Wednesday, January 31, 2007

Understanding Economics: Prices

One of the key features of any modern economy is the existence of prices. Prices are expressed in units of money. The existence of money allows us to quantify value.

Where do prices come from? Why are they what they are? In a free market, both buyer and seller must agree to a price for a transaction to take place. Buyers naturally want to pay as little as possible, while sellers naturally want to be paid as much as possible. A transaction will only occur if both believe they will benefit. Thus the price of an object must be between its values to the buyer and seller. This is what determines prices.

But don't businesses set prices? It's true that a business can try to sell an object for whatever price it wants. But if they set its price too high, no one will buy it, and if they persist, they will go out of business. If they set the price too low, they will lose money on each sale, and if they persist, they will go out of business. Prices are not arbitrary, they are a reflection of reality.

Why do prices change? They change in response to changing circumstances. They are a reflection of supply and demand. If a price increases, then either the supply decreased or the demand increased (or both). If a price decreases, then either the supply increased or the demand decreased.

Prices convey information. Nobody--not buyers, sellers, businessmen, economists, politicians, or bureaucrats--can fully understand all the factors that make a price what it is. Each price is the result of millions, if not billions, of pieces of information about the desires of consumers and the availability of an object.

One of the most appealing notions to many people over the years is that government can "control" prices by passing laws. Thus "price controls" mandate the price of a given object. Price controls work by banning transactions that both buyer and seller freely agree to.

But prices are not arbitrary. If the mandated price is set below the market price, the demand for an object will outstrip the supply, and there will be a shortage. If the mandated price is set above the market price, the supply of an object will exceed the demand, and there will be a surplus.

Much the same thing is accomplished by price floors and ceilings, which mandate minimum and maximum prices, respectively. This is provided that they are above or below the market price, respectively.

Probably the most popular type of price control is the price floor known as the minimum wage. The economic analysis above shows that such laws reduce the demand for labor when the "minimum wage" is set above the market price.

The lack of understanding of the origin of prices makes people easy targets for demagoguery. One example in recent years is "price gouging," which generally refers to a significant increase in prices following a disaster of some sort. Economic analysis shows that in a free market, higher prices are the result of decreased supply, increased demand, or both. This is exactly what happens in a disaster. Nobody likes paying higher prices, but they are a reflection of the reality following the disaster. Attempting to "control" such prices leads to shortages, as described above.

Increasing the money supply results in a general increase in prices, which can be blamed on businessmen, rather than government, the true culprit.


Anonymous said...

Are we doing anything for the state republican convention next friday?

Anonymous said...

This was a simple and decent analysis except for the jab at the end. Please see the comments to the posting about money for needed corrections to Allan's conceptions about the role of money in society.