Cost-Plus Inflation: An Ancient, Beloved, and Utterly Incorrect Myth
April 11, 2008
The economy is a giant auction. Whenever I don't understand something about the economy, I think, "auction."
Let's say you go to an auction. You see an original 1927 doo-dad. You think its value is $1,000. But maybe no one else at the auction knows what it is.
Then a torrential rain begins. People stop coming.
You are ecstatic. The item comes up. The first bid is $35. There is no second bid. The auctioneer says, "Going, going. . . ."
You bid $1,000.
Why? Because, if you factor in price inflation since 1927, the item is worth $1,000. It was manufactured for $80, and prices today are 12 times higher. You are convinced that the cost of production establishes the selling price.
Is this the way you would bid at an auction? Of course not. You might bid $100 to scare off the $35 bidder -- no bidding war. But not $1,000.
What is true about pricing in that rained-out auction is true of every other free market. The selling price is not set by the cost of production. It is set by the highest bid.
This was not understood until 1871, when Austrian economist Carl Menger's book, Principles of Economics, first appeared. (Download it for free here.) All previous economists (except Gossen, who was unknown), argued in terms of cost-of-production pricing. This was mixed up with supply and demand. The two explanations did not fit.
Menger solved the problem. Prices are set by supply and demand, and only supply and demand. Costs are set by competitive bidding earlier in the production process in expectation of what the price of the final output will be, which will also be set by supply and demand.
So, there are three laws of modern economics: the law of scarcity, the law of supply and demand, and the law of high bid wins. All the other laws are derivative.
There is no law of cost of production pricing. Costs do not set prices. Competitive bidding sets prices. It's just you, the $35 bidder, and the seller with the gavel. The three of you will set the price of that 1927 doo-dad.
It has nothing to do with the price of oil, the price of transportation, and the price of any other cost of production, except insofar as costs restrict supply. But the costs were also set by competitive bidding.
The cost of the doo-dad may have been $5,000 in 1927. So what? It's just you, the $35 bidder, and the auctioneer. You will probably take it home for $100, if things go your way.
It's exactly the same with everything else you buy. Don't make it so complicated. Don't confuse yourself. Just follow these three rules: (1) there ain't no such thing as a free lunch; (2) supply and demand; (3) high bid wins.
Prices are not going up -- if they are going up -- because oil costs more. Prices are going up -- if they are going up -- because the FED has created more money. Imagine an auction where the bidders are handed buckets of new currency. Prices will rise. This has nothing to do with the cost of production. It has to do with high bid wins.
There are no exceptions. More costly oil is not an exception. Costly coal is not an exception. Higher taxes are not an exception. The rule is simple: high bid wins. Unless someone is running a charity, high bid wins.
Oil costs more because people are bidding higher prices for oil. If buyers of gasoline bid more for gasoline, the price of gasoline will rise. But buyers of gasoline will have less money to spend on other items. So, in the auction markets for other items, the high bids will fall compared with last month's high bids.
This is simple. You can understand it. You can understand it because you understand auctions. Don't get confused. Stick with what you know: high bid wins.
Now, can you explain to your wife why the widespread expectation of rising demand for the products that use oil is what causes oil's price to rise? If not, re-read this article.