Prices aren't just about supply and demand. They're about control over supply and demand

The limited economy of a Prisoner of War camp offers lessons about the real economy, and the shortcomings of orthodox models

My dad, Frank Lamont, was a lawyer and a financial executive. I wanted to understand his job, and what he did, so we would talk about the economy and the law. And he was pretty good at explaining some complicated ideas. One of the most basic, and interesting, was when we were talking about somebody buying property.

I made the assumption, as we all do, that if you own property, you own property. My dad explained why that was not the case.

“You don’t own the property. You own the rights to the property.”

It didn’t seem to make sense - surely, if you owned property, that was that. How could you not own property?

“Well, then who does own the property?” I asked.

“The Crown.” He said, which is to say, in Canada, the Federal Government.

I wrestled with this idea for a long time, maybe because I was a kid and really should have been doing something more normal and fun, like chucking football around (which we also did), instead of talking about property rights with my old man. But hey, it was his job.

Really, he was just telling me about the weird ways the world worked, in ways he thought were interesting, and ultimately useful.

Anyway, he would tell me things like that, and instead of forgetting about it, I would obsess and think, “How can that possibly be?”

Only having certain rights to the property seemed tenuous - something that could be changed with the stroke of a pen - which it can.

Eventually, I realized there is an easy (and obvious) way of thinking about it - which is that when you buy a house or a farm or property, the transfer of ownership is all registered with the land titles office. You register your car, too. Two of the most expensive property purchases most people will ever make in their lives - and ownership is represented by “having title” - by having a piece of paper that describes the property to which you have the rights.

In fact, we can think of all transactions this way.

I pay for the store to give up control of the apple and let me have it - and they’ll offer me a receipt, so there is a record of the transaction. It sounds weird to say you are going to buy the property rights to that apple, but that is what is happening.

It’s not the object that has a price: it’s the price we pay to release it to us. And while this might seem minor, I promise you it’s not. Because it means there is another dimension to supply and demand - the amount of control the buyer has over their demand, and the amount of control the seller has over their supply.

Things don’t have prices, people do. When we buy something : we are paying people to release it to us.

We don’t usually consider this in retail transactions: where the price is usually set. We don’t haggle, we just pay the sticker price.

The other transactions that go into setting that prices are negotiated (suppliers, labour, overhead etc). In those negotiations, there is always an element of risk that can result in a bad deal. Usually this is chalked up to “asymmetrical information” which is to say the seller knew something that the buyer didn’t. A very polite term for what can range from genuine and innocent ignorance to malicious and criminal fraud.

In a negotiation where each side is of course trying to establish the best deal, it’s not just supply and demand. It’s each side’s capacity to control their supply and control their demand.

This reflects the difference in power between the parties on either side of the exchange. So, it’s not a smooth and simple relationship between supply and demand. Prices and the market will be distorted by market power.

So long as buyers and sellers each exercise their control over their supply and control over their demand, prices will vary - sometimes wildly, as they do in the actual economy.

That would seem to imply that the only cases where prices would move smoothly up and down would be an economy where buyers and sellers had no control over their demand or supply.

The Economic Organisation of a Prisoner of War Camp

There are somewhat famous, real-life examples of just such an economy - where buyers and sellers had no control over their supply and demand: R. A. Radford’s 1945 account of the economy of a prisoner of war camp.

It’s been called a “toy” economy, and the circumstances of the organization made it easier to analyze. As prisoners of war, they by definition had no control of either the supply of goods or services, or their ability to hold off in the hope of a better deal later is severely constricted, because everyone is operating at subsistence level.

As an economy, everything was about exchange, because there was no production - everyone is either a seller or a consumer. This “streamlined” or simplified economy is similar to the large-scale mainstream, orthodox economics we use today, in which production is a “black box”.

Radford wrote

THE DEVELOPMENT AND ORGANISATION OF THE MARKET

Very soon after capture people realised that it was both undesirable and unnecessary, in view of the limited size and the equality of supplies, to give away or to accept gifts of cigarettes or food. "Goodwill" developed into trading as a more equitable means of maximising individual satisfaction.

We reached a transit camp in Italy about a fortnight after capture and received a Red Cross food parcel each a week later. At once exchanges, already established, multiplied in volume. Starting with simple direct barter, such as a non-smoker giving a smoker friend his cigarette issue in exchange for a chocolate ration, more complex exchanges soon became an accepted custom. Stories circulated of a padre who started off round the camp with a tin of cheese and five cigarettes and returned to his bed with a complete parcel in addition to his original cheese and cigarettes ; the market was not yet perfect. Within a week or two, as the volume of trade grew, rough scales of exchange values came into existence. Sikhs, who had at first exchanged tinned beef for practically any other foodstuff, began to insist on jam and margarine. It was realised that a tin of jam was worth 4 lb. of margarine plus something else ; that a cigarette issue was worth several chocolate issues: and a tin of diced carrots was worth practically nothing.

In this camp we did not visit other bungalows very much and prices varied from place to place ; hence the germ of truth in the story of the itinerant priest. By the end of a month, when we reached our permanent camp, there was a lively trade in all commodities and their relative values were well known, and expressed not in terms of one another-one didn't quote bully in terms of sugar-but in terms of cigarettes. The cigarette became the standard of value.

While a few people performed services as barbers or portraitists, all goods flowed into the camp from outside in the form of care packages from the Red Cross or others.

Since it was a P.O.W. camp, the prisoners lived in a relative state of continual deprivation. Cigarettes were used as currency, but also smoked by addicts, and different groups of prisoners had different cultural and religious appetites. The British valued tea, the French coffee, and Indian prisoners did not want beef.

While some individuals were able to build up small stores, generally speaking the suppliers had very little control over their supply, and the buyers had very little control over their demand. As a result, prices moved very smoothly as supply and demand changed to the “equlibrium price” - which is not what usually happens in the real world.

As Radford wrote, the organization that arose happened spontaneously - without labour or production. Radford noted that this seemed to undermine the labour theory of value - but that is because the value had already been created elsewhere. The demand - human hunger and actual appetite, based on personal and cultural preferences, was the basis for the value.

Even the quality of cigarettes affected the value of money, with high-quality brands of cigarettes, like Churchman’s, being kept for smoking, while lower quality smokes circulated as money.

Cigarettes were also subject to the working of Gresham's Law. Certain brands were more popular than others as smokes, but for currency purposes a cigarette was a cigarette. Consequently buyers used the poorer qualities and the Shop rarely saw the more popular brands : cigarettes such as Churchman's No. I were rarely used for trading.

What’s more, the cigarettes, as currency, were being actively introduced into the camp, and then consumed.

our economy was repeatedly subject to deflation and to periods of monetary stringency. While the Red Cross issue of 50 or 25 cigarettes per man per week came in regularly, and while there were fair stocks held, the cigarette currency suited its purpose admirably. But when the issue was interrupted, stocks soon ran out, prices fell, trading declined in volume and became increasingly a matter of barter. This deflationary tendency was periodically offset by the sudden injection of new currency. Private cigarette parcels arrived in a trickle throughout the year, but the big numbers came in quarterly when the Red Cross received its allocation of transport. Several hundred thousand cigarettes might arrive in the space of a fortnight. Prices soared, and then began to fall, slowly at first but with increasing rapidity as stocks ran out, until the next big delivery. Most of our economic troubles could be attributed to this fundamental instability.

In other words - the cigarette/money supply was what created economic instability.

It should say something about the fact that economic theories about price equilibrium do work well in a prisoner of war camp, but not in an open society.

Implications of control over supply and demand

This extra wrinkle of control over supply and demand is significant. Often it’s assumed that there are so many players in the market that competition will keep prices in check.

That “equlibrium” is an assumption that there are forces in the market that will moderate excess - that the market is self-balancing. This is the argument against regulation or government intervention.

For example, it might be assumed that if supply shrinks, that prices will increase, which will reduce demand because fewer people can afford it, which will lead to a rebound in supply - which means prices will drop again. This seems intuitively correct.

But there are many other possibilities that happen when you recognize that you are paying that person (or organization) for the rights to something, not for the thing.

There’s another possibility, however. Imagine that there is a demand for a specific luxury good - say, ivory from elephant tusks. As more and more elephants are hunted for their tusks as trophies, the supply dwindles and the price goes up. But instead of reducing demand, more poachers may enter the market, because the high value of the tusks means they can make more with less work. The cost of the good is not related to its real-world rareness, but to the cost of paying people to obtain it, which may be high or low.

The idea of price equilibrium is that the market will intervene through competition, or creative destruction, or technology, in ways that bring a distorted market back to balance.

However, the reality of concentration of power means that those differences in bargaining power and market share can be, and are used to keep prices skewed, and keep people at a permanent disadvantage.

Risk, Reward, Who Wins and Who Loses

There is a connection between the risk you take and who gets the reward in the economy - something that reflects the real uncertainty we all live with.

When it comes to risk-taking and payoff, we need to consider all the participants - not just the winners.

The very nature of certain investments - of some kinds of high-risk venture is that they will have a low chance of success for most people who try it. That’s what makes it high risk.

Imagine a lottery with 100 tickets, where the prize will be evenly divided between 80 winners. It is a low-risk, low reward game. If there are 50 winners and 100 tickets, there is a medium risk and medium reward, and if there is a 5% chance of winning, a small number of people will get a big payoff.

This is an important way of thinking about risk: how risk payoffs distribute rewards.

High-risk investments will not work to spread the wealth for everyone. They will, by their very nature, concentrate wealth in the hands of a few, because high risk means most people will lose and a very few will win big.

Once that has happened, the process can be self-reinforcing - because the big winner may be able afford to continue making high-risk, high-reward bets, so long as they can bear the losses. And if you’re a big enough player, you can control the game.

Mr. Behemoth Plays the Lotto

There’s an old saying about buying a lottery ticket: while it is certain that someone is going to win that jackpot, the odds are that it will not be you.

The value of thinking about the economy in terms of a lottery is important in at least one very important way - which is that our world and the economy are fundamentally uncertain. So much of what we do as human beings is about more safety, more certainty, and people do not want to take risks and lose.

This “thought experiment” has uncertainty about the future baked into it - including fundamental uncertainty.

Imagine a lottery draw with 1 million tickets at a dollar each.

A billionaire — Mr. Behemoth — comes up with a scheme to buy 600,000 of the tickets, putting his odds of his winning to 3:2, when for a single ticket purchaser, the odds are 1 in a million.

If Mr. Behemoth wins the full million, he would get his $600,000 back plus $400,000 — a 66% return on his investment. It’s high-risk of loss with high-reward, but odds are that if you the one pulling the winning ticket, it will be his.

For the ticket buyer spending $1, it’s low risk, low-loss, but little chance of winning.

Of course, anyone with $600,000 could do the same as Mr. Behemoth, and go around buying up tickets from draws like this.

But not everyone has $600,000 and not everyone could bear the loss of $600,000.

In fact, a billionaire could buy $900,000 worth of tickets, and increase his chance of winning to 9 in 10, and still get an 11% return on investment if he won. He could risk $999,999 and still come out ahead, though only with a dollar profit.

What this shows is that for some players in the game, they can take stakes so large in a game that they can arbitrarily control their risk and return.

Most people will see what Mr. Behemoth has rigged the game to move money to himself: but he has done it by shifting the risk away from himself to everyone else in the system: in this game, it is possible for him to virtually secure a guaranteed return, and in doing so, make it more unlikely that any of the other players will win. This is why actual lotteries require regulations to limit the number of tickets.

This is an abstract example, but it shows what happens when you get huge players in an economy, because they have a completely different capacity to operate, at a level that can tip the field in their favour.

This is actually the position that dominant companies — monopolies — are in, as well as the mega-wealthy in comparison to small-time investors.

Very large companies and wealthy individuals have the ability to take such large stakes in markets that it alters the possible outcome, tilting the playing field and the wins in their favour, while shifting the risk onto others in the system.

But there is nothing unique about this model that restricts it to the private sector: it can equally apply to government, which can (and often is) the largest single player in a system.

The New Yorker profiled Leon Cooperman, one of a number of hedge fund billionaires who felt ill-treated by the Obama administration, since Obama had said that millionaires and billionaires — the 1% — should pay their “fair share”. One of many revealing passages in the article illustrated the difference in Cooperman’s ability to take risks and absorb losses compared to the average investor.

“Cooperman mentioned that over the weekend an acquaintance had come by to get some friendly advice on managing his personal finances. He was a seventy-two-year-old world-renowned cardiologist; his wife was one of the country’s experts in women’s medicine. Together, they had a net worth of around ten million dollars. “It was shocking how tight he was going to be in retirement,” Cooperman said. “He needed four hundred thousand dollars a year to live on. He had a home in Florida, a home in New Jersey. He had certain habits he wanted to continue to pursue.”

“I’m just saying that it’s not an impressive amount of capital for two people that were leading physicians for their entire work life,” Cooperman went on. “You know, I lost more today than they spent a lifetime accumulating.”

This shows that the idea of being able to absorb massive losses is not theoretical. Cooperman lives in a different world. He can lose $10-million in a day without feeling it, sustaining a loss that would have wiped out the retirement savings of a couple that, at $10-million in retirement savings and $400,000 a year to live on would be the envy of most Americans, to say nothing of everyone else on the planet.

Cooperman did not inherit his wealth: he grew up in the Bronx and his father was a plumber, joining Goldman Sachs in the 1960s, where he became a partner, then started his own hedge fund in 1991. It’s also worth pointing out that he was in the right place at the right time - being in finance in New York, at a time when, from the 1970s U.S. public policy started officially operating on the trickle-down premise, that financial wealth creation was the key to prosperity for all.

Since that time, as a very wise person said, “The rich get richer and the poor get the picture.” These are some of the reasons why.

It’s why the growing concentration of wealth, of more and more companies owned by fewer and fewer conglomerates, is an issue that has been confronted in the past with what Americans call “Anti-Trust” and what Canadians call “Anti-combine” law.

The reason for doing that is because at a certain point, monopolies and oligopolies will continue to distort the market in ways that reduce the total productive capacity and potential of the economy.

Because the idea of returning to equilibrium requires there be an actual, real-world mechanism that rebalances exchanges between buyer and seller, not just a mathematical formula that assumes it.

So, why is this important?

Well, it’s because of the assumptions that are built into the too-simple idea of supply and demand alone. There’s an idea that the market works properly because it overwhelms or overrides other personal factors. The problem can be illustrated by this example. An individual owns a home, and it is valued at $500,000.

There’s a kind of assumption that in a properly working market, you just have to offer that person the price the house is worth, and they will sell it. But they don’t want to. They could offer any amount of money, but the person just doesn’t want to sell.

This is the reality of markets, and it goes well beyond questions of preference or taste. People may refuse to buy or sell because they are negotiating, and they are trying to get a better price through deception. They could be boycotting or supporting a brand for personal, religious or political reasons.

That’s the case on just about everything - which is also supposed to be the point of the private market, which is that people are free to choose who they trade with, what price they’ll accept, or whether they’ll accept a price at all. Consider, for a moment, the economic impact of different religions’ dietary restrictions on the global economy.

The consequence of this is, there are a lot more economic transactions that go into the final price people pay for a product or service. The economy is not just everyone paying the retail price for everything, as if the families and corporations make every purchase as if they were buying something at the self-checkout at the grocery store.

The reason all this matters is that - once again - it means the diagnosis of what is happening in the economy may be wrong.

If we are talking about control over supply and control over demand, it means that if something is starting to cost too much - like housing - it’s not as simple as having a housing shortage. The problem may be that housing is being taken off the market by speculation, or that too much of the market is held by commercial landlords.

And with housing in particular, supply and demand is not the only market driving prices: there’s another one, the mortgage and debt market. And as far as banks seem to be concerned, they’re not the penny-pinchers they used to be when it comes to lending. It’s because they’ve realized, the more money they can lend you, the more they can make - in the short term, anyway.

It’s very clear that large companies do abuse their market power. They get charged and convicted of price-fixing and collusion.

And if we recognize the role of bargaining power in supply and demand, it means we can see the other factors that are playing into the price, so we can actually address the issue in a way that’s based in reality.