SECTION 2

HOW PRICES ARE SET

The central question in an examination of shortages is whether the price system is capable of eliminating the condition without undue returns to sellers. The answer depends upon the degree of competitiveness among producers of raw materials with particular reference to their pricing policies. There is unfortunately no conclusive evidence on whether raw materials producers have "market power" sufficient to "control the market" and "set prices" above the level that would prevail in a perfectly competitive market. Moreover, the demand for raw materials is a demand derived from the value of the product; unless the buyers are totally indifferent about price, the final arbiter is the buyer. Thus the control exercised by the seller is limited and conditional, and the price the seller may have to take may not be one consistent with maximizing his profit. If he provides an insignificant part of the total market supply of a commodity his influence over its price, whatever action he takes, is not significant. He cannot raise the price by selling less or lower it by selling more. On the other hand, a company with a price policy has one because it actually can influence the market price. The company sets price with the intent of maximizing profit, as does the competitive producer, but has at least some option of a price different from the going market price, an option not open to the competitive producer. Still, the "best" price may be difficult to determine and its sustainability is dependent upon the price and output behavior of rival sellers of products substitutable for his own.

The degree of competitiveness is dependent upon the characteristics. of the market. At one extreme a perfectly competitive market has the following conditions set forth in most elementary textbooks. These are that there be:

(1) A large number of buyers and sellers so that no one of them can affect the market price by changing the demand or supply of the product.

(2) Given a large number of buyers and sellers each buyer can assume that each buyer or seller recognizes that he can ignore the actions of others.

(3) Complete knowledge of the market is possessed by each buyer and seller.

(4) Freedom of entry of competitive producers exists.

(5) The products they supply are homogeneous and there exists. close substitutes for the commodity offered.

If these conditions of a perfectly competitive market prevail the demand curve for any seller is perfectly elastic, i.e. he can sell any quantity he has available at the existing price.

At the other extreme of the market system is the perfectly monopolistic firm. A single seller, he accounts for the entire output. He can

sell more of his product only by reducing his price and if he raises his price he will sell less. He recognizes that his decisions to offer or restrict supply will have an impact on market price. The major condition required for a monopoly is that no other producer offers a close substitute product easily accessible to the buyers of the monopolist's product. For this reason, the monopolist may well invest in differentiating his product to ensure that no rival producer penetrates his monopoly.

The monopolist must have exclusive control over one or more of the inputs essential to the production or sale of his output, i.e. he must be able to exclude any other producer seeking to penetrate his market by offering a substitute product. The greater the number of substitute products the less the range of opportunity for a price policy by any seller.

The primary materials seller may be compelled to pay close attention to competition from secondary recycled materials, (e.g. steel industry suffering competition from scrap steel). While most primary industries are dominated by a few large corporations the secondary market is made up of a very large number of suppliers whose competition may curb the price targets of primary producers.

When a market is shared by a few large sellers, a condition termed oligopoly, pricing and output decisions of different sellers are interdependent. A single firm under these conditions has the ability to affect market prices by its output decisions, but with the recognition that rival firms can do the same. If one firm in a oligopoly raises prices and others do not follow, the firm loses customers. If one firm lowers prices, it may increase its share of the market unless other firms follow suit. If all of them do, the relative market shares of each are the same as before the cut, but the industry is worse off. In some instances price wars may develop and strategic behavior must be employed to reestablish stability. The usual explanation for this instability is that the demand is inelastic for price reductions and elastic for upward adjustments in prices. The situation is easy to describe in a general way, but each situation is unique and is governed to a large extent by institutional features of the specific industries involved. It is fair to say, however, that during past periods of inflation there has been considerable price rigidity so that raw material prices have been relatively low; this may go a considerable way in explaining past shortages of particular commodities. From time to time producers combined to withhold supplies but such combinations tended to break down because of differences in price and output targets, which in turn were due to differences in costs of production faced by each producer.

There are a number of procedures that industries adopt to avoid the risks of price warfare. One is the acceptance of a price leader. If the highest cost firm sets the price, that may be all that is necessary to ensure an adequate return to rival suppliers. The desire of most firms to avoid the 'hazards' of price competition is reflected in the employment of trade journals as signaling devices. In recent years, however, there has been increasing resort to control of an industry from the raw material source to the delivered finished product, so as to ensure a stable price structure and to deny new entrants the opportunity to compete. The high capital costs of a fully integrated operation such as aluminum manufacture illustrate the barriers that face would-be

competitors. The degree of price competition, however, is hard to determine in fact because published prices diverge from transactions prices, which are relatively more sensitive to the prices of substitutes such as copper and secondary materials.

9

There is some question whether producers of primary metals restrict their profit in the shortrun in the interest of maximizing long run profit, a goal that incorporates the objective of excluding rival sellers and competitive materials. According to one prominent writer on "How Prices Are Set" the "power to set the price means that any other major firm in the industry-Ford or Chrysler in the case of automobiles or Bethlehem or Inland in the case of steel-can by fixing a lower price force an alternative on the level first established. This may happen. But there is also a general recognition that such action . . . could lead to a general price-cutting." In a study of the oil industry considerable emphasis is placed on vertical integration as a means of reducing risks inherent in various stages of its operations, some of which are riskier than others; drilling oil explorations, for example, are highly risky. The adoption of these techniques does not insure profitability and, indeed, may encourage the undertaking of projects that are more risky for the firm than would have been the case had integration not prevailed. There are some critical questions not fully answered by the description of an industry as integrated or nonintegrated. In the case of any multipleproduct firm or multistaged operation it is necessary to assign rates of return to the various stages of production. It is argued that this facilitates price discrimination. Furthermore, an integrated firm has an advantage over non-integrated competitors in that it can foreclose access to markets, deny essential raw materials or manipulate prices in favor of integrated membership at the expense of outsiders. The evidence of higher profitability of integrated as compared to non-integrated firms is not definitive, and there is considerable debate as to what pricing procedures the ultimate buyer will permit before demand contracts. If an "integrated" producer selling a product identical to one produced by a "non-integrated" firm must sell it at a common market price, this will produce transaction prices that do not reflect the real cost of resources and cannot prevail in the longrun.

It is useful to describe some conditions where few firms have an influence on price as an acceptable influence and less pernicious and distorting than monopoly pricing. A forthcoming Senate Interior Committee print on the structure of the oil industry advances the notion of 'loose' and 'tight' oligopolies to distinguish lesser and greater amounts of industry concentration and market power. A tight' oligopoly is described as a condition in which the four largest firms control 50 percent or more of total sales and in which the largest control 70 percent or more. Based upon this criterion there appears to be either a 'tight' or loose' oligopoly situation in most raw materials and market power may be based on their controls. 10 Does the concentration of the production of minerals in the hands of a few producers suggest the presence of a market power needing modification and to which public policy should be directed? What would reflect this market power? Differing

Charles River Associates An Economic Analysis of the Aluminum Industry, March, 1971, and Testimony of Dr. James C. Burrows before the Subcommittee on Economic Growth of the Joint Economic Committee of the Congress of the U.S., Washington, D.C., July 22, 1974.

Galbraith, J. K. Economics and the Public Purpose (Boston, Houghton Mifflin, 1973, p. 114.)

10 Martin, David R. "Resource Control and Market Power" in Mason Gaffney, Extractive Resources and Taration University of Wisconsin Press (1967). For an excellent illustration see John Blair "Market Power and Inflation", Journal of Economic Issues, Vol. VIII, No. 2 (June 1974).

patterns of price behavior initially appeared to provide some clues. For example a perverse price behavior, in which prices rise in both recession and expansion periods, might be indicative of growing industry concentration. It may happen, however, that raw material prices (for example ores) experience their traditional cyclical swings, and yet the prices of products manufactured from raw materials such as metals (for example steel) rise substantially in recessions. John Blair points out that the price of steel is not an isolated case and that primary metal prices rise in both recessions and expansions as firms press for target returns that would have existed at standard volumes of output, even when those outputs fall short."

Blair, op. cit.

SECTION 3

GOVERNMENT INTERVENTION IN MARKETS

Rights to property as established in law are the immediate means by which the legal system and the state play a role in the determination of prices. The development of resources will differ with the legal responsibilities imposed upon a developer and the rights he enjoys under that law. For example, one form of market intervention is that which occurs when a producer is compelled to consider as his own responsibility costs that may be imposed upon others. Government policy may require a producer of petroleum or coal to take into account the impact upon the environment and to bear the costs of environmental contamination that may be imposed upon others by the processes of production.

Government may try to facilitate the flow and development of resources by anticipating the need for social overhead capital requirements such as roads and transport and providing the basic geological research to learn what resources may exist. There are grounds for arguing that the unavailability or non-disclosure of relevant privately gathered research information is the most important barrier to the optimal development of resources. The market structure may well have contributed to this lack of information which has had a profound effect on resource policy in the United States. In turn this has altered not only the price and output of the resources at any one time but will contribute to determining future allocation, a subject we will discuss below. For the moment, attention may be centered upon what public policies may be adopted in the short run to offset market price changes that are not desired. Another form of Government intervention in markets originated in the 1930's when attempts to raise prices resulted in the accumulation of Government owned stockpiles. The process became more widespread after World War II. It is only recently that a reversal of policy has taken place. For the first time, in 1974 sales from stockpiles were used deliberately to influence market prices rather than for military related activities. The reduction in stockpiles may make it more difficult for price support operations to be carried out in the future. In addition precipitate disposal of stocks may well contribute to intensified price fluctuations. The General Accounting Office reported 12 on the procedures to reduce stockpiles of materials judged to be in excess supply. The U.S. stockpile of various materials relative to domestic consumption at mid-1974 can be seen in the following table.

12 General Accounting Office, U.S. Actions Needed to Cope with Commodity Shortages (April 29, 1974).