Chapter 14: Pricing and Distribution
Updated: 1/13/20
Christian Economics: Teacher's Edition
Again, the kingdom of heaven is like a merchant in search of fine pearls, who, on finding one pearl of great value, went and sold all that he had and bought it (Matthew 13:45–47).
This passage is an aspect of point three of the biblical covenant: ethics. It is an aspect of property rights. The man who found the pearl had the right to sell all that he owned for money, and then use this money to buy it. He did not steal the pearl. He obeyed the biblical principle of legal boundaries, which is another aspect of point three. The covenantal principle of legal boundaries is derived from God’s legal boundary around the forbidden tree.
The merchant wanted to own that pearl. To obtain sufficient money to buy it, he had to sell all that he owned. Why was it so expensive? There are two possible explanations. First, other rich people knew of this pearl and also valued it highly. They were in competition against each other for the ownership of that unique pearl. There was only one pearl like it. They bid up its price. Only one man would walk away as the owner. The existing owner of the pearl was the beneficiary of a bidding war. Lots of rich people wanted to buy it. This is always an ideal situation for an existing owner who wants to sell. The more bidders who show up, and the more money they are willing and able to bid, the better for the seller. The explanatory model here is the auction. The fundamental principle of every transaction at an auction is this: high bid wins.
But there is another possible explanation. Only two people wanted to own the pearl: the existing owner and the merchant. The existing owner did not want to sell it at a low price. He was an implicit bidder. Finally, the price bid by the merchant was so high that the owner sold. Economists have a phrase to describe the existing owner’s unwillingness to sell: reservation demand. The auction’s rule applies even when there is no exchange: high bid wins. This rule imposes a cost of ownership on the existing owner. The existing owner kept deciding to do without all of the things that the money would have purchased, if he would just sell the pearl.
For as long as any asset commands a price, there is an auction going on for ownership of this item. There is someone bidding to buy it from the existing owner. The owner keeps deciding not to sell it. He is therefore bidding for it. The asset’s price is proof that someone else besides the owner is bidding, moment by moment. This means that the owner bears the cost of ownership. What is this cost? This: doing without all of the goods and services that he would otherwise be able to buy if he were willing to sell the item at the market price. Costs are foregone opportunities.
The best way to understand something complex is to understand something less complex that operates in much the same way. If you already understand the less complex arrangement, it will be easier to learn how the more complex arrangement works. Fortunately, an auction is relatively easy to understand. It is widely understood. Here is a crucial fact: the market is a gigantic auction. So, whenever you are dealing with some unfamiliar or confusing aspect of economic theory, try to understand it as an aspect of the auction’s principle of high bid wins. This conceptual approach works because the market really is a giant auction. The market’s process is the auction’s process. It is an institutional system of competing bids.
In a market transaction, the seller is the economic equivalent of an auctioneer. He wants money, as does an auctioneer. An auctioneer wants as much money as he can persuade the top-bidding buyer to bid. It is his self-appointed task to persuade the bidders to keep bidding until only one bidder remains. This is how he maximizes his return from the sale. This is also true of a seller.
A standard auction operates in terms of implicit rules. First, anyone can attend the auction. There is open access. In an economy, we call this open entry. Second, property rights are honored. No bidder is allowed to steal the item from the auctioneer before the bidding begins. Nobody is allowed to steal it after the item is sold. Third, every bid must be honored. The person who makes a bid that turns out to be the final bid is required to pay whatever he bid. This keeps the bids honest. This is the market principle of honoring contracts. If an auctioneer secretly hires a stranger to make fake bids in order to keep the bids rising, the auctioneer will lose his reputation as an honest seller if this becomes common knowledge. Hired people who make such fake bids are called shills.
Here is the fundamental economic fact of every individual auction: bidders compete against bidders. An auctioneer may use certain psychological techniques to keep bidders bidding, but he does not control the bidders. He serves them. He provides an opportunity for them to make purchases on these terms: high bid wins. No one resents the fact that the person who bids the highest price takes home the item. There is no widespread envy against this person. He is not resented merely because he bid the highest price. Everyone accepts the distribution principle of high bid wins. This is the demand side of the auction process.
I have said there must be open entry. This also applies to auctioneers. There must be open entry for another auctioneer to rent space and conduct a rival auction. This makes available other goods offered for sale. This is the supply side of the auction process. Here is the fundamental economic fact of the auction system as a whole: auctioneers compete against auctioneers.
This leads me to the fundamental rule governing pricing in a free market: buyers compete against buyers, while sellers compete against sellers. If you understand this, you understand the essence of the market process. Every aspect of the market process rests on this principle of pricing. Also, every analytical aspect of economic theory rests on this. It is easy to understand. Sadly, most people who think they understand the market process do not accept the fact that the market process is at bottom the auction process. They think that buyers compete against sellers.
Whenever there are negotiations between a buyer and a seller, the reasons why there is negotiation are these. First, the buyer does not know how little money the seller is willing to accept. Second, the seller does not know how much money the buyer is willing to pay. There is a knowledge gap between them. There is an absence of competing sellers. There is also an absence of competing buyers. There is no open auction of competing bids. So, there is ignorance. The negotiations focus on the gap of information about what each party is willing to accept in exchange. In a free market, there are few gaps. Most items are sold at a listed price.
When you shop at a supermarket, it has check-out lines. You do not negotiate prices with the person at the check-out register. The person has a digital bar-code reader. You do not negotiate with a digital bar-code reader. So, there are only two decisions when you shop there, item by item: take it or leave it. That arrangement saves time. It also saves money. There is another supermarket down the street. Also, you may be able to buy the item online. There is open entry of shoppers. There is open entry of sellers. Out of this competition comes an array of prices.
Consider what Americans call a weekend flea market. Here, buyers come with currency, and sellers come with piles of used goods. Most of the items are junk in the eyes of everyone attending. Most shoppers would not pay anything for the vast majority of the items offered for sale. They are looking for a unique bargain: a diamond in the pile of rhinestones. They want to pay a rhinestone price for the diamond. This is the economic logic of the bazaar. Bazaars are common in economically underdeveloped societies. They are not common in rich industrial nations. Where the division of labor is advanced, supermarkets replace bazaars.
The buyer owns money, the most marketable commodity. He is therefore in a position of superior economic authority. Sellers want what the buyer owns. They compete with each other for his money. Sellers compete against sellers.
The buyer confronts a vast array of goods and services. These have prices attached to them. The buyer competes against other buyers for ownership of specific goods. Buyers compete against buyers.
The buyer has some idea of how much money most of the items he is shopping for have sold for in the past. The more research online that he has done, the more aware he is of two things: what comparable items sold for in the past, and what such items sell for in other locations. He has a sense of continuity with the past. He has a sense of continuity across geography. If he is buying online, he cares little about geography. The item will be delivered to his front door. He also can find information about what an earlier version sold for in the past, and what a used one sells for now. Amazon lets sellers of used books or used software make offers to sell. These are listed from the cheapest to the highest. There are also evaluations by owners of the new item, ranked by one star (worst) to five stars (best). This rating system reduces the zones of ignorance. The used goods provide alternatives to the listed new goods at the fixed price.
Then there is eBay, which is a true auction system. High bid wins. No one is upset when only one person made the final bid in a time-limited mini-auction. The principle of high bid wins clears the market. Every item offered for sale gets sold. It gets sold to the person who made the highest bid when the mini-auction ended. No one challenges this as unfair or immoral. No one complains that someone who did not make the highest bid really deserves to own the item, since he is poor or she is an unwed mother. The question of just deserts is not a factor on eBay. Only this is a factor: high bid wins.
The buyer imputes value to each item he is shopping for. This value is subjective. Some other shopper imputes a different value to it. But a good does not sell based on its highest imputed subjective value. It is sold in terms of an objective money price. On eBay, this price is publicly the highest price bid. On Amazon, this price is the listed price. For new goods, there is usually more than one offered for sale. You can buy several at a fixed price. On eBay, you can buy only one at an auction price.
The free market’s system of distribution is based on objective pricing. The pricing process is based on two factors: sellers compete against sellers, while buyers compete against buyers. Buyers bid with money. The money price is the objective price. This is what other buyers and other sellers pay attention to.
Participants in a free market do not ask how a buyer got access to his money: by inheritance, by a salary, by a lottery, or by wise investing. They cannot afford to do the research. In any case, their findings would not affect the outcome of the market process. Only this matters: high bid wins.
A buyer has limited funds. This limit establishes limits on the top prices he can pay. A buyer has some sort of budget. He cannot buy if he runs out of money or credit. He subjectively imputes value to various items that are offered for sale. His budget establishes objective limits on what he can pay, no matter how much value he subjectively imputes to an array of goods and services. As the Rolling Stones sing, “You can’t always get what you want.” But if he shops wisely, and if he budgets wisely, he will not have to sing, as they also sing, “I can’t get no satisfaction.”
We know from personal experience that we do not always stick to our budgets. At an auction, a person can get so excited by the bidding process for some item that he pays more than he had planned. His subjective imputation of value changes in the heat of the bidding. This is what the auctioneer wants to happen every time. He wants all of the attendees to overshoot their budgets, but not by so much that they cannot pay for the items after the auction is over, or that they will be afraid to come to his next auction. “I just can’t risk it. I get carried away. I will probably bust my budget.”
The bidding process in an auction is a means of price discovery. No one knows in advance what some item will sell for. Everyone knows after the gavel goes down: “Sold!” This is retroactive price discovery. In a free market, this process of price discovery is continual. No one knows at the opening bell what some stock or commodity will sell for two hours later or after the market closes. The retroactive results at the close provide information. It can be used by others to make decisions.
The seller is a specialist in information. He is constantly searching for better information. He probably sells to lots of buyers, or at least he hopes to. They own what he wants: money. He owns what they do not have: specialized information about his product. The better their information, the less room for bargaining he has. As the zones of buyers’ ignorance shrink, his opportunities for making a profit shrink.
Most markets price goods anonymously. This is true of every new item that has a digital bar-code symbol. There is no time for negotiating prices. The buyer in the check-out line cannot affect the price of the item. Neither can the person at the check-out register. What applies in a check-out line also applies to most products offered for sale. “Take it or leave it.” This saves time. That is, it leads to larger sales volume per time period. It also leads to a lower profit margin per sale.
A seller lets buyers decide among themselves who gets what. A seller wants to sell everything he offers for sale at the manufacturer’s suggested retail price. He wants money, not goods. He has made his plans in terms of sales, price, and time. If he meets these objective criteria, he will have more money than he did before he stocked the inventory. He knows that buyers are in charge. They have money. Money talks. Once he stocks his inventory, the pricing process will determine the distribution of his inventory. Either buyers will own it or else he will. He prefers that buyers own it, but at the prices he originally asked. He cannot force them to buy. He may have to lower his prices. But his initial pricing opens the auction process.
A buyer does not plan far in advance how many pencils he will buy on a particular date. He has a supply of pencils in some convenient location. He can see if he is running low. He takes a pencil and writes “pencils” on a shopping list. He has some vague recollection of how much he paid the last time. Pencils are not a high priority for him.
In contrast, pencils are a high priority for a manufacturer of pencils. He pays attention to prices of components and what retailers are willing to pay.
The retailer is in between. He is more interested in pencils than the typical buyer is today, but he is less interested than the manufacturer is. His business does not live or die in terms of pencils.
A pencil is a common product. Everyone knows what to expect. A buyer is not clear about pricing, but he has a rough figure, easily erased if necessary. He knows where to buy pencils. He may not recall the aisle, but he knows which store sells them.
The manufacturers have a good idea of what the demand will be for their pencils at traditional prices. Not much changes. Profit margins are low. Prices are low. Production runs are steady. There are few surprises.
Buyers set prices for the next production run. If they will not buy today’s inventory at set prices, retailers will not re-order as many unless the manufacturer reduces the wholesale prices. Buyers are in charge. They possess money. But they can’t always buy what they want at a price they prefer to pay. They are not autonomous. Pricing is set by competition: buyers vs. buyers, sellers vs. sellers.
The production of pencils is determined by the manufacturers’ expected demand by future consumers. If sales are expected to fall, manufacturers must adjust prices, or the size of production runs, or quality.
Production is aimed at expected distribution. Pricing determines future distribution, so it indirectly determines future production. The pricing process is the auction process: high bid wins.
The market is a giant auction. The logic of a local auction is the logic of the world market. The auction process dominates market affairs because the same legal and customary factors: open entry, property rights, laws against theft, honoring contracts. The pricing principle of market distribution is this: high bid wins.
An envious person resents the success of others. He seeks to destroy the other person’s advantage, even at the expense of everyone’s reduced wealth, including his. He thinks this: “That person has what I want. I can never have it. Therefore, I prefer to destroy it.” In modern politics, there is well-organized envy against those who possess great wealth. Most of these wealthy people gained their wealth by competing successfully in terms of high bid wins. They were winners in the auction’s process. They were allowed to take home the goods they bought. This fact outrages envy-driven voters. Political envy is a threat to the auction process. It opposes the moral and legal principle of high bid wins. Envious people stay away from auctions. They are offended by an auction because they resent the auction’s distribution principle of high bid wins. Envious people have the right to vote. They join with other envy-driven people to place legal restrictions on the distribution principle of high bid wins. They are also joined by other voters who have not grasped the analytical connection between the auction process, which they do not resent, and the market process, whose outcomes sometime produce results that these voters do resent. They all vote for legal restrictions on market processes that would clearly undermine any auction. If an auction’s system of distribution were required by law to abide by the following principle, there would be no more legal auctions: “The most deserving person’s bid wins. Politicians have the right to determine which bidders are truly deserving.”
If there is little envy in politics, this leads to secure property. This in turn leads to rising per capita productivity and therefore rising economic growth per capita.
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For the rest of this book, go here: https://www.garynorth.com/public/department193.cfm