Economics

Do Supply and Demand Define Economic Value?

Economists have taught us that nothing by itself has intrinsic value. The value, according to them, rather depends on supply and demand for that thing. If the supply is high and the demand is low, then the value automatically decreases. Conversely, if the demand is high and the supply low, then the value automatically increases. This idea has led to the notion that monetary value is a figment of our collective imagination; that there is nothing intrinsic in nature that has monetary value, and therefore economics isn’t the study of intrinsic value but rather the study of how humans perceive the value in things based on supply and demand. This post challenges this idea and argues that monetary value can be a natural property of matter, quite like physical properties in science are considered natural properties of matter. It also shows how all variety of economic problems arise when monetary value is treated as arising from supply and demand.

The Supply and Demand Theory

The supply-and-demand theory of value argues that value is a function of human perception. For example, if bell-bottom pants are considered fashionable, then a number of people would want to buy such pants and depending on the supply for such pants you may be prepared to part with less or more money to buy such a pant. As the bell-bottom pants go out of fashion, the demand for them drops, and the price you are prepared to pay for it also drops. The material object in this case—i.e. the bell-bottom pant—is the same, and yet it is sometimes more valuable and at other times invaluable.

Of course, the cost to produce such an item may be the same—cloth, stitching, packaging, shipping, retailing—but the price of the item drops if people don’t want to buy it.

The question now is: should we attribute value based on what it takes to produce that thing, or based on how much a purchaser is willing to pay for it? Clearly, the price of a commodity cannot be less than the cost of producing that commodity, because then nobody would want to produce that commodity. However, the price can be significantly higher than the cost.

To change the cost of production, we need to find new ways to produce—i.e. develop new technology and processes of production. This, in general, is much slower and harder. Therefore, the cost of a commodity changes much slowly, but the price of the same commodity can go up and down rather quickly. For example, the cost of a bell-bottom pant is higher than a slim-fit pant (because slim fit pant needs less cloth) but the price of the slim-fit pant can be much higher depending on the fashion of the times. The cost of a commodity depends on how much matter and energy is needed to produce something, but the price depends on only our desire for that commodity.

Is Value Cost or Price?

Should the monetary value of something be based on cost or on the price? If the value were based on costs, then we would pay just what it takes to produce that thing. If a better process for producing that commodity was found, it would decrease the cost, and therefore the price. This, in turn, would force a producer to be more competitive relative to the other producers but it fundamentally doesn’t change their profits. It does shift the consumer from a higher-cost to a lower-cost producer.

Economists abhor this idea because economics aims to increase profits. If value is decided by costs and the costs fall, so do the prices. The producer makes no extra profit although he can garner a larger market share. The system fosters competition for the betterment of the consumer, but not to the betterment of the producer because despite making improvements the producer does not have increased profits. To incentivize greater profits for the producer, economists place the value in the price rather than the cost. But now the price is not tied to how hard it is to produce, package, transport and deliver a commodity—but only to the perception of its value by a consumer.

The world would tend towards economic stability if the economic value were defined to be the cost rather than the price because such an economy would foster decreasing costs, and as time passes the cost reduction bottoms out leaving the prices constant unless the supply of raw materials itself changes. If the raw materials are in adequate supply, then cost of production (human endeavor and natural resources) reduces rapidly due to competition but eventually bottoms out. This rock bottom cost represents the point of stability in an economic system because higher cost products cannot be sold, and cost reduction by further optimization is no longer achievable.

If for whatever reason people’s desires or needs changed to something new, the older commodities would go out of fashion and be replaced by the new commodities, although the prices would still be based on the costs of production. Unless you want to possess something naturally rare—e.g. gold ornaments—the prices would be low. Also, since gold is naturally scarce, the cost of its production cannot be significantly changed, and therefore the price of gold would also remain unchanged. In short, economy naturally stabilizes once we shift the notion of economic value from price to cost.

When Economic Value is Price

Modern economic theory shifts our notion of value from costs to prices. The value is not intrinsically in anything; the value rather depends on our desire for that thing.

The belief is that if we increase our material desires, then lots of material things would seem to be of value to us because we would want to have them: by increasing such desires and thereby acquiring the things that are desirable, we would create a lot of value. Economics is primarily aimed at the creation of value, and given that value depends on our desiring material things, the value can grow only when our desires grow.

In order to grow our desires, the seller must “advertise” the product, making it alluring to the buyer. The greater the allurement, the greater the price that it can command. If you have a limited supply of money, then you have to decide which of the allurements you would succumb to. However, given the fickle nature of such allurements, the buying patterns of consumers keep changing—many things being bought are unnecessary anyway, so we can often live without them. As the demand for a commodity changes, the prices too change, even if the costs were unchanged—the producer was selling at an inflated profit margin and can therefore accommodate a lower margin.

If prices were costs, and the costs were fixed (based on supply of natural resources) then a seller will not incentivise a commodity by lowering the price—through a sale or additional advertising—because these fundamentally increase the costs and should therefore increase the price. If people are not buying something, then increasing the price would not make them buy it anyway. Thus, a producer must either stop producing less desired commodities, or stop and start based on the demand, or steadily produce them at a lower rate and maintain an inventory (which in general increases prices). The economy driven by costs quickly drives down costs, eliminates inflation, and prevents unnecessary stockpiling (inventory) to make a profit at a later time.

As the prices of some commodities stabilizes, the prices of other commodities which use and depend on these other commodities stabilizes too. The demand and supply may change temporarily but it doesn’t change the prices. Now producers have a natural preference for producing those commodities where the demand and supply is unlikely to change—i.e. the bare essential necessities. This is because changing demands require either stop-and-start or inventory, both of which are hard and expensive. The producers therefore prefer the production of only those things where the demand and supply will be steady over time. Unnecessary commodities that were previously being pushed in a market simply by aggressive pricing or aggressive advertising disappear automatically. The society now goes back to a stable system in which people produce and consume what is necessary, bringing down the consumption to the bare necessities. As these necessities don’t change with our whims and fancies, the economic oscillations end.

Economies can never stabilize as long as values are attributed to prices, and prices are determined by supply and demand, because expecting the stability amounts to a state in which our “wants” are fixed. Human “wants” have no upper limit, although these “wants” can be reduced to the bare minimum “needs”. An economic model that depends on wants, rather than needs, must keep oscillating due to feedback loops of changing wants: if I reduce my wants, then some producers must also reduce their wants, which triggers a domino effect. Similarly, increasing wants in me too create a domino effect. As the dominos fall to the left and the right, the economy must oscillate. Economy can quickly stabilize if the value is attributed to the cost, because that reduces consumption to the bare necessities, which in turn removes the domino effects. 

Meritocracy and Free Market Economics

Economic value is today regarded as a human construct only because we treat value in prices rather than costs, and the prices are decided whimsically based on total demand and supply. Economic value can be a natural property if it is defined as the cost of production—namely the amount of matter and energy required in order to produce it. A capable person can produce a commodity efficiently, and that capability, therefore, does not command a higher price, because for the capable person the cost of that production is low. Similarly, the cost of production would be high for an incapable person, and that would, in turn, mean that nobody would buy the product from the incapable person.

The shift from price to cost, therefore, does not remove competition in society—which is what a free market economist would expect. Rather, the competition (by way of reducing costs and thereby prices) would favor the competent over the incompetent. The mechanism, therefore, favors the development of competence in the production and producer, in order to compete in the market. It also naturally displaces the incompetent because they have higher costs of production.

The shift from price to cost as a measure of economic value, therefore, has all the advantages of a free market economy without the problems that the current system brings to the world—i.e. random and rapid fluctuations in demand caused by whimsical shifts in people’s desires.

Value as a Natural Material Property

When the value is attributed to the costs of production then the value can be treated as an objective property of a material process—i.e. the raw ingredients, and the effort involved. This is when the economic value can be treated as a scientific construct about matter. It is no longer a fact of our perception alone; indeed, a price that surpasses or underestimates the cost would be tantamount to an illusion in our perception where we fail to estimate the true process of producing a commodity. Indeed, prices divorced from costs are an illusion because we perceive much higher value than there truly is. 

Economics can therefore also be natural science, rather than a social science if the economic value was defined as cost rather than price. It has all the benefits (i.e. free market system, development of competence, and focus on the best product based on the lowest price) without any of the attendant issues in the current economic systems (price manipulations, random fluctuations, exploitation of the consumer by artificially creating a perceived value when the real value doesn’t exist).

Free Markets vs. Globalization

Globalization is hinged on the idea that the production costs must be minimized by employing the cheapest labor and resources available, while the prices of the commodities thus produced must be maximized. This causes the flight of labor from high-cost to low-cost productions, while the commodities thus produced are sold in places where the higher prices can be commanded. The business that globalizes thus creates huge profits for the producer while ripping off both the consumer and the worker. The workers are made to work in impoverished conditions, and they don’t receive the value as determined by the prices. And the consumers are made to pay a price unrelated to the costs of production. The gap between the costs and prices are increased by globalization.

Indeed, as has become quite evident now, all those people who own globalized businesses are accumulating an increasing wealth at the expense of consumers and workers. This is made possible because globalization facilitates a greater disparity between prices and costs, and the difference between the two becomes the profit of the globalizing corporate owners.

The modern argument for globalization is a free-market economy where goods and services can be purchased and sold anywhere in the world, but as already noted above, free markets by themselves don’t entail globalization if the prices are proportional to the costs. There is no harm is reducing the costs of production if the prices are proportionately reduced. Humans everywhere have talent and they can exchange this talent with the talent of other people. The problem is that prices are determined by desirability rather than the cost of production. Thus, simply by making something more desirable a business can command a higher price, even though the cost involved is low.

Globalization – Developing vs. Developed Economies

The prices in developed nations have inflated because the desires have increased, which allows a business to command a higher price. In a developing nation, the desires are much lesser, which means that they are not going to pay a higher price, although they can easily produce. As the means of production fly to the developing nations, the people in the developed economies lose jobs and thereby have even lesser capacity to purchase the higher priced products. This again causes a fall in demand, thereby a fall in prices, causing businesses to fail, and ultimately economies to fail.

Globalization depends on the disparity between developing and developed economies. If all economies were developing, then everybody can easily produce but nobody wants to pay a higher price. That would, in turn, mean that the means of production would move nearer to the place of consumption and thereby invert globalization into localization. Conversely, if all economies were developed, then everybody has a higher level of desire, which commands a higher price, which means that the producers too would need to be paid well, thereby destroying the incentive for globalization which seeks desperate workers who can work more for less. In other words, if the entire world is either a developing or a developed economy, globalization would never occur; the economy will be localized.

A system that depends on fanning people’s desires in order to increase prices while aspiring to reduce costs by producing in a place where these desires are low simply causes chaos as the prices go up and down, thereby causing businesses to see a meteoric rise and cataclysmic collapse. As the economy collapses, the desires don’t disappear; it results in frustrations and societal dissent. At the root of all these problems lies the fundamental issue in believing that economic value is man-made rather than natural, and ultimately that value is decided by demand, rather than by costs.

Can Economic Theory Deliver Happiness?

Neither free markets nor globalization are problematic per se. Historically, nations have traded goods based on where the costs were lowest. The recent twist in the tale is that this trade involves ways to increase the prices, by manipulating people’s desires, because the value then commanded is determined by demand, rather than the cost of production.

This manipulation involves social engineering where people are encouraged to increase their material pleasures and once they are hooked, the prices can be increased because the consumers will pay whatever is necessary to feed those desires. A society and business that relies on fanning such consumption in order to command a higher price cannot be ethical because it amounts to trapping a consumer before sucking them dry.

Society cannot be happy under an exploitative system. For a happy society, economic value must be equated to the cost with competition for a reduction in costs. Nature provides a natural limit to the lowest cost, but no limit to the highest price. Cost reduction, therefore, has a limiting point, but the price rise has no limit. When the economic value is defined by the price someone is willing to pay, this value will artificially rise and fall, thus creating economic churn and chaos. If instead, economic value is defined by the costs, the value will decrease and stabilize because nature provides the limits to how low the costs can be—by the laws of nature and the availability of resources.

The real value of something isn’t the highest commanded price, but the lowest requisite cost. When society pursues this economic model, it can nurture competition of reducing costs by the development of expertise (or what we call “innovation”). This doesn’t mean that every low-cost commodity can be sold, but only that only those commodities which are demanded can be sold, although the seller who succeeds must compete by lowering the production cost. Falling costs mean falling prices, which naturally drive down the tendency to consume unnecessary things. The system protects the environment, prevents overexploitation for profit, and delivers stability.

Costs and Complexity – The Underlying Science

We can go from point A to B in space using many paths. But do we take a random path, or seek the shortest path? Early theories in science were based on the Least Action Principle in which a certain quantity (called action) was minimized. This action represents the effort required to go from A to B and constitutes what we ordinarily call the cost of production. The best path to go from A to B is also the path that involves the least cost, and the value thus produced must equal the cost.

The least action or the shortest path involves the minimization of complexity. While someone can convert A to B using a longer path, or higher amount of effort and complexity, this increase in action and complexity doesn’t represent the most optimal cost. The process of such production simply represents an inefficient system. The real value in the transformation of A to B, therefore, isn’t what an inefficient system will produce, but what the most efficient system can produce.

Nature facilitates such minima, which decide the lowest cost, and therefore the real value. At present, however, we disregard this natural process of deciding the economic value of things. We rather decide the value based on demand, creating an unsustainable system. A simple shift in the definition of value from price to cost can generate a tremendous shift in society at large because it will change the focus of value from a man-made construct into something that can be natural and objective.

Modern Economics Is An Illusion

Nature provides a system to decide the real value of a commodity based on the process it takes to produce it. The process can be optimized but there are limits to that optimization. Modern economics—by disregarding this natural process of fixing the price by the cost—produces an illusory system in which prices are decided by human perception rather than the most optimal natural cost. As a result, economics has become a social science rather than a natural science. The consequence of this viewpoint is that economic systems constantly fluctuate as the human perception changes, businesses aim to exploit and alter the human perception, thus creating great chaos and unhappiness.

Society can never stabilize under the profit motive when profits are based on manipulating human perception. It can stabilize when humans compete to attain the most optimal production permitted by nature. Such an economic system constitutes a free market economy that encourages competition without the cycles of boom and bust. The reductions in cost are limited by nature, which provides the point of stability because human production can only hope to attain the limits, not cross them.

The Objective Measure of Value

Unlike the current economy which oscillates like a pendulum, the alternative economic system is like a slope that ends in a plane: there is a well-defined minimum that cannot be breached, and that minima represents the point of stability whereupon costs and prices cannot rise or fall unless the supply of natural resources themselves is altered. Such a system is aligned to nature and constitutes the best possible economic system that we can hope for. It still doesn’t entail an eternal paradise because the economic system will fluctuate as the supply of the natural resources changes. And yet, with every such change the economic system will quickly settle into a new state of optimality. Such an economic system evolves with nature’s progression but does not fluctuate arbitrarily. In so far that nature’s progression is gradual, the societal changes—under the cost-based system—too will be gradual.

Unlike the economic system based on prices which are subjective, the economic system based on costs is objective because nature decides the least cost for everything. While the human perceptual process is amenable to manipulation and illusions, the natural costs are fixed based on the availability of natural resources and constitute an objective measure of value. This objective measure is not eternal, nor can it be universal. But within the constraints that humans can exchange goods and services with each other through trade, it constitutes the most optimal system that we can envision.