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then, as a given aggregate sales volume is distributed among the two groups
in such a way that a significant discrepancy exists between the marginal
revenues associated with the last units sold in each group, an opportunity
exists for profitable price discrimination. By exploiting the division be-
tween the two buyer groups, the seller may take advantage of the greater
eagerness of some of the buyers to buy in the one group at the same time
as he taps the revenue obtainable from the large number of potential buy-

26 A standard textbook example is provided by the market for electric power.
MONOPOLY AND COMPETITION IN THE GENERAL MARKET 293


ers in the second group who are prepared to buy only at low prices. The
seller will have exhausted all opportunities for further profitable price dis-
crimination when he has adjusted prices in the two groups so that marginal
revenues are the same for both groups.27
Where discrimination in the price of a product is possible in this way,
the monopolist-producer will determine his optimum output accordingly.
As always, he will seek to adjust his output to the point where his marginal
revenue is just balanced by his marginal cost. The marginal revenue rele-
vant to the case where discrimination is possible is of course the additional
revenue obtained through a unit of expansion of total output when output
(both before and after the proposed expansion) is distributed between
the groups by means of the different prices asked so that the marginal
revenues of the quantities sold in each of the groups are equal to one an-
other.
By discriminating in this way between the two groups, the monopolist-
producer may be able to profitably employ all of the resource that he mo-
nopolizes, even though, without price discrimination, it might have been
in his interest to raise the over-all product price through monopolistic
output restriction. Price discrimination enables the monopolist-producer
to gain at least some of the additional revenue resulting from a higher
price, without having to sacrifice all the revenue that he would have to
lose (without discrimination) on the units that cannot be sold at the high
price. The price-discriminating seller is able to sell the units that cannot
be sold at the higher price to a group in which they can be sold at a
lower price.
Where price discrimination is practised, those charged the higher price
are being deprived of part of the consumers' surplus ^8 that they might have
enjoyed in a market without discrimination. Without discrimination
those buyers most eager to buy would not have had to pay a price any
higher than the price paid by the least eager buyer. Now the division of
the market into buying groups forces the buyers in each group to pay a
price no lower than that paid by the least eager buyer within the group.
The segregation of the more eager buyers into one group thus forces them
all to pay prices higher than would have been paid when less eager buyers
were in their market as well. Of course, each of the buyers, even those
paying the highest prices, consider themselves better off by buying than by
refraining from buying (or else they would not be buying); nevertheless

27 T h e point made in the text is frequently expressed alternatively by saying that
discrimination will be worthwhile where the aggregate demand curves of the two (01
more) sectors of the market have respectively different elasticities at a given price. Since
MR = p + p/e, it follows that where the sector demand curves have different elasticities
for a given value of p, the respective marginal revenues will not be the same.
28 See p . 110.
294 MARKET THEORY AND THE PRICE SYSTEM


the division of the market has enabled the monopolist-seller to prevent
them from gaining an even greater advantage from their purchases.29
A special case where this can be achieved almost completely is some-
times termed perfect price discrimination. Perfect price discrimination
is possible where the seller divides buyers from each other so completely
that each of the buyer's "groups" consists of only one buyer.30 By dealing
with each buyer individually, a seller conceivably might charge (assuming
he possesses complete knowledge of each buyer's eagerness to buy) each
buyer a price so high that all consumers' surplus is wiped out for all buyers.
Where a number of buyers are included in a group of buyers, even where
they are all very eager buyers, the most eager still gain some consumer
surplus, since they pay a price no higher than is sufficiently low to induce
the least eager in the group to buy. When the size of a "group" dwindles
to one buyer, however, it may be possible for the seller to extract from
each buyer the highest price that he is prepared ever to pay for each
unit bought. (This implies, of course, that a different price will be ex-
tracted from a buyer for each of the units that he buys.) The seller can
achieve this by offering a given quantity to a buyer and demanding a price
for the whole quantity (the price being what the seller believes will just
leave no consumer surplus), with no option to the buyer of purchasing
any smaller quantity at a proportional price. (The seller will determine
the sizes of the lots he will offer to the various buyers, in this all-or-nothing
fashion, in the way that will maximize his own net proceeds.)
Analysis analogous to that presented in this section can be developed
to deal with the conditions price discrimination might be practised under
by a buyer.*1 In the absence of institutional divisions between different
groups of sellers, however, it is doubtful whether monopsonistic price dis-
crimination could be maintained for any length of time.

SUMMARY
This chapter has examined the modifications in the general market
process that are introduced as a result of the concentration of the supply
of particular resources (or the production of particular products) in the
hands of single market participants.
When the entire natural endowment of a particular resource is con-
centrated in the hands of one owner, it may or may not be profitable for
29 For a situation where each of the buyers is better off with price discrimination
than without it, see Mises, L.v., Human Action, Yale University Press, New Haven,
Connecticut, 1949, p. 387.
30 The standard textbook example of this possibility is a physician selling medical
services to his patients.
31 See Robinson, J., The Economics of Imperfect Competition, The Macmillan Com-
pany, London, 1933, pp. 224-228.
MONOPOLY AND COMPETITION IN THE GENERAL MARKET 295


him to force up the price by restricting supply (depending on the elasticity
of demand for the resource). Where the monopolist finds it worthwhile
to hold some of the resource off the market, corresponding changes are
brought about in the methods and volume of production affecting the
availability of goods to consumers. Where a resource is exclusively owned
by a group of owners able to act in concert, they too may conspire to force
up the resource price by restricting supply. (Several variants of resource
cartel possibilities can be analyzed.) However, such cartels may face seri-
ous problems of enforcing the respective cartel agreements. Where all the
buyers of a resource combine, they may be able to exert short-run effects
on prices and production.
Where the sole owner of a resource chooses not to sell any of it to
other producers, but establishes himself as the sole producer of a product
for whose production the resource is essential, he can employ his monopoly
power in the product market. Detailed analysis shows the conditions under
which he will be able to profit by using his monopoly power to raise the
product price through output restrictions. Further analysis explains how
his favored position may also have an impact upon the markets for the
other resources required for the production of the exclusively produced
product.
In a market where there are numerous, slightly differentiated compet-
ing products, it may not always be immediately apparent whether or not
some of the resources are monopolized.
The analysis also clarifies the existence and impact of the sole producer
in situations where he does not have monopoly power, as defined in this
chapter. In such cases market activity is carried on under the influence
of potential competition. A special case typical of this kind of situation
is where the economies of large-scale production result in only one producer
or a very small number of producers.
The absence of monopoly power, as defined in this chapter, does
not imply that each buyer of any good or service faces a perfectly elastic
supply curve, nor that each seller face a perfectly elastic demand curve.
These latter conditions are usually required for much discussed models
of "perfect competition." The idea should be avoided that such models
are in any sense "normal."
One particular possible result of monopoly control is that more than
one price may emerge for a particular good, even in equilibrium. Such
possibilities are investigated by the techniques of the theory of monopo-
listic price discrimination.
296 MARKET THEORY AND THE PRICE SYSTEM


Suggested Readings
Mises, L. v., Human Action, Yale University Press, New Haven, Connecticut, pp.
354-388.
Hayek, F. A., "The Meaning of Competition" in Individualism and Economic
Order, Routledge and Kegan Paul Ltd., London, 1949.
Machlup, F., The Economics of Sellers' Competition, Johns Hopkins University
Press, Baltimore, 1952, Ch. 4.
13

The Price System and the
Allocation of Resources



this book has been con-
JLYJLOST OF
cerned, "positively," with the operation and mechanics of a free enterprise
system and the market process. We have discussed the process by which
the market determines (a) the prices and quantities produced of each possi-
ble product, (b) the prices and quantities employed of each of the available
resources, (c) the particular group of resources used for the production of
each of the products produced, and (d) the income secured in the market
by each of the consumers and the particular group of products each con-
sumer spends his income on. In Chapter 3, as part of our over-all pre-
liminary survey of a market economy, it was noted that such a system can
(like so many other things) be viewed not only positively but also norma-
tively. That is, a market system can be examined not only in order to
discover chains of cause and effect, which may exist under such a system,
but also in order to judge the degree of success with which the system
achieves specified goals. In the present chapter we return to such an ap-
praisal.
We have seen that each market participant takes part in the market
process only because he believes that he can in this way achieve his own
goals more fully than by acting completely on his own. In Chapter 3
we saw further that each of the participants is concerned that the system
coordinate the activities of all the participants. A participant will special-
ize in repairing other people's automobile engines only if he can rely on
the market system to ensure that other people will bake his bread, build
his home, and produce his clothes. The more efficiently such coordination
is achieved, the more fully each of the participants will be able to fulfill his
own goals through the market. Coordination, we found, must involve
297
298 MARKET THEORY AND THE PRICE SYSTEM


(a) the priority system according to which the wishes of consumers are suc-
cessively satisfied, (b) the method of production employed for the produc-
tion of each of the products produced, and (c) the means by which the
several contributions of different individuals, who have cooperated jointly
in a single productive process, can be separated for the purpose of assigning
incomes corresponding in some way to individual productive contribution.
In the market system, we found, it is through the assignment of market
prices to resources and products that these coordinating functions are ful-
filled. In the present chapter, within the framework of such a price-co-
ordinating system, we appraise the market system as a means to achieve
the appropriate allocation of the available resources, as judged from the
point of view of the market participants. Market participants, in general,
will wish to know how faithfully the market process impresses upon the
organization of production the pattern that "efficiency" requires, as meas-
ured with reference to the very price system upon whose coordinating prop-
erties the market participants are relying.

THE POSSIBLE LEVELS OF "WELFARE" APPRAISAL
Inquiries into the allocative efficiency of an economic system usually
are termed "welfare economics." (This term goes back to a time when
economists uncritically believed it possible to talk meaningfully about the
"total welfare" of a group of individuals. Since then it has come to be
used to cover discussions of the efficiency of a social apparatus in which
"efficiency" is far more carefully defined.) It should be stressed that in-
quiries into the allocative efficiency of a market system can be attempted at
tïuo levels, and that it is only one of these that primarily concerns us here.
The first kind of welfare inquiry assumes all the relevant data are
known, in principle, to the inquiring economist as well as to the market
participants. The initial problem for the economist is to devise "op-
timum" patterns of productive utilization of the known quantities of all
resources, and of distribution of the resulting products among participants
with known tastes. A market system will then be appraised as to whether
its freedom from ignorance enables it to attain such an optimum-allocation
pattern of activities. With full knowledge of all relevant data assumed,
the market position that is set up for appraisal on this level of inquiry is
the position of full equilibrium. The conditions that spell out an equi-
librium position for a market economy (endowed with a given initial set
of factor endowments and with participants of given tastes) are appraised
and compared for their consistency with the conditions for optimality.
We do not consider this kind of welfare inquiry in this chapter.1
1 This first kind of welfare inquiry, presents an essentially mathematical problem. The
general results of this kind of welfare inquiry usually lead to the conclusion that the so-
THE PRICE SYSTEM AND THE ALLOCATION OF RESOURCES 299


The second kind of welfare inquiry we are concerned with proceeds
from the assumption that each of the participants is to a large extent
ignorant of the body of information that includes all the "data" of the
market. The initial position assumed for the market is thus a state of
disequilibrium. Initially, the market is understood to be making numer-
ous "errors"; the initial decisions of the various participants are to a large
extent z¿rccoordinated with one another. The market process brings al-
terations in these decisions. The process may be appraised as to the
efficiency with which, employing the limited scraps of information scattered
among the participants, it discovers and corrects the initial errors and fail-
ures in coordination. In this second kind of appraisal, it is the market
process that is being judged rather than the state of equilibrium the proc-
ess leads toward. In many respects this second kind of inquiry is the one
that market participants may be expected to be the most interested in.
After all, in a changing world, a state of market equilibrium, as we have
seen, is hardly an attainable goal. The precise degree in which the state
of market equilibrium deviates from the conditions of optimality is there-
fore likely to appear a distinctly academic question. On the other hand,
participants will be most interested in knowing the direction the market
process moves in; they are vitally concerned with the efficiency whereby
existing m^allocations are discovered and removed, and with the faith-
fulness and speed whereby the market process tends to adjust market ac-
tivities to changes in the basic data. (Of course, participants would hardly
be concerned with the efficiency of a market process unless they also knew
that the final state of equilibrium the process tended toward was also at
least reasonably efficient from the point of view of the first of the two kinds
of welfare inquiry mentioned in this section.) It is the normative exam-
ination of the market process that concerns us in this chapter.

MISALLOCATION OF A RESOURCE IN A MARKET SYSTEM
First of all, we should fix in our minds precisely what is implied in the
statement that a resource has been misallocated in a market system. A
unit of a particular resource, let us say, has been employed together with
quantities of other productive factors in the production of a particular
product. The employment of this unit of factor in this way has deprived
consumers of the productive contributions that it might have rendered
in an alternative employment. On the other hand, consumers under the
existing arrangement, are enabled to enjoy the productive contribution
that the unit of factor is making in its present employment. In a market
called "welfare conditions" for optimality, with some reservations, are fulfilled by the
equilibrium conditions for an economy where "perfect competition" prevails in all
industries.
300 MARKET THEORY AND THE PRICE SYSTEM


system there is a market value placed upon each of the various foregone
productive contributions that might have been rendered elsewhere by the
factor, and there is also a market value placed upon the productive con-
tribution that the factor actually does render. If the market value of
any one of the foregone productive contributions is greater than the value
of the actual contribution of the unit of factor, then we say that this unit
is being employed in the "wrong" use. Measuring "usefulness" by market
value of productive contribution (since we are conducting our examination
of the market system in terms of its own "guide lines"), it is evident that
the unit of factor is being employed less usefully than is possible.
The market value of a productive contribution is an objective mag-
nitude determined jointly (a) by the physical increment of product at-
tributable to the employment of the unit of factor, and (b) by the market
value of a unit of the product. The physical increment of product at-
tributable to the factor depends upon the technological laws of production
and upon the quantities of other factors the unit of the first factor is to
cooperate with in production. The price of a product depends, as we
know, on the willingness of buyers to buy, and of producers to produce and
sell, the particular product. The difference between the market values
of the different possible productive contributions that a unit of factor may
be able to make may thus be due to the different degrees of physical pro-
ductivity of the factor in the various proposed processes of production and/
or to the different conditions of market supply and demand for the relevant
products. Misallocation of a resource may thus be due to its employment
in a productive process where its potential physical productivity is not
being exploited to the full, and/or to its employment in the production
of a product that the market pronounces less important ("importance"
being measured, once again, by market price) than another potential prod-
uct.
Our statement of the meaning of the term "misallocated resource"
refers to any given state of affairs (insofar as concerns other market phenom-
ena). We do not here speak primarily of a resource that is not being
employed as it would be under conditions of equilibrium. A resource is
misallocated if it is in the "wrong" place in terms of actual market prices
and with respect to a state of the economy as it is. Our task is to examine
the effectiveness of the market process in detecting and eliminating this
kind of "waste." This is waste (a normative word) because, under the
current conditions of the market, a resource is being used in an employ-
ment that the market declares to be less important than an alternative
available employment.
THE PRICE SYSTEM AND THE ALLOCATION OF RESOURCES 30 ¬



IMPERFECT KNOWLEDGE, THE SOURCE OF
RESOURCE MISALLOCATION
The discussions in Chapters 7, 10, and 11 concerning the market proc-
ess commencing from a state of disequilibrium clarified the reasons for any
resource being misallocated in a competitive market economy. A resource
may be misallocated only as a direct result of the imperfection of the knowl-
edge of market participants. If knowledge of all relevant data were
possessed by all participants, no perverse discrepancy could exist between
the market value of the productive contribution of a factor in its actual
employment and the value of its potential contribution elsewhere. With
perfect knowledge the price of the unit of factor would be the same in
all areas of the market; differences in the technological efficiency of the
factor in different uses, and in the desirability to consumers of the different
products, would be fully reflected in the prices and output volumes of
the various different products. No room would be left for a perverse
difference between the market values of actual and potential productive
contributions.
But we proceed here from a position where all the available informa-
tion is initially widely scattered in the form of scraps of knowledge pos-
sessed by individual participants. Resources will be misallocated as a
result of this incomplete knowledge. A resource may be employed in a
less important manner because the entrepreneur is unaware of the more
important employments possible, or because those who are aware of the
more important possible employments do not know of the availability of
the resource. In the first ease, the entrepreneur using the resource in
the less important employment may be unaware of the greater technological
productivity of the resource in other branches of production, and/or of
the higher prices obtainable in the market for the other products. In
the second case, the entrepreneurs who are unaware of the more important
productive contribution that such a resource can make elsewhere may
mistakenly believe that the price of the resource is too high to make its use
worthwhile in these more important employments.
In general, then, the misallocation of a resource can be equated with
widespread (if uneven) ignorance of the gaps in pertinent information.
Some market participants may know all about one piece of information
(for example, the availability of the resource); others may know all about
a second piece of information (for example, the value of the contribution
that the resource could render). But because nobody simultaneously
knows both these pieces of information, nobody is aware of any possibility
of improving the existing allocation of resources. An appraisal of the
efficiency of the market process therefore involves an appraisal of the way
the market process disseminates these missing links of information neces-
302 MARKET THEORY AND THE PRICE SYSTEM


sary for the discovery of superior opportunities for the allocation of re-
sources. In the case of the changing economy, the basic data (concerning
resource availability and productivity, and consumer tastes) are free to
change. The efficiency of the market process in this case is again a question
of its ability to transmit to the relevant decision makers those pieces of new
information necessary for the "correct" allocation of resources in terms
of the new conditions.
It should be apparent by now that the answer to an inquiry into the
efficiency of the market process is embedded in the very description and
analysis of the process itself. In the following sections we will merely
make explicit what has already been implied in the earlier chapters.2

PRICES, PROFITS, AND THE REALLOCATION OF RESOURCES
The market process, as we have seen, is kept in motion by entrepre-
neurial activity. Entrepreneurial activity is undertaken to gain profits
and therefore, of course, avoid losses. The discussions in earlier chapters
concerning the circumstances where opportunities for profit exist, and
where entrepreneurial activity may be undertaken are sufficient to indicate
that these circumstances are precisely those where resources are misallocated.
Thus, the general proposition emerges that the market process itself tends
to correct existing misallocations of resources”in fact the essence of the
process is inseparable from the tendency toward such corrective activity.
On the level of the inquiry made in this chapter, this proposition has
a definite meaning which must not be confused with other propositions
possible at other levels of inquiry. This proposition asserts there are
market forces operating upon the price system that tend to remove all in-
ternal inconsistencies within the system. In other words, prices are under
the pressure of forces tending to ensure that, as measured by prices, no
resource should be used except where the value of its productive contribu-
tion is highest. This merely restates the proposition, developed in previ-
ous chapters, that the market process tends to achieve the dovetailing of
the numerous decisions being made. The process commences with an
initial absence of such consistency among decisions. The process itself is
the agitation whereby decisions are rendered consistent. This agitation
is the continual reshuffling of resources from one employment to another;
the process does not cease so long as complete consistency had not been
achieved.
The key point is that the misallocation of a resource implies the exist-
ence of an unexploited opportunity for profit. A profit opportunity exists

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