One of the best parts of Alchian and Allen’s classic textbook, University Economics, discussing its price-value illusion. Analysis, though worded somewhat differently, is also in the new textbook Universal Economics, which is based on the original. It’s free online from Liberty Fund.

Here is the paragraph:

Speed ​​in detecting changes in demand or supply: The illusion that consumption determines price

Buffer stocks, inventories, and reserve capacity help make it appear as if prices are inelastic or inflexible and determined by cost rather than by competition between consumer-demanders. Suppose for some reason (perhaps higher income) the demand for meat increases. As sales and consumption increase, butchers’ inventory unexpectedly declines. Generally, as with any retailer, product inventories are large enough so that producers do not have to raise prices. Larger than average daily sales inventories help ensure that supplies are immediately available to those in need at predictable prices.

A one-day above-average sale is not immediately considered a continuous increase in that price; Nor is it seen as long-term sales growth that requires higher prices to protect inventories from further depletion. While an increase in sales reflects a higher average demand, no seller will be able to detect an increase in demand immediately. A high short-term variance may induce retailers to buy more to replace normal inventory, but they would buy more if they knew long-term demand had increased.

If the public’s overall demand does increase (not just toward this one butcher and away from other butchers), inventory replenishment demands by all butchers will increase the demand faced by meat packer-suppliers. Packers will see their inventory decrease as they deliver more meat to retailers.

To replenish their dramatically depleted inventories, packers will compete with each other for more cattle than ever before. But with the unchanged supply of cattle, some packers must get less than the increase in their demand at the old price. They increase the price of cattle. Packers, in this situation, see an increase in price (cattle cost) as a result of increased consumer demand and will correctly interpret this as an increase in their costs.

The existence of inventory in the supplier chain from producer to consumer can cause delays during which increases in consumer demand are communicated Edition: current; Page: [149] Retailers to primary producers. This delays price increases at the cattle-producer level.

Who is responsible for the high prices? Tas Jas Ja Ta Jas

Packers raise their prices to retailers, saying their prices are higher because they cost more. But we know that costs are higher because it is increased consumer demand that has driven higher cattle prices in the feedlot. Due to increased consumer demand, a higher price is obtained and maintained in the consumer market. When consumers complain about high meat prices, butchers say it’s not their fault. Their costs have increased. And the Packers can say the same. To see who is really responsible for the high prices, consumers can look in the mirror behind the butcher’s counter and see themselves.

Not all prices adjust immediately to the new equilibrium price to clear the market, as they do in organized stock and commodity markets. Indeed, there is a lag between when some demand or supply situation changes and when people detect and distinguish from a random, transient, reversible change in the current purchase rate or supply situation.

As emphasized earlier, the claimed quantity may refer to the underlying mean quantity claimed over an interval, with transient random offsetting deviations around that mean value. Because of the transient variation around the mean, a change in that mean can be difficult to detect quickly. The increase in sales can be interpreted simply as a randomly higher sales rate rather than as a new higher normal sales rate. And once a seller begins to suspect that demand has shifted, the difficulty exists in knowing how best to adjust supply in response.

If demand is believed to have decreased, should the supplier shift to another production activity or lower prices and continue to operate at lower rates? Should an employer attempt to reduce employee wages when sales decline?

The so-called lags and lags in adjusting prices or output are the result of an inability to accurately predict the future and understand what is actually happening. They are not the result of some inherent rigidity or inability to change in prices. It takes time to decide that an underlying change, a random, transient deviation has occurred. And the time it takes to discover what is the most appropriate adjustment misleads outside observers into thinking that prices are “inflexible.” Prices are actually flexible instantly – as soon as it is discovered that a change is appropriate.

Version: Current; Page: [150]

Why is it particularly relevant today? Because many commentators argue that rising costs cause rising prices. It may be true. But often, given the huge recent increase in money supply, it is the increase in demand that leads to price increases. But the way it is often seen is similar to Alchian and Allen’s analysis.

Leave a Reply

Your email address will not be published.