What’s a fair price?
Determining what amount to charge for produced goods or services is an important part of any business. If the amount is set too low then there will be no profit and the business will fold. If the amount is set too high there may be no customers who can afford it and there may be other businesses who will undercut the price.
Because people have free will and each value different goods as adding to their wealth it’s not possible to simply compute the price. We can however apply the law of diminishing marginal utility to point us in the right direction.
At a given price there is a number of buyers willing to pay that price for the product. If we lower the price there will be more buyers. This is because the original buyers who were willing to pay more will still buy at the lower price (of course) and there are other buyers with a lower marginal utility who will also buy at this lower price. These new buyers may already have a unit of the product or they may not value it as greatly but they are glad to take advantage of a perceived bargain when they get a chance.
We now know that demand will be greater as the price goes down and demand will be less as the price goes up. We know how much supply we have so we will try to match the demand with our supply for an optimum solution.
Pick a price that is big enough to make a reasonable profit. Now test this value. If there is great demand for the good the price is too low. If there is less demand than the supply the price is too high. After adjusting prices for a while the right value will be found.
This interaction is called the free market. This final price might be below the cost of production, if that is the case a more efficient production procedure must be found or the business must close its doors because there is not enough demand. If this value is far above the cost of production the business will make a healthy profit but runs the risk of another business moving in to take a share of the market.
Some truths to note:
- The price for a good does not depend upon how much it cost to make.
Many items found on EBay are a good example of this; it originally cost more to make these items than what they are sold for on the open market. - As the price for any good goes up, the demand for that good goes down.
This second point is important because it explains why minimum wage laws hurt the poor and handicapped. If labor is a good that can be purchased for a price and the price is increased then fewer businesses will be willing to purchase labor; instead they will find other means of getting the work done
What is Praxeology?
Praxeology is the science of human action. People are very complex. Consider the combination of free will and self-awareness. They may respond to a stimulus the same way for 100 occurrences in a row but then do something different on the 101st. Their reason? Just boredom. It is simply impossible to reliably predict a person’s behavior based on historic or aggregate trends.
Instead of using observations and drawing conclusions, Praxeology starts with simple unquestionable truths and builds logically upon them. Lets look at a couple:
1. People act with purpose
This is always true. Acting without purpose is impossible because to act without purpose is in fact a purpose. People have free will and their own unique purposes. This foundational truth is very important because if it were not true, people’s actions would be random and there would be no reason to look any further for our answers. We know that there is method to the madness of human behavior.
2. People always focus on removing the largest area of dissatisfaction in their life.
This is the essence of a “ToDo” list. People priorities their activities based on their current circumstances. If a person’s primary needs such as food and shelter or met then other activities will become paramount. These other needs are based on their personal values, but they will always have one which is the most important until it becomes satisfied.
This being the case, it is easy to see the law of diminishing marginal utility. If a person’s biggest desire is to watch TV then they will pay the price necessary to buy one. After they have it they would not pay that same price to buy a second because they now have a different top need, probably a cold drink. If they were offered a second TV at a discount they may purchase it as a spare. The utility of the n-th TV will diminish as more are added.
Read more about the founders of these great economic thoughts:
Carl Menger
Ludwig von Mises
Everyone wants to be wealthy
What does it mean to be wealthy? What is wealth? It’s easy to gloss over these questions and simply equate wealth with money but it may surprise you to know how often this is incorrect.
There are as many answers to these questions as there are people on the planet. Some people value friendships and relationships above all else while others want many toys and possessions. There are also many seeking positions of leadership and honor. Each person has their own reasons for chasing after the things that they do. They believe in their heart that their life will be more full or ‘wealthy’ if they can achieve these goals. Some of these people may be right but most of them are probably wrong. Regardless, it’s their own decision, made by putting their own beliefs on the line even in the face of evidence to the contrary.
Very few people take criticism of their behavior well, this is because of pride. Being proud of the “truths” they “know”, people naturally ignore information that does not conform to their preconceived view of the universe. When this information is pressed upon them they will often react in negative ways and become even more committed to the original mistaken belief.
Because a significant number of people act on their most heartfelt beliefs without taking into account new truths it becomes obvious that ego and pride are driving most economic decisions, and not the quest for money as most economists think. If this were not enough also change their minds for unexpected reasons. All this greatly limits the usefulness of any mathematical models put forward by investors and economists to predict markets.
So how can we understand the markets and become financially wealthy?
In our next post we will look into praxeology for some of the answers.