of $15 to $20 per hour and getting a more reliable and more highly-motivated employee.
In a broader sense, an employee is just another category of seller marketing a service, namely, his labor. Your cell phone company also sells you a service.
If an immensely strong consumer’s union or government price controls or some other factor drove the price for cell service below the “penny wise/pound foolish” point, the consumer might well see an increase in secondary and tertiary costs in the form of poorer coverage, loss of network expansion, loss of technological advancement, transmission-quality problems, equipment upgrade delays, speed stagnation, poorer customer service, etc.
Prices that are below the level needed to fund healthy product improvement, growth, innovation, quality advancement, customer service, employee training and benefits, safety and toxics programs, etc. may ultimately cost both the buyers and the economy as a whole more than the per-unit savings that were derived from the penny wise/pound foolish low price.
Exceptionally low prices might well introduce other inefficiencies into the economy that would overbalance the immediate cost saving to the buyer from the lower price.
These inefficiencies in the economy as a whole cannot be taken into account by the Power-Struggle pricing mechanism.
The Law Of Diminishing Returns
Power-Struggle prices can also be too high.
We understand the existence of and the application of the Law of Diminishing Returns. We understand the wastefulness of blindly spending more without getting a commensurate increase in value.
Paying more for a product or service without getting a roughly equivalent increase in value is a wasteful expedition into the domain of the Law of Diminishing Returns.
A Simple Example
Let’s say that we can get a dedicated, hard-working, loyal, trustworthy, productive, reliable, long-term employee for $25/hour. You might even decide to overpay that employee a little and go up to $30/hour just to make sure that he/she will go the extra mile for your business and will stay with your company for the long term.
Paying that person $50/hour or $100/hour instead of $25-$30/hour isn’t going to get you any equivalent additional benefits from that employee.
That $100/hour wage is a waste that runs smack into the Law Of Diminishing Returns.
Expanding this principle to the economy as a whole, paying materially more for a product than is needed to motivate the seller to deliver a high quality product or service is wasteful, a misallocation of resources, and inefficient.
If you wouldn’t pay a good employee $100/hour when that same good employee is more than happy to accept $25/hour, why would you want an economic system where the buyer pays the seller two or three times more than the amount that the seller would be happy to accept in exchange for their product or service?
Upper & Lower Price Boundaries
In an efficient economy the price would be bounded on the bottom by the Penny Wise/Pound Foolish price, that is by the price that takes into account the secondary and tertiary, short-term and long-term costs that will accrue from paying less than that price, and on the upper end by a price beyond which the benefits gained by paying a higher price will not be commensurate with the higher cost.
In more practical terms, it’s penny wise and pound foolish to pay your cashier the minimum wage and it’s wasteful and inefficient to pay him/her 5 times the minimum wage.
If we pay too little for cell service the economy may suffer collateral, secondary, long-term loses that overbalance the price savings and that distort the telecommunications’ market.
If the price for cell service rises to the point where we run into the Law of Diminishing Returns then that higher price is a misallocation of resources because more wealth is going to the seller than is needed to motivate the seller to produce a high-quality product or service and thus less wealth is available for consumers to spend on other products in the market.
For an economic system, the effective, efficient price is someplace between those two boundaries.
How Prices Are Distorted Out Of The Pricing Sweet-Zone
At its core, prices in a market economy are set by bargaining power.
An extreme mismatch between the buyer’s and seller’s bargaining power in favor of the buyer will drive prices below the Penny Wise/Pound Foolish level.
An extreme mismatch between the buyer’s and seller’s bargaining power in favor of the seller will drive prices above the Law of Diminishing Returns level and toward the monopoly price level.
These bargaining power mismatches can arise in various ways, for example:
- Defacto monopolies
- Patent-based monopolies
- Informal cartels,
- Restriction of the channels of distribution
- Government regulations
- Strong unification of one side of the transaction and extreme lack of unity in the other side
To the extent these extreme mismatches between the bargaining power of the sellers vs. that of the buyers drive prices either below the Penny Wise/Pound foolish price or above the Law of Diminishing Returns price the economy becomes distorted and inefficient in that wealth either will be diverted to the buyers thus degrading the seller’s willingness to produce more products, better products, more features, more reliability, more efficiency, etc. or wealth will be diverted to sellers without a corresponding increase in the seller’s motivation to produce more products, better products, more features, more reliability, more efficiency, etc.
Theory Versus The Real World
In classical economic theory, the profit motive on the one hand and market competition on the other keeps prices above the Penny Wise/Pound foolish level and below the Law of Diminishing Returns level, but that only happens in the theoretical world.
In the real, human world, there are many products and markets where that does not happen.
In the real, human world, buyers will almost always ignore the potential long-term costs and secondary costs that may arise from obtaining the lowest possible price and instead buyers will almost universally seek to pay the absolutely lowest possible price no matter what the negative long-term consequences to the economy or the society of that low price may be.
This is normal human behavior. People live in the present. The future is unpredictable. Costs today can be exactly determined and quantified. Potential costs someday in the future can neither be exactly determined nor accurately quantified.
No buyer will tell a seller, “I know that you’ll very unhappily and reluctantly accept $100/ton for your coal, but I want you to have a big enough profit to be able to explore for new deposits, install additional health and safety equipment, adopt a medical-insurance plan for your workers, and invest in cleaner mining methods so I’m going to pay you $200/ton so that you’ll have enough additional profit to allow you to do all that stuff.”
In the same way, no seller is going to tell the buyer, “I know that because you need immediate delivery in order to meet urgent demand for your products that you would be willing to pay me $200/ton for my coal, I’m perfectly willing and able to continue operating my coal mine in a safe, clean, efficient and highly profitable manner by selling my coal for $100/ton, so therefore, I’m only going to charge you $100/ton.”
Buyers are always going to try to pay the lowest possible price even though in the long run that lower price may have a negative effect on the economic system, and sellers are always going to try to charge the highest price possible even though that higher price may have a negative effect on the economic system.
Because price is set by the bargaining power of the two directly-involved parties at the time the transaction occurs the power-struggle pricing system is functionally incapable of taking into account indirect costs and benefits to third parties flowing from a very high or very low price, namely:
- The future indirect costs of that transaction price on the buyer and the seller
- The present indirect costs of that transaction price on the universe of all of the other participants in the economy/society,
- The future costs of that transaction price on the universe of all of the other participants in the economy/society, including but not limited to its effect on actual or potential buyers and sellers of alternate or competitive products and services.
Generally Needed Products
The ubiquity of certain products — vaccines, clean water, primary education, fire protection, data access, efficient transportation systems, etc. — is directly or indirectly financially beneficial to almost every member of a society.
Conversely, the unavailability of those products and services to a material percentage of the population will cause not only those people but most if not all members of the society to suffer material costs and damages.
Even if the seller furnished these goods and services at cost, that price might still be too high for a substantial percentage of the population to be able to purchase them.
What is it worth to an employer not to have his workforce decimated by an epidemic caused by a material number of unvaccinated people? What is it worth to a business not to have its factory burned down in a fire spawned by the lack of adequate universal fire suppression services? What is it worth to employers not to have a substantial illiterate population that cannot be trained and cannot be employed?
For this category of generally necessary products and services the seller’s price not only needs to be in the “sweet zone” but also every citizen needs to have the ability to pay that price.
So, if the power-struggle price cannot automatically avoid prices that are too low and too high and cannot automatically allocate goods and services that are of great benefit to the society as a whole or whose lack may cause material damage to the society as a whole, what mechanisms can we create to fill the gaps in the power-struggle pricing system?
Avoiding Penny Wise/Pound Foolish Prices
Excessively low prices are the result of the sellers having extremely low bargaining power vis-a-vis the buyers. The most common occurrence of such a massive bargaining-power imbalance in favor of the buyers is in the context of the sale of unskilled and semi-skilled labor.
The buyers of unskilled and semi-skilled labor are massively richer, have hugely greater resources and are far more united than the sellers of unskilled labor. Moreover, the businesses that purchase unskilled and semi-skilled labor are generally decentralized with only a dozen or two workers in each facility, thus making strikes more difficult and also less effective than would be the case with labor performed in large, centralized manufacturing facilities.
This power imbalance can be corrected in several ways. The most common one has been for the sellers of unskilled labor to unite politically and obtain the passage of minimum wage laws.
An alternative would be for every worker receiving a wage less than 150% of the minimum wage to be automatically enrolled in an Unskilled Workers’ Union which would have the authority to bargain for wage and benefit compensation on behalf of all those workers on a state-by-state basis. The result of that bargaining would have to be approved by a majority of a quorum of all such workers and all employers of such workers would be required to pay the negotiated price.
If an agreement could not be reached with employers the union would call a state-wide strike by all such workers who would be entitled to specified unemployment benefits equal to some percentage of their normal, full-time salary during the strike but capped at some set period of time.
This “automatic enrollment” union would increase the bargaining power of the sellers of minimum-wage labor.
Avoiding The Law of Diminishing Returns Prices
Excessively high prices are the result of the sellers having extremely high bargaining power vis-a-vis the buyers. The most common factors causing such a massive bargaining-power imbalance in favor of the sellers are: a monopoly, a cartel, or a product scarcity .
We see this in the case of legal monopolies, i.e. the sale of patented products, defacto monopolies, the sale of a vital product that has only one principal manufacturer, e.g. the EpiPen, or informal cartels, e.g. the sale of certain generic drugs like digitalis and insulin.
We also see this situation in the case of the sale of supply-constrained products where the demand vastly exceeds the supply, e.g. housing units in certain metropolitan areas or scarce goods such as water during a drought or gasoline during wartime.
In these latter cases, the seller often has an incentive to even further reduce the supply of the scarce product in order to increase the price from the elastic range to the point where the price becomes inelastic.
All of these situations can be ameliorated with the imposition of some version of an excess profits tax.
The Excess Profits Tax
Using the profit and cost numbers for highly successful companies such as Apple and Google we know that a ratio of profits/costs of 25% is more than sufficient to strongly motivate companies to be formed, funded, innovate, build great products, expend large sums in research and development, and highly compensate their employees.
Applying an Excess Profits Tax to profits in excess of this 25% ratio of profits to costs would automatically eliminate much of the incentive for sellers to increase the price of their products to a point where we would encounter the Law of Diminishing Returns.
For a more detailed discussion of this excess profits tax mechanism, see my column:
Dealing With Prices For Generally Needed Products
The most common way to achieve universal distribution of generally-needed products is with a subsidy where the government collects a tax from everyone and then either
- Spends that money to directly provide the good or service, e.g. police services, fire-protection services, schools, or
- On a sliding-scale basis, e.g. food stamps, Section 8 Housing, etc. subsidizes the cost of purchasing the goods or services
Are There Other Alternatives?
I would love to hear of other, more efficient, alternatives to supplement the power-struggle pricing system which other alternatives could automatically deal with
- Extreme prices derived from a massive imbalance of either buyer or seller bargaining power, and
- Paying for generally-needed products and services.
— David Grace (www.DavidGraceAuthor.com)
