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Source link: http://archive.mises.org/10176/windfall-profits-and-that-which-is-not-seen/

Windfall Profits and That Which Is Not Seen

June 23, 2009 by

Market prices turn incomprehensibly complex relationships into very simple ones. Government policy does the opposite. It turns the simple into the extraordinarily complex, and, as Ludwig von Mises has argued in various places, government intervention in one aspect of the economy will displace resources, change prices, and likely lead to calls for government intervention in other areas of the economy. FULL ARTICLE

{ 13 comments }

Stephen Grossman June 23, 2009 at 9:29 am

“As a merchant, do you care at all what it costs your suppliers to produce their wares?”

You might if it influences their ability to be your long-term supplier.

KMcC June 23, 2009 at 10:39 am

I have a friend who recoils from this line of argument (many such friends, in fact) because they fear that allocation by prices will make it impossible for the poor to compete with the rich in securing goods and services.

Please, help out an amateur economist and give me a handle on how I can counter such fears without getting bogged down in justifications of private property and the signalling function of prices.

Many thanks in advance

Ron June 23, 2009 at 11:03 am

KmcC,

I know what you mean. I have friends who are the same way. While most of such sentiments result from a lack of understanding of prices (and the market in general), it’s tough to not get bogged down in theory when explaining it. A better tactic is to ask questions about everyday examples.

For instance, you might ask who controls the price of something common, like bread. The simple answer (ignoring the FDA and other intrusions) is either “no one” (if they have a basic understanding of economics), or “bakers” (if they display typical Marxist leanings). In either case, you could then ask why it is that a loaf of bread can be purchased for less than a dollar at the local supermarket.

By answering objections with questions, you can typically get them thinking about things themselves, instead of having to watch their eyes glaze over while you go into a lengthy explanation of the function of prices. Often this will draw contradictions into the light, and since they’ve come to the conclusion on their own it usually has more “staying power” than if you’d hammered them with facts and theory.

Just my $.0003 ($.02 inflation-adjusted).

Mushindo June 23, 2009 at 11:08 am

thanks for this. In my country ( SOuth Africa) the question of windfall profits gets a lot of media attention from time to time, usually coinciding with a high oil price. At these times, all the noises on the Left clamour for ‘windfall profit tax’ to be levied against the synfuel maker SASOL (Itself having felt the punitive sting of antitrust suits lately in the EU over paraffin pricing, but thats another story).

The question of windfall profits, and taxes thereon, is the exact inverse of bailout support .

All the usual moral property rights arguments aside, this does not make sense even within the statist paradigm. If the government imposes windfall taxes on Sasol in times of high oil prices, it must concomitantly assume responsibility for subsidising the same company when the oil price is low and it posts losses. From the perspective of any responsible CEO, the profits made from spikes and wide margins driven by factors outside the company’s control are the primary source of reserves to tide it over the inverse, when times are lean and margins are thin or negative.

As egregious as the multitude of interventions by my country’s appallingly centralist State is, it is to that government’s credit that it has (to date) firmly resisted these populist calls for windfall taxes whenever they have arisen.

All this reminds me – whatever the subject matter, SOuth Africa offers a microcosmic view of just about all of the issues at stake in th eongoing debate between Austrians on th eone hand and the rest of th espectrum smeared across Keynes and Marx on the other.

there is hardly an example of any fundamental issue described and analysed from an American perspective in this INstitutes work, that is not mirrored in topical issues in South Africa. Whether its the public healthcare mess and debate around a single Health INsurance fund, or ill-considered iintervention in struggling industrial sectors, or (of course) the cash haemorraging from appallingly-managed state enterprises ( hows that for an oxymoron?), its all here in spades. Just with fewer zeroes on the gross numbers. And they are re-learning and failing the same lessons the rest of the world’s ‘leaders’ seemingly have to re-learn every generation.

Ron June 23, 2009 at 11:13 am

I understand the argument as I saw what the government did in the 70′s to our neighboring town with rent control.

Mom and Pops used to rent out their family homes at reasonable rates and the city of Lawrence Ma was heavily occupied with a working class of people eking out a living. No one asked but rent control was forced upon the masses. (My theory was to stir up the housing market to force people to sell, thus getting Banks secured into th economy) the reason I say that as by 1970, most people were second generation home owners and living with one rent to pay the taxes and outright owned there homes.

The crushing economic conditions brought on by rent controlled forced the houses to become valueless and they were sold in deteriorating conditions. Then forced competition arrived in the shape of Federal housing that depleted the common housing market reducing the available tenants further exasperating the condition.
Stores closed, businesses moved out due to the influx of none paying tenants that could now live for below market worth, not work and steal their way through the economic falsehood, created by government intervention of value.
Soon again the houses deteriorated and de-leading was implanted to force renovations on the market to falsify the value again so people were forced to deal with bank loans. Again the government gave a cash flow to bankers at the expense of the marketers (Landlords) Soon houses and whole blocks were bought up by real estate conglomerates in cahoots with the Banks and government and chapter 8 was invented to sustain the false economy. Rent control was released and now the economic growth of the community was stifled and controlled under a few Real estate /bank/government partnerships designed around a hostile take over of the once privately owned, individual prosperity of a once vibrant working city.

All a product disguised as helping the poor while it really destroyed the city. What it was successful at though was creating a dictatorship of principles and economic struggle that the government can control, as long as they can rob the tax rate from federal assistance and windfall profits of their own making by local extortion.

No longer is Lawrence’s value controlled by its residence but by the propped up influences of Federal and state aid to a housing market that should be bringing financial security to those willing to own it.

So in fact, justifiable profit was taken from the hands of those that possessed it lawfully and with merit to those that stole it with aggressive accumulative government force so the profiteers could be from a select group of com padres willing to play the governments systematic raping of individual destiny and personal profit from self set values.

This is the insidious roll of government intervention in the market place, it soon displaces the individual liberty and set personal value under a controlled environment that breeds coercion over self determination.

Private-Freedom June 23, 2009 at 12:07 pm

Art,

You said:

“…expected prices determine the costs an entrepreneur is willing to incur. As a rule, people don’t incur costs and engage in arbitrary productive activity irrespective of expected benefits. In short, the price one expects to receive for a product — say a gallon of gasoline — determines the prices he is willing to pay for factors of production, how he will produce the product, and the quantity he is willing to supply. **Prices are not cost determined** [emphasis added].”

I would like to propose a challenge to this claim. Bohm-Bawerk showed, quite convincingly, that the prices for most manufactured goods are primarily determined by the costs of production.

I have seen more than one Austrian claim as much, for example, Reisman provides a good case in his textbook. David Ricardo also wrote about it.

The flaw in the argument that costs are determined by selling prices can be conveyed using an example.

Consider the production of a car. If the costs of building that car rest on the expected selling price of that car, then what would be the expected selling price of a particular car that is missing a steering wheel? The value of a car missing a steering wheel would be virtually zero. In this case, the marginal value of the steering wheel, a component, must be equal to, or very close to, the value of the car with a steering wheel. We can do this for each necessary component, from the wheels to the engine to the exhaust.

If any one of these integral components are missing, the value of the car collapses to near zero.

Putting all this together, what this means is that if the costs of the components are determined by the expected selling price of the car, *with* the component included of course, then the price of each component would *each* be the price of the whole car. This means that we arrive at a contradiction, namely, that the prices of the components must sum up to be greater than the price of the whole car. Clearly this cannot occur.

Therefore it is more correct to say that the price of the car is primarily determined by the costs of the components, plus a competitive rate of profit. In the market, many businesses actually price their goods in just this way. They consider the factor costs of their lowest cost competitors, and then add a “mark-up” to get a selling price for their own goods.

Perhaps the easiest way at arriving at the conclusion that costs determine prices (for manufactured goods) is to consider what would happen if selling prices deviated substantially from current costs plus a competitive profit.

If the selling price of a manufactured good exceeded the sum of costs of production plus profit by a significant enough extent, then investors have an incentive to place more capital in the production of that good to take advantage of those relatively higher profits.

By doing so, this will increase the supply of the good, and the price will drop, all else equal. The drop in price will decrease the rate of profit on producing and selling that good until the price settled around the costs of production plus a more modest and competitive rate of profit.

By the same token, if the selling price of a manufactured good were substantially less than the costs of production plus a competitive profit, then investors have an incentive to remove their capitals from producing that product. This will decrease the supply of the good and hence raise its price, all else equal. The price will keep rising until it affords a competitive rate of profit over the costs of producing it.

Since we have just seen that prices will fall if they are too far above costs, and will rise if they are too far below costs, it follows that selling prices for manufactured goods will gravitate around the costs of production, plus a competitive rate of profit.

It is not true that selling prices determine costs in the case of manufactured goods. However, costs of production themselves are resolvable into either further and smaller manufactured sub-components, or raw material or labor. If the sub-components of the components are manufactured, then they too will be priced according to costs of production. If the component or sub-component is labor, or a raw material, then supply and demand prices them.

Ultimately, every component of a car is priced according to supply and demand, if we break a car down into its most elementary components.

What are your thoughts on this?

filc June 23, 2009 at 1:42 pm

From Private-Freedom
[blockquote]
I would like to propose a challenge to this claim. Bohm-Bawerk showed, quite convincingly, that the prices for most manufactured goods are primarily determined by the costs of production.
[/blockquote]

Prices are determined by the supply and demand. This is the pricing system. Regardless of how much it costs you to create widgetA. Production costs may play a roll on a products price originally but if the product cannot sell the manufacturer must drop the price or sit in a warehouse full of unsold widgets.

Jonathan Finegold Catalán June 23, 2009 at 1:55 pm

An industry may increase the price of a car to make a profit, but it doesn’t necessarily mean that their product will sell, because other companies are selling their cars at market price (or at a better price). Usually, companies at that point would have to cut production costs (for example, lowering wages or reducing the amount employed).

billwald June 23, 2009 at 2:09 pm

We were driving through Illinois on 911 and one area had jacked up the gas prices outrageously which apparently induced panic and created long lines. This is the sort of situation that needs to be controlled. I suppose that web access would now limit this problem

Mark June 23, 2009 at 2:24 pm

It seems to me the best definition of reasonable is the supplier and the customers. By definition, reasonable people agreed on the price.

Eric June 23, 2009 at 9:14 pm

I think the same argument against minimum wages can be made against rent control:

If the minumum wage is great, why not raise it to $1000/hr.

If rent control is so wonderful, why not reduce rents to near zero?

If it can’t be seen that this would completely halt any renting or new rental construction, then no logic will prevail. But if the response is reasonable, i.e. at zero who would want to rent, then raise it to $100, then $200 etc. and consider what would happen at each step as it got higher or lower.

This sometimes works for me.

Emil Suric June 24, 2009 at 12:42 am

KMcC said,

“I have a friend who recoils from this line of argument (many such friends, in fact) because they fear that allocation by prices will make it impossible for the poor to compete with the rich in securing goods and services.”

It depends on what kind of goods you’re talking about. There are many different kinds of goods, some more expensive than others, for whatever reason. People of more modest means will not be able to bid away goods and services from the wealthy when it comes to specific types of goods. The lower income earners will have to wait for the price of that product to fall, which usually occurs when that product is replaced by a better product on the market. For example, you may desire the newest and most advanced computer, but its initial cost will be relatively high, and you may not be able to afford it. Luckily for you, you can wait 18 months and see that very same computer cost 50% less. This is the nature of price elasticity, and normal vs inferior goods. At any given time, an increase in the price of one product must necessarily mean a decrease in the price of another (proportionately). Inflation demeans this principle in nominal terms, but not in real terms (at least not completely). There are plenty of high quality substitutes which are far cheaper than the newest and most expensive products.

Walt D. June 24, 2009 at 10:18 am

I see this as a right to property issue. While libertarians view the right to property as fundamental, it is a right we don’t actually have in the US. All levels of government seem to think they have the right to commandeer private property for the public good, or at least for their own good.
The issue is simple, if we can’t agree on a price, I don’t have to buy from you and you don’t have to sell from me and vice versa. IMHO the right to property should prevail even if it were not the case that there is a strong economic argument that price controls create shortages
The issue is distorted in cases of natural disasters. However, government actions always seem to exacerbate the situation. This is a good example of what Jay Richards refers to as “The Piety Myth (focusing on our good intentions rather than on the unintended consequences of our actions)”.

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