The Price System

Lecture 4

What role do prices play in the economy?

Textbook Econ 101: prices adjust so that markets clear.

What role do prices play in the economy?

Textbook Econ 101: prices adjust so that markets clear.

When price is set too low: Q_supplied < Q_demanded, a shortage.

Price rises until the market clears.

What role do prices play in the economy?

Textbook Econ 101: prices adjust so that markets clear.

When price is set too high: Q_demanded < Q_supplied, a surplus.

Price falls until the market clears.

What role do prices play in the economy?

Textbook Econ 101: prices adjust so that markets clear.

But prices don’t adjust to clear markets by magic!

Léon Walras (1834–1910) recognized that all prices in the economy are interrelated.
There are billions of different prices that must adjust relative to one another for the economy to function effectively.

Yet the economy is amazingly effective.

Despite the mind-boggling complexitybillions of prices, hundreds of millions of people, countless goods and servicesmarket economies consistently deliver an extraordinary variety of products to those who want them.

Contrast: When the Price System Is Suppressed

When prices are not allowed to function, coordination breaks down:

Bread lines in the Soviet Union
Food rationing in Venezuela
Gas station queues in the 1970s United States

In each case, prices were prevented from adjusting, so the system that coordinates supply and demand could not do its job.

How Do Hundreds of Millions of People Coordinate?

Individuals have very limited information.

Each person has knowledge of their own particular circumstances of time and place, but often little else.
That alone is not enough to make an economy work.

Individuals need to effectively make use of others’ knowledge.

Leonard Read, “I, Pencil” (1958)

“I am a lead pencil, the ordinary wooden pencil familiar to all boys and girls and adults who can read and write. […] I, Pencil, simple though I appear to be, merit your wonder and awe[.] Simple? Yet, not a single person on the face of this earth knows how to make me. This sounds fantastic, doesn’t it? Especially when it is realized that there are about one and one-half billion of my kind produced in the U.S.A. each year.” Leonard Read, I, Pencil (1958)

Key insight: No one planned the pencil. Millions of peopleloggers, miners, truck drivers, factory workerseach contributed a tiny piece of knowledge without knowing the whole.

Friedrich Hayek marveled, “The Use of Knowledge in Society” (1945)

“The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparinglyi.e., they move in the right direction.” Friedrich Hayek, The Use of Knowledge in Society (1945)

The Price System

Knowledge of particular circumstances includes the prices we face and how they change.

We most often don’t know why prices are changing, but we adjust our behavior in response.

Example: the price of cedar increases.

Did saws become more expensive? Did loggers’ costs rise? Did demand for building materials surge?
Regardless, pencil factories buy less cedar. The resource moves in the right direction.

Hayek on the price system as a communication mechanism

“We must look at the price system as […] a mechanism for communicating information. The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.” Friedrich Hayek, The Use of Knowledge in Society (1945)

The price system (1) communicates information and (2) economizes on information. Individuals need not understand the whole to act correctly within it.

Hayek on the price system as a human marvel

“I am convinced that if it were the result of deliberate human design […] this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.” Friedrich Hayek, The Use of Knowledge in Society (1945)

The price system was not designed, it emerged spontaneously. Yet it solves an information problem no central planner could solve.

What does this “marvel” require to function effectively?

Three conditions must be in place:

A reliable and stable currency
Individuals and businesses that enjoy profits and bear losses
Prices that are free to adjust to changing conditions

Requirement 1: A Reliable and Stable Currency

Prices communicate relative values, but only if the unit of account is stable.

Ludwig von Mises on monetary calculation

“Monetary calculation is the guiding star of action under the social system of division of labor.” Ludwig von Mises

Prices ultimately convey the quantity of certain goods that we must sacrifice to obtain other goods. Money allows us to express all of those ratios in terms of a single unit of account. Without a stable currency, those ratios become noise.

Requirement 1: A Reliable and Stable Currency

Prices communicate relative values, but only if the unit of account is stable.

“Loose” monetary policy can make monetary calculation less reliable.

High and/or unstable rates of inflation make price changes hard to interpret.
Is a price increase a signal about real relative scarcity, or just inflation?

Venezuela: hyperinflation rendered price signals meaningless. Economic coordination collapsed.

Requirement 2: Profit and Loss Signals

Individuals and businesses must enjoy their profits and bear the consequences of losses.

Price changes provide incentives for changed behavior because they create profits or losses.

Resources move towards uses that are profitable.
Resources move away from uses where losses are incurred.

Requirement 2: Profit and Loss Signals

Resources move towards profitable uses and away from loss-making ones.

Policies that insulate individuals and businesses from losses make the price system ineffective.

Resources will move in the wrong direction.
Bailouts, subsidies for failing industries, and soft budget constraints all blunt the signal.

Requirement 3: Prices Must Be Free to Adjust

Prices must be allowed to adjust to changes in market conditions.

Policies that prevent price changes (or make them unnecessarily costly) render prices uninformative.
Price ceilings, price floors, and price controls all impede the price signal.

U.S. gas price controls in the 1970s prevented prices from rising to clear markets, producing long queues and shortages instead.

The Price System: Three Requirements

1. A reliable and stable currency

So that price signals are not obscured by inflation or monetary instability.

2. Profit and loss signals must be transmitted

So that individuals and firms face the right incentives to reallocate resources.

3. Prices must be free to adjust

So that the system can communicate changes in scarcity and value in real time.

The price system coordinates billions of individual decisions without any central direction.

Each person acts on local knowledge and price signals, and the result is a spontaneous, effective coordination of the entire economy.

When the three requirements are met, the price system achieves something that no planner could: it communicates dispersed knowledge and aligns individual incentives with social outcomes.

Key Terms

Practice Questions

Question 1 of 5

Thanks for your attention!