Is the fall in prices bad news?

Contrary to the popular way of thinking, we suggest that there is nothing wrong with declining prices. What signifies industrial market economy under a commodity money such as gold is that prices of goods follow a declining trend.

 

According to Joseph Salerno,

 

In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.[1]

 

In a free market the rising purchasing power of money i.e. declining prices, is the mechanism that makes the great variety of goods produced accessible to many people. Obviously, in a free market economy it does not make much sense to be concerned about falling prices.

 

On this Murray Rothbard wrote,

 

Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.[2]

 

For most economic commentators a general fall in prices is always “bad news” for it generates expectations for further declines in prices and slows down people’s propensity to spend, which in turn undermines investment in plant and machinery. All this sets in motion an economic slump. As the slump further depresses the prices of goods, this intensifies the pace of economic decline. However, does it all make sense?

 

According to Salerno,

 

Thus, for example, a mainframe computer sold for $4.7 million in 1970, while today one can purchase a PC that is 20 times faster for less than $1,000. Note that the substantial price deflation in the high-tech industries did not impair and, in fact, facilitated the enormous expansion of profits, productivity and outputs in these industries. This reflected in the fact that in 1980 computer firms shipped a total of 490,000 PC’s while in 1999 their shipments exceeded 43 million units despite that fact that quality-adjusted prices had declined by over 90 percent in the meantime.[3]

 

To suggest that consumers postpone their buying of goods because prices are expected to fall would mean that people have abandoned any desire to live in the present. Without the maintenance of life in the present, no future life is conceivable.

 

On this Menger wrote,

 

An imperfect satisfaction of needs leads to the stunting of our nature. Failure to satisfy them brings about our destruction. But to satisfy our needs is to live and prosper. Thus the attempt to provide for the satisfaction of our needs is synonymous with the attempt to provide for our lives and wellbeing. It is the most important of all human endeavors, since it is the prerequisite and foundation of all others.[4]

 

Are rising prices prerequisite for profits?

The popular view that price deflation is the root of economic slumps seems to overlook the essential role of prices in a free market economy and the conduct of businessmen. Whenever a businessman sets a price for his product it is in his interest to secure a price where the quantity that is produced can be sold at a profit. In setting this price, the producer entrepreneur will have to consider the following:

  1. How much money consumers are likely to spend on the product.

 

  1. The prices of various competitive products.

 

  1. The production cost.

Although producers set the price, consumers by buying or abstaining from buying are the final decision-makers whether the price set will lead to a profit.

 

If, at a set price, a producer cannot make a positive return on his investment because there is not enough people eager to buy his product, then the producer forced to lower the price to boost the turnover.

 

Obviously, by adjusting the price of the good the entrepreneur must also adjust his costs in order to strike a profit.

 

Every individual in his given set-up decides how much of his income he will save and how much he will use on consumption. The income used for consumption the individual allocates in accordance with his priorities regarding various goods and services.

 

A producer will secure a profit when at the price of a good set consumer buying will generate revenue that will exceed the cost plus interest. Profit is an indication that both producers and consumers have improved their wellbeing.

 

Producers by investing a given amount of money have secured a greater amount of money. This in turn enables them to secure a greater amount of goods and services, which in turn promotes their life and wellbeing.

 

Likewise, consumers, by exchanging their money for goods that are on their highest priority list have raised their living standards.

 

Goods and services are valued in accordance with people’s views regarding their usefulness in promoting their lives and wellbeing. The importance people attach to various goods and services varies over time.

 

Thus if a great majority of people have reached the conclusion that lowering the consumption of red meat will benefit their health, then people will allocate a smaller proportion of their income towards red meat and more money towards other goods.

 

Because of new ideas, some goods may become obsolete in attaining particular goals and demand for them either falls sharply or disappears altogether.

 

According to Mises,

 

The business of the entrepreneur is not merely to experiment with new technological methods, but to select from the multitude of technologically feasible methods those which are best fit to supply the public in the cheapest way with the things they are asking for most urgently. Whether a new technological procedure is or is not fit for this purpose is to be provisionally decided by the entrepreneur and will be finally decided by the conduct of the buying public. The question is not whether a new method is to be considered as a more “elegant” solution of a technological problem. It is whether, under the given state of economic data, it is the best possible method of supplying the consumers in the cheapest way.[5]

 

In a free market economy when at a particular price a good makes a profit then it is a signal to entrepreneurs that consumers, at the set price, are willing to support the product. Prices therefore are an important factor in establishing how producers/entrepreneurs employ their resources. The prices of goods dictate the quantity and the quality of the goods produced. On this Mises wrote,

 

The consumers patronize those shops in which they can buy what they want at the cheapest price. Their buying and their abstention from buying decides who should own and run the plants and the farms. They determine precisely what should be produced, in what quality, and in what quantities.[6]

 

Observe that what matters here is not the general direction of prices but whether businessmen are making a profit on their specific goods and services.

 

Once, producers/entrepreneurs have discovered the “right” price, they adjust their costs in accordance with this fact of reality. Entrepreneurs, in the pursuit of the price that will yield profits, set in motion an allocation of real funding towards the improvement of people’s lives and wellbeing.

 

Consequently, a monetary policy that aims at stabilising price fluctuations will make it “mission impossible” for entrepreneurs to discover the correct price. Needless to say that this will undermine the formation of real wealth.

 

 

 

 

[1] Joseph T. Salerno An Austrian Taxonomy of Deflation presented at “Boom, Bust, and the Future,” January 19,2002, The Mises Institute, Auburn, Alabama p 8.

[2] Murray N. Rothbard What Has Government Done to Our Money? P 17.

[3] Joseph T. Salerno An Austrian Taxonomy of Deflation presented at “Boom, Bust, and the Future,” January 19,2002, The Mises Institute, Auburn, Alabama p 8.

[4] Carl Menger Principles of Economics New York University Press p 77.

[5] Ludwig von Mises Planning For Freedom Libertarian Press p 110-111.

[6] Ludwig von Mises Human Action Contemporary Books third edition p 270.