Higher Costs Don’t Mean Higher Prices
There are limitations to the standard economic model of supply and demand curves intersecting to reveal the optimal or equilibrium price and quantity of a good. Those limitations, as Austrians are well aware, are due to unrealistic assumptions. But noting that the assumptions are out of this world is not enough, especially if the models are used to explain a world that does not match the assumptions. The application of the simplified models, which indeed reveal important facts about how the economy works, tend to lead many economists astray.
Increasing Costs to Producers Does Not Increase Prices
A recent EconTalk episode, in which the host Russ Roberts interviews journalist and author Tom Wainwright of the Economist on his recent book Narconomics, illustrates how simple Econ 101 logic can be misleading. While the episode is well worth listening to and the discussion is both interesting and informative, a significant portion in the beginning is dedicated to discussing the issue of the price of illegal drugs. Noting an apparent “paradox” and the author’s “fantastic” argument, Roberts and Wainwright embark on and get stuck in a discussion that is fundamentally flawed and therefore may delude listeners.
In his argument, Wainwright notes that the government’s focus on cutting back on the supply of illegal drugs has not affected price as expected. He uses an example of art to illustrate the point, and this is in fact a better example than he probably realized. Here’s his example: If the paint used to produce a painting costs $50 and a certain painting is sold at the price of $1,000,000, then raising the cost of a box of paint by 100 percent to $100 should also double the price of paintings — the next painting should be expected to be sold for $2,000,000. But it does not, the price of this painter’s next painting may still be $1,000,000, or, to reflect the increased cost, $1,000,050.
The example illustrates the paradox in what is going on in the illegal drug “business” and, specifically, why government’s attempts to affect the supply have not worked. As argued by Wainwright, even partially successful measures to cut back on supply has not increased final prices for consumers (which was partly the stated rationale). This interesting and unexpected result suggests government should instead “invest” in reducing demand for illegal drugs.
The problem with the argument is that it relies on the simple equilibrium analysis in the demand-and-supply models used in Econ 101 courses for university freshmen. And it doesn’t actually apply here. Had the paintings or illegal drugs markets been in equilibrium, there might indeed be a paradox. But this is hardly the case, especially in these markets.
Also, in a state of equilibrium costs perfectly reflect social opportunity costs, and “perfect” competition brings price and cost together so that no one is able to make economic profits. In other words, there is no difference between price and cost. There is, consequently, no reason to in this theory distinguish between them temporally or causally — they appear to be determined instantaneously and accurately. This is also how they are treated in various economics models that students learn to “maximize.”
Price Drives Cost — Not the Other Way Around
As we know, however, the real market process is driven by entrepreneurship and market actors are not just responsive agents. Entrepreneurs do not live in equilibrium, and they base their business decisions on their own appraisal of the different actions and their imagined outcomes. In this real market, price drives cost — not the other way around. Indeed, Carl Menger noted that the value of any production good is derived from consumers’ valuation of the consumption goods that it produces, not the other way around. This is also core to for example Mises’s argument about economic calculation.
What this means is that entrepreneurs assume (choose, even) costs based on the anticipated revenue of their imagined product. The reason an expensive good is produced at high cost is that those high costs can be covered by the anticipated price that it can be sold for. It doesn’t mean that entrepreneurs choose high costs for the fun of it, but that they motivate a certain level of costs based on the anticipated price — and that price is really dependent only on consumer valuation of the final good.
In imperfect markets, this means there can be high markups that offer entrepreneurs enormous profits. But this is also what lures other entrepreneurs to enter this particular market, so where there are no significant barriers to entry profits will tend to get squeezed until they reach the standard market rate of return. In this process, costs are pushed down but consumer good prices even more so, thereby making consumers the ultimate winners of this process.
So it is not in any sense a paradox that the market price of a box of paint has very little to do with the final price of the painting. The box of paint is traded in the market at a price that partly is derived from the anticipated value of paintings. Similarly, the coca leaves that will eventually end up in a nostril on Wall Street are valued because the end product is valued.
If government burns half of those fields, this will not lead to a doubling of the final good’s price. Instead, it will increase the costs that need to be covered by producers to make the final good available in consumer markets. As margins are enormous in illegal drug production and distribution, primarily as a result of government repression, producers don’t think twice to continue just like before without changing prices: it only causes a small dent in their income.
In Wainwright’s example, a kilo of cocaine, with a market value of $100,000 when sold in “tiny portions,” is produced from a ton of fresh coca leaf sold at a price of $500. The refined product sells at $1,000 in Columbia, and to “distributors” in the United states for $15–20,000. In this situation, if the fields of some coca farmers are burned, those farmers lose all their revenue while prices of the remaining product could potentially be bid up (assuming some form of market). How much those prices are bid up depends on the reservation prices of existing cocaine producers and the chance of new entrants. It does not cause a proportional ripple effect throughout the supply chain.
This is easy to see if we adopt the Austrian view that pricing of production goods is done “backward” through entrepreneurial bidding aiming for anticipated consumer prices. But using the supply-and-demand schedule for equilibrium prices can produce a fundamentally flawed analysis — even by those who recognize that the assumptions are unrealistic (which Roberts naturally does).
This is not to say that the prices within the cocaine supply chain are not some form of equilibrium prices. The assumption of partial equilibrium is not what makes the analysis flawed. The error lies in failing to recognize that cost (that is, the existence and shape of supply) is a function of the anticipated price (demand) of the final good.
From this follows that changes in factor prices are not necessarily reflected in prices of consumer goods, especially in the short term. Rather, they will be reflected in the profit margins of producers, and can thus cause them to change their behavior.