Orthodox economics, George J. Stigler and Fred Hirsch
By HaiCuan, Ooi
Abstract
Everyone knows that prices are determined by supply and demand. The phrase “supply and demand” was first used by James Denham-Steuart in his Inquiry into the Principles of Political Oeconomu, published in 1767. As a father of economy, Adam Smith used the phrase in his book, The Wealth of Nations which indicated the influence of this model begins from 18 century until today. George J. Stigler, a Nobel Prize winner in Economics (1982), further discussion the application of this model in his book, The Theory of Prize, which further provided an empirical support for this theory.
Fred Hirsch, late Professor of International Studies, University of Warwick, previously was a senior adviser at the International Monetary fund and Financial Editor of the Economist. His publications include Money International (1967), Newspapers Money (1975), Social Limits to growth (1977) and other books and articles mainly in the field of international finance. He grouped his arguments under three main headings: the question of social scarcity, or the pursuit of positional goods; the commercialization bias of the market economy; and the depleting moral legacy of capitalism. He argues that Adam Smith’s invisible hand, bringing benign out of selfish actions in the economic arena, is no longer operative[1]. Why does Fred Hirsch argue the Adam Smith needs to be stood on his feet, and that in matters economic, getting what we want is increasingly divorced from doing as we like? Do ‘positional goods’ affect the classical supply-demand model in determining the theory of price?
1. Introduction
In 18th century until today, the classical Supply-Demand model is used to determine the price of a commodity and is influential among all economics studies. Professor George J. Stigler has further explained this theory in his book by considering the searching cost for a commodity. But when considering the public return of searching, the prices of a commodity tend to being lower in respect to time.
In Hirsch important book, Social Limits to Growth, he brings up various kind of absolute consumption scarcity. The first category comprises physical scarcities and the second classification of consumer scarcity is social. Previously, the discussion surrounding the physical limits to growth raised up by orthodox economics dominated the public debate. With his notion of the competition of positional goods, Hirsch gave the debate a new dimension in the theory of price.
2. Supply-Demand model
In the viewpoint of Adam Smith, the market is work efficiently when it is ‘free’. To achieve such conditions, there should be limited government intervention (i.e. government’s power should only limited in law protecting property rights, citizen safety and some public works) and rational individuals. In this case, rational individuals mean he or she should be profit maximizing. After such conditions are achieved, the market is operated by an ‘invisible hand’.
Therefore, to determine the price of a commodity, according to Adam Smith, the price for a good or service should be at its market clearing point (where the supply curve and demand curve intersect).
Figure 2.1: Determine market clearing point with Supply-Demand model
3. Offered price of a commodity
Although Supply-Demand model tells us that most of the transactions occurred at the equilibrium price of the commodity show in the figure 2.1, but in fact the there is deviation (a few percents, perhaps) of equilibrium price in market due to factors such as some market powers hold of certain firms and asymmetry of information etc. Therefore, we can use the Supply-Demand model to show such variation of prices in the market.
Figure 3.1: The offered price for the commodity in the market
Using an experiment in Chicago as example, thirty dealers offered prices for an identical automobile ranging from $2350 to $2515, with an average price of $2436. In this sample, P1 = $2515, P2 = $2350 and P*=$2436.
Since the buyers will search more for low prices on commodities which take more of their income (i.e. more expensive commodities), any seller who quotes a price that is high relative to other sellers’ prices will sell little – most buyers will search on to find a lower price[2]. Therefore, we can predicts that the range of prices of washing machines quoted in a city’s retail outlets will vary more (relative to their average) than the prices of automobiles. One illustrative but real set of data are taken to test for this theory:
| Commodity | Average Price ($) | Coefficient of Variation (%) |
| Automobile | 2436.00 | 1.72 |
| Automatic Washing Machines | 223.45 | 3.42 |
Among the variation of prices, as orthodoxy economist assume the consumers are rational and profit-maximizing, it is obvious that their will purchase at the lowest price, if the services of dealers were identical.
4. Further explanation by George J. Stigler
In George J. Stigler’s book, The Theory of Price, he further discuss about the purchasing prices choose by the consumers. If shopping for low prices is not a sheer pleasure, the buyer will soon find that the probable savings from searching further do not compensate for the cost[3]. So the cost of semi exhaustive search would be high and shows a diminishing return.
This is simple common sense, which the economist translates into the language:
To maximize his utility, the buyer searches for additional prices will the expected saving from the purchase equals the cost of visiting one more dealer. Then he stops searching, and buys from the dealer who quotes the lowest price he has encountered[4].
Stigler defined that the cost of searching out one more price varies and it is dominant by the searching to a degree governed by costs and expected returns and act sensibly on the information. The consumer must have been able to attach a workable meaning to costs, or the predictions would have been contradicted; the dispersion among sellers on prices of commodities like washing machines would have been as small as for automobiles[5].
5. Asymmetry of Information?
In Stigler discussion, he has brought out one factor that highly correlated with the prices of commodity in a transaction, which is the cost of searching for the lowest price of the product. This issue bring out the question that we found controversy among most economists that is “Whether there is exist of asymmetry of information in the market?”; “If the answer is yes, how does it affect the market prices of the commodity?” In fact, there is present for asymmetry of information as different consumers are having different prices range for a product due to differences in experience and geographic limitation etc.
But people should realize that there is sharing of information between consumers which largely reduce the cost of searching. The point that brought up by Stigler in his book, The Theory of Price as where the returns from searching for the lowest price of a commodity appeared in a diminishing rate, is only apply to a single consumer. But when it comes to a large population, where there is exchange of information between consumers, although the private returns (to the consumer who searches for the product) from searching for the lowest price of a commodity is diminishing, but its public return is appeared in an increasing rate. The increasing rate of public return is largely depending on the speed of exchanging the information between the consumers and the relationship is positively correlated (i.e. the higher the speed of exchanging the information, the higher the increasing rate of public return). Therefore, if we still obeying the rule that, “To maximize his utility, the buyer searches for additional prices will the expected saving from the purchase equals the cost of visiting one more dealer. Then he stops searching, and buys from the dealer who quotes the lowest price he has encountered[6]”, the exchange of information between the consumer tends to move the transactions to a lower price respect to the time due to the external return (public return) from the searching (i.e. the longer the time, the wider the information of prices being spread and therefore, the transaction will occurred at the lower price) and finally after a certain of time (x period of time), the transactions will occurred at the lowest price in the market. But we should also considering the other costs which might bear by consumers, such as transportation cost, which limits the size of market for that particular lowest price (for the same commodity and same services), and cause the different “lowest price” in different particular area.
Therefore, even the return of searching is diminishing as mentioned by Stigler (I would like to say to private return of searching is diminishing), but it does not stop the transacted price of commodities to move toward the lowest price in the market (In a particular area when considering the other costs applied on consumers including the transportation cost), as there is present of external return (public return) from the searching, achieved by sharing of information between consumers.
This theory can be tested by the same sample used above or by using a simple econometric sample. Using the sample above, the experiment conducted in Chicago, thirty dealers offered prices for an identical automobile ranging from $2350 to $2515, with an average price of $2436, we can continue to collect the sample after a certain period of time (y period) from the same dealers for amount of transactions made and continues for a few times. If the theory is correct, where there is public return for the searching of lowest price of a commodity, we find that there is increase in the transacted amount for the dealer with the lowest price, provided the price offered, the services of each dealer and the quality of commodity is the same. The format of samples collected is listed in the appendix A and a graph is present below:
Figure 5.1: the data collected from the 30 dealers when there is present for the external return for the searching (the dealers might adjusted to lower price due to decrease in sales; if not, the y-axis can changed to be the dealers and the dealer with the lowest price will tend to have the most sales.)
Therefore, we can see that, to determine the price a commodity in the long term, the practice of the orthodoxy economy still applied here, which is occurring at the market clearing point where supply and demand meet, but the equilibrium price tends toward the lowest price in the market. To show this using the Supply-Demand model in figure 3.1, we can substitute the P* to $2436 and calculating the P1 and P2 using the variations of the sample as shown below:
Figure 5.2: The offered price for the automobile in the market and in the long term, it will tend to move to the lowest price which is $2350.
6. Fred Hirsch and “positional goods”
Fred Hirsch has brought up the different between the material economy and positional economy, where the prize determination in the material economy is highly correlated with its physical scarcity; whereas the prizing system in the latter is determined by physical scarcity and social scarcity.
Figure 6.1[7]: A Categorization of Consumption scarcity
Figure 6.1 gives a summary of various kinds of absolute consumption scarcities and presents them in a simple categorization. The first category comprises physical scarcities where consumers derive at least part of their satisfaction just from the inherent characteristics rather than as object that are scare. The concept of physical scarcity was introduced and continued carried out in the orthodox economics before the raising of social scarcity in public debate.
A second classification of consumer scarcity is social where consumer demand is concentrated on particular goods and facilities that are limited in absolute supply not by physical but social factors, including the satisfaction engendered by scarcity as such. The social scarcity may be derived from psychological motives of various kind, notable envy, or pride. As Hirsch points up, if the sole or main source of satisfaction derives from the symbol rather than substance, this can be regarded as pure social scarcity. This limitation is socially derived, though the influence of fashion.
But, a social scarcity may also be a by-product, or incidental. A social limitation may be derived from influence on individual satisfaction that are independent of the satisfaction or position enjoyed by others and that are yet influenced by consumption or activity of others. Essentially the phenomenon of congestion or crowding is in that category.
7. Price system (Material economy versus Positional economy)
Material economy, can be defined as, the output amenable to continued increase in productivity per unit of labor input. It is assumed that a continued increase in the materials productivity of product, that is, in final output obtained per unit of raw material input, will be sufficient to contain emerging shortages of raw materials as a result of technological progress, which is broadly what has happened up to now.
On the other hand, positional economy relates to all aspect of goods, services, work positions, and other social relationship that are either a) scare in some absolute or socially sense or b) subject to congestion or crowding through more extensive use. By positional goods, Hirsch means those goods the enjoyment of which is dependent on their non-possession by others. This may happen either a) because satisfaction is derived directly from the fact that others do not have the good, or b) through the phenomenon of crowding or congestion[8]
Therefore, the theory of prize used by orthodoxy economist as discussed above is only practicable in material economy and for the positional economy, although consumers do care about the prizes of a commodity, but they care more about their satisfaction. An example for the positional goods is the luxury goods, where consumers do not care much about the prize of the product. The behaviour of consumers are still the same with the assumptions that we made above, which is the consumers are rational and maximizing their utility, but the different is that the utility is no longer only accounted for physical scarcity; but also accounted for social scarcity. In such case, the demand is no longer predicable, as the lower the prices does not ensured the higher the demand. Consumers may focus more on the current fashion, the quality of the commodity and the satisfaction gained through the phenomenon of crowding or when comparing with others. Thus, the demand curve in such case tend to be upward slopping, where the demand for the products are going up when the price is higher (as the higher price meet those satisfaction of consumers perhaps, especially when comparing with others). The supply curve in this case will tend to be the same which is upward slopping or vertical (We notice that the supply of the commodity is limited by the resources and more important, the more commodities being sales, the less satisfaction the consumers will because the consumers gain satisfaction when comparing themselves to those do not have it). We can still use the Supply-Demand model to determine the price of the commodity but model is very different from the traditional Supply-Demand model as shown below:
Figure 7.1: Supply-Demand model (positional economy versus material economy)
People might question about the upward slopping of the demand curve, as is it possible that consumers will purchase more if the price of a commodity is rising? This phenomena can be explained by positional goods such a diamond, where people care more their satisfaction than the prices. Therefore, the higher the price of a positional followed with a higher quality (such as diamond), the higher the demand for that product (the demand of the product in limited in the high-earning classes as it is unaffordable among middle classes and low-earning classes). But this phenomena is happened only with a limited quantity of the product (in this case, Q1), as when the quantity of the product exist Q1 in the market, the satisfaction gained by the consumers is diminishing.
With this theory, we can offend found that there is a trend of changing in prices for those positional goods, from P1 to P2 in the market and their conversion from positional economy to material economy after their quantity in the market changes from Q1 to Q2, which also show the flow of demand for those good from high-earning classes to middle- and low- earning classes. Taken the first edition BMW as an example, when the first edition of the BMW is first introduce into the market, it first was in P1 and it is highly demanded among the high-earning classes and the higher the prices, the higher the demand of it from the high-earning classes as more satisfaction are gained after purchasing it. After certain periods (where the quantity of BMW existed Q1), it is being transformed from positional economy to material economy and this time the price of this first edition BMW is being determined by the traditional free market theory, where the supply and demand (from middle- and low- earning class; the demand from high earning classed is decreasing at this period, due to less satisfaction gained from purchasing, and they may shift their attention to other positional goods, in this case, the second edition BMW) being meet. The price was reduced from P1 to P2 whereas the quantity of this first edition BMW is being increased from Q1 to Q2.
8. Conclusion
The orthodoxy economists (such as Adam Smith) have brought up the Supply-Demand models for determining the theory of price. Stigler in his book, The Theory of price has further explain this points, but if considering the external return from searching the lowest price for a commodity, the price for in transactions tends to move towards the lowest price in the market in the long term.
Fred Hirsch has brought up as issue in the economy when he introduced his finding in positional economy. The price of a commodity is still determined by the market clearing point when the supply and demand meet, but the behaviour of consumers is very different compare to material economy brought up by orthodoxy as positional economy taking physical and social scarcity into account when determining the price of a commodity. None of his arguments make possible a blanket rejection as they are not only sound logic theoretically, but also highly support by perhaps, history evidences in the market processes.
Reference list
1. Hirsch, Fred, 1931- Social Limits to growth. Routledge, 1995
2. Jack Bakunim, The failure of Individualism (http://www.religiononline.org/showarticle.asp?title=1179)
3. J. Stigler, George - The Theory of Price. Macmillan Publishing Co., Inc. 1966
[1] Jack Bakunim, The failure of Individualism (http://www.religiononline.org/showarticle.asp?title=1179)
[2] George J. Stigler, The Theory of Price, 1996 (pg:3)
[3] George J. Stigler, The Theory of Price, 1996 (pg:1)
[4] George J. Stigler, The Theory of Price, 1996 (pg:2)
[5] George J. Stigler, The Theory of Price, 1996 (pg:3)
[6] George J. Stigler, The Theory of Price, 1996 (pg:2)
[7] Hirsh, Fred, 1931, Social Limits to growth, Routledge, 1995: pg 20-25
[8] Adrian Ellis and Krishan. Dilemmas of liberal democracies: studies in Fred Hirsch’s ‘Socials limits to growth’. Tavistock Publications, 1983: pg 185 -189
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