Friday, November 16, 2007

Where Do Prices and Wages Come From?

The following is an excerpt from my lecture notes on supply and demand. It starts with a quote from a former colleague in the Philosophy department, who proposed that employers control labor markets. I then present two alternative theories: workers or consumers control prices, and finally, Supply and Demand determine prices. Only the latter makes sense.

Where do prices and wages come from?

Theory One: Businesses choose them (because they have “power”)

I have read and heard the claim that the market produces equilibrium between employers and workers, and I find it unpersuasive. The need to earn a living in order to survive requires that the worker sell labor. Workers are thereby required to accept the employer’s right to command their behavior, and are typically excluded from participating in the decisions that determine their efforts. Certain rights, claimed to be inalienable, are forfeited or suspended, consigned to the control of others. This imbalance of ‘power’ can be observed early: in the process of getting a job. Standards of work and performance, even the time, place and duration of the job interview, are established by the employer. The employment system seems not very different from the feudal arrangement in which the noble owned the land and the serfs were subject to his rule.”

-A colleague in Philosophy

Theory Two: Workers/Consumers choose them (because they have “power”)

The need to sell products to survive requires that the employer purchase labor. Employers are thereby required to accept the employee’s right to choose the circumstances of their employment, and are typically excluded from participating in the decisions that determine the use of labor.”

Or:

The need to earn profit to survive requires that the firm sell goods and services. Firms are thereby required to accept the consumer’s right to choose the circumstances of their purchases, and are typically excluded from participating in the decisions that determine quality and price of goods produced.”

Theory Three: Marshallian Scissors

“We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.”

-Alfred Marshall

What is the point? The point is that statements like "employers set wages" or "consumers set prices" don't make sense. These are not real explanations of wages or prices, because they predict a world that does not exist. If employers really had complete control over wages, they would set wages of all employees such that they could barely survive. Clearly this is not the case, even for non-unionized employees. If employees set wages, they would set wages such that businesses could barely survive (or possibly lower, if there was a coordination failure). Clearly this is not the case. If consumers set prices of goods and services, they would set prices such that businesses could barely survive (or, again, possibly lower). Clearly this is not the case.

Alfred Marshall showed the solution: Arguing about whether consumers or producers (or employers or employees) determine prices is like arguing about whether the upper or lower blade of a pair of scissors cuts a piece of paper. It takes both blades to cut paper, and it takes both producers and consumers--Supply and Demand--to set prices (a wage being merely a price of labor). For this reason, Supply and Demand diagrams are sometimes called Marshallian Scissors.
The amazing thing is that in such a market, no one is in charge of setting the price. The price emerges as a result of the activities of tens or hundreds or thousands or even millions of people, with no central direction. Of course, this assumes that the market in question is competitive--there must be several buyers and several sellers. This is almost universally the case in labor markets, and mostly true in product markets, but there are exceptions.

EDIT: An alternate graph has been added for readers confused by the previous graph.