What determines the prices of goods and services in a market economy?

Basic Economics: Prices are set by supply and demand
Basic Economics: In a free market, prices are set by supply and demand

A few days ago, I posted the meme above on the blog’s Facebook page. The meme makes fun of unionized public school teachers, who feel entitled to the same salary and benefits as doctors, software engineers, etc. in the private sector. I thought that all Americans were familiar with basic economics. But judging from some of the comments to the meme, that is not the case. This post will help.

So, the point of this meme is simple, it’s to point out that the teachers who belong to teacher unions are ignorant of basic economics, specifically, the law of supply and demand. As we’ll see in a minute, this is literally lesson 1 of Economics 101.

When there is more demand for a product or service than there is a supply for it, then prices go up. When there is more supply for a product or service than there is a demand for it, prices go down.

A good place to see this explained is in a book by famous black economist Thomas Sowell. Thomas Sowell has written many books, but he wrote one book in particular for people who have no knowledge of basic economics. It’s called “Basic Economics: A Citizen’s Guide to the Economy“. And the first few chapters explain how prices are set by supply and demand:

  1. What is Economics?
  2. The Role of Prices
  3. Price Controls
  4. An Overview of Prices

Most people who commented on the meme had some knowledge of basic economics, and how prices are determined.

Here’s Bruce:

Wages–the prices of labor–are set by free people bidding in an open market for the labor of people willing to work. They are not set by an emperor weighing abstractions. There are 3.7 million teachers working in the US, and only about 5000 professional athletes.

And Chris:

My coworkers and I (we are fintech people with highly specialized knowledge and computer skills) were talking about some computer-related consultants who are so specialized and so good that they command hundreds (if not thousands of dollars per hour). The top of the top cyber security guys, who do presentations at conferences on threats and vectors? Yeah, thousands if not tens of thousands of dollars per hour.

So far, so good. But others argued that the prices of goods and services are determined by a sinister cabal of politicians and other elites, who paid athletes lots of money in order to distract the masses with “bread and circuses”. Now, I know what you’re thinking. How does paying athletes MORE get people to care about sports? It doesn’t. Actually, it’s the (widespread) demand to see the performance of (scarce) elite athletes that causes the wages of those athletes to increase. It’s not a conspiracy – it’s free people making choices about what they want to buy in a free market.

It turns out that there are two views of how wages are set in an economy:

The labor theory of value (LTV) is a theory of value that argues that the economic value of a good or service is determined by the total amount of “socially necessary labor” required to produce it.

LTV is usually associated with Marxian economics… The LTV is central to Marxist theory, which holds that the working class is exploited under capitalism, and dissociates price and value. Marx did not refer to his own theory of value as a “labour theory of value”.

Mainstream neoclassical economics tends to reject the need for a LTV, concentrating instead on a theory of price determined by supply and demand.

Marxists economists believe that the value of a good or service is determined by the social utility of the work produced. But classical (“free market”) economists believe that value is determined by the scarcity of the good or service relative to the demand from consumers.

So, a Marxist economist might say “teaching English is valuable because it is relevant and meaningful”. But, a classical economist would say “conducting a security audit on distributed point-of-sale system is valuable, because few people can do it, but many people want it”.

So, the conspiracy theorists view of economics, which asserts that teachers should be paid more than software engineers and doctors, is actually based on Marxist (atheistic) assumptions. And yet many of the people who hold to the conspiracy view of prices fancy themselves to be Christians and conservatives.

I’ve noticed that school teachers and non-STEM university students and professors are very likely  to hold to the conspiracy theory view of prices and wages. Robert Nozick wrote a paper about why this happens. It turns out that “wordsmiths” (his word) are conditioned by their performance in the classroom to expect success in the free market economy. But when they find that their “brilliance” in English poetry, Medieval history, or lesbian dance theory has no value to anyone else, they fall in with these Marxist assumptions and conspiracy theory views of the economy. It’s a coping mechanism for people who value academic acclaim more than doing something useful for their neighbors.

Consider this article from College Pulse about a survey of 10,590 undergraduate students:

Students with certain majors are far more likely than their peers to approve of socialism. Philosophy majors, in particular, have a positive view of socialism. Nearly 8 in 10 (78%) say they view the economic system favorably, followed by 64% of anthropology majors, and 58% of both English and international relations majors. Accounting and finance majors are least likely to view socialism positively (20% and 22% respectively).

Do you know what accounting and finance students have to study? Basic economics.

I noticed that the practical commenters who were trying to explain why teachers earn less than software engineers all had some experience working for a living in the private sector. A couple of them mentioned how studying economics on their own had led them to a correct understanding of how the economy works. That’s what happened to me, as well.

As soon as I got my first job as a software engineer, and finished my study of Christian apologetics, the very next thing I studied was economics. It was Dr. Jay Richards who got me interested in it, when I heard him speaking about economics in an apologetics lecture for Stand to Reason. I contacted him, and he recommended the works of two famous economists, F. A. Hayek and Thomas Sowell. And that’s what I want to recommend to you, too. Our continued liberty and prosperity depends on ordinary Americans taking the time to educate themselves about basic economics.

7 thoughts on “What determines the prices of goods and services in a market economy?”

  1. They teach the “we value athletes more than teachers” meme in college to teachers. My wife was one of them. Besides my leadership, watching as incompetent teachers continue to be employed and cause havoc in public schools has convinced her that she was wrong on that point. You can’t have that much incompetence and remain employed in the NFL (unless you’re Jason Garrett working for Jerry Jones).

    Liked by 1 person

  2. Even the communists didn’t actually make everyone the same. Doctors, military, athletes etc will get better food and goods to make sure they perform to their best.

    It is only a philosophical claim of a socialist or communist that all will be paid the same. Otherwise step one of a socialist politician is to reduce their pay and pension to a middle income pay and the same pension given to the average worker.

    But it is never about equality for them, it is about gaining more rights for a few.

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  3. I found that, when I learned basic economic principles by reading books like the ones you mentioned above, it really gave me a better understanding of the way the world around me works. I would suggest that learning these ideas would be highly advantageous for anyone. But maybe some people would rather cling to their cherished myths?

    Liked by 1 person

  4. Sowell’s Basic Economics is an absolute must read. The one example he used to demonstrate scarcity always stuck with me and I’ve used it ever since.

    Sowell points out that scarcity, not greed, is the reason that people have unfulfilled desires. No matter who is elected, no matter what policies are enacted, no matter what protests are stages, there will never be enough resources to satisfy everyone’s desires entirely. Thus, the resources must be distributed either through free markets with prices, or by force through central planning.

    Sowell then uses beach front property as an example. The reason beach front property is so expensive is not because landlords are greedy, but because there are far more people who want to live on beach front property than there is beach front property. Even if the government declared that beach front property was a “basic right” of all members of society, it would not change the underlying scarcity in the slightest. The property must be rationed somehow. You can allow individuals to do it voluntarily in the market. Central planners can seize the property by force and then distribute it randomly, or they can seize it by force and distribute it deliberately to those parties that they choose. However, no matter what economic system is used, the rationing must take place.

    Until such time as the government can create resources out of thin air, this reality will remain.

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  5. I really liked the discussion on the theories of value, excellent work.

    One thing I’d like to pile on with that I think people who complain about this gap forget is that there is a difference between marginal value and aggregate value.

    A baseball player provides me with a relatively small amount of value. Not even the full value of a baseball game. A teacher provides me with an immense amount of value (assuming I am learning something). [Let’s set aside that value is subjective and grant for the sake of argument that teachers provide more value to individual people.]

    The problem is that both of those values are marginal values. The value that I get for taking in their services. And wages are based on aggregate value (and influenced by supply and demand of course). IE I might charge $20 to mow a lawn versus $100 to detail a car. The latter having more marginal value. But if I mow ten lawns versus detailing only one car, I take home $200 in wages rather than $100. That is an aggregate value.

    Teachers provide value to at most 60 students a year lets say. Baseball players provide their value to tens or hundreds of thousands, perhaps even millions including TV. That difference in scale makes any difference in marginal value nearly irrelevant.

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  6. Although for many people such as myself a teacher in school can be replaced by an online program at far lower cost. Maybe the few people having trouble can use a tutor or teacher but having to have a teacher is living in the past mentality.

    We should be moving to much more online school and training, only having teachers and tutors to focus on the areas of difficulty for an individual.

    As a result I see lowering value to a teacher compared to the past as less of them should be needed over time

    Liked by 1 person

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