[tony.destro]

Recently I was told by someone that high demand for a product causes producers to produce more which lower prices. I responded that high demand is a force for raising raises prices always and everywhere and that they are just talking about the subsequent increase in supply.

Which brings me to my question, is it always the case that increased demand brings with it a subsequent increase in supply and hence lower prices (obviously not if there is interference). I know economies and diseconomies of scale is one part. The entire structure of production has to change to meet the new demand however, so I’m wondering if there’s more I don’t know about.

[jmherbener]

Entrepreneurs base their production decisions on their anticipations of the array of prices of outputs and inputs that will occur over the period of production and sale of their output. They expand lines of production in which they anticipate profit and contract lines of production in which they anticipate losses.

So, not every case of increased demand driving up the price of some good right now will lead entrepreneurs to choose to expand its production. They might anticipate that other lines will generate more profit in the future from as yet unrealized increases in their demand. Also, as you imply, the economy is a lattice work of integrated production processes and therefore, prices are interrelated. Entrepreneurs might anticipate that other entrepreneurs bidding more heavily for inputs will drive their prices up and make unprofitable what would otherwise appear to be a profitable line of production. Another example how one must consider the integration of all economic activity is the specificity of capital goods used in production. If there is a highly specific capital good used as an input in the production of a good, then an increase in the price of the good from greater demand will dramatically increase the price of the specific capital good which raises the costs of production of the output. Entrepreneurs would then shift production toward the capital good which would moderate its price and bring the costs of production of the output down. The final effect on production of the output from an increase in its demand, therefore, may differ from the initial effect.

[tony.destro]

Thanks again Professor Herbener.

[tony.destro]

I was at the bar this weekend with another economist who normally agrees with 95% of what I say, and we discussed this topic.

He basically said: Now, what you appear to be arguing is that entrepreneurs will respond to an increase in demand by finding more efficient ways to produce the product.

You create a causal link between the increase in demand and the increase in supply by saying that entrepreneurs anticipate the increase in demand. The fact is that the causality you are implying is artificial. If entrepreneurs can find more efficient ways of producing, they’ll do so regardless of whether demand increases (or is anticipated to increase) or not.

Now I don’t know which end is up.

But I’m thinking the argument is not that entrepreneurs become more efficient, they build more machines, factories, etc. They expand production.

[jmherbener]

The dynamic I described does not depend at all on entrepreneurs lowering costs through finding more efficient methods of production. It is set in motion by increased demand for the good produced by the entrepreneur. Higher demand will increase the price of the good. The higher price of the good will increase the net income of producing it (even if the cost structure stays the same). The entrepreneurs’ Increased supply of the good will then moderate its price and the entrepreneurs’ increased demand for factors of production will increase their prices. These changes will eliminate the extra net income from further increased production.

[tony.destro]

My friend is trying to make sure he understands what you’re saying, he says this is what he gathers from your comments.

1. Demand for output up.
2. Price up –> Profit up.
3. Profit up –> Supply up.
4. Supply up –> Price down (by a lesser amount than in 2)
5. Demand for inputs up –> Price of inputs up.
6. Price of inputs up –> Supply down (by a lesser amount than in 4).

This doesn’t seem quite right to me. I’ve done some thinking and now it seems totally wrong, but I need help explaining it. Prices of inputs increase to the point where there is no longer profit potential

[jmherbener]

Your list is not quite right.
1. Demand for a consumer good increases.
2. Price of consumer good rises.
3. Profit for production of such consumer goods increases.
4. Entrepreneurs produce more of such consumer goods, which has two effects:
a. As they increase their supply of such consumer goods, the market-clearing price declines, which
reduces the profit from even more additional production.
b. As they increase their demand for the inputs used to produce such consumer goods, their market-
clearing prices rise, which also reduces the profit from even more additional production.

If your friend is a neoclassical economist, what is probably tripping you up (and it appears in your item no. 6) is that supply in the Austrian view is not based on costs of production. Production decisions are made based on costs of production, but selling decisions are based on the opportunity cost of selling the output, not the opportunity costs of producing it. Only in neoclassical models are selling decisions and production decisions synchronous. In reality entrepreneurs made production decisions and incur production costs before they made selling decisions and receive revenues. Once a good is produced, then production costs are sunk and are no longer opportunity costs of using or selling the good. But in order to sell the good and receive the revenue from the consumer, the good must have already been produced and therefore, production costs aren’t relevant for making the decision to sell or not to sell to the consumer.

If these points aren’t clear from the Austrian Economics lectures, take a look chapter 11 in Bob Murphy’s book, Lessons for the Young Economist:

http://mises.org/books/lessons_for_the_young_economist_murphy.pdf

[tony.destro]

Perhaps I am wrong, but I do not think he has been exposed to these arguments before. He has yet to reply to me (usually he does). So, unless he’s constructing some giant retort, I think he realizes the Austrian theory is internally consistent. He buys into most of what Austrians have to say anyhow, perhaps this is just another step.

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