The Role of Prices

Now that we know that the key task facing any economy is the allocation of scarce resources which have alternative uses, the next question is:

How does an economy do that?

Different kinds of economies obviously do it differently. In a feudal economy, the lord of the manor simply told the people under him what to do and where he wanted resources put. It was much the same story in twentieth century Communist societies. In a market economy, however, there is no one to issue such orders to anyone else. The last premier of the Soviet Union, Mikhail Gorbachev, is said to have asked British Prime Minister Margaret Thatcher: How do you see to it that people get food? The answer was that she didn't. Prices did that. And the British people were better fed than those in the Soviet Union, even though the British have never grown enough food to feed themselves in more than a century. Prices bring them food from other countries.

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

Many people see prices as simply obstacles to their getting the things they Want. Those who would like to live in a beach-front home, for example, may abandon such plans when they discover how expensive beach-front property is. But high prices are not the reason we cannot all live on the beach front.

On the contrary, the inherent reality is that there are not nearly enough beach-front homes to go around and prices simply convey that underlying reality. When many people bid for a relatively few homes, those homes become very expensive because of supply and demand. But it is not the prices that cause the scarcity, which would exist under whatever other economic or social arrangements might be used instead of prices.

If the government were to come up with a "plan" for "universal access" to beach-front homes and put "caps" on the prices that could be charged for such property, that would not change the underlying reality of the high ratio of people to beach-front land. With a given population and a given amount of beach-front property, rationing without prices would now have to take place by bureaucratic fiat, political favoritism or random chance-but the rationing would still have to take place. Even if the government were to decree that beach-front homes were a "basic right" of all citizens, that would still not change the underlying reality in the slightest.

Prices are like messengers conveying news-sometimes bad news, in the case of beach-front property desired by far more people than can possibly live at the beach, but often also good news. For example, computers have been getting both cheaper and better at a very rapid rate, as a result of the development of technological ingenuity. Yet the vast majority of beneficiaries of these high-tech advances, insights, and talents have not the foggiest idea of what these technical changes are specifically. But prices convey to them the end results-which are all that matter for their own decision-making and their own enhanced productivity and well-being from using computers.

Similarly, if vast new rich iron ore deposits were discovered, perhaps no more than one percent of the population would be likely to be aware of it, but everyone would discover that things made of steel were becoming cheaper. People thinking of buying desks, for example, would discover that steel desks had become more of a bargain compared to wooden desks and some would undoubtedly change their minds as to which kind of desk to purchase because of that. The same would be true when comparing various other products made of steel to competing products made of wood, aluminum, plastic or other materials. In short, price changes would enable a whole society-indeed, consumers around the world-to adjust automatically to a greater abundance of iron ore, even if 99 percent of those consumers were wholly unaware of the new discovery.

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. All that automobile manufacturers, for example, know is that when they produce cars with a certain combination of features they can sell those cars for a price that covers their production costs and leaves them a profit, but when they manufacture cars with a different combination of features, they don't sell as well. In order to get rid of the unsold cars, they must cut the prices to whatever level is necessary to get them off the dealers' lots, even if that means taking a loss. The alternative would be to take a bigger loss by not selling them at all.

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 the 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. That amounts to producing what the consumers want and stopping the production of what they don't want. 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.

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