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Private Power and Price Stability

By James H. Nolt

Often when I have pushed economists about how unrealistic their perfect market assumptions are, they have pushed back with the claim that free market equilibrium must be approximately correct, otherwise prices would never stabilize and economies would be utterly anarchic. Supposedly the free market assumptions “explain” observed relative stability. Without them, chaos would reign.

This is far from true. As I have argued, all prices are political. Prices have always been regulated by power, including sometimes public or governmental power. However, when public regulation is absent, private regulation typically prevails, not perfect markets. Prices are stable to the extent that business and labor organize stability. They are unstable when conflicting forces pushing in opposite directions go to “war” over price levels, including interest rates, the price of credit.

Competitive wars in the business realm have a lot in common with wars among nations. As Prussian strategic genius Karl von Clausewitz said:

War is a clash between major interests, which is resolved by bloodshed -- that is the only way it differs from other conflicts. Rather than comparing it to art it would be more accurate to compare it to commerce, which is also a conflict of human interests and activities; and it is still closer to politics, which in turn may be considered a kind of commerce on a larger scale. . . . In war, the will is directed at an animate object that reacts.

Those of us who study international political economy have studied wars, strategy and international relations theory as well as economics, so we can grasp better than most what is missing from each. I start to map the vast terrain of business conflict ignored by both economics and international relations theory in my book, International Political Economy: The Business of War and Peace.

Modern economics embeds its ideological bias in its characteristic assumptions. One of those most pertinent to notion of equilibrium is the presumption that free markets operate through the rapid adjustment of prices to any disequilibrium between supply and demand. If demand exceeds supply, prices increase; if supply exceeds demand, prices decrease. This is one of the first lessons taught. However, like so much taught in economics, this is one-sided. There are actually two possibilities, but economics nearly always presumes only one of them because the other is less conducive to the stability of free markets. 

The characteristic assumption of price-led adjustment is called the Walrasian price mechanism, after Léon Walras, one of the founders of neoclassical economics. The opposite possibility is called the Marshallian quantity-adjustment system, named after Alfred Marshall, the most prominent of the second-generation neoclassical economists who was also one of the main teachers of John Maynard Keynes.

Marshall argued that business leaders, facing insufficient demand, might cut their prices, as Walras presumed, but since Marshall understood the classical political economy arguments that price is based on the cost of production and since capitalists are not likely to want to produce at a loss, they are more likely to cut their production quantity rather than cutting price when demand slackens. Marshall entertained the possibility that either course of action was within the power of capitalist choice. Indeed it is.

However, textbook economics, in keeping with the theme of consumer sovereignty and producer powerlessness, denies capitalists this choice. All textbooks (except as a minor footnote) and nearly all formal economic models assume the Walrasian price-adjustment mechanism prevails in all markets all the time. Consumers are deemed free to choose; capitalists are not.

Neoclassicals, particularly macroeconomists, do occasionally consider the impact of market failure when prices are “sticky,” that is, they do not adjust rapidly enough to maintain supply and demand in equilibrium. In fact, this possibility is at the heart of what is now called Keynesianism in the textbooks, though it represents only a pale shadow of Keynes’ thought. However, sticky prices, given the typical economist blindness to business power, are most often blamed on workers’ unions rather than on corporate power. Sticky prices are rarely introduced into microeconomics, however, because that might draw attention to the business power to choose between Marshallian quantity adjustment and Walrasian price adjustment.

What prices are not sticky? The most responsive prices are typically those in secondary financial markets: stock and bond prices. Also highly variable are commodity prices, such as wheat, raw cotton, oil, copper, gold, pork bellies, coffee beans, etc. These commodities are also called primary products because they represent the direct output of farms and mines, the initial processing of products of nature. 

The fact that the prices of commodities and financial instruments are highly volatile does not prove the absence of private power in those markets, but it does suggest that the Walrasian price-adjustment method is more applicable to these, if only these prices were not also buffeted by speculator power.

As I said at the end of my previous blog, capitalists often try their best to avoid market prices, particularly when prices are volatile. Commodity markets illustrate this. Thus, for example, the players in today’s oil markets are largely not buyers who need oil, but speculators. Any end-user who needs oil products, such as an airline or shipping company, typically avoids buying oil products on the unstable free market, and instead prefers to sign long-term fixed-price contracts with suppliers to stabilize the price by private agreement precisely because a Walrasian price-adjustment scheme is too unpredictable for routine business. Spot prices are thus influenced most by the strategic machinations of speculators, as also occurs in financial markets.

Most intermediate products such as steel, cement, shipping, and chemicals are produced by massive companies, often organized into cartels, setting price by negotiations rather than free market competition. Many commodity markets also have powerful trading firms or cartels with potent influence over price. Occasionally, price wars may break out, but mostly such prices are stabilized by private collusion. They are then not subject to Walrasian dynamics since a cartel is likely to agree to production cuts in order to maintain prices when demand falls and contracted prices do not adjust as readily as free market prices would.

Consumer goods, the last stage in the chain of production, are much more differentiated, using marketing techniques including branding and product differentiation by design (such as the great variety of clothing as an artifact of fashion). Marketing strategies are designed to escape market pressures, not yield to them. They are premised on the idea that consumer preferences are not immutable, but may be molded by the private power of persuasion. An essential introduction to this perspective is the brilliant book Propaganda by Edward Bernays, one of the founders of the public relations business. Marketing creates a power-rich competitive environment that economists label monopolistic competition, but mostly neglect.

Not only marketing removes consumer goods from free market price determination. Consumer good input costs and hence prices are often regulated by formal cartels established because of legal monopoly powers granted to the owners of copyrights and patents whose components appear in nearly every high-tech consumer device. The growing dominance of innovation in everything from pharmaceutics to entertainment means that little that consumers buy is not priced by private power. 

Agreements regulating price, not free markets, promote price stability. The prices least subject to private regulation are those that are most unstable. Indeed, price volatility was greatest during the nineteenth century when laissez faire capitalism was at its peak. Unregulated prices invite a different sort of private power in the form of speculation. Regulatory power, public and private, not the mythical equilibrium tendencies of supply and demand, promote price stability.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Flickr]

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