Economic Thoughts, Part XI: Prices

This posting is Part XI in a series of postings about economic thoughts.

The excerpts in this posting are taken from Chapter 3 in Thomas Sowell's book Basic Economics: A Citizens Guide to the Economy and discusses prices, a key structural element in a competitive capitalistic economy.

Prices play a crucial role in determining how much of each resource gets used where. Yet this role is seldom understood by the pubic and it is often disregarded entirely by politicians.

Many people see prices as simply obstacles to their getting the things they want...

Prices are like messengers conveying news...prices convey...the end results...

Prices not only guide consumers, they guide producers as well. When all is said and done, producers cannot possibly know what millions of different consumers want...

While a free market economic system is sometimes called a profit system, it is really a profit-and-loss system - and the losses are equally important for the efficiency of the economy, because they tell manufacturers what to stop producing. Without really knowing why consumers like one set of features rather than another, producers automatically produce more of what earns a profit and less of what is losing money...Although the producers are only looking out for themselves and their companies' bottom line, nevertheless from the standpoint of the economy as a whole the society is using its scarce resources more efficiently because decisions are guided by prices...

What this all means as a general principle is that the price that one producer is willing to pay for milk (or any other ingredient) is the price that other producers are forced to pay for that same ingredient. Since scarce resources have alternative uses, the value placed on one of these uses by one other individual or company becomes a cost that has to be paid by others who want to bid some of these resources away for their own use...this means that resources tend to flow to their most valued uses...

Prices coordinate the use of resources, so that only that amount is used for one thing which is equal in value to what it is worth to others in other uses...The efficient allocation of scarce resources which have alternative uses is not just an abstract notion of economists. It determines how well or how badly millions of people live...

...prices convey an underlying reality: From the standpoint of society as a whole, the "cost" of anything is the value that it has in alternative uses....

Different economic systems deal with this underlying reality in different ways and with different degrees of efficiency, but the underlying reality exists independently of whatever particular economic system is used...

The consequence was that far more resources were used to produce a given amount of output in the Soviet economy as compared to a price-coordinated economic system, such as that in the United States...

The Soviet Union did not lack for resources...What it lacked was an economic system that made efficient use of scarce resources...Soviet enterprises were not forced to economize - that is, to treat their resources as both scarce and valuable in alternative uses. While such waste cost these enterprises little or nothing, they cost the Soviet people dearly, in the form of a lower standard of living than their resources and technology were capable of producing...

While history can tell us that such things happened [in the transitional years of Communist China to a less politically controlled economy], economics helps explain why they happened - what there is about prices that allows them to accomplish what political control of an economy can seldom match. There is more to economics than prices, but understanding how prices function is the foundation for understanding much of the rest of economics.

In a society of millions of consumers, no given individual or set of government decision-makers sitting around a table can possibly know just how much these millions of consumers prefer one product to another, much less thousand of products to thousands of other products - quite aside from the problem of knowing how much of each of thousand of resources should be used to produce which products. In an economy coordinated by prices, no one has to know...

Knowledge is one of the most scarce of all resources and a pricing system economizes on its use by forcing those with the most knowledge of their own particular situation to make bids for goods and resources based on that knowledge, rather than on their ability to influence other people...

In a price-coordinated economy, employees and creditors insist on being paid, regardless of whether the managers and owners have made mistakes. This means that capitalist businesses can make only so many mistakes for so long before they have to either stop or get stopped - whether by an inability to get the labor and supplies they need or by bankruptcy...

When people try to quantify a country's "need" for this or that product or service, they are ignoring the fact that there is no fixed or objective "need." The fact that people demand more at a lower price and less at a higher price may be easy to understand, but it is also easy to forget. Seldom, if ever, is there a fixed quantity demanded...

Likewise, there is no fixed supply...

When people projects that there will be a shortage...in the years ahead, they usually either ignore prices or implicitly assume that there will be a shortage at today's prices. But shortages are precisely what cause prices to rise...Price fluctuations are a way of letting a little knowledge go a long way...

There are all kind of prices. The prices of consumer goods are the most obvious examples but labor also has prices called wages or salaries, and borrowed money has a price called interest...Prices produce incentives to conserve...

...So long as people are free to spend their money for what they see fit, price changes in response to supply and demand direct resources to where they are most in demand and direct people to where their desires can be satisfied most fully by the existing supply...

To treat prices as resulting from greed implies that sellers can set prices where they wish, that prices are not determined by supply and demand...

The fact that prices fluctuate over time, and occasionally have a sharp rise or a steep drop, misleads some people into concluding that prices are deviating from their "real" values...But their usual level under usual conditions is no more real or valid than their much higher or lower levels under different conditions...

Prices not only ration existing supplies, they also act as powerful incentives to cause supplies to rise or fall in response to changing demand...

...In short, people tend to do more for their own benefit than for the benefit of others. Freely fluctuating prices can make that turn out to be beneficial to others...

Part XII to follow...

For previous postings on Economic Thoughts, refer to:

Part I: What is Economics?
Part II: Myths About Markets
Part III: Why Policy Goals are Trumped by Incentives They Create & the Role of Knowledge in Economics
Part IV: The Abuse of Reason, Fallacies & Dangers of Centralized Planning, Prices & Knowledge, and Understanding Limitations
Part V: The Relationship Between Economic Freedom and Political Freedom
Part VI: More on the Relationship Between Economic Freedom and Political Freedom
Part VII: The Role of Government in a Free Society
Part VIII: The Unspoken, But Very Real, Incentives That Drive Governmental Actions
Part IX: More on the Coercive Role of Government
Part X: The Power of the Market