Sunday, January 31, 2010

The role of prices

Debating politics is fun but frustrating. So I think I'll entertain myself and talk about prices and the important role they play in any economy.

The proper role of prices is to convey information about the state of affairs in the real world so individuals can take meaningful action.

Every one of us makes decisions based on the best information we have. And making good decisions is very difficult even with good information. But given bad information, it's impossible to make good decisions. Therefore, better information allows us to make better decisions. Prices are one mechanism for getting us that information.

When prices reflect reality, say when the price matches supply with demand, things work fairly well. All who want something are able to get it. But when prices don't reflect supply and demand, problems ensue.

Imagine a hotel which sells rooms for $100/night. Normally there are only so many people who want hotel rooms and everyone who wants one can buy one. Now say that there is a convention in town and demand for hotel rooms shoots up. The price will also rise. This is very useful because by means of the price, we are told that something fundamental has changed. You don't even have to know why the price has risen, only that it has in order to make a better decision. Given a higher price you may decide to postpone your trip or go somewhere else. Clearly, the new information would in some way modify your decision.

But let's assume the price was not allowed to rise because that would not be "fair". In this case, there is no ready information telling you that a convention is in town. You have no idea that the situation has changed. As a result your decision on whether to go or not is based on a false information and your trip is a bust.

The better prices reflect reality, the better decisions individuals can make. Many people don't like prices because they discriminate between those with money and those without. That's true, but any system must discriminate between people. There are limited resources and unlimited wants and rationing (it's not a four letter word, but a reality of life) is the only mechanism we have to deal with the situation. Prices allow individuals to self ration, to decide what it is they value most and devote their resources accordingly. There are other types of rationing that involve someone else deciding what you want most. That's the four letter word variety.

As a society we can make a choice that some basic goods should be available to all. The way to do that is to give people the necessary resources to purchase those goods, not to manipulate the pricing system which literally informs us of the world.


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