Philip Pilkington is an Irish writer and journalist living in London. You can follow him on Twitter @pilkingtonphil

Perhaps the most effective myth that mainstream economists have propagated over the course of the last century is the idea that the majority of prices in an advanced capitalist economy are set by the interaction of supply and demand in a market for scarce resources. Perhaps the second most effective myth they have spread is that this interaction tends toward equilibrium and stability.*

Both myths, being myths, are completely untrue. In fact, empirical surveys, together with more realistic theories, tell us that the prices of most goods in advanced capitalist economies are, in some way or another, administered. Moreover, observation tells us that markets that are largely subject to supply and demand interactions are highly unstable and prone to sometimes dangerous speculation.

Yet it is accepted without question that in “normal” situations, supply and demand for scarce resources sets prices and that such processes, left undisturbed, tend toward equilibrium and stability. We’ll explain why this is a superstition and will see what truth we can tease out.

First let us focus on how most prices in our economies are actually set. After that we will turn to those markets where supply and demand do indeed play a rather large role and see what properties are typical of such markets.

Administered Prices

The neoclassical fable that supply and demand for scarce resources sets prices in modern capitalist economies rests critically on the notion that firms experience rising marginal costs as they increase sales past a certain point. Those familiar with mainstream economics will recognise this as the condition for a so-called “upward-sloping supply curve” which ensures that prices are set at a stable equilibrium. In theory, the firm tries to maximise gains by producing up to the point where the cost of producing one more unit of output becomes unprofitable.

This conclusion, in turn, rests on the notion that firms are constantly producing at full capacity. That is to say, for example, that all the machines in a given firm’s factory are being used in their most effective capacity any given point in time. Thus, to try to increase production would only result in marginal costs increasing and the firm making a loss.

There are many problems with this theory but here is not the place to run through them in detail. Instead we will simply point out that empirical research, time and again, has refuted the idea that firms face rising marginal costs. For example, in his study of pricing “Asking About Prices”, former vice-president of the Federal Reserve Alan Blinder wrote that:

Only 11 per cent of [U.S.] GDP is produced under conditions of rising marginal cost… Firms report having very high fixed costs-roughly 40 per cent of total costs on average. And many more companies state that they have falling, rather than rising, marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks. (P. 105)

The reason for this is that, contrary to what the neoclassical economists implicitly assume, the engineers and managers that operate businesses are not stupid. Like the fairly rational beings that they are, they take account of the fact that the firm may need to increase output some day and so they ensure to build excess capacity into said firm.

It’s not hugely surprising that they should do this. Imagine, for example, that an employer asks you for a deadline when you think you will finish a certain project. Since you are planning for an uncertain future, and provided you are not naive or self-sabotaging, you will set the deadline slightly later than you think you might actually complete it were you to work exactly according to schedule. This way if circumstances change, which they might, you have some breathing room. When they can, most people tend to build uncertainty into their plans for the future. Similarly, those that plan capitalist firms build in breathing room should demand for their goods or services increase.

Post-Keynesian economist Nicholas Kaldor puts it as such in his paper “Limits on Growth”:

The manufacturing sector is the archetypal case of a fix-price market… In markets of this type uncertainties concerning the future growth of demand mainly affect the degree of utilisation of capacity; it pays the manufacturers to maintain capacity in excess of demand and keep the growth in capacity in line with the growth of demand. (P. 193).

So, how do these firms set prices? Unlike in the neoclassical theory there is no abstract agency called ‘The Market’ ensuring that firms set prices in a precisely dictated manner. Instead all firms have a certain amount of agency. In practice the empirical literature suggests that firms estimate the amount of output they expect to sell, calculate the total costs involved and then place a mark-up on the price that they deem to yield an appropriate amount of profit for their investment. Needless to say, this is subject to norms and even firms with a fairly substantial degree of monopoly will not get away with blatant price-gouging. Even Apple are aware that consumers will only pay so much for an iPad.

This is, in somewhat simplified form, how the prices for most goods – and possibly even most services – in a modern capitalist economy are set. This should be obvious to anyone who takes a look at the world around them. The prices of most goods and many services do not fluctuate significantly when demand varies – indeed, apart from keeping up with the slow drift of inflation**, they do not generally fluctuate at all. For the most part, the price changes we do actually notice are the result of technological innovation – camera phones and laptops, for example, have become significantly cheaper in recent years.

Before moving on to markets based on scarcity where the interaction of supply and demand proper does play a role, let us briefly consider a thought experiment that will prove useful shortly in showing why such markets are prone to instability.

Speculating on Refrigerators

Administered prices clearly have the advantage of ensuring stability. Provided that we do not live in a country that is experiencing significant inflation, the prices of most goods are pretty constant. And yet, as shall be discussed further below, the prices in some very particular markets – say, the housing market – are subject to wild fluctuations. This is, as everyone is aware, due to speculation. That is, the fact that price-rises can often beget price-rises as eager investors pile into a given market in order to try to profit, thus inflating unsustainable bubbles – and driving up costs for consumers in the meantime.

But why doesn’t this occur in markets for manufactured goods? Why don’t investors ever speculate on refrigerators in order to turn a profit? This may seem an absurd question but it is one that, if considered for any period of time, actually yields a rather interesting result.

Imagine for a moment that speculation began to take place in the refrigerator market. Speculators started buying up significant quantities of the output coming out of the refrigerator factories. And, as demand for new refrigerators began to outpace supply, the price of new refrigerators rose. This, in turn, provoked more speculators to pile into the market buying up new refrigerators to the point where consumers largely stopped buying new refrigerators and instead started buying second-hand refrigerators. But then, as the price for second-hand refrigerators began to climb, the speculators piled into the second-hand market and the prices for second-hand refrigerators started to rise too.

The end of this story need barely be told. Eventually the Great Refrigerator Bubble would burst. Whether due to interest rate hikes, underlying demand for refrigerators falling as prices rose too high or some other arbitrary reason, refrigerator-mania would eventually come to an end and many of those that participated would take heavy losses.

Pretty fantastic story, right? After all, we could never imagine such a thing happening. But why not?

Well, recall what was said above about manufacturers ensuring that they have excess capacity should demand increase. The simple fact is that a speculative bubble could never arise in the refrigerator market – or, indeed, the market for any manufactured good – because as demand began to rise, rather than the price rising, the amount produced would increase instead. Since the price for refrigerators would stay the same and instead the amount of refrigerators produced would increase there would be no incentive for more speculators to pile into the market. And those that were silly enough to try to speculate on refrigerators would find themselves holding large inventories that were subject to depreciation.

It is the excess capacity itself that provides a barrier against speculation. If we think carefully about this it has a rather fascinating consequence: namely, that the mechanism for speculation is actually inherently built into the very market-mechanism that is championed by the neoclassical economists as a bulwark against disharmony. It is the interaction of supply and demand under conditions of scarcity that opens the door for speculation and it is only markets in which prices are administered in a manner that allows for flexible output and so in which scarcity is largely not an issue that are immune.

Let us turn now to the housing market, the most extreme of the “free markets”, to see how this occurs.

Housing Bubble!

The housing market is, of course, well-known as a cesspit of speculation. The reasons for this are many and much discussed but we will here focus only on the fact that housing is a somewhat scarce commodity that is subject to almost perfect market forces (yes, new houses can be built slowly, but it’s all about location and space is scarce).

A fairly well-known neoclassical economist once told me that the housing market is based on arbitrage; that is, on buying low and selling high. The idea here seems to be that a crew of house-arbitragers stalk the streets pricing homes, buying up those of them that they estimate to be below the going market price, selling them at this price and pocketing the difference. Presumably the speculation we sometimes see in the market thus comes from this process – that is, when arbitragers start buying up too many houses in the hopes of future gains.

When I told this economist that I worked part-time selling houses all through college (yes, this was during the Irish property bubble), that arbitrage only really took place in the market for land and that his abstractions were at best a misunderstanding, he quickly shut up. The way the property market actually functions is more like an auction – hence why in Ireland we call real-estate agents “auctioneers”.

The prices are already known prior to bids. Sellers know roughly how much their property is worth based on past values in the area and buyers have access to enormous amounts of price information simply by reading the property section of their local newspaper. When bids around the asking price are made they are passed by the real estate agency (or “auctioneer”) back to the seller who then surveys the offers and either accepts the highest or leaves the property on the market in hopes of an even higher bid. This, of course, is as close one can come to a so-called ‘Walrasian auction’ in the real world, thus making the property market, in a very tangible way, an almost perfect neoclassical market.

So, why then is our perfect market subject to consistent and catastrophic speculation? Again, it is impossible to delineate the precise reason why the housing market is often chosen as the playground of speculation rather than any other market with similar properties; however, we can confidently say that the auction structure of the market accommodates speculation enormously. The bidding process gets people all hot under the collar in boom-time and they engage it with reckless abandon – yes, I’ve seen this first hand.

Even more important, however, is that the supply of housing is scarce; very scarce. As we have already noted, not only does it take a rather long time to build new houses but given that space is strictly limited and location matters more than perhaps anything else in the market the supply of housing is basically fixed. In contrast to our market for refrigerators, when people increase their bids on houses in a given spatial location it is the price of the houses that rises, not the quantity produced. This means that, in the housing market, a bubble could begin to form simply due to a rise in wealth or population. The process doesn’t even require a gang of nefarious speculators to set it off. This, in turn, probably explains why in a housing boom all homeowners and aspiring homeowners become speculators in certain sense.

And so we’re back to our startling conclusion: it is the very fact that the market for property is an almost perfect neoclassical market that accounts for its vulnerability to the wiles of speculation. It is the very fact that there is no excess capacity on tap which can be readily poured onto an overheating market to cool prices that accounts for the market’s proneness to disequilibrium and instability. It is the neoclassical market, based as it is on scarcity and supply and demand fundamentals, that generates the chaos.

The same can be said for every market where speculation plays a part and occasionally causes trouble: the stock markets; currency markets; markets for various other financial instruments; commodities markets; the list goes on. All these markets are characterised by the fact that they are based on scarcity and are driven almost purely by supply and demand.

The clever reader will, however, point out that many of these markets could easily be thought of as functioning with excess capacity. After all, if the demand for a company’s stock or a country’s currency goes up couldn’t the firm simply print up more stock or more currency? Even in the oil market insiders are well aware that the Saudis ultimately set the price. This is true, of course, and under certain very specific circumstances we do see this happen. However, generally speaking while a higher demand for refrigerators will always be met by higher refrigerator production as the single goal of refrigerator producers is to sell refrigerators, companies and governments issuing financial liabilities or oil producers with excess capacity will be primarily interested in maintaining a given price level or undertaking actions that will increase this price level.

The key point is that in order for a market to be immune from speculation there must be a quasi-automatic response on the part of the supplier to increase output rather than letting price rise. The potential for this, however, is simply not present in the housing market. And while it is present in other markets for financial assets, it is most often not utilised as issuers of these assets are often more concerned with their price rising rather than the amount sold***.

Conclusion

Now perhaps the reader can appreciate why we referred to the idea of the dominance and perfect functioning of markets driven by the neoclassical rules of scarcity and supply and demand as being the most effective myth spread by mainstream economists. Because, not only is this type of market not remotely dominant – at least, so far as the real economy goes – but it is a generator of price instability.

And as this bizarre myth has gathered pace over the past 30 or so years and politicians have worked as hard as they can to turn our world into one dominated by such markets, is it any wonder that we see around us only chaos, instability and disorder? In trying to turn various sectors of the economy into an approximation of the neoclassical market policymakers have merely summoned up the daemonic forces of speculative finance. When you crown anarchy is it any wonder you get a lunatic for a king?

* The following article is an outline of what the author hopes to present later this year as a dissertation.

** The keen reader will here note that we are quite consciously not assuming that the general moderate inflation – the “drift” – experienced in all advanced capitalist economies has anything to do with excess demand. More cannot be said about this here than that this inflation is probably institutionalised rather than strictly demand-led.

*** Such a mechanism is utilised, however, in the case of a currency peg. This, together with many other government initiatives in which the price-level is targeted, is just another example of administered prices, albeit undertaken for different reasons. The principle, however, is identical. In the case of a currency peg, if the government in question has enough breathing room to credibly defend their currency – i.e. if they possess sufficient foreign currency to defend their currency or they are simply printing money to suppress its value – one would be better off speculating in the refrigerator market.